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 Office by Order of the House. All publications of the Committee (including press 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 Ev 47 Director, Northern Rock
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, Ev 78 Comprehensive Spending Review, and Mr Clive Maxwell, Director, Financial Services, HM Treasury
Tuesday 13 November 2007
Professor Willem Buiter, London School of Economics; and Professor Geoffrey Ev 93 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, Ev 105 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
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 Ev 123 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
Mr Richard Sexton, UK Head of Assurance, and Mr John Hitchins, UK Banking Ev 135 and Capital Markets Leader, PricewaterhouseCoopers
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, Ev 144 Wholesale, Investment Management Association, and Mr David Pitt-Watson, Chairman, Hermes Equity Ownership Service
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 Ev 153 Compensation Scheme
Tuesday 18 December 2007
Ms Angela Knight CBE, Chief Executive, British Bankers' Association, and Mr Ev 169 Adrian Coles, Director General, Building Societies Association
Mr Mervyn King, Governor, and Sir John Gieve, Deputy Governor responsible Ev 177 for Financial Stability, Bank of England
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, Ev 197 HM Treasury
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 Letter from Chairman of Northern Rock Ev 240 7 HM Treasury, letter from the Chancellor 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 Ev 272 Follow-up to evidence session on 13 November 2007 Ev 276 16 Moody's Ev 280 Follow-up to evidence session on 13 November 2007 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
Session 2007–08 Report
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
Session 2006–07 Report
First Report Financial inclusion: the roles of the Government and the FSA, HC 53 and financial capability
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 HC 279 processes
Seventh Report The Monetary Policy of the Bank of England: re-appointment HC 569 hearing for Ms Kate Barker and Mr Charlie Bean
Eighth Report Progress on the efficiency programme in the Chancellor’s HC 483 department
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 HC 299 years on
Thirteenth Report Financial inclusion follow-up: saving for all and shorter term HC 504 saving products
Fourteenth Report Globalisation: prospects and policy responses HC 90
Session 2005–06 Report
First Report The Monetary Policy Committee of the Bank of England: HC 525 appointment hearings
Second Report The 2005 Pre-Budget Report HC 739
Third Report The Monetary Policy Committee of the Bank of England: HC 861 appointment hearing for Sir John Gieve
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 HC 1121 hearing for Professor David Blanchflower
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: HC 1595 appointment hearings for Professor Tim Besley and Dr Andrew Sentance
Twelfth Report Financial inclusion: credit, savings, advice and insurance HC 848
Thirteenth Report “Banking the unbanked”: banking services, the Post Office Card HC 1717 Account, and financial inclusion
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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 George Mudie Mr Michael Fallon Mr Mark Todd Ms Sally Keeble Peter Viggers Mr Andrew Love
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 insurance, it is limited in size, it is limited in amount your colleagues and welcome. Can you introduce to each individual bank, and that provides a strict your colleagues for the shorthand writer, please? limit on the extent to which there is some ex post Mr King: On my immediate right is Sir John Gieve, insurance, so we have balanced the concerns about Deputy Governor for Financial Stability. On his moral hazard against the concerns that arose at the right is Kate Barker, one of our External Members beginning of this week about the strains on the on the Monetary Policy Committee. On my banking system more generally. immediate left is Paul Tucker, the Markets Director at the Bank, and on his left is Andrew Sentance, another of our External Members. 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 Q2 Chairman: Governor, you will recollect that the Northern Rock problem? idea for the meeting arose from your suggestion that Mr King: Could I set out my explanation for why I we consider the August Inflation Report. Obviously do not think that is an argument that I accept. After this meeting has been given added relevance by the events in August, which essentially closed the recent developments so in that context we are markets in asset-backed securities, Northern Rock grateful for the paper you sent me last Wednesday 12 was then a company with a highly illiquid set of September.1 In that letter you told us that providing assets. Its assets comprised essentially mortgage- extra liquidity at longer maturities—in your backed securities and plain mortgages which have words—undermines the eYcient pricing of risk by not yet been securitised. The markets in those assets providing ex post insurance for risky behaviour and were closed. Northern Rock tried to sell some of that you would conduct such operations only if there those assets, not just to the UK banking system but were strong grounds for believing that the absence of overseas as well, without a great deal of success. The ex post insurance would lead to economic costs on a real problem facing Northern Rock has been that scale suYcient to ignore the moral hazard in the the assets side of its balance sheet suddenly became future”. However, yesterday you conducted such highly illiquid, and one has to ask the question who operations. What has changed in the past seven would have lent to, or who would have bought the days? assets, from Northern Rock? Well, they tried and Mr King: I think the events of last weekend and the did not find any buyers. At that point I think it was impact on the confidence that people have in the clear that, in one form or another, Northern Rock banking system generally could have been shaken by required as a backstop a lender of last resort. The the scenes that were seen on television. I do not think natural place to look for a lender of last resort is the there is any fundamental reason to doubt that central bank. You could ask whether the market confidence but, as I said in the statement I sent to could have been the lender of last resort for you, the balance of judgment between how far you Northern Rock. I think the only circumstances in extend liquidity against a wider range of collateral which that would have been feasible would have on the one hand and being concerned to limit the been when we had gone back to normal moral hazard on the other, to limit the ex post circumstances and banks had already financed the insurance, is a judgment that we are making almost taking back onto their balance sheets of the conduits daily in the febrile circumstances of the time. The and vehicles that they now expect, over a period, to operation announced yesterday was carefully take back onto their balance sheets and were once designed and judged. It does not give ex post again in a frame of mind to be willing to lend to others who had illiquid assets. To go back to those 1 Ev 214 circumstances quickly and get back to where we Processed: 30-01-2008 10:39:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG1
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 Mr King: I will come back to that. The most amount of liquidity. The Federal Reserve and the important point I want to make is to ask yourselves ECB have gone nowhere near that far at all. So the how would the Bank of England have dealt with this question is how could the market have been an in earlier years. How would it have dealt with this in eVective lender of last resort to Northern Rock? In the 1990s? The first way it might have dealt with it these circumstances it is natural to regard the central was to invite the directors of Northern Rock and bank as being the lender of last resort. In a minute I prospective purchasers into the Bank or the FSA for would like to go on to explain what were the a weekend to see if that could be resolved and a problems that arose in our trying to be lender of transfer of ownership agreed over the weekend such last resort. 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 Q4 Chairman: Let me ask a question, if you like what possible because any change of ownership of a the ordinary person in the street is asking: Governor, quoted company—and Northern Rock is a quoted V how did we get to a situation where the e ort put company—cannot be managed except through a into rescuing Northern Rock is the equivalent of long and prolonged timetable set out in the screaming “Fire!” in a crowded and darkened Takeover Code. The second way in which the Bank cinema where everybody rushes for the door and would have preferred to do it in years gone by, and there is sheer and absolute panic, all as a result of one did do it in the 1990s, and the way that I would have company maybe having a bad business model? I wanted to do it on this occasion, is to have acted want to extend the questions to Mr Tucker who is covertly as lender of last resort, to have lent to the Executive Director of Markets and also to Sir Northern Rock without immediately publishing John Gieve who has the responsibility for financial that fact, publishing it after the operation had been stability. How did we get there? over so that you and others could hold us Mr King: Can I just answer that first and explain accountable for the operation itself. As a result of how we got there. You are quite right to be the Market Abuses Directive in 2005, we were concerned about shouting “Fire!” in a crowded unable to carry out a covert lender of last resort cinema. One of the major considerations during operation in the way that we would have done in the August was there was no reason to believe that it was 1990s. There is a great tension between asking inevitable that Northern Rock or any other bank companies to disclose things which may aVect the would get into diYculty. There were clearly liquidity decisions of shareholders and on this occasion problems; they might or might not have been asking them to disclose something which actually resolved. To have announced at that stage either a undermined the ability to carry out an operation liquidity injection on such a scale that all the banks which I believe was in the interests of everyone would have had their immediate liquidity diYculties connected with the company. We were forced back dealt with or to have announced at that stage a to doing it in a covert way. guarantee for depositors in every bank would undoubtedly have been a signal that the authorities Q6 Chairman: Sir John Gieve and Paul Tucker, the were deeply concerned about the entire UK banking Governor mentioned the assets were illiquid. system. That is wholly unfounded. The UK banking Certainly the financial services companies who have system as a whole is well-capitalised. In this context spoken to me in great numbers over the past few we should be grateful that banks did make profits in weeks have said that Northern Rock was on the lips the last five years. They have a large capital cushion. of a number of people for the past few months. Sir They can take the conduits and vehicles that they set John, you sit on the FSA; were you having a sleep in up in recent years back on to their balance sheets. It the back shop while a mugging was taking place in will take a little time and the banks will make lower the front? profits than they would have wished but there is no Sir John Gieve: I am on the board of the FSA, that threat to the stability of the banking system. To have is true. I do not think the FSA or the Bank were announced measures on such a scale that would have asleep at the wheel. suggested that we did not have that confidence I think would have been irresponsible, so the question Q7 Chairman: I am asking you, Sir John, about your is what happened with Northern Rock? The main responsibility. Do not talk to me about the FSA— point I want to make to you this morning is that the Sir John Gieve: I thought you were asking me as a interaction between four apparently unconnected member of the FSA board. 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 Q8 Chairman: Exactly, about your accountability. position where these problems will not arise again. 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 Q5 Chairman: We want to broaden this inquiry—I business model made it more vulnerable than other certainly want to—to have the FSA before us who banks. The timing of the troubles in August was are coming just after we come back to Parliament particularly severe for them because they were and also to have the Treasury as well. I will ask you working up to a securitisation in September. So later but the Tripartite Agreement seems to me to be through August there was very close monitoring of fundamentally wrong. their position and before it came to a Bank of Processed: 30-01-2008 10:39:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG1
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 markets into the banking markets or the money with Northern Rock in looking to see if there was a markets, and that was based on the fact that the private sector solution. But a private sector solution banks had provided very large committed lines of was not available, could not be mounted, and as a credit or liquidity to a lot of vehicles in the system; result we then moved on to our oVering a liquidity and faced with an increased probability of the facility to them. We knew when we did that that the drawdown of these massive lines of credit, they announcement of that would have two eVects: a started to stockpile liquidity rather than lend in the good eVect because it would show they had a new term money markets. The striking thing is that this source of finance but a bad eVect because it would was a feature not just of the sterling markets in send the market a signal that they really needed a London but of the dollar markets in the States and new source of finance. We knew that there was a risk the euro markets on the Continent; and irrespective that that balance would go the wrong way and it did. of the fact that the three central banks concerned have taken diVerent approaches to their operations Q9 Chairman: But let me go back a bit because in those markets, there has been a global drying up Northern Rock grew three times faster than any of term liquidity and, as you say, Northern Rock other company in the past year. I was with a major was badly exposed in those circumstances. retail bank just the other evening and I said to the Chief Executive, “Why didn’t you grow like Q12 Chairman: Governor, I am not getting much Northern Rock?” and he said they would not do it comfort from the answers I am getting here. There is because it would have been folly to do it and the risks an obfuscation going on. There is a simple issue here. were too great. Someone should have seen the risks Mr King: Let me try and put it simply: what that Northern Rock were taking. It does not seem to happened on 9 August was that there was a me as if anyone had any concern about it, so we have realisation of an event that we had been warning one company with a bad business model which ends against for a long time which is that the markets and up threatening the financial stability of the country the securities that many banks and others had been and therefore your role as Deputy Governor and as creating suddenly dried up. In the Mansion House an ex oYcio member of the FSA seems to me crucial speech in June I said very clearly the liquidity of here. Should that not have been spotted? markets in complex instruments is unpredictable. Sir John Gieve: The first people of course who are The problem for Northern Rock was that if that responsible for the business model and the decisions eventuality materialised they would end up with a of Northern Rock are the Northern Rock board. massive maturity transformation on their balance Secondly, of course the FSA through their sheet. At that stage it was clear that at some point a supervision team have been keeping closely in touch lender of last resort might be necessary. My basic with Northern Rock, as with other banks, point to you this morning, as I started earlier, is that throughout. You are saying should someone have the interaction between diVerent pieces of stepped in and prevented them running the business unconnected legislation made it almost impossible they ran? for us to conduct the lender of last resort option in the way that we would prefer. I am willing to go Q10 Chairman: No, what I am saying to you is a through the other events and explain what wonky business is in existence that may jeopardise happened. financial stability; you have an obligation to ensure that you are up to the mark in seeing that and taking Q13 Chairman: You have just explained the model anticipatory action. That is what I am saying. I am of the lender of last resort. That model is really not not saying you should interfere. Mr Tucker, fit for purpose now, is it, it has to be looked at. everybody was saying that Northern Rock was Mr King: Can I explain why. almost a basket case. Mr Tucker: It is not just a question of the individual Q14 Chairman: It has to be looked at. firm; it is also definitely a question of the wider Mr King: There are certainly question marks over it market circumstances and, as the Governor but the question marks are not because we cannot in mentioned, there are two key features to those, first theory act as a lender of last resort but because in of all the asset-backed securities market seized up on practice we are hemmed in by this interaction the basis of problems in a relatively localised area— between these four pieces of legislation. Firstly, you sub-prime—most obviously because of severe cannot transfer the ownership of a bank over a concerns— weekend because of the Takeover Code. Secondly, the ability to conduct covert support, which would Q11 Chairman: But Northern Rock never had sub- avoid the risk of creating concern among depositors, primes on its books and the fact is everybody knows is ruled out because of the Market Abuses Directive. that Northern Rock grew because it depended on Once retail depositors have become concerned—and wholesale markets, they did not have enough lenders it was not obvious that the announcement of the so they went to the wholesale markets all the time. lender of last resort operation would result in people Mr Tucker: That is where I was leading, Chairman. wanting to take money their out, it could have gone So the concerns around the asset-backed securities either way—once that run had started people were markets and about the credibility of ratings caused not behaving illogically in joining it and wanting to the asset-backed securities market to dry up. The key take their money out also because of the two other point I think is the way this jumped from the capital pieces of legislation. There was the way in which, Processed: 30-01-2008 10:39:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG1
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 Mr King: It is good that it has come at a time like this depositors find their deposits frozen and they cannot rather than at a time of weakness and the reason for access them, even in a solvent bank, and that is not that is in the past many diYculties in the banking something that any depositor would want to take a sector have come as a result of serious risk on and, lastly, that the deposit insurance is less macroeconomic problems where there have been than 100% for most of the deposits. We now require major defaults and holes in the assets side of the a serious reform of deposit insurance, of the bank’s balance sheet and we are not in that position, administration of banks, of the clash between the this is entirely a question of the structure of the wish for transparency of companies to their liquidity funding of the banking system. 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 Q18 Chairman: When you talk about everybody one of those had not been there, there would not knowing their own job, Governor, I have to ask you have been the problem with the lender of last resort this question because it has been in the public press: operation. It required all four to be there to prevent are you your own man? Were you lent on in this us acting in the way that we wanted to do. 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 Q15 Chairman: These are issues which we are going announced was designed in the Bank. Of course in to be looking at, Governor, because the focus of this these circumstances I want to discuss it with Callum Committee will be looking at where the weaknesses McCarthy and the Chancellor. It would be very odd are in the whole system. One area of weakness I if they were to have woken up and found we had would suggest to you is in the Memorandum of done this and they did not know anything about it, Understanding in Financial Stability because that so of course we discussed it, but I give you my means that diVerent authorities in the tripartite personal assurance that I would never do anything agreement can “lead diVerent parts of a crisis” and unless I thought it was the right thing to do. The when Mr Jon CunliVe was here before the independence of a central bank is not just about Committee a few months ago he gave a commentary legislation; it is about having people in the central on the Memorandum of Understanding saying that bank who will do what is right for the country in the parties will agree who is in the lead of a crisis or their job and not do what people ask them to do, particular aspects of the crisis. Who was in the lead whether it is the banks or whether it is politicians. 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 Q19 Chairman: What I take from this just now, Memorandum of Understanding, I do not think it Governor, is that the issue of lender of last resort, the would have made any diVerence to the substantive tripartite arrangement, deposit protection—to name problems we faced and I think it would actually have three at the moment—are issues that really need to made it harder to manage the process. The great be looked at and addressed again. virtue of the MoU is that it does not change the Mr King: Absolutely, and I would urge you all to instruments available to the authorities in any way. regard this as a cross-party issue and I think it is of What it does do is to clarify responsibilities, fundamental importance. Our system for dealing everyone knows what their job is, and it enables us with insolvency of banks and deposit insurance is to know and to practise beforehand how we markedly inferior to other countries. That has been communicate with each other. When it comes to the true under governments of all parties in this country. I think this was the unintended consequence of question of decisions that might involve taxpayers’ V money it is right and proper that in the end the di erent pieces of legislation coming together and it Chancellor has to approve any risk to taxpayers’ needs to be acted on speedily because the guarantee money. 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 Q16 Chairman: Everybody knows what their job is needs to come first. Parliament is absolutely crucial but really the view in society is that nobody knows in this and your Committee has an enormously what they are doing in this case, Governor, that is important role in leading a cross-party discussion on the reality. how we improve these matters which in the end, in Mr King: I think that people outside the financial my judgment, were responsible for the diYculties sector must regard what has happened with utter that we had last weekend. bemusement. We are in a strong British economy— Chairman: It does not look today as if people have we still are—we are in a strong world economy and come out well of it so we have got to try and rescue these problems were not caused by what was going it somehow. Michael? on in world markets.
Q17 Chairman: God help us if we get a weak Q20 Mr Fallon: Governor, how long have you been economy in the future. at the Bank? Processed: 30-01-2008 10:39:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG1
Treasury Committee: Evidence Ev 5
20 September 2007 Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance
Mr King: Sixteen and a half years. markets that we carry out is our responsibility at the Bank and the judgment about individual institutions is that of the FSA. 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 Q26 Mr Fallon: Do you not see that three of you suddenly inadequate? having diVerent responsibilities all trying to reassure Mr King: Some of them we had realised and investors in your diVerent ways that Friday morning discussed before as a result of exercises. On some of ended up with the result that savers did not trust any them work is already going on, as I understand it, to of you—the Chairman of the FSA, you as think of the legislation; and others are much more Governor, or the Chancellor—because there were recent. I think the problem in the Market Abuses three people saying the same thing. Directive which prevented my first preference course Mr King: No, it is not true there were three people of action here, which was to be a covert lender of last all out there saying the same thing. The question of resort, is that it only came into eVect in 2005 and the trust is one that you may want to reflect on. The wording in it is ambiguous. I had still hoped and behaviour of depositors in Northern Rock was, in indeed I pressed strongly for the ability to conduct a my judgment, a consequence of a perfectly rational covert operation but in the end the strong legal interpretation of what the end game might be. It was advice among the tripartite authorities was that it not so much a question of trust. Once the depositors could not be done. of Northern Rock had heard the bad news and they suddenly realised that Northern Rock needed a Q22 Mr Fallon: It is like the designer of the Titanic lender of last resort facility—this is the problem with saying it was unsinkable and then we discovered that an overt operation—once they had seen that there once four of the first six compartments are flooded was bad news about Northern Rock, and they could the whole thing sinks. You are telling us you cannot not possibly be reasonably expected to have been handle a financial crisis. sitting at home thinking about the wholesale funding Mr King: No, none of what happened was structure of Northern Rock, once they learned that inevitable. But given what happened at each stage, if there was concern about Northern Rock it is not that any one of those four pieces of legislation were not surprising that they thought perhaps it might be there, we would have been able to get through it. safer to take some money out. This was the unintended consequence of these things. The legislation on disclosure was ambiguous Q27 Mr Fallon: Would it not have been easier to and I thought the right way was to conduct a covert have handled this aVair if you were still in charge of lender of last resort operation. I believe that would banking supervision? not have caused what we saw last week—the run of Mr King: I honestly believe not. I think that now depositors on Northern Rock. there is a much more formalised and legalistic framework of supervision, which is not a Q23 Mr Fallon: Okay, let me come back to the consequence of the division between authorities but Chairman’s question as to who is really in charge of of the evolution of the financial system. I know that this aVair. You provided the additional funding that Callum McCarthy and Hector Sants have been Northern Rock wanted but you are isolated in the working day and night to monitor all the institutions Bank from its operations; the FSA said it was for which they are responsible. We have been solvent but they cannot intervene in the markets; extremely busy in the Bank doing the same for our and the Chancellor then guarantees the deposits. responsibilities. The idea that one institution should Who is actually in charge? cope with all of these I honestly do not believe would Mr King: I think those diVerent actions are all make sense. As I said, the root cause of this, in my important and they all go to the responsibilities. This view, is not the question of who does what—you can would have been no diVerent without the argue the merits of that quite separately and I do not Memorandum of Understanding. believe it is a question of who is responsible for what or the fact that there is a tripartite agreement. My Q24 Mr Fallon: Who was in charge? own view, for what it is worth, is that the MoU Mr King: What do you mean by “in charge”? Would worked well and it is very sensible to have the you like to define that? 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 Q25 Mr Fallon: What our constituents want to know the economic position that Northern Rock found given this mess is who is in charge of it, who is itself in and the various constraints that were placed responsible? on the ability of the authorities to take action. 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 Q28 Mr Fallon: Okay. Given the that additional taxpayers’ money at risk obviously belongs with the funding oVered to Northern Rock had to be overt in Chancellor, you would expect that. I do not have the the end why have you not made public the advice in authority to put taxpayers’ money at risk. The the letter that you sent to the Chancellor last responsibility for the design of the operations in Thursday? Processed: 30-01-2008 10:39:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG1
Ev 6 Treasury Committee: Evidence
20 September 2007 Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance
Mr King: I should be very happy to publish it at any Q35 Mr Fallon: Were you not involved, Sir John? moment but that is a question for the Chancellor and Did you not read the interim statement of not for me. Northern Rock? Sir John Gieve: No, I did not read the interim statement of Northern Rock. Q29 Mr Fallon: He is preventing it being made public? Mr King: No, I do not think. I would welcome it if Q36 Mr Fallon: It was the bank that was most you would like to ask him now for the letters. I have exposed to the freezing of the wholesale markets nothing against publication but I do not think it is because of its particular business model and it for me to proVer that. produced interim results on 25 July and you did not read them? Sir John Gieve: No, I did not. Remember this was 25 Q30 Mr Fallon: I see. If all the deposits in any bank July. At that point the markets were disturbed but are now guaranteed by the Government how does the events of 9 August had not happened, and I do that not encourage exactly the kind of excessive risk- not as a member of the FSA board try and second- taking that you warned us about? guess the teams who actually carry out the Mr King: It does not encourage the moral hazard of supervision, who of course would have been in close the banks themselves. It encourages potential moral V contact with Northern Rock and indeed with any hazard on the terms that might be o ered to retail other bank. 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 Q37 Mr Fallon: So neither you nor the Governor are quite right, however, that this is not a sustainable realised how exposed Northern Rock was until the position and it is very important that we move as middle of August? Is that the position? quickly as possible to an exit route towards a Mr King: The 14 August was when we were first sensible framework, but that sensible framework informed through the tripartite process. That is the will not be where we started. The system of process that informs the Bank. We do not monitor administration for banks which means that retail individual institutions. depositors find their deposits frozen for months on Sir John Gieve: Can I just say that in our Financial end and they cannot access them is a system which is Stability Report in April, for example, we identified a direct inducement for retail depositors to take their the increasing wholesale funding of banks as a money out at any sign of trouble. 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 Q31 Mr Fallon: On what date did you first become lending. Did I know the details of Northern Rock’s aware that Northern Rock was seriously exposed position before this blew up? No, I did not. 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 Q38 Mr Fallon: You were concerned about calendar in doing that? 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 Q32 Mr Fallon: I just want the date you first became access to the wholesale markets—Northern Rock— aware of it. that it was going to be in trouble? Mr King: 14 August was when the first Tripartite Sir John Gieve: As I have said, there is a range of phone call between deputies took placed and I was institutions— 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. Q39 Mr Fallon: For four months nobody at the Bank realised the implications? Sir John Gieve: The implications of what? Q33 Mr Fallon: On what date were ministers first alerted? Q40 Mr Fallon: Of the fact that Northern Rock Mr King: On the same day, I imagine, because it is a would be exposed if the wholesale markets froze. tripartite process. I cannot vouch for who in the Sir John Gieve: I think Northern Rock has the most Treasury was told. You would have to ask them; I do developed wholesale funding model among the not know that. mortgage banks in Britain. There was a detailed knowledge in the FSA of the positions of the Q34 Mr Fallon: Were you aware that in its interim individual banks. Did we foresee that the way that statement on 21 July Northern Rock reported that events would unfold exactly in terms of the freezing the FSA had allowed it to weaken its balance sheet of the mortgage securitisation market and the by widening its Basel II waiver and thus enable it to impact on term money markets? No, we did not see pay a 30% increase in its dividend? exactly how it would come through. At the point of Mr King: I was not aware of that on 25 July. After April—this is before the events—we identified that that it became irrelevant, it was water under the there were vulnerabilities in the system but we did bridge. What I had to deal with on 14 August was the not see exactly the path that they would lead back to position as it was on 14 August. Northern Rock. And I do not think anyone did. Processed: 30-01-2008 10:39:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG1
Treasury Committee: Evidence Ev 7
20 September 2007 Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance
Q41 Mr Fallon: You did not see that Northern Rock limiting the moral hazard very clearly by capping the would run out of money? size of the operation in order to give assurance that Sir John Gieve: No, I do not think we did. whatever strains we might see would be alleviated.
Q42 Chairman: There was no risk analysis of Q46 Mr Fallon: Governor, you have spoken on Northern Rock? moral hazard and you have written us an eloquent Sir John Gieve: I am sure that as part of the essay on moral hazard, but is not the criticism that supervision of Northern Rock—I am sure this is the you have passed the theory but when it came to V case—the FSA team require them to do di erent dealing with Northern Rock and when it came to stress tests, so I am sure the FSA and Northern Rock dealing with three-month funding actually you looked at the impact on their balance sheet and failed the practical? V operations of di erent stress tests. I do not have the Mr King: No, I do not think that is true at all. I am details of what those were but that is something that happy to explain a bit later if you like why I think I know the FSA has been doing a lot of work on. moral hazard is such an important issue. Can I just Mr Tucker: I hold the same position on the answer this point. I have tried to set out a sequence individual institutions, Chairman, but what I would of events in which Northern Rock required add is that from July onwards we were focused on ultimately a lender of last resort, the way in which we what was happening in the markets as a whole and would have preferred to do it was not open to us, and analysing the channels of strain. And we did identify at that point we did it in an overt way. I do not think that there could be spillover to the asset-backed it was at all obvious what impact that would have. It securities market and to the ABCP funding market might or might not have led to people wanting to and we briefed colleagues on that. Our job in this take their money out. In the event it did and once structure is to identify what is going on in markets that run had started people were not behaving as whole. illogically by joining it and at that point the only solution was the Government guarantee. I think this Q43 Mr Fallon: You briefed which colleagues? is a very clear chain of events. Mr Tucker: Colleagues in the Bank and colleagues in the tripartite structure, but this was not about individual institutions. 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 Q44 Mr Fallon: All right, could I turn, Governor, to people understand it in this story. I think you were the three-month facility that you announced quite correct in saying that the initial step with yesterday. Can you explain to us the role of ministers Northern Rock could have been interpreted in two in this three-month facility? Have they been urging ways. On balance, people felt that it gave a signal of it on you as long as the big banks? insecurity in that particular institution and they Mr King: No, the banks have clearly been urging us headed for the queues. Is there not an argument for to do an operation like this for a long time and to saying that subsequent extension of the guarantees some extent they would, would they not, because given to Northern Rock to the banking system at they are in a position now of having to acquire large, with depositors eVectively being secured by liquidity at a much higher price than they would the Government, and also the wider steps taken have wished, given that in their risky business yesterday, also convey a more generic message of models, the risk materialised. The real aim of trying wider concern about the banking system in this to minimise moral hazard, which is one of the country, which may convey similar messages of objectives set down in the 1997 MoU, is not to alarm to people on a wider scale? So what I am provide liquidity at a zero cost, and we are not doing exploring is how actions that you can see and others that. The concerns that led me to want to propose in the tripartite agreement can see are logical in this yesterday were concerns about the banking themselves can be perceived on the outside in a system as a whole. This operation was designed rather diVerent way? entirely in the Bank. We have the competence to do that; I do not think people in either the Treasury or Mr King: I think that the announcement of a the FSA have the competence to do that, just as we guarantee, had it come before the run on Northern do not have the competence to do their jobs. But of Rock, would indeed have been interpreted in the course I discussed it with the Chairman of the FSA way that you suggested might have happened and I and the Chancellor. In these diYcult times it would think would have been an irresponsible thing to have be wholly irresponsible not to do so. 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 Q45 Mr Fallon: But when did Ministers first canvass because and,, at that point, only a Government the option? guarantee was capable of stopping that run, there Mr King: This was discussed among all parties over was no other way out. 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 Q48 Mr Todd: That guarantee has now been banking system as a whole, and at that point I extended beyond Northern Rock, that is the point I judged that it was worth doing something, but also am making. Processed: 30-01-2008 10:39:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG1
Ev 8 Treasury Committee: Evidence
20 September 2007 Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance
Mr King: For the reason that, once depositors see Q52 Mr Todd: Nor do I. that if a run starts our current ability to deal with it, Mr King: It is moral hazard that has actually led us given that the insolvency legislation and the deposit to where we are. I do not want to blame anybody at insurance, is inadequate, people must know that all for what has happened. I think one of the there is a Government guarantee and it is the interesting aspects of this crisis is that all the players Government guarantee that prevents the run. This is have acted completely rationally given the position not a permanent solution. We have to find a way they were put in, and the point about taking moral through to a better permanent system but a hazard seriously is that if what we do is to say to the Government guarantee is there now to give complete banking system if you take these risks again in the reassurance that no depositor will lose. The future then do not worry we will provide you with ex important point to hang on to here is that no post insurance, that means there is no incentive for depositor has lost anything at all. 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 Q49 Mr Todd: Absolutely but extending that point a listening to an interview on the radio in which a little further, the extension of liquidity that you have V young woman was explaining that she had taken out o ered yesterday, on terms I entirely accept, does a mortgage for her and her husband. They had not that not also convey a wider implication of concern, anticipated the events that occurred with the rise in because I think that I have interpreted your actions interest rates and she had found herself in a problem as being to try and act cautiously and in a rather where they were short of liquidity. They had turned focused way and give a clear message that the broad to other sources which were more expensive and they system is working reasonably well, we have a strong had now built up debts of £100,000 which she could economy and our banking system should be able to not repay. She put those points to someone from the cope with these circumstances? There is an argument banking industry who I thought responded very for saying that some of the actions which have been reasonably, namely “We are deeply sympathetic, we taken most recently suggest to an outsider that that understand the nature of your problems, but can you statement of confidence is misplaced. imagine what would happen if the banks were to Mr King: I do not think confidence in the banking forgive you those debts? What could the banks say system as a whole is misplaced. As you say, there is to those customers who actually behaved more always a delicate judgment to make about whether prudently, that did not borrow more than they could putting in place an auction of the kind that we did aVord? What would happen to people’s willingness would create more concern because of the fact that to behave prudently in future if we bailed you out?” we were doing it than it would benefit the system in It is a little bit strange that that seems to apply to the terms of alleviating the strains, but my judgment was borrowers from banks but not to the banks that after the Northern Rock run and the impact of themselves. 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 Q53 Mr Todd: By my question was slightly diVerent against. It is a diYcult balancing judgment. I cannot to that because I have to say I agree with your claim that it is obvious that the judgment was right missives on this (I have got a rather stern puritanical or not but we have to make these judgments in real streak too!) but the puzzle is why that has not been time and I think given where we are today I would emphasised by your colleagues. still have done it yesterday. Mr King: It may not have been emphasised in speeches to the same extent. Q50 Mr Todd: In your covering note to the letter that has been published—and I do not know Q54 Mr Todd: Or acted on. whether the letter to John was published at the Mr King: It has been acted on. If you look at what time—I quote the words you said there: “I am the ECB and the Fed have done in their market operations they have not provided complete ex post conscious that in sending you this statement I am Y taking a snapshot of a fast-moving situation with a insurance, they have not put su cient liquidity into long exposure camera.” the banking system to enable the banks immediately Mr King: Absolutely right. 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 Q51 Mr Todd: I think that was a reasonable a price for what has happened. What I want to do is summary of the position you found yourself in. Can to make sure that when they get liquidity from we talk about moral hazard. Your focus on that has central banks they pay a price for it and do not get perhaps been interpreted as being academic, even it free. The banking system as a whole can aVord to puritanical, in comparison to the approach taken by do this. If I thought there was a risk to the British other central banks, and it is certainly noticeable banking system as a whole and that the capital that that in the public statements of other central bankers the British banking system has was inadequate to there has not tended to be the same emphasis on take this onto their balance sheets, I would be out moral hazard as you have placed on it yourself. Can there putting liquidity in at a lower price to stabilise you explain that diVerence of approach? the British banking system. That is not necessary. If Mr King: I do not believe that moral hazard is just you always provide ex post insurance you can be some dry academic concept. quite sure that in five or ten years’ time another crisis Processed: 30-01-2008 10:39:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG1
Treasury Committee: Evidence Ev 9
20 September 2007 Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance will come. That is exactly what we have seen in the This Committee clearly has an important role in last 20 years. The one thing I do not want to do is to leading it because this is not—and I would urge you find myself five or ten years down the road saying, not to regard it as such—a political issue, this is a “Why did I take the easy option? Why did I do that? cross-party issue in which everyone has an incentive Why did I sow the seeds of a future crisis?” The for putting in place a more stable structure for our whole regime of monetary policy that we have put in banking system. place has been to demonstrate that taking the easy option and giving in in the short run without looking Q59 Mr Brady: Can I also ask for some clarification to the long-run consequences of those actions is about the extent of the guarantee. I do not think this damaging. Every manufacturing company I go out is clear yet. Does the guarantee extend to retail and meet around the country every month has come deposits held with overseas banks operating in the to realise that the short-term option which they UK or is the guarantee only to British banks? wanted ten to 15 years ago—a cut in interest rates at Mr King: Sir John has been involved in the the first sign of a problem—is not the way to go; it is discussions. Can I just summarise the broad having a stable framework. We need to put that view principle behind it which is that this would be back into the financial system. extended to other banks if they found themselves in a similar position, that is to UK retail depositors and Q55 Mr Brady: Governor, can I ask when you first other unsecured creditors, but perhaps Sir John discussed the possibility of the 100% guarantee for could comment on that. The Treasury put out a retail deposits? notice at 7 o’clock this morning and I think Mr King: The first discussion I had about that questions on the detail of that should go to them. subject was on Sunday after the run had started. Sir John Gieve: The note that the Treasury put out was about the guarantee to Northern Rock, and that Q56 Mr Brady: Did the impetus for that come from is the only guarantee in place at the moment, and it the Bank or from the Treasury? defines what “existing deposits” means and it defines Mr King: It came out of discussions among all three that in terms of “accounts up to midnight on of us. I think it was clear to everyone that the only Wednesday 19 November”, with the addition that way to stop the run at that stage was indeed a accounts closed in the last few days can be re- guarantee. opened. It defines the wholesale market cover as being to existing and renewed wholesale deposits, so Q57 Mr Brady: And what was it that finally made wholesale deposits that are rolled over at the end of that decision necessary? You referred earlier to their term will be covered and so will existing and seeing the screens and the impact on the screens, was renewed wholesale borrowing which is not that part of the rationale? collateralised. The point about the broader banking Mr King: No, I think it was clear that if the run had sector is covered in what the Chancellor said. If continued then all the retail deposits would have another bank found itself in the same circumstances disappeared because once it had started it was not it would get the same treatment. illogical for others to come in behind it, and therefore something had to be done to stop the run, Q60 Mr Brady: And it is your understanding that and at that point without an adequate insurance that would apply whether it was a UK bank or a scheme, without the ability to put the company into foreign bank operating in a UK environment? a position where it could immediately repay the Sir John Gieve: If you have a foreign bank with a depositors, only a Government guarantee would branch here obviously the lead on that is taken by stop the run. It was the only solution at that point. their own supervisor and central bank in their country of origin. So, for example, if there was, I do Q58 Mr Brady: You have already said that it is a not know, a French bank that had a branch here, the temporary solution, which I suppose is obvious, but question of whether or not that needs liquidity support depends on its position in its home country what is the set of circumstances which needs to be in Y place for the guarantee to be removed? Does it and internationally. It is di cult to think of an require the piece of legislation to which you referred example where there would be a purely British and the whole regulatory environment to be changed liquidity crisis for a branch of a foreign bank. or can it happen sooner? Mr King: I think you have to ask the question why Q61 Mr Brady: So UK depositors with such a bank was this not regarded as something so urgent in the can take no comfort from the guarantee that has past? Governments of all parties did not regard it as come from the Chancellor? a top priority and I think the reasons are because, Sir John Gieve: The Chancellor’s words are not first of all, the recent circumstances are pretty specific on this and it would obviously depend on the unusual so it was not a pressing problem and, circumstances, but generally the home country secondly, at that point the Bank of England did have authorities would take responsibility for their banks, the ability to act as a lender of last resort in ways that and that would apply to us, too. we were not able to this time. However, I think that has all gone now. My feeling is that legislation Q62 Mr Brady: Thank you. Can I ask just one other introduced not too speedily but after careful thought slightly diVerent question to the Governor again. is absolutely crucial now and that is the exit route Governor, you said earlier that you had pressed from where we are into a more stable future system. strongly for the ability to conduct a covert Processed: 30-01-2008 10:39:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG1
Ev 10 Treasury Committee: Evidence
20 September 2007 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 Mr King: Can I just— not sure whether that was a reference to the period when the Market Abuses Directive was under Q66 Mr Mudie: You said it is not our responsibility consideration or whether it was in the period since it but you have spent the time up to now saying, “We had come into force. would have loved to have done something but it was Mr King: No, it was during this particular crisis with a lack of legislation, it was this, that and the other,” Northern Rock where I found it hard to believe that and I say okay, you appear to be very concerned and a public policy intervention that was in the interests wanting to do something, you looked at various of everyone in Northern Rock could not go ahead things and you found excuses for not doing them, so because of a legal responsibility to disclose. There is what on earth were you going to do? wording in that Market Abuses Directive which Mr King: Let me tell you an answer to that question. would give you the impression that, in a case of financial distress, it would be possible not to disclose Q67 Mr Mudie: Good. but we had to take legal advice. I would say this Mr King: The problems in Northern Rock were occurred in the period between about 22 August and drawn to our attention on 14 August. the date on 9 September when it became clear that we were discussing seriously doing the lender of last Q68 Mr Mudie: No, Mr Tucker— resort operation and we were advised finally that it Mr Tucker: To be clear about what I said— could not be covert, but Sir John was involved in many of the discussions here at the deputies level. Q69 Mr Mudie: Mr Tucker, I know what you said, Sir John Gieve: Can I just clarify one point about you said that you became aware of the problems in foreign banks. Of course many foreign banks form the capital market and you sent it across to the British subsidiaries here and they are authorised in relevant people and institutions. Northern Rock’s their own right by the FSA, so the legal structure business model is regarded as extreme. It works but matters a lot here. I do not want to mislead you on it is extreme because it depends on cheap credit and that. easy money, liquidity at a high degree. You were telling people in the institutions and your own Q63 Mr Mudie: I find it hard to believe and sad, I institution, the other departments and divisions, think, that you were warned by Mr Tucker—and I that we have got a problem, and anybody would am speaking to the Governor and yourself—the have put two and two together and said which of our relevant people were warned and the relevant institutions is going to be hit first. Northern Rock institutions were warned in July about the problems was an obvious one and I am just saying that should that were there in terms of the money markets and have rung bells. Is that fair? Thank you, Mr Tucker. yet took until 14 August for it to get on your desk I am just saying in a well-run institution it should and there be some thought of action. What I have have rung bells and we would have expected the heard today (which alarms me) is that you have Governor of the Bank of England to say, This is spent some time in the last question telling us what going to cause us problems; what can we do?” We you could not do but I am sitting here as a politician have heard he did say that and then he discovered and I am thinking you are the Governor of the Bank that he could not do things. What could you do, of England, you knew about this in July, you gave it what were you planning to do? Mr King: I will tell you what we were planning to do. some attention in August before those crowds built The problems that could have arisen in all these up outside Northern Rock and it became an issue; institutions, Northern Rock and any other British what was the Bank of England’s inclination or bank were triggered by the events of 9 August and policy intention because you could not sit and do we knew that if this were to cause problems we could nothing, you knew there was a problem, you knew it act as lender of last resort but a lender of last resort was going to blow up in September because that is is a lender of last resort. If we had jumped in within when Northern Rock was going for money in the a week and announced that we were lender of last markets in a major way. How was it going to be resort to Northern Rock that could have been very solved before you took that action in September? damaging to the institution. We knew that we were What was your plan? there as the backstop, as lender of last resort.2 Mr King: The Bank of England is not responsible for individual institutions. Q70 Mr Mudie: So you were content to watch this impending disaster, this train running towards the Q64 Mr Mudie: Sorry? buVers, you knew it was going to happen in Mr King: The Bank of England is not responsible for September and you were saying, “I cannot do individual institutions. We act when the FSA come anything, but I will be the lender of last resort when V to us and say, “We think an individual institution it hits the bu ers”? Did you tell the Government and ...” did you tell the FSA, did you get that Tripartite
2 Note from witnesses: I explained to Mr Mudie that, during Q65 Mr Mudie: That is nice to know, but the the weekend after the lender of last resort facility was made impression you have given this Committee is you available to Northern Rock on Friday September 14, I was asked by the FSA whether that facility would continue to be were very anxious to do something, not the answer available in the event of a successful bid for Northern Rock. you have just given that it is nothing to do with us. I explained that it would be. Processed: 30-01-2008 10:39:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG1
Treasury Committee: Evidence Ev 11
20 September 2007 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 Q76 Mr Mudie: Let us just be clear. TSB were still at do, if anything, or did they sit with you and say— the table until last Sunday when they got word from because this is the impression you have given which you that the legal advice you had got meant you is horrifying—we do not know what to do. I will tell could not be the lender of last resort? you what is horrifying, that on both things—your U- Mr King: No, not at all. I was asked by the FSA turn on three-month money and on Northern whether in the event of someone bidding—and this Rock—it was forced upon you by people queuing was a generalised proposition, not a particular outside the building societies, not that you had a institution— well-ordered plan, not that you were preparing plans; you just watched it hit it and you panicked Q77 Mr Mudie: Who asked you? because it hit the buVers? Mr King: Callum McCarthy at the FSA. He said in Mr King: I am afraid that none of that is true. the event of a bid being made would it be the case that the lender of last resort facility that had been put Q71 Chairman: Answer that short question, in place the previous Friday would be extended and Governor! rolled over to a bidder, and I said yes. Mr King: Indeed. Q78 Mr Mudie: Let us clear it up for the City and for Q72 Mr Mudie: It is a relevant question. the media. This has been in the press for some time Mr King: It is a very fair question and I would like that Northern Rock were touting themselves to answer it. 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 Q73 Mr Mudie: That is what ordinary people and saying this took place last Sunday when they got the that is what the City are asking. bad news? The City has got the impression they Mr King: Would you let me answer it. On 9 August walked away long before that because they were told the events were triggered that meant that the risks we you would not agree terms. had been warning about for a long time materialised. Mr King: That is absolute nonsense. The lender of On 14 August we discovered that those risks were last resort facility was only announced at seven serious in Northern Rock. At that point there did o’clock in the morning on the Friday. not seem much point in blowing up the train before V it hit the bu ers because there was a long time in the Q79 Mr Mudie: It was only announced that you intervening period in which we might be able to find were going to be lender of last resort. Lloyd’s TSB, it a way for Northern Rock to survive. That was the is rumoured, had put it as a condition of taking over main responsibility of Northern Rock’s Northern Rock and giving a market solution that management. It tried to find funding and it tried to would have saved all this nonsense, and they put that sell its assets. If it had been successful in these events to you some time before. then the problem would not have materialised. We Mr King: That is not true. 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 Q80 Mr Mudie: Okay. open to us but if we had activated lender of last Mr King: The lender of last resort facility was resort earlier the same problems would have announced on the Friday and on Sunday I was occurred beforehand without giving a chance to find asked—to be quite clear because it was a facility we another way out. 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 Q74 Mr Mudie: There is a suggestion that TSB explicitly would the lender of last resort facility that walked away from the table because you were had been extended to Northern Rock be rolled over unwilling to give that guarantee. I heard that it took with the rest of the bank to a bidder, and I said yes. you about nine days to get legal opinion, which I find I encouraged the bid process. However I can tell you alarming. that last Sunday the only solution to stopping the Mr King: I am sorry, this is complete nonsense. run was a Government guarantee; anything else was a sideshow. Only a Government guarantee would Q75 Mr Mudie: Why did TSB walk away? have been suYcient to have persuaded the Mr King: I have no idea what bid discussions were depositors to leave their money in Northern Rock. going on. I knew that there were some bidders interested. When I was asked last Sunday what the Q81 Mr Mudie: Just going on to one last question in terms on which a bid could be completed were, I terms of the second major matter of the three-month confirmed very quickly that we would roll over the money. The Chairman asked you that question at lender of last resort facility to any bidder. I am the beginning and you said later on to one of my absolutely in favour of having a bid as a long-run colleagues that there were four reasons. I wrote solution to Northern Rock if that can be achieved. I down, not in shorthand but as best I could as a poor did not oppose a bid, I supported it, but last Sunday, Scot, your four reasons. I got two of them, if I can Mr Mudie, only a Government guarantee would read my writing, queues was one, the media was one, have stopped that run. A bid would not have done it and I am not sure I got the other two. In that letter nor would any other solutions. that you wrote—and you knew about Northern Processed: 30-01-2008 10:39:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG1
Ev 12 Treasury Committee: Evidence
20 September 2007 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 and we did that because we felt that it was the corner—you said “strong reasons” and then you breadth of the collateral that was important rather said to one of my colleagues “four strong reasons”. than the size of the operation. Could you spell out— Mr King: The number four was referring to the four Q85 Peter Viggers: Is there a qualitative element in unconnected pieces of legislation that were relevant Y the guarantee you are giving to retail deposits? Does to the di culties we had. the guarantee cover less prudent as well as more prudently run banks or is it a blanket guarantee? Q82 Mr Mudie: So what were the strong reasons Mr King: The Chancellor said that the guarantee then because you needed strong reasons to depart would be available to banks who found themselves from your macho line? Tell us the strong reasons in a similar position. I think what that means is then. depositors should be reassured that when they put Mr King: As I said in the statement to the Chairman, deposits in a British bank they will be completely the balancing between concerns about strains in the protected. In the long run that is clearly not a banking system as a whole and the moral hazard sustainable resting position but in present that I have described is a balancing judgment that we circumstances I think it is absolutely vital. 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 Q86 Peter Viggers: How severely do you think the movement in the spread in longer term markets, and principle of moral hazard has been compromised we had seen people worried about the reputation of since you wrote us your rigorous and lucid letter? the British banking system and strains in it, and I Mr King: I hope that it has not and I do not believe judged at that point that the right balance to strike— that it has but, as I said, this is a balancing judgment. V When I listened to the banks I do not believe that and people can reach di erent views on it, I do not V pretend there is an absolute right or wrong here—I they felt that o ering them an ability to bid for reached the judgment on balance that it was better liquidity at a 100 basis point premium over bank rate to conduct a limited operation which minimised the was something that they regarded as entirely risk of moral hazard but did inject at that point generous, so I think there is still a fair chunk of through the announcement of the auction to be held restriction against moral hazard in what we have next week some additional liquidity. That balance is done. one that everyone has to strike in a central bank and I struck it in that way. Q87 Peter Viggers: When you make advances under the proposed auction it will be against, as you have Q83 Mr Mudie: What do you think of the FSA just explained, a very wide range of collateral meeting the bankers in the morning, when you met including mortgage collateral. How rigorously will them in the evening, either directly or implicitly you be able to scrutinise the mortgage collateral that indicating that they thought you should do this U- has been oVered to you? Will there be collateralised turn? debt obligations, securitised mortgages, which will Mr King: I cannot comment on the meeting with the be in a bundle and which will not be capable of FSA but I can comment on the meeting that I held. proper analysis by you? I had asked for a confidential meeting with the Mr King: Let me ask Mr Tucker who is responsible bankers and they came along and I had hoped that for dealing with the practicalities of this. it would have been regarded as confidential. In that Mr Tucker: We will announce the details tomorrow. process of course they said they would prefer to have There will not be collateralised debt obligations. more liquidity at a lower price. That is not very There will be triple A tranches of prime mortgage- surprising. If I were in their position I would ask for backed securities. The issue that you raise is an exactly the same. I tried to explain why if they were important one. It will be addressed by conservative in my position they would understand that I had to haircuts so that we would lend against X% of the make a public policy judgment which is to balance value of the security and the haircuts will be the use of providing free liquidity to them against conservative for precisely the reason you say. moral hazard. Q88 Peter Viggers: Perhaps for those who are not Q84 Mr Mudie: But it was not the rate that you were conservatives and do not know about haircuts you charging, it was the assets that you were prepared to would just explain that? take, you were extending them. Mr Tucker: Sorry. Say a security is valued at £100. Mr King: And what I discussed with them at that We might lend £50 against that £100 security or £70 meeting quite explicitly was to ask them why they against that £100 security and that would protect us felt that extending support with liquidity injections against a fall in the value of that security during its against a much wider range of collateral would be life. That is the first step. The second is that the loan helpful to them and they explained that it would. In will be for three months. If the value of the collateral the auction that we announced yesterday we we hold falls during that period we will call for more announced that we would be willing to allow people collateral to protect ourselves and then if a borrower to bid against collateral for a very much wider range were to default we would be protected by the of liquidity including mortgages. That is not haircuts I described at the beginning—lending a something that either the Fed or the ECB have done fraction of the value of the securities that we hold. Processed: 30-01-2008 10:39:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG1
Treasury Committee: Evidence Ev 13
20 September 2007 Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance
Q89 Peter Viggers: Very well. Governor, when the Q92 Peter Viggers: Finally can I ask Paul Tucker if Memorandum of Understanding eVectively took he would comment on the current state of the direct banking supervision away from you and gave commercial paper market? it specifically to the Financial Services Authority it is Mr Tucker: A little bit better than a week ago. This now quite specifically responsible for the prudential is important and over the last few weeks the supervision of banks, building societies and for the underlying problem has started to be addressed. The conduct of operations in response to problem cases underlying problem is that investors should aVecting firms. You happen to be here today and the distinguish between one type of security that has got original intention was to talk about the Inflation real diYculties and other types of security that are Report— maybe okay. That process will take a while and it Mr King: Indeed! does seem to be gradually underway. I think there is still a long way to go and there could still be Q90 Peter Viggers: But it should really have been the setbacks. The last ten days in terms of global Financial Services Authority which should be markets as opposed to our local position have been answering many of the questions which are being put very mildly encouraging. now. Yet on the other hand when a proposal came through to provide a lifeline and a rescue operation Q93 Peter Viggers: And how important was it that it was the Bank of England, as you have explained to banks were unable to raise money on the commercial us, which led on this. Would you not agree that the paper market? comment originally made in 1997 that the Mr Tucker: I think the fact that banks and these so- Memorandum of Understanding was “unworkable called conduits were not able to raise commercial in a crisis” has actually been proved to be correct? paper or were only able to raise commercial paper at Mr King: No, I do not accept that. One of the very very short maturities is right at the heart of the good reasons for taking supervision away from the problem. It is diYcult to see that the problem will be Bank of England was that it was becoming more and resolved without either that market being restored to more impracticable to regard banks as being part of something like normality or, alternatively, a lot of the financial system that could be regulated that paper coming on to banks’ balance sheets, independently of a wider range of financial reintermediation if you like from the capital markets institutions. The whole process of supervision now is into the banking system. It is because of the latter much more formal, much more legalistic, much possibility that banks have been stockpiling liquidity more international. I think it is a full-time job. It and trying to protect themselves against that takes up all the energies of senior people to do that. eventuality and that has been individually rational In the event of any crisis like this it is inevitable that but collectively deleterious. those responsible for supervision, those responsible for central banking activities and the Government Q94 Ms Keeble: I wanted to ask a bit about the role have to work together irrespective of where they are of the credit ratings agency. I have also got some actually located, so even if two of those had been in questions, Paul, on some of the things you have just the Bank of England we would still have had to work said. Sir John, I wonder if you could say from the with the Government so having all three people FSA’s point of view if you think that the ratings there I think is crucial. The MoU in my experience agencies have provided markets with the kind of has ensured very eVective, speedy communication. information that they need on which to base their Callum McCarthy, the Chancellor and I have talked decisions? regularly and frequently. We have a team of deputies Sir John Gieve: I think this is something that we are under us who speak even more frequently. I do not going to look at on an international basis with other believe that the communication or the eVectiveness regulators and central banks in the future. I think of the tripartite arrangements have been in any way that people definitely relied on ratings agencies’ responsible for this. Indeed in my experience it has ratings in an inappropriate way. The ratings enhanced it. I just do not believe that one agencies would say that if they had read the fine print institution—a central bank—can manage in today’s there was plenty of explanation about the limited world both monetary policy and the entire range of assurances that they were putting forward. But I financial supervision. think many investors and people setting investment remits did just say “if it is triple A it is all right”, not V Q91 Peter Viggers: And is the communication distinguishing between di erent sorts of between the three members referred to formalised instruments. What we obviously need to look at is and will communications between the three of you did the ratings agencies do it wrong or was it the be published? investors who did not use the ratings agencies Mr King: I think that will depend on the chair of the properly and put too much dependence on them? tripartite arrangements. I would expect a lot of the conversations that we have held to remain Q95 Ms Keeble: If I can just come back on that. confidential because they are market sensitive. We Firstly, why so late and, secondly, it is fairly well- have had many communications both formal and established, is it not, that the ratings agencies work informal and the informal collaboration and very closely with the banks to compile the vehicles to communication between the Chancellor, Callum attract the kind of ratings which are then required to and myself has been absolutely crucial in dealing be attractive on the market; would you accept that? with what was a fast-moving set of events. Why so late and do you not think that it is really Processed: 30-01-2008 10:39:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG1
Ev 14 Treasury Committee: Evidence
20 September 2007 Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance unacceptable to have the ratings agencies virtually Q99 Ms Keeble: That is right, I want to know where colluding with the banks in the construction of the risks are and if there are more out there. vehicles which are then, as the Governor has Mr King: I will come on to that. There is one point I accepted, risky? want to make about ratings agencies. There is a very Sir John Gieve: I think the ratings agencies’ response important call and longer term analysis to be made to that is that their reputation and their future of how ratings agencies behave. The conflicts of business depends on producing ratings which stand interests that you have alluded to are clearly part of up in practice. 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 knee- Q96 Ms Keeble: But what is your response? jerk response to go completely in the opposite Sir John Gieve: I think there is a question about direction and to downgrade everything at sight whether they went too far in relying on their models because they might be held responsible for their to put firm ratings against products which did not behaviour. That would lead us into a really diYcult have an obvious market value. Particularly in the position and I know you are not suggesting it but it sophisticated credit derivatives field, where they has come up in various international fora. We need have, I think, as good models as anyone, maybe a long look at that. In terms of the risks, what has those models were simply too limited to justify a happened is that many of the banks created these firm rating. vehicles to hold oV balance sheet (perhaps sometimes to avoid regulatory capital Q97 Ms Keeble: And then for Paul, because you are requirements). These vehicles hold securities in which the market is now illiquid. The banks will now obviously working at a diVerent end of it, when you have to take back onto their balance sheets these did your report on July 25 warning of the risks, what assets which may well be perfectly good value in the did you rely on and in saying now that this week is a longer term when the markets re-open but they are little bit better than it was a week ago, what are you highly illiquid. That will require some use of capital actually looking at and what real risks are you of the banks to finance this in the short term and that taking into account? Then I wanted to ask the is why, as Paul said earlier, banks are currently Governor something about this as well. hoarding liquidity in order to finance the taking Mr Tucker: What are we relying on? First of all, we back onto their balance sheets of these vehicles. are relying on two sources of information. One is They know what these vehicles are, they set them up, conversations with people in these markets around and the FSA and the parallel regulatory authorities the world, both people who are selling commercial around the world have been talking to the banks and paper, coming back to that particular question, and finding out whether the banks know about their people who are buying commercial paper. This exposures. They say to us that they are confident would go not just for the commercial paper market that all the major banks know about their exposures but across a whole range of markets. The second and that they could take these back onto their source of information is published information on balance sheets without any major hit on their capital the prices at which, in this case, commercial paper is so that they would still be left with capital well above being issued and also the quantities that are being their capital regulatory minimum. It does mean that issued. It is virtually always a blend of market the banks will have to find more expensive sources of intelligence drawn not just from the banking system liquidity than they had expected or hoped, they will but from asset managers and from many others as pay a price in terms of profits. There is absolutely no well and hard information produced from all sorts of diYculty in due course in their doing so but in the Y sources, some of them o cial. meanwhile there is this great demand for liquidity. You can get liquidity at a price and this is a matter Q98 Ms Keeble: If I can just ask the Governor of price. because this issue about risk assessment is something that the Committee has looked at in the private Q100 Ms Keeble: Can I just come back on that equity investigation as well and you referred to the because is it not the case that people do not know possibility in the coming weeks of what would where the risk is, which is one of the factors which happen if the banks were forced to take risky—and has led to the seizing up of the market, and is it not I have not got your exact words because I have not also the case what we want is not wisdom after the got perfect shorthand either—risky conduits and event, it is a warning of where the risks are, and special investment vehicles back onto their balance unless there is a more robust assessment of that then sheets? Which are those risky investments and how you do not know where the next Northern Rock is do you know where they are if you have not got the going to be? ratings agencies giving a good, robust assessment of Mr King: There are two points I would make on what the risks are? that. First of all, it does not matter fundamentally Mr King: Can I step back one point because I think whether we know exactly where the risk is, provided it is very helpful to put this in the context of the real that the regulators know exactly what the position is financial crisis that started on 9 August. I know most of the banks with retail depositors because the of the questions naturally have been about Northern ultimate aim here is that we are concerned about Rock but we should not forget that all this came out protecting depositors and the payments system, not of this general problem that you are referring to. protecting banks or shareholders or other investors Processed: 30-01-2008 10:39:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG1
Treasury Committee: Evidence Ev 15
20 September 2007 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 Mr King: I have been very clear with this Committee investors themselves know what risks they have throughout. I do not pretend to be able to forecast taken on. This is the issue. I think the problem has the future with any great foresight at all; no one can. been that many investors, ranging from German Nobody that I know said on 9 August these events public banks to other banks, have discovered that would occur. We have been saying for several years they did not know exactly what risks they had that they could occur, that there were risks. It is not taken on. that we were not aware of it. We said these risks are there and the banks themselves decided to take those Q101 Ms Keeble: Yes, which is a bit of an risks. It was their judgment, they decided to take the indictment. risks and on 9 August those risks came home to Mr King: It is an indictment of them. 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 Q102 Ms Keeble: Yes, but it is also the fact that they responded. 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. Q107 Mr Love: You indicated in an earlier answer Mr King: I do think that investors must take that the takeover panel rather curbs the ability to responsibility for what they buy. As Warren BuVett bring the parties together when there is a possible said, do not invest in what you do not understand. 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 Q103 Ms Keeble: Can I just ask one question takeover of Northern Rock and that Northern Rock because you have referred repeatedly to the pressure was in some diYculties—and we have discussed for greater liquidity, the regulation in relation to that—that more active intervention ought to have savers’ deposits is 5% and five days worth of business taken place by the authorities to assist that process? falling due, which Northern Rock actually had, did Mr King: Perhaps Sir John could comment but as far it not, so is there an argument for saying that those as I know a great deal was done. It was clearly the rules need to be looked at? responsibility of the FSA in discussion with Northern Rock’s board, and it cannot be forced Mr King: I think this is a very important point that onto Northern Rock’s board, they have to make the you make of should the regulatory system not put judgments, but I think everyone in this process was more weight on liquidity, and the Bank of England hopeful that discussions about a bid would emerge and the FSA have been urging in international fora to provide a suitable end game to all of this. that more attention be paid to this issue. It takes a However the point you referred to at the beginning very long time to get agreement at international level meant that even if a bank and Northern Rock had about what the appropriate regulatory reached agreement on a bid, that could not possibly arrangements should be and we have been pressing be final until we had gone through all the processes that case internationally for quite some time. 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, Q104 Ms Keeble: Can I ask one further question small though it might be, that something might have which is just about the Inflation Report. We all have gone wrong with Northern Rock in the intervening hindsight but looking at your own Inflation Report period before the bid could be consummated and the one warning I see about all of this is where it was that posed a risk to them and therefore it is not talking about domestic demand and it says: “Recent surprising that they thought they might wish to take developments in financial markets, if they become their money out. 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 Q108 Mr Love: Can I just turn to Sir John because would expect to have perhaps a greater projection of there is unhappiness at Northern Rock, there is an impending crisis. Would you want to re-visit that unhappiness with the suitors; where did it go wrong phrase and give greater weight to the risks that you and what responsibility does the FSA or other had foreseen? authorities have for it going wrong? Mr King: If we were back at that time when we were Sir John Gieve: Firstly, as a member of the FSA writing this— 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 Q105 Ms Keeble: This is August. things: firstly we were alerted first to the position of Mr King: This was before 9 August. If you are asking Northern Rock on 14 August but it was not obvious whether before 9 August we would have said the to them or to us at that point that they were going to same things, I think the answer is yes. After 9 August V require government assistance. There were two we would have said something rather di erent. things that they were actively exploring: one was a possible merger or takeover, and the other was Q106 Ms Keeble: But anyone could have said there raising money both through short-term money is a downside risk, even if I could have said there is markets and by securitising their debt. They were a downside risk. still hoping to securitise some debt and thus relieve Processed: 30-01-2008 10:39:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG1
Ev 16 Treasury Committee: Evidence
20 September 2007 Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance their liquidity pressures right into September, and it provides some liquidity to the markets at a point was only when that proved impossible that it became when the strains seemed somewhat greater. I have clear that they needed another source of liquidity. In explained it was a balance of judgment and that was terms of the crisis, the key question is was it worth the balance that we struck. 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 Q112 Mr Love: It would seem from all that we have deposits? We did realise there was a risk that, if you discussed here that the run on the Northern Rock like, the shock eVect of an announcement would came as an enormous surprise to everyone. Should overwhelm the positive eVect of saying the Bank was we have expected it? Should it not have come as a standing by with some money. We knew that was a surprise? I know we have not had one for 140 years risk but we thought that it was not an overwhelming but should the authorities, whichever of the three risk and it was worth taking that step. As a result the tripartite authorities, have had a better judgment guarantee which proved essential in the end came about how the public would respond to these events? out on Monday. If we had known it was going to be Mr King: I think everyone knew that a run was a essential on Monday we might well have oVered it on possibility. The question was what could you have Friday but that was not certain at that stage. 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 Q109 Mr Love: Can I move on, you mentioned opposite and actually reassured depositors. It did earlier, Governor, that the Market Abuses Directive not and at that point the guarantee was necessary. 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 Q113 Mr Love: Can I just stop you there because it requires the recipient company or bank to make it has been widely reported that the Bank expected that public. the announcement would reassure rather than panic; was that the case? Q110 Mr Love: It has to become public. Recognising Mr King: Nobody could have known what the net that was the case and also you mentioned earlier that eVect would be. It did reassure wholesale funders to you accepted that depositors of Northern Rock were Northern Rock. The situation on that front eased rational in rushing down to Northern Rock after the announcement, but of course those people following that announcement, was there any were aware of the liquidity problems of Northern consideration given that because of the impact of the Rock. I do not think anyone could have known with public statement there might be another way to do any certainty at all what would have been the this that would not have required such a public consequences on retail depositors of the profile for Northern Rock at that time? announcement. Mr King: It was not obvious that the shareholders at that stage would decide to take their money out. If Q114 Mr Love: The interpretation put on they had been reassured by the provision of the yesterday’s events is that everyone is chastened by facility and kept their deposits in then there would the experience of Northern Rock. Have you yet had have been no clash of that kind, but once some an opportunity to try and assess the reputational people had started to do it—and this is the key damage that has been done to the British banking point—once some people had started to take their system as a result of the first run for 140 years? money out did it then make sense for others to join Mr King: I think that is what really matters and I do in. As I have said before, the only solution at that not believe that in a year’s time people will look back point was a Government guarantee. But it is a big and say there was any lasting damage to the British step and to have done that at an earlier stage when banking system. It is very well capitalised, it is very it was not strictly necessary might well have caused strong, and, as I explained before, although the wider problems and I think would have incurred the banks at present are having to pay a bit more for diYculties and we now need urgently to get out of their liquidity than they would wish, they will be able this temporary position into a more stable long-run over the coming months to take these vehicles and structure for the legislation around banks. conduits they have set up back onto their balance sheets and they will be strong. Headlines come and Q111 Mr Love: Let me press you on that because the headlines go and even television pictures come and statement yesterday about the three-month facility go, and I cannot believe and I do not believe that you mentioned that because of the impact on the there is any lasting damage to the reputation of the banking sector but there are some concerns that it British banking system, although I fully understand specifically related to smaller banks—I will not that the impact of the pictures on television last name them but they are being named regularly in the weekend came as a shock to many. 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 Q115 Mr Love: You said earlier on that your individual institutions and you would not expect any concern, if I can call it that, about moral hazard Governor to do that. We put that facility in place for related to the seeds of future financial crises. Do you the reasons I gave. It was designed and structured in perceive any negative eVects from yesterday’s a way that minimised the moral hazard but it announcement of injecting liquidity into the market? Processed: 30-01-2008 10:39:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG1
Treasury Committee: Evidence Ev 17
20 September 2007 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 collapse. The Fed not only gave the financial your statement to this Committee and publicly that markets some help, which you might disapprove of, may have consequences further down the road? but they also put some aid in on the mortgage side Mr King: I think not. I think the banks in this to give some relief to people who were in danger of country realise that they have not been provided losing their houses. A lot of these mortgages are sub- liquidity for free. I think they understand the reasons prime in this country and there were lenders who for the decision that was taken yesterday that they would foreclose in the way the big banks would not. would have to pay a penalty rate to obtain liquidity I had a ten minute rule bill about it and I have from the Bank. I think that is appropriate and it is researched it. I know you are preoccupied with all appropriate because of the circumstances in which the financial markets but have the Treasury, we are providing it, with the realisation of risks that Financial Services or yourselves got it anywhere on the banks themselves took in full knowledge of what the agenda because it is a genuine problem where the consequences would be. The one thing I would people are losing their homes in greater numbers? like to say at the end is if these same problems were Have we got an agenda to see whether and what help seen in the banking system today and they had been can be given to stave repossessions oV until the the result of some completely diVerent cause, say a market turns? major terrorist attack, we would be injecting Ms Barker: I think the first thing I would say in liquidity at absolutely zero cost because that would response to that is although it is certainly true that not be the result of the risks that the banks repossessions have risen, they nevertheless remain at themselves took. The reason for the penalty rate now relatively low levels. is not a punishment it is not to blame anybody; it is simply to make sure that when people think about Q118 Mr Mudie: They have more than doubled, the risks they are taking in the future they do so in Kate. the knowledge that it is costly to take risks. Ms Barker: Yes, I realise that but relative to the Chairman: Graham seeks clarification to one of levels we saw in the last crisis, they are nothing like Andy’s questions and George has a short question so high, and the housing market itself, on the latest before I ask one final question. figures we have, remains relatively robust, so I do not feel that we are yet in a situation where we would Q116 Mr Brady: Just a very quick point of want to necessarily take those steps nor indeed clarification really to Sir John. You said that if you would I really be the appropriate person to carry had realised what the consequences would be when that forward. you announced the facility on Friday you might also have announced the Government guarantee then. Q119 Mr Mudie: But in terms of the wider The Governor has told us that the question of the organisation then if you are not the appropriate guarantee was not discussed until Sunday. Can you person to that, I disagree with you on the figures; the make it clear whether there was any consideration at figures are starting to be alarming. What you have all on Friday or before that as to whether a said is the conventional wisdom of three months ago guarantee ought to come at the same time as the and they are more alarming set against the facility was announced? background of what we have been discussing for the Sir John Gieve: We had of course discussed what last two hours, and there are a lot of people out there would happen if the negative news of the in danger of losing their homes. If it is not on an announcement outweighed the positive news, and agenda and if you do not prove to be correct and the obviously a Government guarantee was one of the numbers stay at this level, would you not think it is possibilities. But I think this the Governor was an appropriate thing to start looking at to see which saying that it was formally discussed as an action, is the appropriate agency, whether it is Treasury, and whether we should take the action now or whether it is Financial Services, whether it is you, to tomorrow, on the Sunday. We did realise that simply do something about it along the lines of the Fed? announcing that there was a new source of funds for Ms Barker: To go back on that, it is very diYcult to Northern Rock might not be suYcient to restore take any pleasure in these numbers. These are very confidence, but we thought there was a reasonable serious events for the individuals concerned. I do not chance that it would, and in any event it was the right feel however they are at the kind of levels I thing to do. They were having to make a profit personally would describe as alarming. warning and I think for them to make a profit warning without having clarity on their sources of Q120 Mr Mudie: I know that and you said that. I am funding would have been disastrous. saying if it turns out that they are—and we have already heard and been critical of the lack of Q117 Mr Mudie: All this discussion today has been activity—would you guarantee that we will have about the financial markets, but of course you are some activity if the numbers keep at this high level? here in a wider capacity and we are talking about the Ms Barker: Again, I have to say, and it must be real economy. I see that Kate has not said a word in apparent, I could not give that guarantee because it two hours and as she is the housing expert I would would not be within my remit. say the number of repossessions on the latest figures Mr King: We have two ways in which we can be has gone up from 33,000 to 77,000 which means that involved in this. One is that we will look carefully at we are starting to get back into the very worrying the credit conditions in the economy and the housing situation where we had the last negative equity market in making our judgments about interest Processed: 30-01-2008 10:39:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG1
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20 September 2007 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 Q126 Chairman: 5% I think it was. Paul Tucker, you aspects of the housing market that require separate, are in charge of the market area. How long has specifically tailored interventions, we can discuss market chatter been going on about Northern Rock? that with other government departments. It would Somebody has described it to me as “a bright red be quite wrong for me to— flashing light which the FSA did not look at” and “they would not know a potential problem if it hit V V them in the face”. Q121 Mr Mudie: No, I realise it is o -the-cu but Mr Tucker: We do not focus on individual that second one is very useful. Will you undertake to institutions. We really do stick to our mandate under do that if the high figures continue and it looks as the MoU and the market situation as a whole and I though we are going to revert? have described and John and the Governor have Mr King: I will certainly undertake to talk with described— colleagues in government. Q127 Chairman: It does not give me much assurance Q122 Mr Mudie: Thank you. that you stick to your mandate because we ended up Mr King: One last point I would like to make is that with a crisis. As George Mudie said, we are looking the United States does face quite serious problems in for some action from people to ensure that we do not its housing market which are of an altogether get into the diYcult situations, so sticking to your diVerent order of magnitude from those here. mandate is a pretty unacceptable phrase. Mr King: Chairman, there have been other Q123 Mr Fallon: Governor, you have just said that occasions when we have come before the Committee you expect the events of the last seven days not to where you have asked us the question “Is not that have damaged long-term confidence in the British going outside of your mandate?” We have been banking system. How much damage do you think it given a clear mandate and our responsibility is to has done to the reputation of the Bank of England meet our mandate. and your Governorship? Mr King: I think only others can judge that. All I can Q128 Chairman: I understand, Governor, but the do is take the decisions that I think to be appropriate fact of the matter, as I said earlier on, is here we have in the interests of the country as a whole, to come a situation where we end up with problems that and explain that to you and others before this aVect the whole financial system and it is how you Committee and elsewhere. You will have to make work that, that is what we are looking for; we are that judgment, not me. looking for reassurance. Mr King: I understand that and what I would suggest is that you talk to all the players involved Q124 Chairman: Paul Tucker, you have discussed and then reflect on it and make your judgment. the liquidity problems, you have done that all morning but what are the markets saying about the Q129 Chairman: We will do that. Are there any sub-prime credit problems? Are they going to wash others in potential trouble? You do not need to up soon and where are they going to wash up? name them! Mr Tucker: This goes to the point that the Governor Mr King: I think you know perfectly well that central was just making. This is the underlying serious bank governors cannot go— 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 Q130 Chairman: Governor, I was not even talking to week has partly been taken with that in mind. I think you; I was talking to Paul Tucker. one of the most important things now will be to see Mr Tucker: Central bank directors take the same whether the action that the Fed has taken starts to approach. stabilise the market in the US. Q131 Chairman: Okay. John Gieve, you say you were alerted to the Northern Rock situation on 14 Q125 Chairman: What action are you taking, Sir August. How many days have you been at the Bank John, at the FSA? Have you got any anticipatory since 14 August? Has every day been a strenuous day action that you are taking on this? Do you vet it for you? very closely? Sir John Gieve: No, I was not at the Bank on 14 Sir John Gieve: On sub-prime within the UK as August. I was away for two weeks in August, first at opposed to the US sub-prime losses, the FSA has a family funeral and then for a week in France. 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 Q132 Chairman: So you were away for three weeks? about mis-selling and standards at that end of the Sir John Gieve: No, two weeks. market. I would just like to repeat what the Governor says that all the analysis that they and we Q133 Chairman: So from 14 August you were away and I think outside commentators have done until the beginning of September? suggests that the sub-prime problem insofar as it Sir John Gieve: No, I was back at the end of August. exists in the UK is very, very much smaller than in I was in touch with the oYce. I discussed with the the US. Governor whether I should return. At that stage he Processed: 30-01-2008 10:39:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG1
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20 September 2007 Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance thought that was not necessary. I therefore came Sir John Gieve: If you look at what we said in April back before the beginning of September and of and what we said in a number of speeches, notably course I have been here since. the Governor’s speech just before the summer, it could not have been clearer about the risks of Q134 Chairman: Okay. Are your FSA and Deputy liquidity problems in financial markets. If you say Governor roles at one? In other words, is the agenda did we see exactly how it would pan out and why it which the FSA has the agenda which the Bank of would impact on Northern Rock, which had no England has at one? If we read some of the papers particular sub-prime connections and credit yesterday we would be forgiven for thinking they derivatives holdings, no, we did not see that, but of were not at one. What is your view as an ex oYcio course you are absolutely right— member of the FSA as well as Deputy Governor? Sir John Gieve: I think, as the Governor said, the co- Q140 Chairman: People were talking about operation has worked extremely well and relations Northern Rock. They were talking to me about are good and there has been no conflict. Of course there are diVerent views between and within Northern Rock and others were talking about institutions about whether we should do this or that, Northern Rock so it is absurd for you to come here but I think the tripartite arrangements have worked and say you did not know anything about it. You are well. Just on this red flashing light, it is easy to be the guy in charge of financial stability. You have wise after the event but the markets through the twin hats on as the Deputy Governor of the Bank spring and early summer were not saying that and at the FSA and, frankly, I do not think you are Northern Rock was a disaster waiting to happen and doing your job. it was not the institution that would be aVected by Mr King: Chairman, may I just say it is very clearly problems in sophisticated credit derivatives. not the job of the Bank or Sir John as a non- executive director of the board of the FSA to take responsibility for individual institutions. Q135 Chairman: But there was market chatter. Sir John Gieve: Market chatter accelerated through August. Q141 Chairman: Governor, understand this, we do not want to be complacent here, there is a big picture Q136 Chairman: Northern Rock increased its we have got to focus on but when we get complacent mortgages threefold beyond anybody else in the answers it gets us riled. market. It had fewer deposits to which to have Mr King: I do not think the answers are complacent, recourse. In other words, it was almost wholly with respect, and I would urge you please to suspend dependent on going to the wholesale markets. Any your judgment about this until you have been able to good risk director worth his or her salt would have talk to all three parties in the tripartite arrangement. 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 Q142 Chairman: Okay. Sir John, lastly, are you FSA on the job, were you on the job in saying, “Wait disappointed that market participants appear to a minute, if things go wrong here, Mr Applegarth, have taken no notice of comments made by you and we are really in trouble.” You are not giving us any the Financial Stability Report warning of the assurance this morning that you were on the job. dangers of a change in the price of risk and the Sir John Gieve: I first spoke to Mr Applegarth about illiquid nature of certain market instruments? the facility we were going to operate on 10 Sir John Gieve: Well, I think some of them took September. It is not my job as a non-executive more notice than others and adopted less risky director of the FSA to get involved in talking to the approaches, but, yes, obviously it would have been risk managers and managers of individual banks, better, and it is not just the Bank, it is the FSA and but I do know that the FSA were very closely in other regulators too. Obviously looking back on it touch with them. they mispriced risks especially some liquidity risks.
Q137 Chairman: Do not try and minimise this. Q143 Chairman: What lessons have you learned Sir John Gieve: I am not trying to minimise this. from that? Sir John Gieve: Well, I think two things. Firstly, Q138 Chairman: You are responsible for the markets under the new sophisticated markets as well strategic focus, that is what it is, we are not asking as under the old banking markets, do get a you to go into micro management, it is the strategic momentum of their own and the players fear more focus, and we are asking you were you alert to that the possibility of being left behind and losing and your answer given to us this morning is that you business than they fear the possible costs if were not doing much. In fact it seems to me that you something goes wrong. That has been apparent in were pretty laid back about it. other financial booms, if you like. I think a lot of Sir John Gieve: I do not agree with that. We were lessons have been learned about the details of how, alert to the dangers of the financial markets. in particular, sophisticated derivative markets work, and I think we will see in the market and among Q139 Chairman: I do not think you have convinced regulators a number of changes in the requirements this Committee. on and structure of dealings. Processed: 30-01-2008 10:39:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG1
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20 September 2007 Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance
Q144 Chairman: Governor, this £10 billion facility Dr Sentance: I think it is very early to talk about that was announced yesterday what about the point indications. I think so far the indications from the of view from banks who say, “We are not going to real economy, if you take for example the most go near that money, we are not going to ask for it recent CBI survey, do not show much impact but we because if we go for the money then there will be a would expect it to take some time if there are going question mark about us and some people will say to be impacts. I think the things we are looking at there is a problem with our bank.” In other words, where we expect these financial market there is a mark of Cain on people who approach you developments to impact are through the cost of for that money. How are you going to get over borrowing and through the availability of that issue? borrowing in various forms, both to companies and Mr King: This is an anonymous auction, we do not to individuals, so we will be monitoring that very reveal the names of the people who appear at the closely and Bank staV have stepped up the auction. 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 Q145 Chairman: You do not think it will leak? very closely the price and the availability of credit to Mr King: I know this is a leaky world but frankly this see if it is being impacted. I think we have to have an is about the only facility— open mind at the moment and it will be the impact on the real economy and hence on inflation that will Q146 Chairman: You are sitting in the leakiest place guide our actions on the Monetary Policy in the world here. Committee. In my mind that is very clear. We have Mr King: That is why I am not going to tell this a mandate on inflation on the Monetary Policy Committee the names of the banks who will take Committee. Clearly demand conditions overseas part in it. and in the UK will aVect inflation prospects and that is where we need to be looking to see if this is going Q147 Chairman: I hope that was not a snub, to have any impact. Governor. Mr King: We have designed this with a balance of Q149 Chairman: Governor, as I said earlier, as an considerations and we are putting on the table some all-party Committee we are intent on ensuring that liquidity. I would say one last thing, you put to Sir we get to the root of this issue and the root of the John what lessons have we learnt, for me the key problem and for us that is to see that the system is lessen in all this is that I do not want to let down working properly. To date that has not been the those banks who did read our report and did get out case. We want to work with you and others in the of profitable business in order to reduce the risks of future on that. As I said earlier, we are taking their activities, and what is most important now is evidence from the FSA very soon after the house returns and then we will hear from the Treasury, but that we actually make clear to all banks that if they as a result of today’s meeting I will also be writing to undertake risky activities we cannot stop them doing the Chancellor and when we have heard from him that and I do not believe you can get the regulators and sought wider evidence then we will no doubt to stop them doing that. The only thing that will stop come back to you for further questions and perhaps banks undertaking risky activities is the knowledge a further evidence session. Can I thank you and your that if things go wrong and the risks materialise they colleagues for your attendance this morning. and they alone will bear the consequences. Mr King: Thank you very much, Chairman. Can I say there is a very key area, as I stressed before, of Q148 Chairman: Governor, thank you very much. I working together forward and that is the exit route have got a last question and, believe it or not, it is for from the current Government guarantee, which can Dr Sentance, sorry, my apologies but in terms of only be an exit route to something better than where inflation what signals are you looking for that would we were before. This Committee has a very indicate that the credit crunches are having a important role to play in that and we would be very worrying eVect on the real economy and have you happy to work with you on it. seen any indications already? Chairman: Thank you very much. Processed: 30-01-2008 10:44:58 Page Layout: COENEW [SO] PPSysB Job: 386890 Unit: PAG2
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Tuesday 9 October 2007
Members present
John McFall, in the Chair
Mr Graham Brady Mr Andrew Love Mr Colin Breed Mr Sioˆn Simon Mr Philip Dunne Mr Mark Todd Mr Michael Fallon Peter Viggers Ms Sally Keeble
Witnesses: Sir Callum McCarthy, Chairman, and Mr Hector Sants, Chief Executive, Financial Services Authority, gave evidence.
Q150 Chairman: Sir Callum, welcome to the the Governor; so no doubt during these private Committee. Can you identify yourselves for the discussions you would have had a view on this shorthand writer, please? concept of moral hazard? Sir Callum McCarthy: Callum McCarthy, Sir Callum McCarthy: Indeed, yes, Chairman. Chairman of the FSA. Mr Sants: Hector Sants, Chief Executive of the FSA. Q155 Chairman: What was your view? Sir Callum McCarthy: I think that there it is an Q151 Chairman: How much responsibility do you important question of balance between the issues of accept as an organisation for the recent damage moral hazard, which the Governor addressed very caused to the UK financial system? clearly in his memorandum to this Committee and Sir Callum McCarthy: I think that you have to look what I would call the problem of damaged innocent at the responsibilities of the FSA in relation to bystanders in the sense that there is a problem Northern Rock in respect of two periods. One is the associated with a worldwide liquidity drying up, V way in which we discharged our responsibilities of which a ects not only people who have played a part supervision up to the time when market conditions in arguably irresponsible behaviour, which is the became turbulent and diYcult in August and the Governor’s concern, but much more widely in terms way in which we have acted since then. I am happy of other people who can possibly be harmed by to describe, and I hope our memorandum to the that event. Committee has described, how we went about it in both those periods. Q156 Chairman: So you agree 100% with the Governor? Sir Callum McCarthy: No, the Governor’s Q152 Chairman: How do you respond to the document was his document. I am saying it is a suggestion by the BBA that “our reputation as a question of balance. country will not have been strengthened as a result of the wall-to-wall coverage of the queues” at Q157 Chairman: I am asking if you agree 100% with Northern Rock? the Governor on that subject. Sir Callum McCarthy: I have made clear that I Sir Callum McCarthy: I think that it is possible for regard the events of Northern Rock as having been people to have diVerent views, and my own view of damaging. the balance between the moral hazard arguments and the other instances is slightly diVerent from the Q153 Chairman: Do you think that the Bank was too Governor’s. wedded to the concept of a moral hazard and that liquidity operations should have begun earlier? Q158 Chairman: In what way is it diVerent? Could Sir Callum McCarthy: Those are questions which, I you speak up, please? think, have to be addressed to the Bank rather than Sir Callum McCarthy: It is diVerent because I place to the FSA, but I would say that our responsibility a slightly diVerent weight on the diVerence. in relation to the period when the diYculties of Northern Rock became clear were essentially three. Q159 Chairman: In what way is it diVerent? The One was to monitor the position carefully, the reason I am asking this is to ensure that we get a second was to give advice to the Chancellor in satisfactory solution to the future and we never see relation to insolvency and in relation to the systemic a bank run again. importance of Northern Rock and the third was to Sir Callum McCarthy: I very much hope that we investigate whether there was a possible private avoid future bank runs actually. sector solution, and I think that we did all three of those. Q160 Chairman: What is the diVerence between your view and the Governor’s? Q154 Chairman: The reason I ask that question, Sir Sir Callum McCarthy: The question that I was Callum, was quite simple. There was a Tripartite trying to explain, Chairman, is the balance between agreement with you talking to the Bank, talking to the moral hazard arguments, which are clearly Processed: 30-01-2008 10:44:58 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG2
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9 October 2007 Sir Callum McCarthy and Mr Hector Sants important, and equally the importance of making need to deal with the question of bank insolvency sure that when there is a liquidity problem there is a problems and also the question of the compensation means of dealing with it. arrangements.
Q161 Chairman: So I can take from that that you Q168 Chairman: So the Market Abuse Directive was would have dealt with it in a diVerent way from the an impediment? Governor? Sir Callum McCarthy: We knew—. I do not think it Sir Callum McCarthy: No, I do not have the is simply the legal requirements of the Market Abuse responsibilities that the Governor has; I do not have Directive which is an impediment. the requirement to weigh up the general monetary policy questions that the Governor has to weigh. I Q169 Chairman: I did not say that. have a diVerent set of responsibilities. Sir Callum McCarthy: I think there are also a variety of other practical questions which made covert Y Q162 Chairman: I understand. Did you ever conduct operations di cult. a war-game type exercise of a similar scenario to the Northern Rock crisis? Q170 Chairman: Let me focus on the Market Abuse Sir Callum McCarthy: We have conducted a series of Directive because the Commission came out with a war games but they have been diVerent because the statement that was contrary to what the Governor nature of the problem that we have dealt with in this said. Was it flashing up in red lights to the Tripartite instance has been diVerent. What we have looked at body that the Market Abuse Directive was an in the past has been institutional-specific problems, impediment and something had to change there? whereas this has been a very diVerent sort of Sir Callum McCarthy: No. I think that what was problem. It has been a worldwide drying up of clear to the tripartite authorities, and certainly clear liquidity, and that gives rise to very diVerent to us, was that there would be obligations of questions. disclosure on a publicly quoted company which would have to be taken into account. Q163 Chairman: You conducted war-games scenarios for avian flu. Is that correct? Did you Q171 Chairman: But it was not a complete conduct any war-game scenarios for a run on a impediment? bank? Sir Callum McCarthy: The obligations for Sir Callum McCarthy: Yes. disclosure are very much specific to the circumstances of any case. It is impossible to say in all circumstances. Q164 Chairman: So why did not things operate smoothly then? Sir Callum McCarthy: Because the circumstances Q172 Chairman: With Northern Rock was it not an that we looked at— impediment? Mr Sants: If I might just explain a little bit further. As Sir Callum has indicated, each individual Q165 Chairman: Because war-games are of no use? judgment has to be situation specific. It was certainly Sir Callum McCarthy: No war-games are useful. I known to us both during any war-games and, of think that the ability of us to work together has been course, generally during the course of our normal significantly improved by the fact that we have business that there would be certain sets of practised. It is almost impossible to anticipate in circumstances which would require disclosure. The advance the particular circumstances of any disclosing circumstances revolve around, of course, particular crisis. the extent of the support being oVered and the relevance of that support to the long-term viability Q166 Chairman: Why did you not discover the of the company and in terms of the knowledge in the problems of launching a covert lender of last resort market place at that given point, and so, of course, operation in the war-game simulation? the nature of support which came into play would Sir Callum McCarthy: The positions that we looked have an impact on its future profitability and so at were rather diVerent from the position that forth. So there are a set of inter-related occurred in relation to Northern Rock. circumstances which determine whether a support operation of that type needed to be disclosed at Q167 Chairman: The Governor said to this that time. Committee that he stumbled on four pieces of legislation which frustrated his ability to support Q173 Chairman: I understand, but I am trying to get Northern Rock in his preferred covert way. Do you a simple answer to this. When the Governor came he agree with the Governor’s interpretation on those said “there were four pieces of legislation here that four pieces of legislation? stopped us in our tracks”. The Market Abuse Sir Callum McCarthy: I agree with him that each of Directive was mentioned. The reason I am asking those four problems are significant problems. I this is quite simple, Sir Callum, because the would add that when we conducted a particular Governor said that this took place in 2005, I think. exercise with the Treasury and the Bank in February If that was a big problem, (a) was everyone in the we had identified in particular the problem of having tripartite agreement alive to that and (b) if they were a means of dealing with banking problems and the alive, was some legislative programme implemented Processed: 30-01-2008 10:44:58 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG2
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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 Q177 Chairman: Would you have preferred a covert doing your simulations, you say, “Look, if a bank lender of last resort operation to save Northern run occurs, then this Market Abuse Directive is a Rock? problem and we really need to get on top of that”? Sir Callum McCarthy: I think that if that had been Sir Callum McCarthy: The point I was trying to a practical possibility it would have had some make, Chairman, is that there is a legal position attractive features. Unfortunately it was not a which, as Hector has explained, is specific to any set practical possibility. of circumstances. It does not necessarily mean that in every single circumstance there would have to be Q178 Chairman: Sir John Gieve is a non-executive an announcement. With the position of Northern member of the FSA Board, due to his position as Rock, in the particular circumstances, the Northern Deputy Governor in charge of financial stability. Rock Board took the view that they had to make an How well did having this connection work during announcement and we believed there was no legal the crisis? basis for preventing them. If I look quite apart from Sir Callum McCarthy: Perhaps I could just explain the law, there is also a series of practical questions what we have done to strengthen the links between which I think also have to be recognised—for the Bank and the FSA in relation to financial example the need to discuss funding with credit stability questions. We have ensured that there is rating agencies, the probability that that would FSA representation or attendance at the Financial become public by a diVerent route—so there are Stability Board at the Bank, which looks at largely both legal and practical questions which are the macro-economic questions associated with important. financial stability although the Bank has a very specific set of responsibilities in relation to payment systems because so many of the important payment Q174 Chairman: So there was no legal impediment systems pass across the balance sheet of the Bank. in terms of the Market Abuse Directive? They also have particularly important positions in Sir Callum McCarthy: I am not sure what the legal terms of various international bodies. They are, for impediment is to. example, leading the work in Basle on liquidity. In terms of the FSA one of the things that I arranged Q175 Chairman: In other words, the Market Abuse was for the Risk Committee of the Board to have Directive was not stopping everything happening in John Gieve on it to ensure that there was a proper terms of the Northern Rock situation? interlinking between the analysis that is made at the Mr Sants: In those particular set of circumstances Bank and the analysis that is made at the FSA. If I we saw no reason to disagree with the Board’s view look at the actual work during the time of the post 9 that it was necessary for them to make an August problems, I think that the clarity of announcement. Of course to some degree this is a information between FSA and bank was quite clear moot point, because once it had been leaked the and I think that the transmission of information in night before they certainly had to make an both directions worked well. From essentially 9 announcement in relation to that set of August we set up a daily Tripartite meeting in which circumstances. we compared notes and information and identified problems. So I think that overall those arrangements worked well. Q176 Chairman: In a sense there is simplicity to this, that if the Market Abuse Directive was a problem, it Q179 Chairman: Sir John gave us the impression was discussed in 2005 and nothing was done about that the FSA Board on which he sits was not greatly it, then you were behind the curtain? engaged. Sir Callum, you sit on the Court of the Sir Callum McCarthy: The point that I am trying to Bank of England. Do you believe that the Court make, Chairman, is that there were disclosure non-executives were kept fully informed and obligations, which we accept, which have been consulted throughout or were the independent accepted by the British Government and the British members equally supine? Parliament. There was also a series of practical Sir Callum McCarthy: I am sorry, I would like to questions and, as Hector has just said, the important make clear that I would not accept in relation to thing (I think it bears out my point about the FSA non-executive directors the adjective supine. I practical importance of these constraints), the thing think that the non-executive directors of the FSA do that actually happened in relation to Northern Rock the task that they are required to do and that is not was the leaking of this information on the evening of a detailed involvement in particular decisions in 13 September and the coverage of that in the news. relation to the firms in the most part. So, irrespective of whether we had sought to conceal it or not, it was actually in the public domain. Q180 Chairman: Were the non-executives in both Mr Sants: I think it would be clear to us that it was the FSA and the Court of the Bank of England kept not going to be the case that all support operations fully informed at all times on this issue? could be covert. It would be clear from the Market Sir Callum McCarthy: Can I explain what we did in Abuse Directive that there would be sets of terms of the FSA? After the liquidity problems circumstances when that was not going to be developed in August I wrote to all Board members possible, and that would be clear from the point the explaining what we were doing. I wrote to them Market Abuse Directive came into force. again in September and gave them a warning that we Processed: 30-01-2008 10:44:58 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG2
Ev 24 Treasury Committee: Evidence
9 October 2007 Sir Callum McCarthy and Mr Hector Sants had a particular problem with an unnamed Q188 Mr Fallon: Could we turn now to the events institution. We briefed them on 13 September and leading up to this fiasco. In your letter you admit there have been, since then, a series of board that you had not carried out a full risk-assessment of meetings in which aspects of Northern Rock have Northern Rock since February 2006.3 That is 18 been discussed. months ago. Why was that? Sir Callum McCarthy: Because it is—. I think I Q181 Chairman: Back to the initial question: do you would draw a distinction between the formal believe that the non-executives in both the FSA and examination that we do under something called an the Court of the Bank of England were fully “Arrow process” which, as you say, was carried out informed at all stages? on a particular date, and the interim work that was Sir Callum McCarthy: I believe, if I can speak for done. If I may, I will ask Hector to describe that the FSA— interim work.
Q182 Chairman: You can speak for the Court of the Q189 Mr Fallon: I just want to know why a full Bank of England because you are on that. assessment was not done in the 18-month period Sir Callum McCarthy: Yes, but I do have some between the last one and the problems that Northern specific responsibilities as Chairman of the FSA Rock ran into? which are diVerent from my responsibilities as a Mr Sants: I will be happy to answer that. There are member of the Court; but if I speak as the Chairman two points to make, first of all. The full arrow of the FSA in relation to the FSA Board, I believe assessment, even for high impact firms under close that they were appropriately involved at all stages. 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. Q183 Chairman: Appropriately? Sir Callum McCarthy: Yes. Q190 Mr Fallon: Every 12 months? Mr Sants: Between 12 and 18 months. The most Q184 Chairman: The Court of the Bank England, frequent assessment we would do would be 12 to 18 giving you a non-executive role there, were they kept months. What we do, however, is engage very closely informed at all stages. with specific thematic issues of concern, and Sir Callum McCarthy: They were informed and took Northern Rock were regularly visited by a particular decision, which was an important supervisors, roughly speaking (and I do have a full decision of the Court, at a Court meeting on the list here), on two to three months or so intervals. If evening of 13 September. I may finish, I would like to say something about our supervisory practices. Q185 Chairman: One final question from me. On the day we had the Governor of Bank of England in (20 Q191 Mr Fallon: Can you just answer the questions September), the Financial Times did a front-page that we put to you. I want to know when was the next story where it was talking about property: “Hector full assessment due? Sants urged the banks to lend to each other, but Mr Mr Sants: The next full assessment due would have King did not respond fully.” Why did your spinners been three years after the one in question, and, in my in the FSA feel it was necessary to go to the Financial opinion, that is inadequate. Times that morning before the Bank of England came along? Q192 Mr Fallon: You are dealing with a bank which Sir Callum McCarthy: I am sorry, it is not a is lending quadrupled from 25 billion to 100 billion, reporting of events that I understand. I believe that that was taking one in five of the mortgage market, that refers— and you only did a full assessment every three years. Mr Sants: As we lay out in the statement we put Q186 Chairman: John must have been telling me the before you, I completely agree with you. I think FSA’s risk people and spinners were out fully just there are lessons to be learnt here with regard to our before they came to our Committee. That just seems supervisory practice and I think we do need to look to undermine the Tripartite agreement with the back over our engagement with this particular Bank of England that the FSA are supposed to work company and do a lessons-learned exercise, in tandem? particularly with regard to particular areas. I think Sir Callum McCarthy: All I can say, Chairman, is we need to look into our assessment of probability you are making statements which I do not recognise. with regard to the set of scenarios that actually did develop. We did have this organisation as a high- Q187 Chairman: You should read the Financial impact organisation, but in terms of the probability Times of 20 September. If you read those statements, of it getting into diYculty we had it as low- you would see yourself that it was the FSA getting probability, and there was no question, of course, their oar in first. looking at the way events transpired, that that Sir Callum McCarthy: I repeat, these are allegations probability analysis has been proved to be incorrect, which I do not know. so we had some serious lessons to be learned in terms Chairman: I do not think you can react as simply as of the way we went about measuring our probability, that, Sir Callum, when you read that report. Michael. 3 Ev 220 Processed: 30-01-2008 10:44:58 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG2
Treasury Committee: Evidence Ev 25
9 October 2007 Sir Callum McCarthy and Mr Hector Sants and linked into that, which I think links into your Mr Sants: As I said before, I think that the set of point about the Arrow risk assessment, which I circumstances that transpired in the market were completely agree with, is that we need to look more highly unusual and was not, I think, in fairness, carefully at the stress testing issues in relation to this anticipated by any regulators around the world; nor, company. I think the question is not: did we indeed, if you look at the individual commentators. understand the Northern Rock business model? I Some, of course, or a number, may have been think we did completely understand the Northern pointing out the share price was too high; there was Rock business model and I would not, by the way, nobody really anticipating that set of circumstances. agree with your analysis of how the Northern Rock It is not just a question of the securitisation market business model worked, but what I would agree with being closed to them for a prolonged period, it is also absolutely is that we did not engage in our a question of other mechanisms of wholesale supervised process in a way to my satisfaction with funding, in particular the repo market being closed. regard to the stress testing scenarios, because the As we indicated, they had high quality assets—there stress testing scenarios which they were operating is no suggestion here this is an organisation taking with did not envisage the set of circumstances that on poor quality assets—and it really is an transpired in August, which was complete closure to extraordinary set of circumstances which lead to them of all reasonable funding mechanisms, them being unable to repo those assets for a period including the repo market. I have to say, I do not of six weeks or so as well as the combined closure of think any reasonable professional would have the securitisation. One final point, if I may, because anticipated that set of circumstances, but I think as I think it is important to understand, they did not a regulator we should have engaged with that in an actually have a complete closure of the wholesale extreme stress test. Indeed, we had been saying over funding market here. As we pointed out in our note, the previous period, in anticipation of market what happened was the duration of that funding conditions declining, that we wanted firms to take a shortage shortened to the point that they were more extreme view of their stress testing; and we had funding over night. They were not not funding this that engagement with Northern Rock in July when themselves. What happened, however, was that with we went to visit them with regard to their stress test the duration shortening the Board very properly and pointed out that we were not comfortable with (and I think quite rightly, and we would agree with their scenarios, but, regrettably, as is apparent to us that) took the view that they needed the insurance of all, that was rather late in the day. So, we take the opening up a facility with the Bank of England. They view that we should look at our supervisory would not have had to use that facility, or it may well practices and we agree with you to that point. 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 Q193 Mr Fallon: That is quite a long answer. Could that market was closed as the sole driver in the set of you answer the questions as briefly as you can? You V circumstances that have taken Northern Rock to have a budget of 300 million; you employ 2,659 sta . where it is now would be incorrect. We need to look How many were supervising Northern Rock? at it as a combination of circumstances which Mr Sants: In terms of direct supervision it, it would included the retail run as a major driver of their be three, which is standard practice for high impact problem. They were not using the Bank of England firms, and, of course, they are drawing on groups of facility until the retail run. specialist individual in the area such as stress testing and risk-management and these areas would also contribute to the visit programme. Q196 Mr Fallon: Why were they allowed a waiver under the Basle II Directive? Why were they allowed a waiver in June? Q194 Mr Fallon: Was Northern Rock treated as a Mr Sants: The Basle II waiver is standard procedure small bank? of the implementation of the CRD and was the Mr Sants: No, it was treated as a high impact bank standard procedure we were going through with any under close and continuous supervision—one of our bank who wished to apply for one at that stage. The top 160 high impact close supervision actual change in their regulatory Basle II surplus at organisations—so it was treated at the same level as that point as a result of that waiver was only some the other major UK banks in terms of its supervisory 30 million, which I do not think in the context of the engagement.4 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. Q195 Mr Fallon: Why do you think now its exposure to a freeze in new securitisations was not picked up earlier? Q197 Mr Fallon: But in their interim report it says, “This means that the benefits of Basle II enable us to 4 Note from witness: I commented on the number of the FSA’s increase our 2007 interim dividend by 30%. You high-impact supervision organisations which were similar allowed them to weaken the balance sheet and, as a to Northern Rock. The number I provided was actually result, they increased their dividend? the number of high-impact assessments (ie the same as Mr Sants: It clearly is the case, as the statement Northern Rock) that the FSA was carrying out at that time; this is not the same as the number of high impact makes clear, that it gave the Board confidence in firms. The number I provided—160—was not current. relation to their dividend increase, or at least that is The correct figure should have been 131. how the statement describes it, but I will be clear, Processed: 30-01-2008 10:44:58 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG2
Ev 26 Treasury Committee: Evidence
9 October 2007 Sir Callum McCarthy and Mr Hector Sants under their Pillar 1 capital, even under Basle I, they of the markets this was potentially an at-risk firm, could have paid that dividend. As I say, this was a but the actual deterioration in the profile does not standard procedure that we were going through at occur until well into September and, indeed, it was that time in terms of implementation of the CRD. not until 10 September that they reached a conclusion that securitisation was not going to be Q198 Mr Fallon: Paul Tucker from the Bank sent possible. They were actually in negotiation, as you you a memo in early July warning of the potential know from our memo, with a number of banks dangers of a liquidity freeze. Why was nothing done about the possibility of doing under-written until early August when the retail market dried up? securitised transactions during that period. So, in Mr Sants: It was actually 1 August, the memo in terms of alerting the Treasury to the fact that we question, and I completely agree with the contents of anticipated a significant issue with Northern Rock, the memo. Indeed, as we pointed out when I took which was done by myself on 15 August, I would say over the chief executive role at the end of July, I that was very early to alert them to specific concerns made a great point in the press conference that I about a specific firm in the light of the liquidity thought market conditions were deteriorating. I do information we had available and not in the light of not think that the content of the Paul Tucker memo our knowledge of the business model. So I think we is materially diVerent from the general sentiment very quickly identified that that business model was that I was expressing in that press conference. I at risk. Also in passing, whether we had told the completely agree with him. I think, once we saw the Treasury on the fifteenth or a few days earlier would V beginnings of the problems in the US sub-prime not have made any di erence to the set of market beginning to develop, it was reasonable to circumstances that transpired. assume that we were moving into a more diYcult period here in the UK and, as I have mentioned Q201 Mr Fallon: Sir Callum, you were quoted on a earlier, we did already step up our engagement with BBC website in September as describing Northern the market place, convening more regular meetings Rock’s heavy reliance on short-term loans to fund its around the current issues, and as I mentioned earlier mortgage business as “extreme”. When did you first as well, we were actually in dialogue with Northern come to the conclusion that Northern Rock’s Rock over their stress testing scenario during the business model was extreme? course of July. Paul Tucker’s memo I say is actually Sir Callum McCarthy: I actually said the business the first week of August. model was extreme but it was in relation to the fact that they had a heavy dependence overall on what I Q199 Mr Fallon: But there was already a profits will loosely describe as wholesale funding. Their warning from Northern Rock; you had the memo on overall pattern of funding was around more 70% 1 August; why did it take until 14 August for you to from securitisation, covered bonds, long-term, and alert the tripartite and Treasury ministers as to the in that respect they are an outlier in terms of most problems that Northern Rock had? Why was there British banks, though not necessarily banks in other a gap? countries. I would point out that that is not Sir Callum McCarthy: I was simply saying that it necessarily a source of vulnerability, the long-term was the events around 9 August which resulted in the funding, because those long-term funds can match fundamental drying up of so many markets, both in the assets that people have. terms of securitisation and asset-backed, commercial paper, asset-backed, and in so many Q202 Mr Fallon: What is the answer to my question? geographical markets and currencies, and I think the When did you first realise that this model was speed with which we have responded to that is extreme? perfectly reasonable. Sir Callum McCarthy: In terms of its reliance on securitisation in terms of the overall balance sheet, Q200 Mr Fallon: Why was there a five-day gap from that was something that was well-known. I do not 9 August to 14 August before you alerted the know what time in the last two years, three years I Treasury? became aware of it, but it was well-known that that Sir Callum McCarthy: Because the identification of was a particular feature. Northern Rock was a reasonable thing for us to consider. The ninth to the fourteenth does not seem Q203 Mr Fallon: You were in charge of supervising to me of particular materiality in this. You may take Northern Rock, you were aware that its business adiVerent view. model was extreme, yet over the last two years Mr Sants: If I can maybe amplify a little bit. nothing was done to prevent this particular crisis. Certainly as of the ninth we were in regular Sir Callum McCarthy: No, that is not a description discussion with Northern Rock in monitoring their of events that I would recognise. I have tried to liquidity, but if you look at their liquidity explain that my comment on “extreme” related to availability in terms of days, which is a way of the overall balance sheet of Northern Rock. The looking at their liquidity regime, you are not actually particular problem, as Hector has explained, related looking at a significant deterioration in their profile to the short-term funding, and the short-term until well after 14 August. So we properly identified funding is a problem which has been acute but has that, because of their dependence on securitisation, been caused by the fact that they had access to which required them in general to do around £5 securitisation, to covered bonds, to commercial billion of securitisation in a quarter, with the closure paper and had high quality assets to repo, and they Processed: 30-01-2008 10:44:58 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG2
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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 Q207 Mr Todd: Can I get some procedural stuV markets, including the repo market, closed and that straight. In your annual report you refer to stress is an exceptional, indeed unprecedented, set of testing: “We reviewed the stress testing practices in events to have occurred for the duration and severity ten large firms in the banking, building society and that has occurred. I absolutely accept, as Hector has investment bank sectors. Was Northern Rock one of said, that we did not identify the probability of that those ten? happening. I would also say that very few people and Mr Sants: No, it was reviewed in May. no regulator that I know anywhere round the world have succeeded in identifying that. Q208 Mr Todd: So it was reviewed after this report was concluded? Mr Sants: Yes. Q204 Chairman: To clear up, Mr Sants, you said you had three supervisors for high impact banks of Q209 Mr Todd: So you did have a stress test under which Northern Rock was one and there are 160 this model that is referred to in your annual report institutions that are high impact. Is that correct? in May? Mr Sants: Yes, I am saying that depending on the Mr Sants: We reviewed their stress test in the context high impact institution, the number of supervisors of their Basle application, and it was that review tends to vary between about two and six so three was which led to the conclusion being reached in July, a fairly standard number within our normal range which I referred to earlier, that their stress testing for high impact banks. Even the biggest UK could take into account more extreme scenarios than financial institution would not have more than six or they were and, as I have already acknowledged in the seven supervisors. earlier statement, I think, in terms of our lessons- learnt exercise, we do need to return to our supervisory engagement with the stress test. 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 Q210 Mr Todd: You have said what is later said in particular told me that FSA have had a line side- your annual report in the same paragraph in which team dedicated to them and over a year they could you say (and this was after seeing the ten firms which did not include Northern Rock, and so presumably see 1,000 to 1,200 people in the FSA in terms of you had already worked out some of the supervision. The group risk director is almost in inadequacies in your stress testing then) that further intimate contact with the FSA almost on a daily improvements were needed, particularly where firms basis and the FSA are coming in for themed visits— were not fully taking into account severe but for example safety, private equity—so there is plausible scenarios when making strategic all-risk intensity there. That was described to me, that management decisions. So you already had some intensity. Are you saying the same intensity was intelligence from the stress testing models that you provided to Northern Rock? had applied elsewhere than Northern Rock on the Mr Sants: I am saying that certainly in the period in perhaps limited compass of that exercise. Did that question during the second half of 2006 and early not give you any hints as to the insight you ought to 2007, yes, I was answering the very direct question, apply to a business model which I think Sir Callum possibly not giving a full answer in that respect of the was not alone in regarding as an outlier in this precise number of dedicated supervisors in our market place? supervisory group, but the supervisory model is like Mr Sants: I agree with you. As I said before, if you that of other investment banks, as I have indicated look at the type of stress test Northern Rock was earlier, namely you have coverage supervisors, you using, they were not anticipating closure of the have the relationship with the bank and then you securitisation market and the repo market. The only have a series of specialist teams who regularly visit set of circumstances actually which they had in the bank on particular issues. So, the question, for which those type of closures occurred were example, of stress testing would be addressed by a operational failures rather than market failure and, specialist team who come and visit to look at the as I said earlier, I think that type of scenario should stress test, and that was the visits that were carried be in a stress test; and we would like to see more out in this case in April and May 2007 and, indeed, extreme stress tests and we were making those we also have teams looking at the securitisation points, as you kindly point out, in the document in process and so forth during that period. So, if you question, and it is incumbent on us to make sure that are asking the question about the total number of we carry that through with all the major firms that people involved in the FSA engaged with Northern we regulate, and I think that lessons learnt point, as Rock, you would have a much higher number. I have said before, needs to be picked up in our supervisory practices and we will be returning to—
Q206 Chairman: The question I am asking, before Q211 Mr Todd: My point was a slightly diVerent we go on, was it of the same intensity as your one, which was that from what one can understand relationship with say the big banks? from your annual report, which refers to a period Mr Sants: Yes, for our high-impact institutions we before this, you were already learning some of those have the same coverage model, which includes all the points about the lack of testing of severe but specialists that you refer to. plausible scenarios. Presumably this particular Processed: 30-01-2008 10:44:58 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG2
Ev 28 Treasury Committee: Evidence
9 October 2007 Sir Callum McCarthy and Mr Hector Sants scenario did not fit into your category of severe but completed for any institution currently in terms of a plausible. You regarded it as wholly implausible, central IT depository. We carry data of the same did you? nature on all major high-impact institutions. So the Sir Callum McCarthy: I think it was unprecedented, answer in that sense is yes. and I would say that we have for some time been emphasising the importance of severe but plausible. Q217 Mr Todd: I am sorry, the answer is yes but you I would also point out that that is a matter of sound as if you are at an early stage. It sounds as if judgment, it is particular to any institution and it is the answer is no actually. quite diYcult to decide what level of stress to test Mr Sants: I am slightly confused by your question. against. If you are asking me is the FSA holding the same set of data on Northern Rock as it does on the other Q212 Mr Todd: Can I follow this line of argument a major UK institutions, the answer is yes. If you are little further? We have got again in your Annual asking a very particular question about an IT Report, if you turn to 66, 67, the role of the Risk system, the answer is no because it is not generally Committee of the FSA—and you have already ready, it is in development. referred to one of the august members we met earlier. In the list of risks that the Committee does Q218 Mr Todd: Even though actually this was consider one can see some resemblances to some of referred to as to something that was needed back in the issues that have occurred in this particular case. October 2005? Is it perhaps the case that this Risk Committee Mr Sants: Yes, I agree. It would be a useful tool for treated this as a rather academic exercise of running speedy decision-making. through risks in a routine way or did not actually consider this in the depth that one might expect? Q219 Mr Todd: It is one of these projects which is What was this risk committee actually up to? rolling away gently in the background. Sir Callum McCarthy: Perhaps I could describe the Mr Sants: Yes. It would be a useful tool for speedy Risk Committee of the Board. It is chaired by Hugh decision-making, but in the context of this issue, Stevenson; its members are Deidre Hutton, Peter which arose over a long period of time, I do not think Fisher, who is ex New York-fed, New York based, it is a relevant gauge of our handling of it. 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 Q220 Mr Todd: When Michael was asking you John Gieve. 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, Q213 Mr Todd: They are not lightweights. “We thought that was okay and would not have Sir Callum McCarthy: They are absolutely not made any diVerence anyway because it was a small lightweights and were carefully chosen for that sum of money.” Is that the way you appraise your reason. approach to this? It was delivered actually only shortly before the crisis hit this business and it did Q214 Mr Todd: They have big reputations anyway! give a signal of apparent health. I do not know Sir Callum McCarthy: If I may say so, the idea that whether you recognise that, particularly the way the they were looking just at what I think you described company responded, which was bumping up their as academic points is absolutely not the case. They dividend. Do you appreciate the linkage between looked at a variety of issues and those included the your decisions and market reactions to what a credit risk, derivative risk, the sub-prime risk in the company does? US; so they were examining those— Sir Callum McCarthy: Could I explain a little bit about the Basle I to Basle II change, which is to try Q215 Mr Todd: I have got that. We are tight for and have a much greater granularity and a much time. I just want to explore the linkage between your greater accuracy for the estimate of the capital that Risk Committee and the stress testing models that individual financial institutions require. I do that you have used. Is there some linkage? You have just because I think the description that you gave of it as touched on one issue, sub-prime markets and its a box-ticking exercise is absolutely incorrect. It is a possible implications. Is there any linkage in which rather detailed analysis but it was concerned with the risk committee communicates to those who capital and the capital requirements of Northern deliver this process on the ground? Rock have remained intact during the whole of this Sir Callum McCarthy: Yes, indeed. One of the period. So, this is not a capital requirements responsibilities of the Risk Committee is to examine problem, this has been a liquidity problem and the the way in which the FSA mitigates against the risks fact that Hector has said, I believe completely that have been identified. correctly, that the change is immaterial to the problem should not be taken as in any way saying Q216 Mr Todd: You prepare fact books. Was there that we treated this in a lightweight way. a fact book on Northern Rock? Mr Sants: If I could be clear here, if the issue is Mr Sants: A fact book is a very particular statement whether the CRD or Basle, which, of course, is a about a particular set of data which we are preparing European directive and international agreement, is for the Tripartite, and that is an electronic set of data relevant here, then we need to bear in mind that we which is held on a particular IT system and is not yet are talking about a liquidity issue here, not a credit Processed: 30-01-2008 10:44:58 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG2
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9 October 2007 Sir Callum McCarthy and Mr Hector Sants issue, and we actually do agree that the liquidity Q227 Mr Todd: But obviously not as carefully as you regime should be modernised. We do not want to in now are. Mr Sants, I think it would be helpful, any way not indicate there are some other lessons to bearing in mind the time, if you can produce a paper be learnt here. for us on the distinction between your practice before this crisis and your practice now so we clearly Q221 Mr Todd: Let me turn to the liquidity issue. understand your point about the press not You have just sent out liquidity questionnaires to understanding quite what you were doing. banks and building societies. Mr Sants: I would be very happy to do so. Mr Sants: With due respect, I think that is a Chairman: Again, it amuses some of the large banks misreporting by the press. 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 Q222 Mr Todd: Let us get the record straight then. will be coming back to these things in the future and Mr Sants: I think the press were a little confused in no doubt we will be seeing you again sometime. that particular case. Obviously, from the moment that the market conditions deteriorated, we intensified our liquidity communications with the Q228 Mr Breed: Briefly, because we have major institutions. That was being done on a regular concentrated rather a lot on one side, obviously basis. I think the press either picked up on the fact liquidity and the liabilities, but it has been said by that that was one of the weekly reports that we had you this morning and, indeed, in the Chancellor’s requested or, and I hesitate— written statement yesterday that Northern Rock had a good quality loan book. There are various tests of Q223 Mr Todd: So you have not changed your that and one of the essential tests would normally be practice at all? arrears, repossessions and so on. It does seem Mr Sants: We have significantly increased our somewhat strange to many of us that an practice from the beginning of August, and they only organisation which has a lending criteria somewhat noticed it when they reported that article and gave outlying, reported to be five or six times income and the impression that was the first time that we had so such, even lending up to 125% of the property, done. Or else, I think they may have possibly apparently has arrears statistics and repossession confused it with a diVerent piece of paper that we figures somewhat lower than the industry average, had recently sent out to some sub-prime lenders. So and that does not seem to ordinary, sensible people I think, to be honest, it was a complete misreporting to be a likely scenario. We keep on saying this of the facts. 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 Q224 Mr Todd: It sounds as if there was something yourself that there was indeed a good quality loan there actually. book on an organisation which has lent five to six Mr Sants: With due respect, no. times income and up to 125% of a property? Sir Callum McCarthy: If I look at the assets of Q225 Mr Todd: Obviously you have explained that Northern Rock, of course we were concerned to it was not an entirely novel activity, and I would look at its record. If I look at, for example, the three have been shocked if it were, but the impression one month arrears figure, although it has increased gets is that you have significantly ramped up your slightly over the last year, it is still running at less activity since August. than half the industry average. Northern Rock has Mr Sants: Yes. no exposure to the sub-prime market because it laid oV all that exposure to another institution. If you Q226 Mr Todd: So the point stands that clearly you take the particular 125% oVering, which actually has felt that you had inadequate intelligence on this. got some limits within it which have to be You have correctly drawn the distinction between recognised, the record of bad debts and arrears on the capital base of the business and liquidity, but the that was also very limited relative to the industry important issue of liquidity was an area where your average. The loan to value is not excessive. So, in all intelligence was presumably relatively weak before those respects, we believe that it is correct to say that August because otherwise you would not have been the loan book was a good quality loan book. 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 Q229 Mr Breed: But it was not a means of the way feel in a crisis. You would expect us to respond to a in which they constructed their lending to crisis diVerently than the way we respond to business individuals in respect of the mortgage and the as usual. I think you would not expect us to be personal loan, the secured and the unsecured and the asking for minute to minute, real-time information way in which the unsecured proportion could from our banks in normal business, in usual actually assist the repayment of the mortgage circumstances. I think you would feel that was over monthly figure, thus ramping up, on an unsecured regulation. In the circumstances of a crisis you basis, the lending to an individual whilst at the same would expect us to be carefully monitoring their time appearing to, of course, satisfy the arrears liquidity positions, as we were doing. statistics on the mortgage itself? 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Ev 30 Treasury Committee: Evidence
9 October 2007 Sir Callum McCarthy and Mr Hector Sants
Mr Sants: The diYculties they have got into, as we Mr Sants: Under. I am sorry? have all reflected on, was their diYculty in achieving a securitisation programme, or repaying the Q238 Chairman: The Channel Island subsidiary. mortgage book, or in some way or other sensibly Mr Sants: Granite. raising funding on those asset base. In addition to us having obviously looked at those assets and, of Q239 Chairman: It was under Granite? course, as you would no doubt expect, also the Bank, Mr Sants: Yes. 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 Q240 Chairman: That was actually established point have we heard from any of those parties any under charity law and actually owned by a Channel suggestions that the loan book is anything other Island subsidiary of the Law Debenture than Sir Callum has described. So I think there is no Corporation. Does that not seem a totally artificial suggestion here that the problem is that their loan construction to shift liability and avoid book is anything other than, generally speaking, a responsibility? Did the FSA not smell a rat? good quality loan book that can, indeed, be turned Mr Sants: It is possible with regard to the Granite into rated paper; the problem is with the failure or structure. We would probably have to come back to the reluctance of the market to take any of this you with the detail of that proposition. I am not rated paper. 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 Q230 Mr Breed: But you base that upon the statistics or returns provided to you by the company not in an investigation? Q241 Chairman: I would welcome correspondence Mr Sants: No, we have been to see the company and, on that. Have you spoken to the Northern Rock as I mentioned before, we know the commercial auditors to find out why they were content with this banks that have been looking at that mortgage and, if you have not, can you include that in your book. correspondence to us? Mr Sants: We would certainly be happy to do that.6 Q231 Chairman: You are aware that the Northern Rock funding was carried out through oV-balance Q242 Mr Love: Can I just be clear from one of your sheet special purpose vehicles, a lot of that funding? earlier answers, Sir Callum, that what you said was Mr Sants: Yes. that the reason why Northern Rock has got a high Mr Breed: That is the other side? quality loan book is that they have passed on all the bad risk to others? Q232 Chairman: I know it is the other side, but you Sir Callum McCarthy: No, I said that one part of it are aware of that. is that the sub-prime business that they do, which is Mr Sants: Indeed we are. 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 Q233 Chairman: Was it clear to the FSA that that of assets. 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 Q243 Mr Love: Going back to questions that were here careful that we do not inadvertently stigmatise asked earlier on, we know that Northern Rock were wholesale funding operations as necessary bad for taking up one in every five mortgages; so there was a banks. In order to have a securitisation programme massive expansion in the loan book. We know from which, once a securitisation is done, creates long- American experience that because a lot of these term secure funding, you need a special purpose banks like Northern Rock were passing on the risk vehicle which provides the avenue. through securitisation, the lending practices had become somewhat suspect. Are you concerned about that in the Northern Rock instance? Q234 Chairman: Were you aware it was done Sir Callum McCarthy: We are concerned about that through a Channel Island subsidiary? across the board, which is why, since we took Mr Sants: The visibility, the content of the responsibility for mortgage brokers, we have been programme was perfectly visible to the FSA. consistent in looking at the standards that have been used and have taken significant enforcement action Q235 Chairman: So you were aware of that? across the board. Mr Sants: Yes. Q244 Mr Love: If I extend the American experience, Q236 Chairman: What was the subsidiary in the I think almost all commentators say that the high- Channel Islands? risk, if you like, sub-prime mortgage eVect grew Mr Sants: We are fully aware of the content of the exponentially in the last months before the crisis hit. special purpose vehicle. Is that the case? Have you been able to track the
Q237 Chairman: What was the subsidiary in the 5 Ev 223 Channel Islands it was under? Do you know that? 6 Ev 224 Processed: 30-01-2008 10:44:58 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG2
Treasury Committee: Evidence Ev 31
9 October 2007 Sir Callum McCarthy and Mr Hector Sants quality of the loans that Northern Rock were of this at this stage to say that their practices were making as they grew to consume one in every five out of line with quality market delivery. Do bear in mortgage and is that a continuing concern for you? mind on this sub-prime point that we are only Sir Callum McCarthy: Can I just deal with the fact talking here in the UK around 8% of the UK market that Northern Rock did get a significant increase in being sub-prime relative to around 25% in the US. market share in the first half of this year. The first We do not have any particular signs of the sub-prime point I would make is that the mortgage market is a market growing, and, indeed, probably as a result of competitive market which has quite considerable recent market events it will contract a bit, and there swings in market share from quarter to quarter, and is a genuine social purpose in the sub-prime market, that is not unusual and it is not something which in which is to deliver aVordable housing to some. It is itself we should take action about; this is a a question of whether the practices that go alongside competitive market. What we should be concerned with that are reasonable. 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 Q246 Mr Love: Let me ask you: looking at it now think Hector has got the figures on it. should the FSA have reigned in the aggressive growth strategy that Northern Rock has been Mr Sants: Yes, as you rightly point out, clearly the pursuing? balance sheet for loans to customers did grow in the Mr Sants: I think relative to the funding issue which first half of 2007 something of the order of £10.7bn was the cause of the problem that they have put extra loans net to customers. It is an increase, but I themselves into, it does not seem to me that the think we need to put it into perspective. The second particular market share increase in those few months half of 2006 was £9.3bn, so clearly an increase, as was a trigger that we should have been particularly you say, growth, but I think we need to have a concerned about. I do think we should have been context there. But also, critically, back to our earlier concerned around the stress testing issues that I conversation, if I may, we are talking about the referred to earlier. So, I am more than happy to vulnerabilities which resulted from that business indicate, I think there are some significant lessons to expansion to its funding process and actually where be learned, but I am not sure that the market share you look there, a degree of that was covered by point is particularly the critical point in terms of increased retail deposits, probably around two identifying the driver that led to their problems and billion or so, and the actual amount of quarterly the scenario that we should have envisaged. securitisation which, back to our earlier conversation, of course, was what they failed to do when they subsequently encountered the market Q247 Mr Love: I am not absolutely clear. At any turbulence, in terms of volume did not change stage in your discussions with Northern Rock did hugely. In the first half of 2006 that was about you highlight the strategy they were pursuing? Did £5.8bn, in the first half of 2007 it was £5.6bn. So their you say there might be significant risks involved in dependence on what we previously identified as it? Did you try in any way to discourage them from being the issue here, the securitisation volume, did being as aggressive as they turned out to be? What not actually materially change too much at the time role did you play? Obviously you were monitoring their balance sheet was expanding. So, yes, them. Were you advising them and did that advice absolutely, a period of growth should well be a signal include: “Hey guys, this could be very risky for for regulators to take increased interest (back to my you”? earlier point there) but I think if you look at the Mr Sants: Yes, but as I have said earlier, I think the actual impact on the securitisation programme, that intensity of that dialogue, at the time of the original growth has not really been the point at issue here. arrow visit and subsequently, should have been more forceful. I think those points were being identified by July when we were engaging in the Q245 Mr Love: Before I come to the securitisation discussion around their stress test, but obviously at programme I just want to be absolutely clear. Of that point in time events overtook the firm. I want to course, in general terms, competition is a good thing be clear here, and I know you are questioning the but there is also a negative impact of competition in FSA, but let us remind ourselves, it is the Board’s that in the desperation to sign up mortgages the responsibility to run a company prudently and the lending practices will be set aside to some extent. stress test scenarios are designed by the Board, not Was there any concern in the FSA in relation to that? by us. We do not give prescriptive stress tests to Mr Sants: I think, as you rightly point out, you firms; we think it is the job of firms to identify the should always be concerned where you see market right set of stress for themselves, but I agree with share growth and the question always has to be you, yes, we should have been in more intensive asked, therefore, around the conduct around that. dialogue with the company earlier. 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 Q248 Mr Love: Is there any evidence to suggest that are securitising mortgages to wait for a period of they changed any of their practices, any of their seasoning to see what happens to the performance. aggressive growth strategy as a result of the So, in terms of looking at the financial data, it is discussions they had with you, because we cannot diYcult to tell at this point. In terms of mortgage see any. Is it the case that they ignored entirely what practise, from our point of view we have no evidence you were saying to them? Processed: 30-01-2008 10:44:58 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG2
Ev 32 Treasury Committee: Evidence
9 October 2007 Sir Callum McCarthy and Mr Hector Sants
Mr Sants: As I have said before, I think the stress test and building societies, so if something goes wrong it that they were operating with and their funding is your fault. I assume you would not wish to policy statement set out in 2006 did not anticipate disagree with that. the severity of the market downturn, and when we Sir Callum McCarthy: I absolutely accept, and I get to July 2007 that was still the case, which is why think Hector has made clear, that we believe that we were intensifying our dialogue with them. there are lessons to be learned which we are busy identifying and will apply in respect of the Q249 Mr Love: There have been suggestions that supervision of Northern Rock. In that respect I actually you should not have treated Northern Rock agree. In one respect, I think it is important to as a bank but more as a finance company. They took recognise that we cannot run and do not run what is called a zero-value regime, because if we were to do in mortgages for mortgage brokers and they securitised them. That is eVectively the direction in that we would insist upon a degree of avoidance of which they were going very aggressively. Do you risk across financial services which would be deeply have any sympathy with that argument and should damaging to the economy. you have dealt with them slightly diVerently from the way you would deal with ordinary retail banks? Q253 Peter Viggers: If I probe the chronology, it is Mr Sants: As we have mentioned before, the use of simply so that we can understand the manner in wholesale funding is not in any way an unreasonable which this works. The crisis emerged on 9 August tool in the funding proposition for a bank and, and in the memorandum to us you say that from 9 indeed, securitisation programmes per se which August onwards senior management held daily create long-term secure funding are in fact a very meetings, increased supervisory activity, passing good source of funds. May I remind you here that daily telephone calls. It does not sound to me like the ultimate problem here is a retail run which very much co-ordinated action at that point until 14 reminds us that we should not necessarily equate August when the Bank of England was informed. retail deposits with having greater stability than Sir Callum McCarthy: No. If I may say so, from 9 long-term securitisation products. I think in terms of August we set up a daily, and sometimes more the way we address this supervisory issue, I realise I frequently than daily, meeting, which was a am repeating myself and I do agree with you, I think telephonic meeting, of the Bank, the Treasury and the stress test should have been looked at. the FSA. We exchanged information—I believe that information exchange has worked well—we Q250 Mr Love: Let me ask you finally, Victoria identified problems and we have agreed actions. Mortgages has gone into administration now. We all accept that was a very small bank, that it was Q254 Peter Viggers: I put it to you that, whilst you completely in securitisation, but are there any other have the duty of supervision, many of the actions problems out there of a larger nature that you are that need to be taken by government lie elsewhere aware of and are concerned about? and that real action in seeking to find a solution only Mr Sants: I think in terms of the wider public emerged after 16 August when you set up a project interest you can reasonably expect me to say that team with the other two regulatory bodies? would not be a question I would ever want to answer Sir Callum McCarthy: No, I think it was in terms of particular companies. I am sure you appropriate. I think Hector gave an account of the appreciate that. developing liquidity problems. I do not believe that it was a mistake not have to set up those project Q251 Mr Love: Are there any other continuing teams before 16 August and I think that there was no problems in the market place? indication that the date of 16 August was too late a Sir Callum McCarthy: Could I make clear that that date. is an answer which Hector or I would give in good times or bad times. It is, as a question of principle, a Q255 Peter Viggers: So who was negotiating with question that should not be answered and I do not Northern Rock? Who was discussing actively on a believe would be answered. personal basis the solutions that might emerge? Was Chairman: That is okay. I anticipated that would it you or was it the other members of three come from your lips. Do not worry about that. You regulatory authorities, the Treasury and the Bank of mentioned about Northern Rock. We are having the England? company before us next week, so I will be sending Sir Callum McCarthy: It was principally the FSA, you a letter after this hearing in terms of your and we can give you details of the various relationship with the Northern Rock Company so discussions and who conducted them if you would we can be ready for that. We then go to Peter. like.
Q252 Peter Viggers: When the so-called Tripartite Q256 Peter Viggers: What was your position as to system of regulation was set up in 1997 by the former whether Northern Rock should be taken over? Chancellor of the Exchequer some commentators Sir Callum McCarthy: I am sorry? 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 Q257 Peter Viggers: What was your position as to responsible for the prudential supervision of banks whether Northern Rock should be taken over? Processed: 30-01-2008 10:44:58 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG2
Treasury Committee: Evidence Ev 33
9 October 2007 Sir Callum McCarthy and Mr Hector Sants
Sir Callum McCarthy: One of the responsibilities Q261 Peter Viggers: Would that involve the that we have under the Tripartite arrangements are Financial Services Authority being given more to identify whether there is a possibility of a private authority or more power which is currently held by sector solution. We did that and encouraged and another body? closely monitored discussions that took place Sir Callum McCarthy: Not necessarily. The issues between Northern Rock and potential acquirers. that I have been dealing with I think are wider than that.
Q258 Peter Viggers: The Governor of the Bank of Q262 Mr Brady: The Governor of the Bank when he England has spelled out to us a number of statutory came before us was very specific, that he believed and regulatory matters which prevented a takeover there was the interaction of four diVerent pieces of of Northern Rock or an orderly solution to the legislation that caused diYculties in the response to problems of Northern Rock. Were you inhibited by the Northern Rock crisis: the Market Abuse those statutory and regulatory matters? Directive, the takeover code, the nature of the Sir Callum McCarthy: In relation to the acquisition insurance scheme and the way in which deposits are of Northern Rock by a potential acquirer, I do not frozen in the event of administration. The answer believe that those legal problems were particularly you were giving a few moments ago seemed to significant in relation to that possible outcome and suggest that you do not share that view? my recollection of the Governor’s evidence to this Sir Callum McCarthy: No. I am sorry, if I gave that Committee is that he was commenting on those legal impression it was not the impression I was trying to obstacles in relation to the lender of last resort. give. I was trying to reply to the earlier question in Mr Sants: We were quite properly identifying saying what are the issues, and two of the issues that potential private sector solutions prior to the need to I identified, namely the compensation scheme and apply to the Bank of England for a facility. In that what I described as bank insolvency but in fact prior period I do not believe that there were any another way of rephrasing it is the way you have barriers to those takeovers taking place in relation to rephrased it, are two of the four that were identified takeover rules. It would have been done in the by the Government. conventional fashion through the normal Mr Sants: It is clear there was no consumer framework. 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 Q259 Peter Viggers: You said in your memorandum those mechanisms for improving consumer to us that no acceptable structure for a takeover was confidence, which takes us back to the FSCS and the identified. What were the main barriers to such an bank administration scheme. I think there is a strong operation being successful? argument that says that we might not have had those Sir Callum McCarthy: I think there were two issues queues if consumers had had the confidence their which were significant in terms of the most serious deposits were safe. indication of support. One was the question initially whether the bidding bank would receive support Q263 Mr Brady: So do you share the Governor’s from the Bank of England, the second was the terms view that those four pieces of legislation need to be on which any support would be given and, as I think changed? the Governor has made clear and has elucidated in a Sir Callum McCarthy: I share his view that they are letter to the Chairman of this Committee, there was all important things to look at. a decision that it would be improper to give support to a bidding bank. There was subsequently clarity Q264 Mr Brady: In answering questions earlier that after the lender of last resort facilities had been about the Market Abuse Directive specifically, I announced for Northern Rock those would be think it was Mr Sants who was saying that the available on the same terms if Northern Rock were inhibition appeared to arise really on the part of the acquired by a new bidder. responsibilities on the Board of Northern Rock rather than the regulatory authorities or the Bank. Would that be accurate? Q260 Peter Viggers: Do you think that lessons have Mr Sants: The initial responsibility as to whether been learned about the Tripartite method of disclosure should be made undoubtedly rests with supervising banks and building societies? the board of a company, and in this particular case Sir Callum McCarthy: I think that one of the things they felt disclosure should be made. We had, as you that we need to do is undoubtedly to look at the say, no reason to challenge that conclusion they had lessons of the tripartite arrangements, and I am reached, that is absolutely right, and I would repeat particularly concerned about issues aVecting the point I made earlier. I think it was clear that there financial compensation and the need to have a bank could be sets of circumstances in which disclosure insolvency route which enables us to deal with a would have to be made and we ended up in one in bank in diYculty in a way which gives clarity and this particular case. certainty to its customers so that the probability of the anxieties that led to the queues for Northern Q265 Mr Brady: Is it your view that under Article 7 Rock is something that we can deal with. So I think of the Directive, which exempts central banks from those are very real issues. its provisions, that that exemption is— Processed: 30-01-2008 10:44:58 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG2
Ev 34 Treasury Committee: Evidence
9 October 2007 Sir Callum McCarthy and Mr Hector Sants
Mr Sants: Does not apply to these circumstances. have absolutely no responsibility for any of this at all. Who was in charge of this bank? Who was in Q266 Mr Brady: So there was no impediment on the charge of making sure this did not happen? Bank acting as a covert lender of last resort, except Sir Callum McCarthy: If I may be clear, I think both that it would not remain covert because of disclosure Hector and I have made it absolutely clear that the from Northern Rock? responsibility for supervising Northern Rock lies Mr Sants: Correct, in relation to the circumstances with the FSA, that is point one; and if that is not they were in and concerned as to the implication of clear can I now make it clear to the Committee. We that facility in terms of its magnitude and have also made it clear that we believe that there are implication for their profits forecast, and of course I things we need to look at again to make sure that we repeat this is all a moot point once the leak had discharge those responsibilities in a way which occurred. A more general point here might well be recognises the lessons that we should learn from that it is very diYcult going forward to imagine in Northern Rock. If you have taken the impression modern society that it would be that easy to keep a that we are avoiding responsibilities that are covert operation of that size covert for any length of properly ours, can I make it quite clear that we are time anyway. There are other obligations here, not. particularly to credit agencies. Q272 Mr Simon: I was not asking who is responsible Q267 Mr Brady: So do you think it would be sensible for supervising the institution; I was asking who is to look at changing the disclosure rules or not? responsible for this crisis, this fiasco, this debacle? Sir Callum McCarthy: I think the point that we both Which of the Tripartite Authorities ultimately was have been trying to make is, quite apart from the responsible the most? legal obligations, there are fundamental Sir Callum McCarthy: I am afraid that, rather like practicalities which are at least as important as the the Governor who answered the question, (I believe legal concerns. 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 V Q268 Mr Brady: So if the Directive had di erent and the Treasury, I will give the same answer. provisions it might not have helped? Mr Sants: It might not have helped, no. We are Q273 Mr Simon: Do you think the Tripartite expressing a view that it seems unlikely in the overall arrangements work? set of circumstances that prevail in the market-place Sir Callum McCarthy: I think that they do work. If I today that keeping an operation of this size and look at the exchange of information which has taken complexity covert for any length of time is realistic, place between the FSA, the Bank and the Treasury, independent of the standing of the Market Abuse I think that that exchange of information has been Directive. 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 Q274 Mr Simon: So as a Committee we are supposed it was decided that it would not be a viable to conclude that these arrangements worked and possibility, did your advice change within the that is why it all went so well? tripartite authorities? Sir Callum McCarthy: You are not supposed to Mr Sants: No, our advice had been consistent. In conclude that things have gone well. If I may say so, this set of circumstances if they transpired we would Chairman, you will come to whatever conclusions not wish to disagree with the company’s conclusion you come to. that was reached. Q275 Mr Simon: We are not likely to conclude that Q270 Mr Simon: Sir Callum, have you ever boxed? it worked very well, are we? Sir Callum McCarthy: Twice in my life. 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 Q276 Mr Simon: There was a run on a bank; the have consistently said “that is not a description that nation was a global laughing stock; and you say that I recognise”. I am going to present you with another the arrangements worked? description because it has also struck me that you Sir Callum McCarthy: Sorry, I have said that the may well be the Herol “Bomber” Graham of the Tripartite arrangements in terms of what was done financial services industry, a medium ranking British by each of the parties were clear in responsibilities, boxer who could not punch, who was the very and in relation to the FSA, for which I take antithesis of hard-hitting but upon whom it was responsibility, I believe that we discharged our impossible to lay a glove, you could not hit Herol responsibilities. I also believe—and I repeat this— “Bomber” Graham under any circumstances. It that we consider what has happened and particularly strikes me that during this fiasco the Governor and what happened in the supervision of Northern Rock the Bank have got it spectacularly in the neck up to the time that these problems developed, are whereas you, who actually were responsible for things that we have to learn lessons from and make looking after this organisation, this bank, seem to changes and respond to. Processed: 30-01-2008 10:44:58 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG2
Treasury Committee: Evidence Ev 35
9 October 2007 Sir Callum McCarthy and Mr Hector Sants
Q277 Mr Simon: Given that you have said the Q280 Mr Simon: That is what the Chairman arrangements worked, do you think they would have suggested. worked even better if one of the Tripartite parties Sir Callum McCarthy: Could I just make it clear that had had more responsibility than the others, if there if I knew of anybody within the FSA doing that I was somebody with whom the buck ultimately would fire them. stopped (presumably not you)? Sir Callum McCarthy: If I look at the decision to Q281 Mr Simon: Will you undertake to find out? extend facilities, it was a decision taken by the Sir Callum McCarthy: I have no reason to believe Chancellor on the basis of advice from both the that what you are suggesting has any truth. If I Governor and the FSA, and I think that there is discovered that it were true, I would take action. clarity of that responsibility. I am not quite sure what lies behind your question. Q282 Mr Simon: What kind of things would need to Mr Sants: What is true, if you look at the period happen to you to make you believe? Everybody else prior to the regrettable situation developing of the in this room knows that this has happened; you are queues outside the bank—and I think, as we have the only person here who does not believe it. What indicated earlier, there are a number of contributory would we need to do to convince you that this kind factors to that such as the limitations of the FSC of thing goes on and that your organisation that you Scheme and the Bank Administration Scheme which are supposed to be in charge of is doing this and has should be properly looked at—if you look at the been doing it so disgracefully that the Chairman of period prior to that and ask the question whether the Treasury Committee mentioned it to you right at something could have been done between the the top of his remarks and you just say, “I do not development of the global crisis which led to the know anything about it. I do not get involved in that freezing up of the access to liquidity and the bank sort of thing.” You are involved in that sort of thing. applying for its facilities, realistically the only Sir Callum McCarthy: If you could provide chapter solution to the disappearance of commercial credit and verse and evidence other than assertion, I would would have been the provision of some type of take it seriously. central credit. That is axiomatically true. There was a decision made not to do that, but if you look at the Q283 Mr Simon: But without chapter and verse and logical sequencing of events that is probably the only evidence you do not take it seriously? other thing that could have happened. A judgment Sir Callum McCarthy: I am afraid it is an assertion was made not to do that. Let us just be clear, in terms which is so contrary to the clear policy that is of was there an option that was not considered and established at the top of the FSA, and which has missed, then the answer to that is no. Were there been made absolutely clear, that I do not believe it is options which were considered and the decision true. I do not know if you want to add to that, made for wider policy reasons not to do them, then Hector? the answer to that is yes. It is not obvious to us that Mr Sants: No, I think you are very clear on our there is some action that could have been taken by position. the FSA in that period that would have led to a V di erent set of circumstances at the point the facility Q284 Chairman: How many press oYcers do you was leaked. have, Sir Callum? Sir Callum McCarthy: Do you know the answer? Q278 Mr Simon: Relations between the FSA and the Mr Sants: Not to the precise one. I think we have a Bank have been described recently as “poisonous”. quantum of ten to 15, about a dozen or so, covering V What do you say about that? a variety of di erent issues, which of course include Sir Callum McCarthy: I would say that I have a good retail issues and consumer communications. and clear relationship with the Governor. I believe Chairman: In your responses before next week in that Hector and senior colleagues work eVectively your letter to us, if you could look at that report that was in the Financial Times and give us your and well with their opposite numbers in the Bank, Y and it is a description which I in no way recognise. comments on it and consult your press o cers, that Mr Sants: I would say absolutely not true. would be helpful to us in our inquiry. George? Q285 Mr Mudie: I think there can be some criticism Q279 Mr Simon: I thought we would get to of not anticipating what happened before it “descriptions that you did not recognise”, which happened and your supervision role, but I would like reminds me of your answer to the Chairman, which to just push further on what you said, Hector, about I thought was disingenuous when he asked you there was a big option and you were working against about the spinners, you just said, “Spinners I do not a decision by one of your partners which was not to know anything about spinners.” Are you telling us put liquidity into the situation. That seems to me now, on the record, that either the FSA does not something that exacerbated and brought on the employ people who spin on its behalf or that it does crisis, which has not happened in Europe and has but you do not know anything about it? not happened in the States because the central banks Sir Callum McCarthy: No, I am saying if, as I believe behaved diVerently. Would you care to comment? is the import of your questions, you are suggesting Mr Sants: I think it is logically true and I have that the FSA goes around briefing against the Bank already indicated that, and I would agree with you, of England— from the narrow question of would we be in the Processed: 30-01-2008 10:44:58 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG2
Ev 36 Treasury Committee: Evidence
9 October 2007 Sir Callum McCarthy and Mr Hector Sants position we are now in with regard to Northern properly made sure, as the banks expected us so to Rock, it clearly is the case that if liquidity in smaller do, that those views were communicated on to the amounts had been made available to Northern Rock Bank on a regular basis. 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 Q289 Mr Mudie: And would you not agree that for of that particular institution, for the reason I have the Governor to spell out in written form in such a just said, namely the public markets were closed to lengthy way to this Committee the fact that liquidity it. Its problem was a liquidity problem—we have would not be given, when you all knew you were in discussed that—and therefore if it had been able to an advanced stage of a crisis, was not helpful? find a source of liquidity prior to applying for a Sir Callum McCarthy: I would point out that at the lender of last resort facility then it might not have time the Governor wrote to this Committee he knew needed to have done that, and that absolutely has to that there was the probability of a lender of last be case. 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. 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 Q290 Mr Mudie: But that is the point, if the a lender of last resort. You would have gone to the Governor knew that the various pieces of legislation market the same way as any other bank could have stopped him acting as a lender of last resort or gone, taken the money, freed yourself from your stopped a rescue of a specific institution, another short-term financial diYculties and got on with life, alternative would be to do what the Fed had done and we would not have had these queues and this and the ECB had done, and put liquidity into the crisis. system. What stopped the Governor doing that or Mr Sants: I think, as I have just said, I am agreeing what stopped it happening? with you with regard to the narrow point of Sir Callum McCarthy: Could I point out that on the Northern Rock. There are two particular ways that problems that the Governor identified of a legal could have been addressed, either a facility where nature, I think his points were specifically about that wider collateral should be more generally available, preventing a confidential covert lender of last resort. 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 Q291 Mr Mudie: Sir Callum, I understand all that, taken by the Bank in the context of their overall and I had words with the Governor, but it seemed to policy framework, as to your question for Northern me the Governor was saying, “I can’t do this; I can’t Rock, I think the answer is yes. do that” and my criticism of the Bank if England is, fine, if we accept all these arguments, what were you Q287 Mr Mudie: It goes beyond Northern Rock. Let suggesting you would do other than just watch the us take the Tripartite arrangements, did at any time crisis develop? The obvious thing, which was done the FSA, as part of that, raise the question of the within a week, is put liquidity into the system, and central bank putting some liquidity into the system since he has taken that decision, in fact the last generally? Yes or no? I think we are entitled to know tranche was not taken up such is the confidence of what the FSA’s view is. You have been hauled over the banks in liquidity. Does that not prove if that the coals today for a situation which was maybe decision had been taken earlier you would have been somebody else’s creation, so did you at any time spared this sort of inquisition and the Northern during these arrangements as the crisis developed Rock depositors would have been spared all that say this could be sorted if you come oV your high worry? moral platform and just do what the Fed did or the Sir Callum McCarthy: I am not sure if I can say ECB did? anything other than the point that Hector has Sir Callum McCarthy: May I make two points. One made— is I would point out— Q292 Mr Mudie: Well, Hector agreed with me! I will Q288 Mr Mudie: No, Sir Callum, just answer the settle for that. It is all right, Chairman, he is a question in terms of was this specific approach/ good man! strategy raised? Mr Sants: I think I said that the market agreed with Sir Callum McCarthy: One of the things that was you and we properly reflected the market’s views. done was, as you would expect us to do, after Mr Mudie: The market is king! meetings that were held at chief executive level with some of the major British banks where they expressed their views (meetings that were attended Q293 Chairman: Following Mr Mudie’s point, were by Bank of England oYcials) we reported the views you just an interface or did the FSA support the of those people very clearly to the Bank. banks in their plea for additional liquidity? Mr Sants: We clearly are very aware of our Sir Callum McCarthy: We made it quite clear to the responsibility to interface with the market. I think Bank of England the strength of feeling that was you rightly point out that the majority of the market being expressed, but I would say that I believe that held the view you have just described and we very that was well-known to the Governor. 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9 October 2007 Sir Callum McCarthy and Mr Hector Sants
Q294 Chairman: Okay, so let us get a straight United States obviously about regulation and also in answer, Sir Callum, we are looking for one this Europe. Given the fact that it has to be done morning, give us one. Did you support the banks in internationally, have you talked with your partners their plea for more liquidity? elsewhere about what is happening, and how quickly Sir Callum McCarthy: In terms of the position of the would it be moved forward so that we are not left FSA, the responsibility for making decisions on then several years down the line with still nothing monetary policy (of which this is one) lies with the being done? Bank and it is for them to make— Mr Sants: We certainly have been talking to our partners and I think, as you rightly point out, this is Q295 Chairman: Sir Callum, this is getting absurd, it not an issue that could be addressed nationally, not really is, because here we have a situation where least because these credit ratings agencies are not some people are saying if you had put extra liquidity even based here. in would not have had this run and we would not have had deckchairs outside the 76 Northern Rock Q299 Ms Keeble: Could you just detail the branches. We are just asking you in terms of an discussions that you have had and the timetable orderly and eYcient market (which is your for action? responsibility) did you support the banks in their Mr Sants: We had a discussion last month. There plea for more liquidity? Give us a “yes” or give us a already is a working group within IOSCO, which is “no” or say “we are not going to answer”, but make the main securities global co-ordinating agency, it simple. which had a meeting this month, and we are working Sir Callum McCarthy: Of those three choices, on taking forward those issues. They have a code of Chairman, I am afraid I am not going to answer practice and it was agreed in the IOSCO fora that we would be looking again at that code of practice to see Q296 Chairman: That is better, that is fine; it is on what lessons could be learnt from recent events. the record. There has also been debate here within the CESR Sir Callum McCarthy: Because in relation to the context and the European context as well. There will conversations that we had within the Tripartite be a number of diVerent strands but we will be group I think it is proper that they should be looking to take them forward as quickly as possible. conducted in private. International work does not happen as quickly as Chairman: It is dead easy, Sir Callum, if you do national work but I agree with you, it should be answer a question simply. We understand it now. treated as a matter of urgency. Sally? Q300 Ms Keeble: The code of practice is presumably Q297 Ms Keeble: In terms of going forward, to what voluntary. Given the issues that have been raised extent do you think the current problems in the about people not being aware of the risk and the credit market mean that there should be a re-think comments that you have made this morning about of the regulation of the credit ratings agencies? risk assessment, do you think there is a need for Mr Sants: I think we should definitely take a look at something more substantial and robust than a code our credit ratings agency regime. There are a number of practice? of diVerent issues around that. There is the perennial Sir Callum McCarthy: I think you will find since we one of course of whether or not the credit ratings are dealing with a limited number of credit ratings agencies conflict in the sense that they are being paid agencies that there will be no problem, once we by those who they are rating, but of course that issue identify what we want, getting them to accept it. I do has been around for some time, and there has been not think that is going to be a problem. a code of practice put in place by IOSCO which we supported. I think the question obviously that has Q301 Ms Keeble: Sorry, that kind of agreement been raised by more recent events is two-fold: one, between a small number of people can have other to some degree as to how eVective are their processes names other than a code of practice: it can be a in reaching the conclusions which they reach; and gentlemen’s agreement, a cartel, it can be all kinds of also, just as critically actually, how eVective are the things. If we are talking about transparency of institutions in using that information and fully information and certainty, do you think there is a understanding what it is they are being told about. need for something that is more robust? They are being told essentially about a credit rating, Sir Callum McCarthy: If we get a robust code of of course, not a liquidity rating, and I think there is practice I believe that we will be able to implement it also a risk to some degree that there has been far too eVectively. great a reliance placed on credit ratings by institutions and investors as a shorthand way of Q302 Ms Keeble: Okay. Do you think that there is a reaching quick judgments, and that is one of the need, and Hector you have hinted at this, for a look reasons why the market-place froze up, I think. again at the liquidity rules, because Northern Rock was within the rules and a number of other banks Q298 Ms Keeble: There are a couple of things. You have got similar profiles to Northern Rock? said that the issue about the conflict of interest Mr Sants: There are two separate points. On the between the advisory and the risk assessment credit agency point, we completely agree with you, functions are a problem that has about been around there is work needed to be done as to what use are for a while. There have been discussions in the the institutional investors making of credit agency Processed: 30-01-2008 10:44:58 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG2
Ev 38 Treasury Committee: Evidence
9 October 2007 Sir Callum McCarthy and Mr Hector Sants material, how do they engage with it, and is that things that Basle II will help with is a better properly understood and is there proper identification of the way in which risk can come back transparency with regard to the purposes and from that on to the major banks, and that, for backdrop to the conclusions of the credit agencies’ example, is an area where (quite apart from the work work. If—and I may be misunderstanding and I on stress testing which Hector described) that we will apologise if that is the case—you are referring back want to do a lot more work on. to my earlier comment about are we satisfied with Mr Sants: We should not underestimate the specifics the way that we approached the stress testing work of Northern Rock and the implications there for that was done in Northern Rock, I think I have made consumer confidence and the FSCS scheme of clear, no, we are not satisfied with that, and I think administration. The FSCS scheme is within the we need to address that, and that will be something I remit of the FSA and we have committed ourselves will place as a priority agenda from my point of view. to re-review that. Those issues to do with the wholesale market were components of what Q303 Ms Keeble: It was just that you referred a bit happened and at the end of the day I repeat the point earlier to the need for a look at the rules around that the retail run was the critical element that placed liquidity requirements to which the Governor also Northern Rock in the situation it is now in, but referred? absolutely, we need to look at a number of aspects Mr Sants: Yes. of the framework of the wider wholesale market. Sir Callum McCarthy: There is work going on, led by the Bank of England in the Basle Committee on Q305 Mr Dunne: I would like to probe a little bit trying to establish what should be the basis for a new further the comment you just made, Hector, liquidity regime. One of the diYculties about doing because, as you explained, the Northern Rock crisis that on a national basis, which goes back to Hector’s was essentially a liquidity problem, not a problem comment about it takes longer to do things with the asset base, and the problem stemmed internationally than nationally, if you look at any of internationally from the drying up of wholesale the major institutions which operate internationally markets due to the extreme uncertainty over they run their liquidity on a global basis and they are liquidity, security and value of AAA-rated oV very hostile to having separate national liquidity balance sheet paper. Do you agree that the wider regimes. We believe it is a good thing to try and get collateralised debt obligation market was the an international agreement on it, and that is what we primary trigger to the drying up of the wholesale are working to do, and that is what we will intensify market? our eVorts to do. Mr Sants: Yes, and I think your point identifies the Mr Sants: We should try to use the regrettable other aspect of this which was singular and unusual circumstances that have occurred to get fresh which is what actually happened as a result of the impetus behind that initiative. It is one that we have problems you have graphically described was the been supporting, and indeed the Bank of England mainstream institutional investors, who co-chairs the key Basle Committee here, but I think traditionally purchase commercial paper, which is a there is clearly an opportunity to use this regrettable fairly vanilla sort of product, lost confidence in the set of circumstances to put fresh impetus behind system, so it is a curious combination not just of the agenda. structural elements of actual credit failure but then we had a confidence failure in mainstream investors Q304 Ms Keeble: Obviously what everybody wants which then led to a liquidity problem. Of course your to make sure of is that this does not happen again. I analysis of the origins of this confidence failure is wondered how you see the risk if there is future fall- absolutely right, and I think that takes me back a out from the risks of the sub-prime market in the US little bit to the credit point that when they lost their and if you feel that you have got a proper assessment confidence, because these are very complex of where the risks are in the system, and if you have instruments (which I think takes us back to where we got a proper way of managing them. I think it comes were a minute ago) they were very nervous to go out back to perhaps some of the points that Sioˆn Simon and buy the related revenue flows dependent on was raising about who is going to take the lead on those complicated instruments. this and how are you going to make sure that you have got robust enough systems in place. So far you Q306 Mr Dunne: So when was the FSA first have only talked about the stress testing as being the concerned about price and risk within the CDO one real, substantial lesson that you have learned market? from this. Sir Callum McCarthy: I think you will find that the Sir Callum McCarthy: I think you raise a lot of very FSA has been concerned for some time about the big issues in your question. One is that we have long pricing of risk generally, because one of the recognised that risk is now much more widely problems that we have encountered over the last two distributed than previously through the origination years is, because of the extent of liquidity in the and distribution model that many banks adopt. One world, there has been a mispricing of risk, and that of the issues that has always concerned us was what has been repeatedly a point we have made. It applies was the mechanism for reconcentration of that risk. to CDOs but it applies more generally than that. The One of the things, for example, that has become clear work that we did for example on leveraged buyouts in relation to major financial institutions is their use was concerned about that and other pieces of work of conduits or special investment vehicles. One of the were also concerned. Processed: 30-01-2008 10:44:58 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG2
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9 October 2007 Sir Callum McCarthy and Mr Hector Sants
Mr Sants: And, as you know, we have done a huge confidence, particularly of CP purchasing, and we amount of work with regard to operational risk in need to be careful that we do not undermine some of relation to the credit derivative market, reflecting the beneficial aspects of the growth in the derivative our understanding that where you had a credit issue market as a result of looking at the lessons learned one potential knock-on eVect was operational from this particular period. concerns. This aspect of the crisis was not the unexpected part; it was the confidence— Q313 Mr Dunne: Within your risk management specialist teams do you have individuals who have Q307 Mr Dunne: In that case, you did not answer the direct experience of trading in these derivative question as to when you identified this problem? markets and understand the nature of security and Mr Sants: We were clear in our February Financial risk? Risk Outlook, which is one of our more recent Mr Sants: Yes. publications. I was clear, I believe, in the press conference in July. I believe my predecessors have Q314 Mr Dunne: Good. You have touched on the been clear in various other publications prior to that low probability of Northern Rock getting into really for the last couple of years that there was a diYculty given the quality of its loan book. Given significant build-up of risk in this area and a gradual the role that you have as banking supervisors, what mispricing of that risk that needed to be corrected. emphasis do you place on looking at a bank’s share price as a determinant of concerns in the market Q308 Mr Dunne: Had you discussed these concerns about its performance? Would you like to comment with the SEC and other international regulators? on the fact that the Northern Rock share price Mr Sants: Absolutely. declined some 40% in the period from April to the middle of August in a pretty straight line, against the Q309 Mr Dunne: Throughout this period? bank sector indices, as an early warning sign that Mr Sants: Yes. something was going seriously wrong? Mr Sants: Yes, I think that share prices are Q310 Mr Dunne: So why was nothing more done by indicators of a variety of diVerent potential issues yourselves and other international regulators to and should be scrutinised by regulators. Share prices slow the growth of this market if you had such also, may I say just in passing, impact retail fundamental concerns about it? confidence as well, so there is a variety of the reasons Sir Callum McCarthy: I am not sure what why we should be properly focused on the share mechanisms you believe are available to us to price. Clearly we saw acceleration of that trend with actually constrain global markets. the profits warning, to use a colloquial term, and we significantly intensified our regulatory engagement Q311 Mr Dunne: Possibly Basle considerations. with Northern Rock at that point. I completely Mr Sants: I have made the point that under Basle II agree with you that share prices should be closely the treatment of oV balance sheet capital in SIVs and monitored by regulators, and they are. conduits will be brought back and more accurately reflected, so that will be done. Q315 Mr Dunne: The business model of Northern Rock was heavily reliant, as we know, on the Q312 Mr Dunne: Are you saying that the regulators wholesale markets and you have just touched on have no powers to control the spread of derivative commercial paper. The commercial paper market is instruments, which are not well understood either by of a one to three-month duration typically. For a the market or by the regulators, there are no tools in bank as significant as this with long-term obligations your toolbox? stretching out many years in the mortgage market, Mr Sants: As a national agency there are clear do you think it is wise for funding sources to be so limitations on our ability to address those risks. reliant on the short end, and is this not one of the What we seek to do—and I think this is an fundamental tenets of bank practice that you do not explanation I oVered the Committee when we were borrow short to lend long? talking about financial stability earlier in the year— Mr Sants: To some degree of course, that maturity is to control and regulate the central transmission transformation does have its uses but actually in the mechanisms within the UK economy, which are the context of Northern Rock the figures do not suggest large banks and, as Sir Callum himself said, recently that it was an outlier in respect of its dependency on the large banks have gone into this period of market very short-term funding. We have discussed turbulence well capitalised and well set up to previously the fact that—and I am happy to go back withstand these market shocks. We also place over the ground if you would like me to—its bigger increased emphasis on our banking sector having risk factor was its dependence on the use of the eVective stress tests, which takes us back to where we securitisation products which was the market that were earlier in the discussion, but our ability to froze. The actual percentage of its funding which actually curtail the growth in OTC credit derivatives was dependent on three months or under was not a markets are clearly limited by our national—Indeed, particular outlier, and also just to remind us again, you have to argue it is debatable whether that is I think it is important to remember that it did not necessarily desirable given the wider arguments actually fail to fund itself is this period. What about risk dispersion. I think we need to be clear happened was its maturity shortened back into the here that what has happened was a collapse in overnight period to the point at which the Board Processed: 30-01-2008 10:44:58 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG2
Ev 40 Treasury Committee: Evidence
9 October 2007 Sir Callum McCarthy and Mr Hector Sants thought it prudent to seek the lender of last resort Mr Sants: In that particular case, I am fully aware of facility, and we are all aware of the regrettable the extremely small number of people in the FSA consequences of that in terms of consumer who had the information that it was possible the confidence, but it was not actually an outlier in Board might reach that conclusion, and I have respect of short-term funding ratios, it was an outlier already personally satisfied myself that they did not in respect of overall wholesale funding, as Sir make any communication with the press in that Callum indicated earlier, which included the period. securitisation component. Q320 Mr Dunne: So I should address that question Q316 Mr Dunne: If it is not an outlier, does that not to either the Treasury, the Chancellor or the Bank of suggest that there are many other banks that are England? overly dependent on short-term sources of funding Sir Callum McCarthy: Could I make it clear that and if these dry up there could be contagion across that would be a fair inference if those were the only the sector? people who had information and the assumption Mr Sants: I tread very carefully in this space, but of that any leak must come from one of the Tripartite course, as I have mentioned before, it was authorities is an assumption which I do not believe specifically the short-term funding failure which was is necessarily true. the problem here, it was the absence of the securitisation market, which is a widespread Q321 Mr Dunne: I will have the opportunity to ask phenomenon, and we need to remind ourselves they Northern Rock themselves next week. If you will were oVering good-quality paper, this was not a indulge me a little bit, Chairman, just turning to the Northern Rock-specific problem, and it is because specifics of the regulatory challenge that the they are an outlier in that respect that they put Northern Rock situation provided. As we have had themselves in a position where they became the first run on a bank for 150 years and you are the concerned. As a general point, you are right, and regulators responsible and this has come on your now we are back to our stress testing point, it has to watch, the hard-earned reputation of this country be right that our banking sector gives proper for its financial supervision is essentially at stake at consideration to having a diversified set of funding the moment. We have received evidence from the sources across the whole spectrum of maturity which Governor of the Bank of England that following his it properly gives consideration to even in extreme appearance before this Committee he sought to circumstances so that they can remain funded for a clarify discussions between the Tripartite reasonable duration of time. I am mindful of the Authorities in the run-up to the decision not to other point earlier, that we are not a regime that extend facilities to Northern Rock whilst they were guarantees there are no failures and we need in the midst of whatever discussions. He confirmed innovation in financial markets. To say that we specifically that before 10 September special should not have had securitisation would not be a facilities would not be made available to a purchaser good conclusion to draw from this. 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 Q317 Mr Dunne: Just changing tack a little bit and took place and that was a decision that was reached? picking up a point that Sioˆn Simon made, obviously Sir Callum McCarthy: I can confirm both of those. confidence in regulators is critical during a financial crisis. Has the FSA or other members of the Tripartite group leaked information to the press Q322 Mr Dunne: What attitude did the FSA take in during the course of the last month specifically in those discussions as to whether it would be relation to Northern Rock? appropriate to provide a facility to a purchaser given Sir Callum McCarthy: I do not believe that any that you had the most detailed knowledge of the member of the FSA has leaked any information to situation that Northern Rock was in? the press in relation to Northern Rock. 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 Q318 Mr Dunne: So are you suggesting then that requirements that we thought would have to be either the Bank of England or the Treasury leaked requirements from a potential bidder that would information about Northern Rock to journalists? have to be satisfied, so we identified what would have Sir Callum McCarthy: I am being rather careful to be done if a private sector solution was to be about taking the responsibilities which I have, which pursued. are for the FSA, and you should not infer from my statement that I am making any comment at all Q323 Mr Dunne: Was a request made by a potential about either the Treasury or the Bank of England. purchaser of Northern Rock for such a facility before 10 September? Q319 Mr Dunne: So if the BBC website was able to Mr Sants: Before 10 September, I was just going to report, for example, a decision by the Northern elaborate a bit and say I am clear in my mind that Rock Board as to their dividend announcement we properly discharged our responsibility to bring a recently before the board meeting had even started, private sector solution to the table, and that the only you would be prepared to investigate whether that one that was available was the one you correctly had come through the FSA? describe, which included public sector funding, and Processed: 30-01-2008 10:44:58 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG2
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9 October 2007 Sir Callum McCarthy and Mr Hector Sants
I do not believe any subsequent events, including the was a solution in sight, would that not have provided various discussions that had been going on, suggests suYcient confidence to depositors and the market there was some other solution out there that could alike to have prevented what we are now in which is have been reasonably found in the time in question. a calamitous situation where the whole regulatory We brought the only solution on the table, we made regime of the United Kingdom is in question? In clear what was required to deliver it and there was a terms of moral hazard surely that is a more decision by the Tripartite not to take that significant issue than allowing the bank to go to suggestion up. the wall? Sir Callum McCarthy: I go back to describing the Q324 Mr Dunne: But what was your position which is as I have described it and as the recommendation? Governor set it out in his letter to the Committee. Mr Sants: I think I am back into the answer I gave a little bit earlier. From the narrow perspective of Q328 Mr Dunne: I have got two more quick avoiding the set of circumstances with regard to questions. How many banks in other countries have Northern Rock which then transpired, clearly a requested similar liquidity facilities from their private sector solution at that point would probably regulatory authorities with no distress to their have avoided that outcome; I make that clear. depositors? Sir Callum McCarthy: Could I also add, because I Sir Callum McCarthy: I do not know that. I do know think it would be incorrect to regard the private that there have been at least two banks which have V sector solution as being a firm, cut and dried o er, had serious problems, one of which has resulted in a it was still at an exploratory stage and there were a bail-out and the other an acquisition in the US. number of other issues which would have to be There have been significant problems in the dealt with. Canadian CP market. There have been other Mr Sants: If it had been a firm approach it would problems in France in diVerent aspects of this, so have had to have been declared to the market, so we this has been a global problem. should be clear about that point. Q329 Mr Dunne: Are you aware of market rumour Q325 Mr Dunne: It is clear that it would have been that some 150 banks have applied to their regulators subject to shareholder approvals and regulatory around the world for special funding? approvals, et cetera, but it might have provided the Sir Callum McCarthy: All I would say is that the comfort to those who were both depositors and discussions that I have had repeatedly with shareholders in Northern Rock that there was a regulators in other major countries of the world give solution on the table, and even if it was a contingent me no reason to believe that figure. 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 Q330 Mr Dunne: Is it the case that had Northern to extend facilities at the end of that week. Do you Rock had a European subsidiary and was active in accept that had a diVerent decision been made by the the markets on Continental Europe, it would have Chancellor we would have avoided a run on the been able to apply to the EU facilities for suYcient bank? funding to deal with its liquidity crisis? Sir Callum McCarthy: No, the only diVerent Sir Callum McCarthy: It could have, I believe, decision by the Chancellor would have been to have through its Danish branch have done some things; it not extended facilities. was a question of the length of time that would take.
Q326 Mr Dunne: No, excuse me, there was the Q331 Mr Dunne: So that is a yes? opportunity—we have just discussed it—before 10 Sir Callum McCarthy: Sorry, I beg your pardon, I September when there was a contingent bid on the am not trying to be diYcult. table for the facilities that were extended a week later Mr Sants: If it had been set up to access the ECB to have been available to the bidder and had that liquidity provision it could have tendered diVerent happened there would not have been a run on the types of collateral to that which it would have been bank: question? able to so do in the UK. Sir Callum McCarthy: If there had been an oVer which had been carried through successfully, by definition, this problem would not have occurred. Q332 Mr Dunne: So that is another illustration of the V That must be true. failure of our system, in e ect, because had it been a slightly larger organisation, it might have been able to apply to the facilities that existed in Continental Q327 Mr Dunne: But any oVerer was not in a Europe? position, given the constraints in the credit markets, Sir Callum McCarthy: If it had had the capability of to be able to take potentially up to £100 billion or so organising its assets in the right form. 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 Q333 Mr Dunne: Looking forward, there is contingent and so you could not have had a considerable concern in the markets as credit completely deliverable bankable proposition, but in conditions remain tight that another institution terms of providing comfort to the markets that there might fail. How comfortable is the FSA about the Processed: 30-01-2008 10:44:58 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG2
Ev 42 Treasury Committee: Evidence
9 October 2007 Sir Callum McCarthy and Mr Hector Sants renewal of borrowing facilities for smaller lenders enables us to oVer assistance and so what we did, dependent on wholesale funding and how confident which is what we are required to do, was to try and is it that we will not see another failure? identify what would be needed, and a decision was Sir Callum McCarthy: I think the answer that both taken that it was inappropriate to proceed on that of us have given to the Chairman in terms of not basis. commenting on individual institutions is one I go back to. I would repeat that, on the whole, the Q339 Chairman: The reason why I am asking this, British banking sector is well capitalised and has had Sir Callum, is very simple, the authorities did not the benefit of five years of very good, profitable agree to do this and, as a result, the taxpayer is now business. at risk for £9 billion secured on mortgages which the Bank would never normally accept as adequate Q334 Chairman: Sir Callum, just a couple of collateral, so other than lending to, say, a bank that questions arising from that. You raised the issue of came in—and from the name of the bank that came takeovers and there have been banks in the news in it indicates that they are one of the world’s largest allegedly wanting to take over Northern Rock. and best capitalised banks—the taxpayer has this There are two issues here: the bidding bank receiving risk now. If you are interested in orderly markets support and the terms of that support. Were you in and seeing them function eVectively you should have agreement with the banks on the parameters that a view on it, Sir Callum. V V should have been o ered or should be o ered on Mr Sants: You could say— these two issues? Sir Callum McCarthy: In terms of the discussions that weekend? Q340 Chairman: If you are not going to answer the Mr Sants: I think we are back to the answer, at least question tell us and then it is on the record. from my point of view, that I have already proVered Sir Callum McCarthy: I do not think I have anything that we made clear what the terms were—and they else to say. were indicative terms if I may just say—that would Chairman: So you are not going to answer the possibly lead to the discussions becoming more question. Okay, you are not going to answer it. serious, and those terms were declined by the There are three or four people who want to finish up Tripartite. on the Northern Rock thing before we go on to others, so Colin, Mark, George and Michael Q335 Chairman: Let us make it simple: did you agree quickly. no support or did you agree the terms of the support? That is really what we are looking for. It is a “yes” Q341 Mr Breed: We have got the problems of answer or a “no” answer or “no answer”. liquidity and all that sort of thing and hopefully for Sir Callum McCarthy: The Tripartite decision was the next few months that might calm down. that it would be wrong to advance assistance to the However, is there not a real further problem on the bidding bank. It was subsequently made clear after horizon that if the pricing of risk becomes stricter, if the lender of last resort facilities had been made we have more write-oVs, if we have lower profits, as available to Northern Rock that those facilities seems likely, then capital adequacy rules are going to would remain available to a bidding bank, if there be under real pressure, and we are going to find were a bidding bank. ourselves in a few months’ time with many lending institutions finding themselves up against capital Q336 Chairman: So you were in agreement with the adequacy rules, which is going to produce another Bank of England on those two issues regarding the potential crisis all the way through? parameters which should be oVered, namely the Sir Callum McCarthy: We have clearly been much bidding bank receiving support and the terms of that concerned to look forward as to how this will support; you were at one with them? unwind. We have been particularly concerned, as Sir Callum McCarthy: We explained what would be have our counterparts in other countries, to look at required if things were to go forward. the eVect of bringing back on balance sheet the assets which are at the moment in conduits and special Q337 Chairman: So you were at one with them, Sir investment vehicles. I have no doubt that there will Callum, you were at one with the Bank on that? be pressure on capital, but equally I go back to the Mr Sants: It was not our decision. fact that these banks are well capitalised and that they have the benefit of— Q338 Chairman: This is a “no answer” again. This is getting really, really unsatisfactory. You are one of Q342 Mr Breed: They are well-capitalised under the Tripartite Authorities but what seems to us here, existing rules and existing risk profiles. Once you Sir Callum, is that you are crawling into your den apply those stricter risk profiles, once they have and you are not answering anything, and if we want lower potential profitability, once we have higher to sort out this issue and this problem for the future write-oVs, all of which will aVect the capital base as we really need to know what one of the eminent well as bringing in the new rules next year, are we not authorities thinks, so is that another no answer? going to find that a significant—and I am not talking Sir Callum McCarthy: I am trying very hard, about the very big banks, of course they are— Chairman, to answer your questions as clearly as I number of potential lending institutions, and I am can. The FSA does not have a balance sheet which not going to put it much higher than that, are going Processed: 30-01-2008 10:44:58 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG2
Treasury Committee: Evidence Ev 43
9 October 2007 Sir Callum McCarthy and Mr Hector Sants to find themselves up against capital adequacy rules Mr Sants: I would just add, because you noticed me which they will not be able to meet and they will not nodding, we have a role in consumer confidence, we be able to find the capital to continue? have a role here to communicate with your Sir Callum McCarthy: I do not believe that that is constituents, with the customers, and clearly I think the central case at all. the messaging was not very eVective. Our phrases along the lines of “this bank is solvent” and “lender Q343 Mr Todd: You can correct me, Sir Callum, but of last resort”, this type of terminology— I recall you described the behaviour of he people in the queues to take out their money from Northern Q346 Mr Todd: Were not understood? Rock as being “irrational”. I think that is right. Mr Sants: It is a technical terminology and there is Sir Callum McCarthy: Could I correct you, if I may, a challenge here for us to connect properly with the because I have huge sympathy with the anxieties of consumers and there is a consumer confidence issue the people who queued on that Friday, Saturday that goes into the communication. (and would have queued on Sunday) and queued on Monday. The comment that I made was made only Q347 Mr Todd: Can I just interrupt and say one of after the Chancellor had given his guarantee and at the reasons why other banks have chosen not to take that point the situation absolutely changed. As from up the oVerings of the Bank of England’s rather 5 o’clock, or whatever the time was, on 17 September penal liquidity is partly because they quite readily there was no purpose in anybody queuing because understand the signal that might possibly give to there had been a clear and absolutely unequivocal their customers of doing such a thing, so I think what guarantee given by the Chancellor. That changed the is required is a better understanding of the event and I did say that there was no rational cause mechanics of decision-making that consumers take for anybody after that statement to queue. in these sorts of matters, is it not? Mr Sants: Absolutely. Q344 Mr Todd: And I think we all agree with that Mr Todd: Good, okay, that is fine. but you made no comment on their behaviour before that point? Q348 Peter Viggers: Is your supervision of banks, Sir Callum McCarthy: Absolutely not. exercised jointly with the Treasury and the Bank of England, weakened by the ability of banks to have Q345 Mr Todd: Fine. One of the things that certainly access to the European Central Bank or other struck me out of this whole exercise was that external financial facilities? however we discussed this issue, the reaction of the Sir Callum McCarthy: No, I do not believe that our consumer was not properly predicted or understood, supervision is in any way weakened by that. It is and that the signals given by actions taken by the important that we should understand whether any Bank and yourselves were not properly understood particular institution does have access because it always by the consumer who had their money aVects the liquidity available to them. 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 Q349 Mr Simon: Sir Callum, I have revised my view, both the information that consumers require to you are not the Herol “Bomber” Graham of the properly appraise the risk of what they are doing and financial world; you are the Sugar Ray Leonard of also what the consumer understands the the financial services sector; a world-class ducker responsibilities to be of various people who regulate and diver, bobber and weaver, but let me try one last the institutions in which they place their money? straight left, if I may. You said that if the person who Sir Callum McCarthy: I agree entirely with that line briefed the FT against the Bank that day turned out of argument. I would make one point that one of the to be from the FSA you would sack them. Given things that was particularly diYcult in relation to how glib and dismissive you have been about this Northern Rock was the sheer logistics. It had 72 before this Committee today, if that person can be branches which normally were very small, perhaps shown to have been from the FSA will you not only with a couple of counters, you had oYces where if sack them but sack Mr Sants and resign yourself? you got as many as ten customers arrive there was a Sir Callum McCarthy: First of all, can I make clear queue outside. You had a problem about the band that I do not believe that I have been glib. If I have width of their Internet banking. Everybody who been glib I apologise to all this Committee. I have actually got to the front of the queue got paid oV at tried very hard to deal with very serious issues as 100 pence in the pound and everybody who got seriously as I can, so can I just put that on the record. through on the Internet got their money out. I think Mr Simon: From what the Chairman has said and I the logistics were a problem but much more widely have said that it is very obvious to all of us that this than the logistics was a general problem of first of all briefing against the Bank has clearly happened and the fact that the compensation scheme only gave you it has clearly come from the FSA, you have just said 100% up to the first £2,000 and also the need for a “Not true, I don’t believe a word of it. It simply is not facility which produces rapid pay-oVs rather than the case. Unless you can prove it I am not having people having to wait for an extended period. I think anything to do with it.” If that is not glib, what is it? all those are questions that we have to address and if we address them I think people should have greater Q350 Chairman: I am writing to the FSA and that confidence in comparable events. will be public information. Processed: 30-01-2008 10:44:58 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG2
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9 October 2007 Sir Callum McCarthy and Mr Hector Sants
Sir Callum McCarthy: Can I just be clear, Q354 Mr Fallon: So you do not accept responsibility Chairman, that I have said that if I found that any for this fiasco? member of the FSA had briefed against the Bank I Sir Callum McCarthy: I am sorry, I accept would fire them, and I do not regard that as a glib responsibility in the terms in which I have set it out remark nor an irresponsible remark. because I think there are things which the FSA had responsibility for which, as we have both made clear, were not done well enough. Q351 Mr Simon: The question was whether you would resign yourself having been so glib about it Q355 Chairman: Sir Callum, I looked at the FSA today. Annual Report which you have given us and in table Sir Callum McCarthy: I am sorry, I have repeatedly 5.2 on page 56 is a list of those attending the Risk said I do not regard myself as having been glib. Committee. Everyone has full or perfect attendance Chairman: I got the feeling that you want you can on that Risk Committee other than Sir John Gieve, come along here resigning, Sir Callum, we have still who attended only two out of four of the Risk got an inquiry to be getting on with, so do not worry Committee meetings. In your correspondence to us about that. Andrew? will you indicate exactly what dates Sir John missed those Risk Committee meetings please? Q352 Mr Love: I am still trying to search out the Sir Callum McCarthy: If you would like me to I will essence of the Memorandum of Understanding certainly, sir.7 between the three diVerent organisations. We have pressed on is there a leadership role for one of them Q356 Chairman: Thank you. The FSA handbook in certain circumstances and that does not seem to incorporates the concept of approved persons, apply. We have also been pressing on who takes including executive and non-executive directors; am responsibility and it would appear that what I correct? happens is each of the three organisations runs away Sir Callum McCarthy: Yes. from things that are not its responsibility. You have said quite clearly in response to all the questions that Q357 Chairman: In assessing fitness and propriety that is the responsibility of the Governor of the Bank the FSA has regard to competence and capability; of England. Is there a role for collective correct? responsibility and would the Memorandum of Sir Callum McCarthy: Yes. Understanding work better if there was some collective spirit amongst the three organisations? Q358 Chairman: So do you regard the Northern Sir Callum McCarthy: If I look at what we have been Rock Board as competent and capable and do you trying to do since these problems generally still regard them as that given that all these members developed in August, and in relation to this period are still at the driving wheel? of Northern Rock, I think there has been very close Sir Callum McCarthy: As you say, we authorised, as and collective work. That is point one. Point two: the we authorise non-executives and executives of major point I have made repeatedly is that there are certain banks, all those people. We took a view on the decisions which are not decisions for the FSA but are overall corporate governance, and I would point out decisions for the Bank of England where we have the that for example the Risk Committee or the responsibility to give information, and I believe that Liabilities and Assets Committee of Northern Rock we have done that, and where we may express views was actually chaired by an extremely experienced to the Bank, but those views, I am afraid, I am going banker. We looked at all that. We will of course, to keep private, and that is I think the position that whatever the shape that Northern Rock evolves I have, I hope, explained repeatedly. into—and there has been an announcement this morning in relation to that—wish to look at the Q353 Mr Fallon: Sir Callum, you have implied this continued authorisation that we have granted, as we morning that you have discharged your do with all people. responsibilities throughout properly with a rather feeble caveat where I think you said you should have Q359 Chairman: Okay, if I could just ask you that been “more forceful a little earlier”. Can I put it to again: do you regard all the Board on Northern you that you have been responsible for supervising a Rock at the moment as competent and capable? bank whose business model you yourself described Sir Callum McCarthy: We believe that they were as “extreme” that then became completely illiquid, properly authorised under the processes that we had. was then subject to the first run on a bank for 150 years, has now in eVect been nationalised, with all Q360 Chairman: Again, is this a non-answer, Sir the damage to the British banking system that results Callum? Were they competent and capable? It is a from that. Is it not the case that the FSA has very simple question. fundamentally failed in its supervisory duty? Sir Callum McCarthy: They met our authorisation Sir Callum McCarthy: No I do not think we have criteria, including the criterion of competence. fundamentally failed in our supervisory duty. I think we have discharged our duties in particular ways and Q361 Chairman: So they were competent and I think, as both Hector and I have repeatedly made capable? clear, that there are absolutely things that we have to do diVerently and better than we have done. 7 Ev 225 Processed: 30-01-2008 10:44:58 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG2
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9 October 2007 Sir Callum McCarthy and Mr Hector Sants
Sir Callum McCarthy: Under the terms of the Mr Sants: Yes. authorisation, yes. Q370 Chairman: So we can forget your first negative Q362 Chairman: Does that mean you thought they answer there; it was too short? were competent and capable and Mr Sants thought Mr Sants: I thought you were asking about general they were competent and capable. For God’s sake, supervisory lessons. give us an answer. Sir Callum McCarthy: Sorry, neither of us was in Q371 Chairman: It is Northern Rock we are on any way involved in the individual decisions. about. Mr Sants: I beg your pardon. Three years should Q363 Chairman: But the FSA thought they were have been a shorter period. competent and capable? Mr Sants: Clearly the FSA did and where we stand Q372 Chairman: That was a trick question. Thank at the moment, just to be quite clear, in respect of the you. Basle II liquidity requirements need current situation that Northern Rock is in we deem modernised; is that correct? that it is appropriate for them to remain in place and Mr Sants: Basle II and liquidity is a diVerent point. I think that would be a readily understood point that The overall international liquidity regime needs in these sorts of circumstances it is useful to have a modernising. management team who are fully understanding of Sir Callum McCarthy: Something which we are the set of circumstances the firm is in. already working on.
Q364 Chairman: We are pulling teeth to get the Q373 Chairman: Okay. You perhaps took a diVerent answer, Sir Callum, we are focusing on Northern view from the Governor on the four pieces of Rock and we will come back to you in terms of the legislation? non-Northern Rock issues with the FSA, but maybe Sir Callum McCarthy: Sorry, I think the main some of my colleagues would like to ask a quick diVerence which we have discussed is whether the question to you on that. I do not think we will give problem of a covert lender of last resort is a legal due justice to it given the amount of time we have problem or a practical problem, and we would place spent on Northern Rock, but if I can try and sum up greater emphasis on the practical problems whilst what you have said to us this morning you would say not neglecting the legal consequences. the lessons learned are: the FSA needs to push the extreme stress testing in banks; is that correct? Q374 Chairman: So perhaps you had a diVerent Sir Callum McCarthy: Yes. view. Sir Callum McCarthy: A slight diVerence of Q365 Chairman: So there was an element of emphasis. supervisory failure in that? Sir Callum McCarthy: In terms of not pushing it Q375 Chairman: That is fine. In terms of supporting further than we did, we should have done more, yes. the banks for more liquidity and in takeovers supporting the bidding bank and the terms of Q366 Chairman: So it was inadequate, that is fine. supply, that question remains unanswered here? There is also low consumer confidence in the Sir Callum McCarthy: Yes. authorities; you have said that. I picked that up as I went along. Q376 Chairman: The Tripartite system in your Mr Sants: As was demonstrated by the events opinion worked, everyone played their part? surrounding the announcement of the lender of last Sir Callum McCarthy: Yes. resort facility. Q377 Chairman: So the question I have got then is if Q367 Chairman: Okay. There are problems with the the first bank run for 140 years is success, what is Financial Services Compensation Scheme deposit failure? protection; that is correct? Sir Callum McCarthy: Sorry, Chairman, I do not Mr Sants: Yes. think that any of us has described what has happened in terms of a success. You manifestly have Q368 Chairman: Okay. The three-year period not as a Committee and we manifestly have not. between the full regulatory analysis of “high impact” firms is too short? Q378 Chairman: You are telling us everything Mr Sants: No, I said in specific regard to Northern worked, the Tripartite system worked, and yet we Rock that period proved to be too short and we need have had the greatest cock-up for 140 years. to do a lessons learnt exercise more generally on the Sir Callum McCarthy: We have had a problem of implications for our overall supervisory regime. global lack of liquidity which has resulted in this country in one bank—a major bank—having an Q369 Chairman: We are talking about Northern acute liquidity problem and there have been Rock this morning. You said it was too short for problems, as I have pointed out, in other countries Northern Rock. round the world. Processed: 30-01-2008 10:44:58 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG2
Ev 46 Treasury Committee: Evidence
9 October 2007 Sir Callum McCarthy and Mr Hector Sants
Chairman: Okay, we will be coming back to these Q381 Chairman: We understand that. Could I finally issues and we look forward to your correspondence quickly ask you about inherited estate. How certainly before next Tuesday. We are coming back important on the list of FSA priorities is the £14 to other non-Northern Rock issues but have any billion up for reattribution in the Prudential and colleagues any particular questions on it just now? 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 Q382 Chairman: Do you accept that policy holders would be dismayed if the outcome of either of these the sale and rent back schemes, which are not part of V your remit currently but are becoming increasingly two reattributions left them as badly o as the AXA important. There are complaints about them but policy holders? also I have had clear evidence of diYculties with Mr Sants: I think there are some serious questions to be addressed and we are in the middle of doing that them. Do you have concerns and do you foresee and, as I say, I yesterday indicated that I wished to being able to regulate those? take a direct personal interest in the matter and I will Mr Sants: As you know, I have only taken on this happily return to the Committee with the remit at the end of July having previously been on conclusions I draw. the wholesale side. I am fully aware of the concerns that have been raised and have seen that— 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 Q380 Chairman: You are going to have a letter on that would be very helpful. Sir Callum, Hector your desk from me on that. Sants, thank you very much for your evidence this Mr Sants: I have had a briefing on that and I think morning. We will be having you back on the Annual it should be looked at. I will have to send you a letter. Report questions, and no doubt we could have you To be frank, I have been looking at some other back on this issue, but thank you very much for things but I will come back to you. your answers. Processed: 30-01-2008 10:46:46 Page Layout: COENEW [SO] PPSysB Job: 386890 Unit: PAG3
Treasury Committee: Evidence Ev 47
Tuesday 16 October 2007
Members present
John McFall, in the Chair
Mr Graham Brady Mr Andrew Love Mr Colin Breed Mr George Mudie Jim Cousins Mr Sioˆn Simon Mr Philip Dunne John Thurso Mr Michael Fallon Mr Mark Todd Ms Sally Keeble Peter Viggers
Witnesses: 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, gave evidence.
Q384 Chairman: Good morning and welcome to our year of the risk of tightening in the credit markets inquiry into Financial Stability and Transparency. and we expected that our good credit quality and our Can you introduce yourselves, please, for the diverse funding platform would stand us in good shorthand writer. stead under those circumstances. Sir Ian Gibson: Ian Gibson, I am a Non-Executive Director and Senior Independent Director at Q390 Chairman: So when were you aware of the Northern Rock. risks? What date did you really start discussing the Dr Ridley: Matt Ridley, I am Chairman of risks to the business? Northern Rock. Dr Ridley: As I say— Mr Applegarth: Adam Applegarth, I am Chief Executive. Q391 Chairman: When did you start discussing the Sir Derek Wanless: Derek Wanless, Non-Executive one that got you into this jam? Director. Dr Ridley: I started discussing it with the Chief Executive on 10 August, the day after the markets Q385 Chairman: Good morning to you. Mr Ridley, first froze, and during the next few days we discussed how were you given the Chairman’s job? it in increasing detail as it became clear that this Dr Ridley: The Board chose me as Chairman three freezing was less and less and likely to be temporary. years ago. I had been on the Board for 13 years Chairman: Okay. Michael? before that and in 2004 they chose me as Chairman. Q392 Mr Fallon: Dr Ridley, you wrote to Members Q386 Chairman: What competences and experience of Parliament on 24 September saying: “We have no did you bring to the job? sub-prime loans.” Can you explain why this Dr Ridley: I am a businessman and I am on a number advertisement appeared by Northern Rock saying: of diVerent boards involving a number of diVerent “Open for sub-prime business” in the summer? businesses. I had spent at that point ten years on the Dr Ridley: Yes I can. Board of Northern Rock, including during the transition from a building society to a bank. Q393 Mr Fallon: Including an advertisement for Q387 Chairman: Were you involved in any banking “sub-prime products, dedicated sub-prime businesses? underwriting and processing teams: call our sub- Dr Ridley: Apart from Northern Rock I was not prime support unit”. How can you say that you had involved in any other banking businesses. no sub-prime loans? Do you know what is going on in your bank? Q388 Chairman: Are you at ease with the business Dr Ridley: Yes I do. We introduce sub-prime loans model that Northern Rock has adopted? to a third party. We do not hold those sub-prime Dr Ridley: The Northern Rock business model was a loans on our balance sheet. good one in that it allowed us to achieve good credit quality on our loan book and steady growth for a Q394 Mr Fallon: So the statement “We have no sub- number of years. That business model proved prime loans” can be reconciled with saying “Open unable to cope with an unexpected, unpredicted for sub-prime business”, can it? seizure of the money markets in August. Dr Ridley: Yes it can. We are an introducer of sub- prime loans to a third party and that is what that Q389 Chairman: Were you aware of the risks to the advertisement is about. business at any time? When did you start becoming aware of the risks to the business? Q395 Mr Fallon: You make money out of sub-prime Dr Ridley: I was fully aware of the risks throughout. loans then? We have a Risk Committee and we are continually Dr Ridley: We have made a small amount of money assessing the risks to the business and stress testing out of a very small range of sub-prime loans during against diVerent risks. We were aware earlier in the this year. Processed: 30-01-2008 10:46:46 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG3
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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 expected that as markets became tighter and as thought you were a journalist. You have a sub-prime pricing for risk changed that low-risk prime UK business? mortgages (and we have below half the industry Dr Ridley: I said in my letter that we have no sub- average of arrears on our mortgage book) and such a prime loans; it is true—we introduce sub-prime low-risk book would remain easier to fund than sub- loans to a third party. prime mortgages elsewhere. That is why we were very determined to keep the credit quality of our Q397 Mr Fallon: So you are running a sub-prime book high, in order to be able to attract funding. business? Dr Ridley: We have no sub-prime loans on the Q403 Mr Fallon: But a very high proportion of your balance sheet of Northern Rock. funding was dependent on the capital market, a much higher proportion than other lenders? Q398 Mr Fallon: Mr Applegarth, why was it decided Dr Ridley: We were dependent on, as I said, the a month after the first profits warning, as late as the wholesale markets but also the securitisation market end of July, to increase the dividend at the expense and the covered bond market. We deliberately of the balance sheet? diversified our funding platform so that we would Mr Applegarth: Because we had just completed our have those three diVerent types of funding and Basle II two and a half year process and under that, indeed a diversified programme within the wholesale and in consultation with the FSA, it meant that we funding, and geographically we had programmes in had surplus capital and therefore that could be the United States, Europe, the Far East, Canada and repatriated to shareholders through increasing the Australia. That was deliberately so that if one dividend. market closed we would still have access to others. The idea that all markets would close Q399 Mr Fallon: Was that not exactly the wrong simultaneously was unforeseen by any major time to weaken the balance sheet? authority. Mr Applegarth: No, what hit us was a liquidity squeeze, not a credit crunch, and really dividends Q404 Mr Fallon: But a heavily leveraged bet on the and capital are to do with credit. It was a global movement of interest rates and on capital markets liquidity squeeze that hit us. remaining open for an over-exposed model like this seems to me a fairly basic banking error, is it not? Q400 Mr Fallon: You do not now regret that Dr Ridley: We were subject to a completely decision? unpredicted and unpredictable closing of the world Mr Applegarth: It was a very sound decision. It had credit markets. Our model was entirely transparent no relation to what hit us. What hit us was the to the market and to the regulator. It was discussed freezing of global liquid markets. regularly with both and it was not at the time seen as running a particularly high risk in terms of liquidity. Q401 Mr Fallon: Your business model, Dr Ridley, was described by the FSA Chairman as “extreme”. Q405 Mr Fallon: But it was your duty as Chairman You were borrowing 75% of your funding from the and as a Board to ensure that your bank was liquid. capital markets; you failed to insure against any Dr Ridley: We reviewed liquidity regularly and we increase in the inter-bank rate; you failed to hedge reviewed our policy on liquidity and our policy on the period between taking out a mortgage and its funding regularly. completion, because presumably you thought rates had peaked. This was not banking; this was a heavily leveraged bet on interest rates was it not? Q406 Mr Fallon: But you were wrong? Dr Ridley: I think it is worth clarifying what the Dr Ridley: We were hit by an unexpected and funding side of our balance sheet was. It is true that unpredictable concatenation of events. we had a smaller retail deposit book than many other institutions, although there are many like us Q407 Mr Fallon: So you are the Chairman of a bank overseas. As the Chairman of the FSA also said, in that ran out of money and that caused the first bank terms of the short and medium term wholesale run in this country for 150 years; you have had to funding, as a ratio of our balance sheet assets, we borrow billions of pounds of public money from the were not an outlier. Most of our wholesale funding Bank of England; you have damaged the good name was in the form of securitised bonds and covered of British banking; why are you still clinging to bonds, which are long-term funding. The average oYce? maturity is longer than the average life of a mortgage Dr Ridley: I would like to say that what has on our books. happened has been extremely distressing to us, as it has been to our other stakeholders, shareholders, Q402 Mr Fallon: But why did you not see the risk of employees and creditors. In view of what has capital markets closing to you? Why did you not happened I am extremely keen to try and turn the insure against the danger of illiquidity? situation round and develop a stable future for Dr Ridley: We saw that there was a risk of tightening Northern Rock. I am working night and day to in the credit markets and we prepared for that. What achieve that. I serve at the behest of the Board and we did not expect was that there would be no flight if they think that they can do better by asking for my to quality in that process. In other words, we resignation, it will be available to them. 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16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Q408 Mr Fallon: But this is a humiliation. Has none have a successful strategy, is that correct, or of the Board any sense of honour? Has nobody otherwise you would not have found yourself in this oVered to resign? position? Dr Ridley: I would like at this point perhaps to Dr Ridley: We were not warned of a complete suggest that Sir Ian Gibson answers that question. freezing of all global liquidity markets.
Q409 Chairman: No, you answer it Dr Ridley, that Q417 Chairman: Let me just read it to you again. It is what you are here for. says here “ . . . how participants can be hit by sharp Dr Ridley: Yes indeed, I was going to say I will give reductions in market liquidity”. If that is not a red a quick answer to it first. I have made it clear to the alert warning I do not know what is a red alert Senior Independent Director, as is his role, that my warning. resignation is available to him as soon as he thinks it Dr Ridley: There were sharp reductions in liquidity is in the interests of the company, its shareholders, after 9/11 in 2001. That lasted for a matter of days. creditors, employees and other stakeholders that I Our model was extremely robust in those conditions. go. What was not expected was that all global markets would shut down and remain shut down for as long Q410 Chairman: You did say that you discussed the as they have. risk on this issue with the Chief Executive on 10 August; that is correct? Q418 Chairman: So really what you are saying to us Dr Ridley: Correct. is that the corrective action you took from April, if there was corrective action, was not suYcient to Q411 Chairman: And that this was unpredicted. You avert this crisis? have said that two or three times to Mr Fallon. Dr Ridley: The corrective action we took from April Dr Ridley: Yes. was designed for a tightening of the credit markets and a tightening of liquidity in those markets; it was Q412 Chairman: But were you aware of the Bank of not designed for a complete shutdown of the England’s April 2007 Report on Financial Stability global markets. and were you aware of the Financial Risk Outlook from the FSA in January 2007? Q419 Chairman: It said “sharp reductions in market Dr Ridley: Yes, I was aware of both of those reports. liquidity”. In other words, it is a real warning and you did not seem to take up what that meant and Q413 Chairman: Did it influence Board decisions? therefore found yourselves in this humiliating Dr Ridley: It did influence Board decisions. position on 10 August. That is really the answer to the Committee. Q414 Chairman: What did you do from January to Dr Ridley: We were in constant dialogue with the April? FSA. Dr Ridley: We did a number of things. We prepared Chairman: We will go on to that later on. The main to sell some of our asset books, as you will know point is made there. Colin? because of announcements we made at the half year—our commercial loan book and our unsecured Q420 Mr Breed: Mr Applegarth, can you just loan book and— confirm a few things. Did you and do continue to lend up to 125% of the value of the property Q415 Chairman: I would suggest to you, Dr Ridley, valuation on mortgages? you failed because if you look at the Bank of Mr Applegarth: No, we lend secured up to 95% but England statement it is very clear, in late April it says then we also sell unsecured lending as well. that: “Recent developments in the US sub-prime mortgage market have highlighted how credit risk Q421 Mr Breed: So the total borrowing that assessment can be impaired in these markets and somebody has can be as much as 125% of the how participants can be hit by sharp reductions in underlying value of the security? market liquidity. It is important therefore that firms Mr Applegarth: It could but only 95% is actually stress test and we take them into account . . . ” That secured against the property. was in April so what you did from April to 10 August seemed to have no eVect whatsoever on the Q422 Mr Breed: And do you lend up to five or six position that you found yourself in, so you did not times the income of an applicant? take corrective action that was successful? Mr Applegarth: Theoretically yes, but it has to be a Dr Ridley: As you say, that report was about the very high-quality applicant to get that loan. It pricing for credit risk in the markets as well as accounts for about 1% of our lending. liquidity and we ensured that our funding was— Q423 Mr Breed: Do you consider the lending Q416 Chairman: But Dr Ridley, let us forget about policy prudent? the words here, this talks specifically about Mr Applegarth: Yes I do because there is a great deal reductions in market liquidity. You are telling us of diVerence between phoning up and asking the that this was unpredicted, but this was informed to maximum you can get and actually going through you by the Bank of England in April, you were and applying and qualifying for a loan, so all warned, and from April to 10 August you did not applicants are very heavily credit scored, both at Processed: 30-01-2008 10:46:46 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG3
Ev 50 Treasury Committee: Evidence
16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless point of sale and on a monthly behavioural rescore, therefore we slowed down the rate of growth and we and I think the evidence shows up in the actual gave new guidance against our profits for the year, quality of the loan book and the fact that our arrears recognising the tightening in pricing. for the last 15 years have been consistently around half the industry average. Q428 Mr Breed: So in the five months between March and August, when obviously things were Y Q424 Mr Breed: Your arrears in the past have been getting tighter and more di cult, you still had not below the industry average. Bearing in mind the managed to successfully ensure that the bank did not increase in the volume of your business is in the first run out of money? six months of this year, it is fairly unlikely for arrears Mr Applegarth: We slowed down the rate of lending, we announced a strategy where we were removing to start to appear within a few months of advancing V a loan, do you believe that the quality of your loan higher risk assets o the balance sheet but, in the book is going to continue to reveal in the future event, it could not cope with the complete closure of arrears and defaults at half or so the industry markets on a global basis. average, based upon the significant amount of business that you have taken in the first six months Q429 Mr Breed: When was the first time that you of this year? contacted the FSA and expressed your concerns Mr Applegarth: I do because one of the exercises you about this possible problem that you would have? have to do in order to get your Basle II approval is to Mr Applegarth: Our traders first noted a dislocation actually go through your credit scoring dynamically in the market on 9 August. We first formally and take a loan from point of sale and go through contacted the FSA two working days later. arrears and possessions and feed it back. I think the last 18 months can be characterised for us as learning Q430 Mr Breed: So in the third month, in March, the lessons from our lending and applying them back and presumably in April, May, June and July, you into front end loans. You can track each time cohort did not advise the FSA and at no time during that of lending as you go along, and it looks like the last period of time did you have to complete a return to 18 months lending is actually better quality than the them which might indicate certain liquidity previous two to three years. problems? Mr Applegarth: Sorry, I answered the question thinking that you meant when did we first inform the Q425 Mr Breed: Do you think it is believable that FSA after the dislocation of the markets on 9 any institution which advances up to 125% of August. 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 Q431 Mr Breed: When did you first inform that FSA industry average? that felt you might have a particular problem? I Mr Applegarth: It depends if you are a picky lender might have assumed it would have been in March? or not and, yes, we are a picky lender. If you take the Mr Applegarth: We notified the FSA about a change extremes of lending policy, it sounds racy; if you in our strategy. We are on something called a close look at what happens in practice, it is not, so for the and continuous relationship so as we changed the last 15 years our arrears have been around half the strategy so we told them. We are in very regular— industry average. Q432 Mr Breed: Was that in March? Mr Applegarth: It will have been in March and Q426 Mr Breed: On that basis it would not have before because we were discussing with the FSA as been too diYcult to oZoad your loan book on to a part of our Basle II process and they came to our welcoming market with such a fantastic record? Board meeting in January, I think it was, and we Mr Applegarth: That is what we started doing, took them through what we were intending to do following up the answer the Chairman gave before. going forward in terms of moving to a slower On the back of the warning signs, you saw us growth model. announce a change in strategy with the interim results that were slowing down the rate of asset Q433 Mr Breed: So they came to your Board growth, which we had done from the third month of meeting in January and they satisfied themselves this year, and we announced that we were going to that it was all right. You kept in close and sell various higher risk asset books on the balance continuous touch with them, so between March and sheet. We completed the sale of the commercial loan August you and the FSA between you still failed to book, which is about a £2 billion loan book, over ensure that the bank was able to continue to trade three stages, with the third stage actually taking with a liquid liability book? place after 9 August. Mr Applegarth: We certainly failed to foresee the global closedown in liquid markets. Q427 Mr Breed: So in the third month of this year you began to realise that things were not going Q434 Mr Breed: And the FSA did not point that out very well? to you at any of the meetings between March and Mr Applegarth: In the third month of the year we August? picked up the warning signs that the US sub-prime Mr Applegarth: I do not know of anybody who position was meaning a tightening in pricing and foresaw the global freeze. Processed: 30-01-2008 10:46:46 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG3
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16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Q435 Mr Breed: Do you have a Risk Committee? Dr Ridley: If you are right, yes. Mr Applegarth: Yes we do. Q445 Chairman: But you ended up taking 19% at the Q436 Mr Breed: Who is the Chairman of the Risk end of the day, so was it not a case of looking at the Committee? market and then taking a punt to increase the Mr Applegarth: Sir Derek is. amount because other big mortgage lenders had more conservative estimates about what they would Q437 Mr Breed: Sir Derek, were you entirely happy take in the market? that during that period of time the Risk Committee Dr Ridley: As I say, we did not increase the rate of operated satisfactorily and reviewed its risks so that mortgage lending in the first half of 2007. It was at it could ensure that the bank could continue to exactly the same growth rate as the average had been trade? over the ten years since we converted from a Sir Derek Wanless: The Risk Committee and the building society. Board discussed the strategy on a continuing basis. I am perfectly happy, yes, with that. Q446 Chairman: But it grew three times as much as Q438 Mr Breed: You are satisfied that you had the any other company. That is general knowledge. right strategy for that particular period between Dr Ridley: One of the reasons for that is because we March and August? have become very good over the past few years at Sir Derek Wanless: We talked from the time about retaining our customers. We are unique in this the funding strategy, which was an annual look at all industry in oVering the same mortgage deals to of our funding sources, about both retail and existing customers— wholesale funding, and we talked about the ways in which that strategy was robust against many Q447 Chairman: One of the questions is, Sir Derek, circumstances. have you the funding in place to support this? Where were the cautious voices? Q439 Mr Breed: Were you in contact with the FSA? Sir Derek Wanless: The plan that was put to the Sir Derek Wanless: I was not personally in contact Board, which the Board approved, was a funding with the FSA. The Risk Committee is a Board and a lending plan, it was a complete plan for the Committee which meets three times a year. business, and on the funding side we opened up new retail sources of funding, in Denmark for example. Q440 Mr Breed: The FSA did not contact you or We had products in the UK, too, which were being talk to you about the risk profile of the bank? successful, as well as having the diverse range of Sir Derek Wanless: The FSA at this stage were wholesale lending which meant that eVectively we talking extensively to the executive about the were funding around the world. ICAAP process and Basle II and the executive were talking to the Board on a regular basis on where that process had got to. Q448 Mr Todd: I may have misheard you, Mr Applegarth, but I think you said that after the Q441 Chairman: Mr Ridley, what was the business warning signs appeared in the spring you took action plan agreed in 2006 regarding the amount of to slow the growth of loans; is that right? mortgage lending that the company would do in Mr Applegarth: It is. 2007? Dr Ridley: We planned in 2007 to grow our Q449 Mr Todd: How do you reconcile that with mortgage lending at a slightly slower rate than we what your Chairman has just said about the market had in 2006 to increase the assets on the balance share that Northern Rock were achieving in this sheet by about 20%. period, which he said was much the same as in previous years and according to the business plan? It Q442 Chairman: So what was the mortgage lending does not sound as if any slowing action was in terms of share of the market in 2006? communicated to him. It is hard to visualise, bearing Dr Ridley: We did not target a particular share of the in mind the fact that you were taking 19% of the new market but at the end of 2006 we had, I think 7.5% mortgage market, that that indicated slowing down, of the UK mortgage market. but perhaps you can tell us how that is reconciled. Mr Applegarth: Yes, surely they are consistent. Our Q443 Chairman: And you ended up in 2007 with market share of the gross market is under 10% and, about 19% of the market? as the Chairman said, we retain our customers Dr Ridley: No, those are two diVerent figures. 7.5% increasingly well, and that is what gave you the net is the share of the total UK mortgage market; 19% lending market share. We started slowing lending is the share of net new lending that was done in the down but, as you know, it takes about two and a half first half of 2007. to three months to move house and therefore the actions you take have a delayed impact, so by the Q444 Chairman: The reason I am asking that is that end of the year our balance sheet growth, once we I looked at HBOS—they are one of the largest had completed the asset sales, would have been lenders—and they took 8% net lending in the first somewhere around 16% or 17% versus the figures of half of 2007? Is that correct? the half year, which are higher. Processed: 30-01-2008 10:46:46 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG3
Ev 52 Treasury Committee: Evidence
16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Q450 Mr Todd: So we will not really see the eVects not foresee was what was deemed implausible, which of the actions that you may have taken in the spring was the rapid and long-lasting closure of global until the end of the year? Is that what you are markets. That was not stress-tested, no. suggesting? Mr Applegarth: You saw some of the actions in the Q456 Mr Todd: But nevertheless I think it is fair to pipeline of new business waiting to come through at say the FSA did not feel that your stress testing the half year, and that was ironically one of the model was adequate at the time they reviewed you things we were criticised for at the half year— under the Basle II process? because we were going to deliver lower growth than Mr Applegarth: There are always things you can do the markets had been assuming. better and that was a continual process and had been for the previous ten years with them. Q451 Mr Todd: So what sort of growth were you attempting then in this period after March when you Q457 Mr Todd: So it was a rather mild “there are were taking this remedial action that you referred things we can do better” but no specific criticisms or to earlier? suggestions were made? However, they did suggest Mr Applegarth: We would have ended the year with various other tests which included a dramatic fall in an asset growth of around 16% or 17% but that was house prices, which I must admit I would have said dependent on removing— was rather less likely than some of the events we have seen but still those were the only concrete proposals Q452 Mr Todd: And that is not an aggressive they made? growth rate? Mr Applegarth: I think you would describe it as Mr Applegarth: It is a noticeably slower rate of asset work in progress as opposed to a red flag. growth than the previous ten years where we had averaged between 20% and 22%. Q458 Mr Todd: Just turning to Sir Derek, did the Risk Committee review the advice that the FSA had Q453 Mr Todd: I suppose I must have been running given in the Basle II process on risk stress testing? dull businesses in the past, but certainly a growth Sir Derek Wanless: The Risk Committee in fact rate of 16%, which in real terms is 12% or 13%, the Board— would have seemed pretty aggressive to me. Mr Applegarth: It depends from where you start. If Q459 Mr Todd: You said they only met three times you start as a small lender the percentage sounds a a year. big number. It would be diVerent if you had a much Sir Derek Wanless: The Board looked at what the greater balance sheet. FSA said when they gave us the accreditation under the Basle II arrangement and they made an Q454 Mr Todd: I am hearing incredulity around me adjustment to the capital. It is an assessment of but, anyway, can we turn to the stress-testing Northern Rock’s own model so they made an exercise. You probably have read the evidence of the adjustment to capital in respect of credit FSA to us on this. The FSA did do a full stress test concentration risk, which was their major concern. on you in late 2006/early 2007 and actually They also mentioned pension risk, securitisation risk combined their stress-testing exercise with their and stress-testing, in that order of priority. Basle II exercise with you; is that correct? Mr Applegarth: It is indeed, and as part of Basle II, Q460 Mr Todd: Right. You have emphasised to us which is a two and a half year process, you have to how unpredictable and unpredicted the events have run a whole series of stress tests, including for been. Can you explain why you are the only example a 40% house price fall. Of course I read the substantial business of this kind that has FSA evidence, but what was not stress-tested was the encountered this diYculty? event that was deemed implausible of the global Mr Applegarth: I do not think we are the only markets all freezing at the same time, with rapid business to encounter this diYculty. speed and for a long duration.
Q461 Mr Todd: Of substance and scale. I recognise Q455 Mr Todd: No, the FSA have not said that they there are some smaller operators who have alerted you to that possibility, however, they did— struggled too. quoting Mr Sants—say that they had advised you Mr Applegarth: I think one of the features is the fact that you needed to take into account more extreme that it was a global— 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 Q462 Mr Todd: —In the UK and under the did that suggest to you? governance of the regulatory system here in the UK? Mr Applegarth: Yes of course we did because we had Mr Applegarth: It has been reported that over 150 to satisfy them in order to get our Basle II approval. banks in Europe were able to access the ECB, and The extra tests they asked us to do were primarily to that will of course include bigger UK operators who do with credit, such as the example I gave of the 40% have franchises across in Europe, so they have been house price fall. What we did not stress test and did able to access ECB funds. Processed: 30-01-2008 10:46:46 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG3
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16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Q463 Mr Todd: But that is of course a mechanism of Sir Derek Wanless: Less than 10% of the market. risk management, is it not, that they are able to gain access to other markets? Is that not so? You Q469 Chairman: But 19% of new mortgage lending, emphasise the diVerence between themselves and that is what you had. yourself, but that would of course be a matter of risk Sir Derek Wanless: No, we had less than 10% of which your Board might have considered, the fact gross mortgage lending, that is to say new that you would not have had the access that was mortgage lending. available to some of your competitors; is that right? Mr Applegarth: Indeed, and that is why we have Q470 Chairman: What I am saying to you is 19% of worked very hard over the previous decade to try new mortgage lending— and diversify our funding platform by geography Sir Derek Wanless: 19% of net which is the diVerence and product. That is why we moved to having four between the new lending and what is repaid. funding platforms—retail cash deposits, covered bonds, securitisation and traditional wholesale— Q471 Chairman: Was that not an aggressive and it is why in each of those markets we look to approach? diversify by geography. So for securitisation for Sir Derek Wanless: As I think the Chairman said example not only did we tap the UK but we tapped earlier, the target that we had was an asset growth Europe, the Far East and America. If you look at target, not a market share target. traditional wholesale, we tapped American, European, Asian and Australian markets. Cash Q472 Chairman: The reason I am asking that, Mr deposits, as Sir Derek has already said, we moved Wanless, is I looked up the BBC website before I across to Ireland and across to Denmark, so we came and you are the only one with experience of broadened our funding platform to try and retail banking but it was with NatWest, and what the increase stability. BBC were saying in their website was that you “were seen as having driven NatWest into an ill-advised Q464 Mr Todd: Just one last thing, you will know series of deals, in particular a foray into the highly that the Governor when he saw us emphasised the competitive US market, and a move to expand its message of moral hazard in taking action to deal financial market presence.” They said during his with a crisis of this kind. Do you think he has tenure at NatWest, Wanless made ill-advised forays perhaps a moral message for the way in which your into investment banking in US markets whilst losing bank has been governed, that this is an market share. In 1997 a £90 million trading loss was inappropriate model which should not receive uncovered in NatWest Markets, the bank’s support on a free basis? investment bank, which many commentators Mr Applegarth: The facility of lender of last resort is blamed on the investment bank’s quality of there for businesses that are solvent and viable but management. The trader who ran up the £90 million loss had been trading since 2004, which meant that have a short-term liquidity squeeze, so the lender of he was overlooked by NatWest’s review of its risk last resort is designed for the situation we find control in 2005, but at the time you insisted that ourselves in. Of course what severely hammered us things were going well generally. As we know, was the retail run that followed the announcement NatWest was taken over in a hostile takeover by the of that. Royal Bank of Scotland, so I am putting it to you maybe the risk you missed here was the risk that you Q465 Chairman: Mr Wanless, if I could ask for missed with Northern Rock, and your voice should clarification, 7.5% was Northern Rock’s share of the have been a cautious voice against this aggressive total mortgage lending market at the end of 2006; is strategy. that correct? Sir Derek Wanless: The strategy has been a strategy Sir Derek Wanless: Our share of the total mortgage in place since I joined the Northern Rock Board in market, yes. 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 Q466 Chairman: And at the present time it is just a very regular basis. under 10%? Sir Derek Wanless: The discrepancies are about Q473 Chairman: But there was an aggressive gross and net and the share of the stock. In terms of strategy? net share, we have had 19% in the first half of the net Sir Derek Wanless: The strategy was a growth change in the mortgage market. strategy which was communicated to the market so that everyone knew what Northern Rock was Q467 Chairman: Of new mortgage lending. seeking to achieve, and it was a strategy where we put in place on the funding side of the business a Sir Derek Wanless: Of the new mortgage market, diverse series of funding sources. which is the gross mortgage market; on how much new lending is done, we had less than 10%. Q474 John Thurso: Mr Applegarth, listening to you all here today, you sound like frightfully reasonably Q468 Chairman: That is quite an aggressive chaps who have been the ghastly victims of some approach, is it not? unforeseeable financial tsunami, yet the plain fact is Processed: 30-01-2008 10:46:46 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG3
Ev 54 Treasury Committee: Evidence
16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless you are in charge of the only bank that has had a run Q482 John Thurso: I am sorry, I have got letter here on it for 150 years. Do you actually accept you have from the FA and in it they said under the heading done anything wrong? “Risk Committee” that the Committee met on the Mr Applegarth: I feel great regret for the anxiety our following dates in 2006 and 2007. I will not quote the retail customers have seen. It was a good business 2006 dates but 13 February, 17 April and 17 July are model but, clearly, it could not deal with the the quoted dates for the Risk Committee meetings in unforeseen global freezing of the liquid markets. 2007, so they got that wrong? Sir Derek Wanless: Yes, and we can confirm to you Q475 John Thurso: You keep saying it was if you wish the precise dates of the meetings. unforeseen yet this Committee has been discussing it for six months. We discussed it when we were in Q483 John Thurso: Your meeting was in July. America. We discussed it in open session. Lots of Sir Derek Wanless: We met in July. people were talking about the risks that were coming. Why is nobody else in this crisis? Why are Q484 John Thurso: What discussions did you have? you the only ones? Sir Derek Wanless: At that meeting in July we talked Mr Applegarth: I do not think we are the only ones, about, sorry in June, we met in June. You gave me as evidenced by the number of banks who had to two months and neither of them was right. We met approach the ECB for exactly the same type of at the end of June and we discussed the quality of the borrowing facility— credit portfolio, we discussed the Treasury position and we discussed operational risk. We took a report Q476 John Thurso: None of them has lost their from the head of risk management in the company, brand; none of them is up for sale; none of them is, as we always did, about the activity he had underway frankly, destroyed by what has happened. You are and particularly about the ICAAP activity, which the only real, serious casualty. Was it a question of was the main focus of his activity at the time. the way you were running the bank? Was it a question of the way we regulate? What caused this? Q485 John Thurso: Did you discuss liquidity and the Mr Applegarth: I think the fundamental cause was way in which you would be refinancing at all? Was the speed and duration and the global nature of the that seen as a risk at that time? liquidity freeze, heightened for us by the fact that we Sir Derek Wanless: Treasury management was there did not have access to the same type of borrowing and discussed it at each of the meetings. Not long facilities that have been available for American before that meeting we had had our second Granite banks from the US Reserve and for the European transaction of this year, which was heavily banks from the ECB. oversubscribed. Although the Committee this morning is talking a lot about what happened after Q477 John Thurso: So there was nothing you could March, in fact in May this year we had a Granite have done to mitigate this risk? issue of over £4 billion, which was heavily Mr Applegarth: No. oversubscribed, so there was no indication that our paper, which we regarded as high quality (which is Q478 John Thurso: No action you could have taken why the Risk Committee paid such attention to that could have mitigated this risk? credit risk) was damaged by what was happening. Mr Applegarth: No. Q486 Peter Viggers: What would your advice be for Q479 John Thurso: Sir Derek, how did you set about other institutions in the light of the experience you in your Risk Committees of 17 April and 17 July have gone through in liquidity and how they should examining the future risks? What is the process your assess risk? Committee had to look at risks that were coming up? Sir Derek Wanless: Clearly, as with every other Sir Derek Wanless: There was not a meeting in aspect of risk, you take everything that has April; there was a meeting in July of the Risk happened in the world that you can look at looking Committee. backwards, and it is much easier with hindsight, but I suspect the way other organisations will look at Q480 John Thurso: There was no meeting in April? their risk management in respect of liquidity will According to the letter we had from the FSA there depend very much on how the authorities react to was a meeting on 17 April, but they have obviously 8 what has happened, and what happens, both on a got it wrong. global and a UK basis, in terms of the way the Sir Derek Wanless: There was no meeting of the authorities are going to handle liquidity in future. Risk Committee then. It may be they are referring—
Q481 John Thurso: There was one in July? Q487 John Thurso: Do you think that the Sir Derek Wanless: It may be they are referring to regulations should be amended to have tighter meetings of the Asset and Liability Committee, liquidity rules? which is an executive committee which meets Sir Derek Wanless: I think the BBA has sent to this monthly in Northern Rock. Committee its thoughts about the matter, because clearly there is a great deal of work to be done to 8 Note by John Thurso: The information provided by the FSA work out how a sub-prime crisis in the US became a in fact related to the dates of the meetings of the FSA’s own run on a bank in the UK, and the whole chain of Risk Committee. events, and what could have been done by whom at Processed: 30-01-2008 10:46:46 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG3
Treasury Committee: Evidence Ev 55
16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless which stage in that chain of events is something that Q497 Peter Viggers: Exactly? the authorities are clearly giving a great deal of Dr Ridley: No particular conditions. attention to. Q498 Peter Viggers: So this amount of public money Q488 Chairman: If I could add on to John’s was advanced to the people who had put the bank in question, the Annual Report for 2006 at page 51 this position without any management controls talks about the liquidity risk question. It says here being put on you at all? clearly that the FSA liquidity rules require the group Dr Ridley: The authorities recognised that it is for to be able to meet its sterling obligations without the Board, and through the Board responsibility to recourse to the wholesale money markets for period its shareholders, to run its own business. of at least five business days. On 9 August how many Sir Ian Gibson: Could I comment there, Chairman. days’ liquidity did you hold? The FSA in particular but also the Bank are at Mr Applegarth: We were still funding from 9 August present involved, as you would expect, in a until 14 September but the duration came down, so considerably closer relationship with all the based on the levels of funding we had, we still had executives of the bank and they have been visitors to two or three months’ worth of funding. The reason and demanders of information from the bank in we went to the Bank of England for a facility was as considerable detail since before the issue of the a backstop facility. We had not intended to draw facility and right through including today, and down but of course we had to in the light of the therefore whilst the management of the bank retail run. remains with the executive and the supervision of the executive with the Board, we would not suggest that Q489 Chairman: So you had two or three months’ the authorities are not involved in considerable liquidity? detail in overseeing what we do. Mr Applegarth: Yes— Q499 Peter Viggers: Drawing on my own ministerial Q490 Chairman: So there was no problem then? experience, in a similar situation we bound the Mr Applegarth: The problem we had was you could company in question hand and foot so that the not tell how long the markets were going to be closed management could not take executive decisions and it was a reasonable and proper thing to do to put without our authority. Has something like that a backstop facility in place. happened to Northern Rock? Dr Ridley: We are certainly, as Sir Ian said, in close Q491 Chairman: Had that increased or decreased consultation on every decision of significance with since the start of the year? the authorities, yes. It would be foolish not to be. Mr Applegarth: It had actually increased since the half year because we increased our liquidity by £2.3 Q500 Peter Viggers: Has a formal structure been put billion at the half year stage. in hand which would prevent you from taking certain executive decisions without the FSA’s Q492 Chairman: I would like a note on that please. authority? Mr Applegarth: Of course.9 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 Q493 Peter Viggers: Who is currently running on every decision. Northern Rock? Peter Viggers: Would it be in order, Chairman, to Dr Ridley: The Board is running Northern Rock and ask for a note on this in due course? Adam and his executive team are managing the Chairman: Yes of course.10 operations.
Q494 Peter Viggers: And how much public money Q501 Peter Viggers: One specific question: has been advanced to Northern Rock? Countrywide, a US mortgage bank, relied in a Dr Ridley: The borrowings have been reported in the similar fashion to Northern Rock on short-term press and the sums involved— 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 Q495 Peter Viggers: Perhaps you would tell us. it out? Dr Ridley: I think the sums involved that have been Mr Applegarth: I think the first thing to say is that reported of around £13 billion are approximately our funding platform is broader than Countrywide’s correct. in that we have the four funding vehicles. We did have some insurance in place but clearly it was Q496 Peter Viggers: And what conditions in terms inadequate to cope with the retail run. It was not the of management were put on the company on that same volume of insurance as Countrywide had put money being advanced? in place but we did have swing-line and standby Dr Ridley: In terms of who was to be in charge of the facilities put in place. They were smaller because we company and so on? have a more diverse funding platform.
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16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Q502 Chairman: Just to add on to the question from Dr Ridley: The covered bonds have an average life of Peter, you say you have £13 billion presently from something like seven or eight years. the Bank of England? Dr Ridley: Correct. Q511 Ms Keeble: And what percentage did you have of that? Q503 Chairman: Do you have an idea of the Dr Ridley: They were about 7% or 8% of the maximum amount you may need to borrow in the funding. Securitised bonds, which is what we call the future? Granite programme, had an average maturity of Dr Ridley: I do not think that is a number that we about three and a half years. That is about 46% of would publicly wish to divulge. It depends our borrowing. The rest of the wholesale borrowing V enormously on how things turn out and on di erent was in the medium-term markets. Its maturity scenarios. profile was fairly long by the standards of most banks, ie mostly 90 days plus. Q504 Chairman: Do you think you will have to go back to the Bank of England? Q512 Ms Keeble: Exactly, it was three months plus. Dr Ridley: We are talking continuously to the Bank You obviously were able to fulfil the requirements of England. on liquidity of 5% in five days, and you had two to three months, Adam Applegarth said, but after that Q505 Chairman: But my question is do you think you had a very large amount of loans falling due, did you will have to go back to the Bank of England you not? Your profile looks like that? for more? Dr Ridley: We had a high level of wholesale Dr Ridley: We put in place a second facility about a maturities in August. That was because we were week ago, as was announced by them and by us, expecting to do a securitisation in early September which gives us the opportunity to draw down on that which would have brought in £3 or £4 billion worth until February. of liquidity, so inevitably you tend to slightly run down your other wholesale book as the Q506 Chairman: So you could be going back to the securitisation approaches. Bank of England for more? Dr Ridley: As I say, it is a continuous process. Q513 Ms Keeble: But you actually had a problem— and I am not sure if this was by volume or by Q507 Chairman: But you could be going back to the number—in that just over 50% was between three Bank of England for more? and seven years, so the other 50% of your exposure Dr Ridley: Yes. in the wholesale markets was very much shorter? Dr Ridley: I think that 50% refers to the proportion Q508 Chairman: That is fine. The point about of the balance sheet and of course there is a large Countrywide that Peter made, it was the Governor retail deposit book in there which technically is of the Bank of England who made that speech in short-term funding, as we saw during the run. Belfast last week. He is very clear here when he says “It is a Tale of Two Banks—of similar size and Q514 Ms Keeble: But your exposure to the wholesale facing similar diYculties—just a few weeks apart. markets was 75%, was it not, and about half of that On 17 August Countrywide was able to claim on was three and a half to seven years, you are saying, that insurance and draw down $11.5 billion of and half of that was longer and it was just over the committed credit lines. Northern Rock had not three months; is that not right? taken out anything like that level of liquidity Dr Ridley: Rather more than half of that was in insurance”. So that was really a failure on your part? securitisation and covered bonds. You got yourself into a situation which Countrywide did not get themselves into; is that correct, Dr Ridley? Q515 Ms Keeble: You said earlier that your Dr Ridley: As the Chief Executive said, we took steps borrowing on the wholesale markets was longer than to ensure that we would not need so much insurance your lending, but most mortgages must be longer by diversifying our funding platforms more than term than three and a half years or three to six Countrywide. months? Dr Ridley: One of the features of the mortgage Q509 Chairman: But Countrywide did not get market recently has been that people re-mortgage themselves into this situation; you got yourselves in fairly often and this means that the average length of this situation; there is a lesson there for you, surely? time that a mortgage stays on our balance sheet and Dr Ridley: Yes. on most banks’ balance sheets has recently come Chairman: So you failed. Sally? 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 Q510 Ms Keeble: I wanted to ask some more about product is three years. the liquidity and the wholesale borrowing. Dr Ridley, you said that your borrowing on the wholesale market was long term. What was the Q516 Ms Keeble: And what number are actually profile of your borrowing exactly? three years? Processed: 30-01-2008 10:46:46 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG3
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16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Mr Applegarth: That is the average life of our Q522 Ms Keeble: If we can have the figures and if we mortgage book. You will have something like 60% in can have the exact profile of the business, I think that our two-year fixes and the rest are obviously longer would be very helpful. than three years, they tend to be five-year fixes. The Mr Applegarth: I am very happy to.11 average life of our funding was about three and a half years. As the Chairman said, of our funding, Q523 Ms Keeble: Moody’s Investors Services noted 50% was securitisation, which had an average life of in August 2006 that your funding profile remained three and a half years; 10% was covered bonds, your biggest challenge and the relative lack of retail which had an average life of about seven years; and funding was the one that was most likely to put a of our wholesale borrowings, which is 25%, half of negative pressure on your ratings in the future. How that had a duration longer than one year and the did you react to those concerns and what assessment other half was less than one year’s duration. did you make of those? Mr Applegarth: One of the things we have been able Q517 Ms Keeble: I agree that the profile of some of to do with Moody’s, by moving into securitisation your wholesale borrowing is similar to some other and lengthening the maturity of our funding, is to banks and building societies, but the diVerence is encourage Moody’s and we actually got upgraded that your exposure was greater because it was 75% by Moody’s to Aa3 on the back of our longer so it actually looks that you were not borrowing long funding profile. and lending short; you were actually borrowing short and lending long. Q524 Ms Keeble: When you said you lengthened it, Mr Applegarth: I would not agree with that. The what by and when? average life of a mortgage product is three years and Mr Applegarth: EVectively by adding securitisation. one month and the average life of our funding was We started securitisation back in 1999 and then we three and a half years. introduced covered bonds in 2004. Both of those have maturities considerably longer than traditional wholesales. On covered bonds in particular we have Q518 Ms Keeble: But you had half of your only done deals of a minimum of five years’ duration borrowing falling due round within round about and a maximum of 15, which is how you get the three to six months, did you not? average life of seven years, so it was by introducing Mr Applegarth: We had 10% of our borrowings securitisation and covered bonds that lengthened the which had a maturity of less than one year; we had maturity of our funding that Moody’s actually 10% of our borrowings that were over one year; we upgraded us. 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. Q525 Ms Keeble: Also your share price fell by 20% between February and June this year. What assessment did you make of that? Q519 Ms Keeble: And what were the diVerent Mr Applegarth: I think you can ascribe the share interest rates involved? price fall to the matters that the Chairman was Mr Applegarth: The average rate on securitisation highlighting earlier in terms of the tightening of the for the stock was about LIBOR plus ten basis points; credit markets, so you saw the price of funding the average price for covered bonds, which is the increase, you saw a slowdown of our lending in the seven year, was about LIBOR plus one basis point; second quarter and therefore clearly people were the average price of longer term wholesale was about assuming that in volume terms our profits would be LIBOR plus five; the average rate for shorter, ie less lower over the next two years than had previously than year, was about LIBOR flat. been the case, and indeed that was confirmed when we did a pre-close statement to the market at the end of June. 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, Q526 Ms Keeble: You had some warnings then that including fees that are eVective interest rate were there was suspicion about your business model and about LIBOR plus 90 basis points. 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? Q521 Ms Keeble: Because looking at the profile of Mr Applegarth: We had certainly some warnings the business falling due, I have to say again it would that the credit markets were tightening and therefore be helpful if we could see the graphs as you had them the price of funding was increasing, so the action was because looking at the profiles it looks very much as to change our strategy and announce that publicly to if you were borrowing short on the markets and that the market. That was one of the reasons why the business was falling due at the same time as you were share price was coming down around the half year lending quite long, or longer, which obviously looks because we had made extremely transparent the unsustainable? change in strategy, so we were slowing down Mr Applegarth: If that was the case it would be, but lending, we were removing high-risk assets from the it was not, and maybe I can write and give you the liquidity level. 11 Ev 232 Processed: 30-01-2008 10:46:46 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG3
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16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless balance sheet and we had announced a programme part of the group, so is Adam, who took Northern to sell commercial lending; our unsecured lending Rock through flotation in 1997 and we were very books and our commercial buy-to-let books. proud of the decisions we took on that occasion to make Northern Rock into a good corporate citizen. Q527 Ms Keeble: Do you regret now with hindsight, We have created 3,500 jobs since then. We have set which is always a wonderful thing, that you put so up the Northern Rock Foundation and Adam and I much reliance on wholesale funding? were on the Board that took that decision. Mr Applegarth: Hindsight is a wonderful thing. It is distressing that the global freeze was not in a year’s Q532 Mr Love: I understand all of that but with all time when we had slowed down the lending and the financial services organisations and others that removed assets oV the balance sheet. you are now talking to about the future of Northern Rock, are any of them suggesting that they will Q528 Ms Keeble: Would you accept that to some retain the name “Northern Rock” into the future? Is people it looks suspiciously like gambling? there anybody that is suggesting that Northern Rock Mr Applegarth: No I do not accept that because I will survive as a name? think we reacted reasonably and properly to what Dr Ridley: That is a matter for them, not for us, but we were seeing in the market place in terms of the it is true to say that on the retail funding side, the tightening of the credit spreads, and therefore we name Northern Rock is unlikely to continue. It is slowed down the rate of asset growth and publicly worth pointing out that on the mortgage lending side announced a change in strategy, even though we all our feedback from other brokers is that they knew that would mean lower profit growth going know we are a good and responsible and careful forward, because it was the right thing to do. lender, and that has not changed.
Q529 Chairman: But other banks’ share prices were Q533 Mr Love: I think you are accepting that not falling at the same rate as yours. You mentioned Northern Rock is now finished as a name. I have just my comment on the credit crunch but it does seem a returned from the United States and New York and wee bit unreal to us. It seems that you were out of Washington and all they wanted to know about was step with all other banks here, you say that it was Northern Rock. They have not heard of any other only because a global credit crunch, which nobody British banks but they know about Northern Rock foresaw by the way, that you find yourselves in this and they know about the queues outside your bank position. It does seem a wee bit unreal to us as a over a period of time. Do you fully understand the Committee that you are the only bank in this depth of the reputational damage you have done to country to have precipitated a bank run in 140 years, the banking system in the United Kingdom? so there really must be something deeper at stake Dr Ridley: I fully understand and it causes me here. If I could extrapolate from your point, at the enormous distress. As I said, we had tried very hard end of the day I think you are blaming the Bank of to be a good corporate citizens, creating jobs in this England because you did not get a credit line early country, delivering fair and good deals to customers, on? and giving 5% of our profits to charity. Mr Applegarth: We certainly did not have access to a facility that is available to European banks and Q534 Mr Love: Where does your share price stand American banks, and that would have helped us, but today compared with the high earlier this year? Is it it was a sensible and prudent thing to do to put the a quarter, is it a fifth, is it a tenth, where do you stand backstop facility in place. Ironically, it was the in terms of your share price? announcements and the leaking of the backstop that Dr Ridley: I think it is about a sixth. caused the retail run and it was the retail run that reduced our liquidity. Q535 Mr Love: So your share value is about a sixth of what it was; your name is in the dustbin of history; Q530 Chairman: It had to be announced. At the end the reputational damage you have done to the of the day you are blaming Mervyn King. British banking industry is severe. Can I turn to Sir Mr Applegarth: I am not blaming anybody. The Ian Gibson, why have you not accepted his cause was the chain of events from worries about the resignation, thinking about all of those things that credit quality on US sub-primes linked all the way have happened in the last few months? through to a UK-only prime lender. Sir Ian Gibson: Perhaps it would be helpful at this Chairman: At the same time, Mervyn King points point Chairman, if I explain the process that I have out that Countrywide in Los Angeles had a diVerent followed about resignations from the Board. strategy from yourself and did not get into that position. Andy? Q536 Chairman: Sure. Sir Ian Gibson: First, back on 30 August I asked Q531 Mr Love: Dr Ridley, would you agree that Board members, both executive and non-executive, whatever else happens in the future that the good if they would be willing and would present their name of Northern Rock will be a casualty of your resignations because that might well have aVected failures? the ability to reach some corporate solution, which Dr Ridley: I would agree that there is some damage we were actively seeking at that time. All of them did to the brand of Northern Rock and that is a matter and those have been on the record in the Board of enormous distress to me and my colleagues. I am minutes from that point. Later, in the days of the Processed: 30-01-2008 10:46:46 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG3
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16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless run, the Chief Executive to the Chairman and the Q540 Mr Love: So far, one has to say. Can I just ask Chairman to me similarly said they would be willing you, it is said that the management of Northern to resign. In the week following the run, starting on Rock were incentivised through the growth in the the Monday following, I consulted with brokers, volume of the business that you were undertaking. with shareholders, with other board colleagues and Do you see any problems related to that, the fact it said, “Is this what you believe is right because if it is was that aggressive lending on which was based the it is clearly what the Board is prepared to do?” At salaries of the senior management and the that point there was no contradictory feedback, the organisation? overwhelming feedback was: “You can worry about Mr Applegarth: The salaries incentives were linked that later. What you need to do right now is direct to profit growth and total shareholder returns and the bank through a crisis, find a way to keep people whether that is judged as shareholder returns or as motivated within the place, and respond to earnings per share— 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 Q541 Mr Love: It was mentioned earlier that some what I shared with colleagues, that is what I shared of the products that you sell are multiples of up to with the authorities, and that is what I continue to six times income, we have talked about Together at do with the Board. It is an issue I discuss weekly. 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 Q537 Mr Love: When you come to share that with take that experience and the incentives towards the shareholders at the annual meeting, do you think aggressive lending and the securitisation process they will be as sympathetic? that you were heavily involved with, what is now Sir Ian Gibson: Yes I do. emerging (and they are at a further stage than we are in this process) is some very imprudent lending. Are Q538 Mr Love: We will find out when you get to you totally confident that there has been no that. Can I move on to Mr Applegarth. We have imprudent lending within all of these diVerent already heard that over the first six months of this products that you have been selling over the recent year one in five of all mortgages, including period? remortgages, were sold by Northern Rock, and if Mr Applegarth: Yes I am in that somebody phoning you just take new mortgages I think it was one in ten. up to ask for your maximum lending criteria is not By anybody’s estimation that is aggressive lending. the same as somebody going all the way through a You said earlier on that the quality of your book for loan application. We are renowned as a picky lender. that six-month period was probably better than it One of the frustrating things about this is I had was previously because of lessons you had learned. always assumed that if there were liquidity problems Would you like to think again about that statement? there would be a flight to quality and therefore the Are you putting your name and your reputation on more transparent you could be about the quality of the quality of the lending you have done earlier your assets and the higher quality assets you had this year? then you would be in a better position which is, why Mr Applegarth: Yes, it is really a fallout from the for example on the Granite securitisation that you work we had to do over the previous two and a half mentioned we provide so much data on it on a years in order to get a Basle II waiver. You have to monthly basis. We provide management show that you dynamically manage scorecards from information of something like 250 pages on all the new lending all the way through to arrears and details of the credit quality behind Granite and you possessions and put that information back into your have to do that in order to get the AAA rating. front end score cards, so, yes, I am quite happy with that statement. Q542 Mr Love: Can I ask you finally in relation to going forward, there have been quite a lot of reports Q539 Mr Love: We mentioned earlier the Together about Northern Rock not being as competitive as it product that you have where you give up to 95% secured against a home and the rest, 30% I think it was. Partly that is related to the tightening of your is, in unsecured lending. What is the level of loans lending criteria but also in relation to some of the you have as a result of this Together project? benefits that you gave—£500 or £1,000 towards the Mr Applegarth: The Together project, you are quite costs. Are you confident that in the climate going right, is a first-time buyer product which allows them forward the levels of profitability you have seen in to buy their home and also pay for furniture, so it is the past will continue or are you projecting a a secured loan bundled together with an unsecured significant reduction in the profitability of loan. There are two separate products. It accounts Northern Rock? for about 20% of our share of stock. Its three month Mr Applegarth: We are forecasting lower profits plus arrears at the half year stage were 0.84% which than previously, and that is what we announced at is still lower than the industry average for secured the half-year stage, and that is why you saw the share from the CML, which is 1.06, so it is for us a higher price come down because an aftermath of the risk book and therefore it is charged at a slight tightening of the credit markets was that the price of premium but it still performs better than the funding went up. Clearly we have slowed our lending industry average. because we are short of liquid funds. Processed: 30-01-2008 10:46:46 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG3
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16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Q543 Mr Love: But these additions that you gave in Dr Ridley: The Tripartite arrangements are not the past, the £500 and £1,000 depending on the type really a matter for me obviously; they are for the of mortgage, the free valuations and all the other Government and for those institutions. As far as we incentives, to take out a mortgage with Northern understand it, we were perfectly clear that our Rock, have you stopped doing that simply because supervisor was the FSA and it was the FSA that we of the tightness of your liquidity or is that a were to keep informed about our position and reassessment of the amount of risk that you were through them they would inform the Treasury and taking on in relation to some of the mortgages? the Bank of England. Additionally, we felt it Mr Applegarth: No, the prime driver has been the important to get our view directly to the Bank of lack of liquidity and therefore we have had to slow England as soon as we could about what would help down lending. You adjust price and policy to slow avoid a disaster for ourselves. down the lending and that is exactly what we have done. Q547 Mr Simon: Get your view to them? Dr Ridley: In addition to speaking to them through Q544 Chairman: To get back to you, Sir Ian, it seems the FSA, it was our view that it was important to to me anyway to be an arrogant view here from speak to them directly, and the FSA knew about that Northern Rock in that you are not really out of step and that was quite above board. with anyone else and you just found yourself in this position because of the global markets, and to a Q548 Mr Simon: When did you start speaking to the number of us it seems that you are in denial. The Bank directly? gossip that I have picked up in the past few weeks Dr Ridley: I spoke to the Governor of the Bank of with lots of people talking to me is that as the Non- England on 16 August. Executive 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 Q549 Mr Simon: Were you speaking to the Treasury case, and I have respect for your past business directly as well? background, is there not a case here for more Dr Ridley: I was not speaking to the Treasury humility in your approach about how Northern directly, no. We knew that our views were being Rock got into the situation and how we are going to communicated to the Treasury directly through the see this bank coming out at the end of the day so that FSA. the interests of shareholders, including those of ordinary people in the North East who have invested Q550 Mr Simon: Was anybody at Northern Rock in it, are secured? speaking directly to the Treasury? Sir Ian Gibson: Chairman, there is absolutely no Dr Ridley: In due course, yes, we did have direct arrogance, let me assure you, on my part and on the contact with the Treasury. In the initial stages it was part of the Board of which I am part. There is shock through the FSA. and there is distress. That is reflected in part, although with high morale, in the workforce in Q551 Mr Simon: So when and who began to speak Gosforth and in Sunderland. These are people who to the Treasury? are trying damned hard to serve their customers and Dr Ridley: During the period of the retail run we secure their future, and we are very aware of that. were speaking to them but I cannot remember when Are there lessons to be learnt? I am very sure there the exact first contact was. 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 Q552 Mr Simon: Who is “we”? Dr Ridley: I think it was probably me that made the the world as we knew it; and the world has changed. Y That has been an enormous shock and one that this first call to the Chancellor’s o ce during the retail Board has not finished coping with yet. It has run. acquired time until February next year to create the best solution for its shareholders, for its Q553 Mr Simon: So initially you were speaking stakeholders, for its employees as best it can, and directly to the Bank from the 16th, not at that stage that it will do and it will do it whether it comprises to the Treasury, although later, and generally felt some or all of the individuals that are there now or yourself to be communicating with the Treasury via some others, but it will do it. There is no arrogance; the FSA? there is shock and dismay. Dr Ridley: Correct.
Q545 Chairman: You will understand there is shock Q554 Mr Simon: When talking to the Bank and the and dismay throughout the country as well. Treasury, did you feel you were speaking to diVerent Sir Ian Gibson: Yes. beasts, to whom you had to speak in a diVerent way? Dr Ridley: Inevitably, they have diVerent V Q546 Mr Simon: Dr Ridley, we hear talk about an responsibilities and there were di erent issues to inquiry or even a public inquiry into the Tripartite discuss with them. arrangements. Were there to be such a “dodge-the- blame” fest what would be the main things that you Q555 Mr Simon: Did you get the sense that there was could imagine yourself telling it? a poisonous relationship between the two of them? Processed: 30-01-2008 10:46:46 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG3
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16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Dr Ridley: No. Q561 Mr Simon: No, the retail run on the bank, your bank. Q556 Mr Simon: When the FSA were here, they were Mr Applegarth: Absolutely, and it is a chain of very clear that the Tripartite arrangements had events from— worked admirably well. Do you think that the Tripartite arrangements worked extremely well and Q562 Mr Simon: If you cannot tell us what to do successfully and ought to be admired and perhaps about this, and the FSA cannot tell us and the Bank recommended as a model throughout the world? cannot tell us, who is going to tell us? What is the Dr Ridley: I really cannot comment on that answer? because— Mr Applegarth: I was trying to suggest that perhaps one of the issues—and I have to say that I would like Q557 Mr Simon: Why not? Clearly, you are not to agree with big chunks of BBA memorandum to responsible for the Tripartite arrangements and that you,12 particularly the globalisation aspect, because is a matter for them and you are a matter for you but, if each individual geographic area acts on its own, obviously, as a matter of public policy, you have had you will get dislocations in actions and facilities an interaction with these arrangements in a way that between diVerent geographic areas. Because this was nobody else has, an importance that is absolutely a global issue, the Tripartite being judged against a remarkable, with a whole set of outputs which global issue is somewhat unfair but I think there are everybody wants to avoid. Obviously, your view on major lessons to be learned in how you tie up each of the Tripartite arrangements—you are not just a the diVerent geographic areas. bloke; it is a particularly important view and we would like to hear it. Q563 Mr Simon: You think that is the answer? Dr Ridley: As I said, it is up to them how their Mr Applegarth: For this particular set of arrangements worked among themselves. As I have circumstances, it has to be part of the answer. said, we were quite clear that we had a good communications link with the FSA, with the Bank Q564 Mr Simon: Who is going to do this tying up? and later with the Treasury. Mr Applegarth: Really, that is a matter for the authorities, is it not? I would imagine it would be led Q558 Mr Simon: How did their arrangements work by the Treasury and the Bank of England. for you? How did they work for the country? Dr Ridley: Inevitably, as we have discussed, the leak Q565 Mr Simon: The Treasury and the Bank? Not of the announcement of the facility and the eVect the FSA? that had on our retail depositors was not a happy Mr Applegarth: I do not think I know enough to outcome. I am not here to blame that on the comment as to who should be the right person. particular Tripartite arrangements. That is about events. Q566 Mr Simon: Somebody must know something about this. You said, Dr Ridley, that you are quite Q559 Mr Simon: I am not suggesting that you are clear that the FSA was the regulator, although you trying to blame anybody and I am not trying to get would never know that to talk to the FSA. You said you to blame anybody. The problem with this whole you were quite clear that it was them you were debate is that nobody wants to take responsibility talking to mainly, because they are the supervisory for anything and nobody wants to talk about what body. The next group that you spoke to was the anybody else might or might not do diVerently. So Bank, and last, and presumably least, the Treasury. far all we have is a whole series of people saying Do you think this might have been avoided if it had “Everything went fine. Nothing that anybody did been the other way round, if, instead of a Tripartite could or should have been done any diVerently.” arrangement where nobody was responsible for You have said today that there is no way that you anything, the Treasury was responsible for dealing could have done anything diVerent, the FSA could with you, sorting out the liquidity early and making not have done anything diVerent, no-one could have sure that this did not happen? done anything diVerent, in which case, with the same Dr Ridley: I think that is a hypothetical question set of circumstances again, it will happen again. and— Mr Applegarth: I think the actions we took since 9 August were entirely reasonable and proper. One of Q567 Mr Simon: Clearly it is a hypothetical the problems we had is that it was not a UK question. You are a scientist. There is no other way problem; it was a global issue, and I think there are to seek to make sure that this does not happen again, lessons to be learned about, if you have a global is there? issue, how you get coordination between each of the Dr Ridley: No, there is. As Adam has suggested, the geographic areas. Clearly, the extremely distressing British Bankers Association has made suggestions retail run is not a success although, because it was which we think are sensible for looking at these not a UK-only issue, it is diYcult to judge— issues and for learning lessons from them. There is a division of responsibility between managing Q560 Mr Simon: It only happened in the UK liquidity in the markets between the Bank and though, did it not? supervising individual institutions in the FSA. As far Mr Applegarth: No, the global freezing happened worldwide. 12 Ev 294–307 Processed: 30-01-2008 10:46:46 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG3
Ev 62 Treasury Committee: Evidence
16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless as we were concerned, there was not a problem of tried to repo assets, once we had gone down the communicating our position between those two route of trying to find a safe haven for the company, institutions. We were able to communicate to both. because we started that on 16 August—
Q568 Mr Dunne: I would like to pursue some of the Q572 Mr Dunne: Stop there then. At what point did line of questioning of Mr Simon as to what could you start seeking an acquirer for the business? have been done in the specific circumstances to have Mr Applegarth: 16 August. 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 Q573 Mr Dunne: Those discussions ran in parallel liquidity constraints, can you tell us when you first with all of these other events? identified to the FSA a specific liquidity problem Mr Applegarth: We were trying to do all things at the emerging for Northern Rock? same time, yes. Dr Ridley: I will let Adam answer that because he had the first contact with them. Q574 Mr Dunne: You have not given me a date yet Mr Applegarth: Yes, of course. We first noticed when you discussed the lender of last resort facility. dislocation in the market on 9 August and we waited Could you do that, and could you tell me whether or one working day before contacting the regulator, so not a third party approached the Bank of England that would be 13 August. From then it was a very to secure a similar facility? close relationship, including two formal calls a day Mr Applegarth: Yes, we had been talking with the to update them on the position. Bank of England from the middle of August in terms of what if, what would be a backstop facility, so we Q569 Mr Dunne: So neither the Risk Committee, were talking, as you would expect, because it is a chaired by Sir Derek, nor the Board, nor the prudent thing to do to put a backstop facility in place operations of your own internal treasury had in case of all the other actions in place. That would noticed any tightening in market conditions between have been the middle of August. April and 9 August? Dr Ridley: Can I just interject there? In my first Mr Applegarth: No, I am not saying that. We conversation with the Governor of the Bank of certainly noticed the tightening of conditions and England on 16 August the lender of last resort was that is why we announced to the market publicly a mentioned as a theoretical possibility at that stage. change in strategy for lower growth and removing assets from the balance sheet. What we did not have Q575 Mr Dunne: What was the response of the Bank any foresight of is the closure of the markets. We of England at that stage? have managed and lived through various closures. Dr Ridley: It was mentioned by him. 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, Q576 Mr Dunne: That that was an opportunity but this is the first time that you had seen a very rapid which they might make available? and very widespread, both in terms of geography Dr Ridley: If we got to the point where liquidity and in terms of product, closure of the market. So continued to be a problem and the markets remained yes, of course we noticed the fact and we reacted to closed, then of course that was available and would it. What we had not foreseen is the complete closure need to be discussed. of liquid markets on such a wide basis, whether it is Mr Applegarth: But as a last resort, so their commercial paper, asset-backed commercial paper, encouragement to us was the work we were doing to securitisation, covered bond, medium-term note and try and find liquidity or find a solution. It was lender even the cash deposit markets in the UK and US of last resort. It had to be a last resort. eVectively closed. Q577 Mr Dunne: What I am trying to get to is that Q570 Mr Dunne: At what point did you first discuss the decision to provide that facility was taken after with the FSA or the Bank of England the it was too late, after you had had a run on the bank. opportunity to tap the lender of last resort facility? Why was that decision not confronted before the run Mr Applegarth: We first contacted the FSA on 13 on the bank, either by yourselves or a third party? August, and then— Mr Applegarth: It was actually taken before the run on the bank. It was the announcement of the facility Q571 Mr Dunne: To discuss that issue? being leaked that actually was the start of the run. Mr Applegarth: No, to discuss the issue of liquidity, The run eVectively started on 14 September. Our and then I have to say we did a vast range of things corporate activity ceased on 10 September and to try and get liquidity, whether it was raising it in therefore between the 10th and the leak late on the diVerent markets, because at that point you could 13th, that was when we were putting in place the not tell that the markets were completely closed. lender of last resort. We had intended to announce You actually did see two small covered bond issues that on the following Monday but clearly, the leak get away in August before that market closed. On 9 meant we had to rapidly accelerate and therefore our August you could not foretell the extent and depth communication plans had to be rapidly accelerated of the closure. In terms of the facility of lender of last and they were not as smooth as they would have resort, once we tried to raise liquidity, once we had been had there been a Monday announcement. 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16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Q578 Mr Dunne: Had a third-party acquirer been Q584 Mr Dunne: Had the facility existed, as we have granted the facility, in your opinion, would that have discussed earlier, in the US or the Continent to have prevented the run on the bank? covert funding lines available to you, would we have Mr Applegarth: Had a facility been granted, I am led avoided the run on the bank? to believe that we would have had a bid to consider Mr Applegarth: I think if we had been able to borrow and I suspect that, had an oVer been made with a big on the lines that we did, which is basically using our retail brand, then the run would not have taken mortgage and our mortgage assets as collateral, place, yes. 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 Q579 Mr Dunne: So with hindsight, you would be is not public, then clearly you have not had the recommending that the Bank of England consider shocking retail run that we have had to experience. relaxing its arrangements; the moral hazard So I suspect the answer is yes. argument that prevented that decision from being taken would have stopped the run on the bank. Q585 Mr Dunne: You had no mechanism available Mr Applegarth: I have a little diYculty to you because you were not regulated by the ECB understanding the moral hazard argument. All I to be able to approach them yourselves as an know is from Northern Rock’s point of view, and alternative? avoiding the shock and the huge distress of a retail Mr Applegarth: No. We have a branch across in run, it would not have taken place, in my view, for Ireland and had we had more time, we might have what it is worth, if we had been able to announce an been able to put in place the legal documentation V o er with a big retail brand. and provide the collateral through the Irish branch. The trouble is that would have taken two or three Q580 Mr Dunne: Can we just touch on the leak for a months and in trying to put the backstop facility in moment? Where do you believe the leak came from? from the Bank of England, we were trying to put a Mr Applegarth: That is a hugely diYcult question sensible and prudent backstop in place that we thought we might not have to draw down on because because I cannot answer it. All I know is we had not we were actually still funding—not fully funding, even signed the facility when the leak took place. My and duration was noticeably shorter but we were still treasurer was going down with the company funding until 13 September, but I think it would secretary to go through the negotiations through the have been a gamble to have relied on getting night of the 13th. The facility was actually only documentation and collateral in place through the signed late in the night of the 13th or early in the Irish branch. Had we done that a year ago, then we morning on the 14th, and yet the leak took place on would have been able to do that, but we had not. the evening of the 13th, so it caused immense diYculties. Q586 Jim Cousins: I wonder if I could just ask you, Dr Ridley, before the matter was raised with the Q581 Mr Dunne: Do you believe it is likely to have Bank and the FSA on 13 August, that is to say, the come from the people in the know within the bank sustainability of your situation, did the Bank or the or its advisers? FSA ever approach you with questions about the Mr Applegarth: All I know is it did not come from sustainability of your situation? us. 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 Q582 Mr Dunne: Or your advisers? process and we were talking about risk and stress- Mr Applegarth: Or our advisers. It is massively not testing throughout the process, so there was a two- in our interest. way dialogue but no, we did not take a particular course saying “Markets are getting particularly Y Q583 Mr Dunne: Is there any evidence of any other di cult, we think liquidity is going to dry up” or anything like that, if that is what you are referring to. information that you supplied to either your regulator or to the Bank of England getting into the public domain? Q587 Jim Cousins: So the first doubt about the Mr Applegarth: Yes, there have been things sustainability of your situation came from you to appearing in the public domain that have been them? provided to third parties but I cannot say where the Dr Ridley: Correct. leak was because, as you can imagine, there are a huge number of advisers on both sides. I am not just Q588 Jim Cousins: The Chancellor, in his statement talking about PR advice; I am talking about banking on the 11 October, Mr Applegarth, said “We”—and advisers, accountants, lawyers. It is impossible to tell by that I think he meant not just the Treasury but the where they have come from. All I know is that there FSA, the Bank and Treasury together—“did have been three leaks that have been massively everything that we could to try and resolve the damaging to the business and it has not been in our situation without special support becoming interests to leak them. So I am confident it has not necessary.” In your answer that you have just given come from us. to one of my colleagues it is plain that you take the Processed: 30-01-2008 10:46:46 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG3
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16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless view that there were other things that could have and solvent for the facility and guarantee to be been done that might have avoided special support given. The only explicit requirement for the becoming necessary. guarantee is for the new depositors. Mr Applegarth: I think it is undoubtedly true that in the period from 9 August to 14 September we went Q594 Jim Cousins: Can I stop you? I want us to be through a wide programme of attempts to get clear about this. I am not talking about the facility liquidity, whether it was by raising liquidity, repo- guarantee that was given by the Bank. I am talking ing, but additionally, before we went to the Bank as about the guarantee to depositors which was given a lender of last resort, we did start on 16 August by the Government. corporate activity. It is my view that, had the facility Mr Applegarth: It is to do with new deposits and it had been granted to a major high street retail bank is the fee we have to pay to attract new deposits. ahead of us having to get the facility, that would have stopped a retail run, but that is my view. Q595 Jim Cousins: What implicit understanding was reached between you and the Government at the Q589 Jim Cousins: I would now like to ask you, Dr time that guarantee to depositors was given? Ridley and Mr Applegarth, about the guarantee to Mr Applegarth: It is the same as we had to put in depositors, which of course was given by the place for the facility to be granted, which was the Treasury, and subsequently of course extended to delivery of the viable and solvent business plan. new deposits that had been created. What was asked from you in return for this guarantee to depositors? Q596 Jim Cousins: So there were no additional Dr Ridley: I do not quite follow the question. requirements asked of you in exchange for the guarantee to depositors? Q590 Jim Cousins: The question is a very clear one. Mr Applegarth: For existing customers, no. For new A depositor guarantee was given by the Government customers, yes. to existing depositors and subsequently it was extended to new deposits. What was asked of you in Q597 Jim Cousins: At the time the guarantee to exchange for that guarantee? depositors was given, was any indication given to Mr Applegarth: The first guarantee was for existing you that that guarantee might in any way be time customers and that was later clarified to include limited? customers returning to their account. That was Mr Applegarth: Yes. The form of words used was Y important to us, because that allowed us to refund “during the current financial di culties”. penalties to the customers, and that facility is still available until the end of October to make sure that Q598 Jim Cousins: What did you understand by customers who paid a penalty have not been that phrase? disadvantaged. For new customers, in order for us Mr Applegarth: The foreseeable future, during the not to be advantaged versus our competitors, we period when markets were dislocated. have to pay a fee for each new deposit coming to us to make sure that we are not at a commercial Q599 Jim Cousins: Let us be clear about this. The advantage versus our competitors, who do not have lending facility is clearly time-limited at February such a guarantee for new customers. 2008. Is the guarantee to depositors subject to any such time limit? Mr Applegarth: It does not have such an explicit time Q591 Jim Cousins: Apart from that fee, nothing was limit. The phrase of words used both in the public asked of you? announcement and to us was “during the current Mr Applegarth: Explicitly, no. financial diYculties”.
Q592 Jim Cousins: Implicitly? Q600 Jim Cousins: At the time the deposit guarantee Mr Applegarth: As Sir Ian and the Chairman made was given was there any indication that if there were plain, our communication to the regulator is to be a merger, break-up, takeover, what you will, of extremely close, of course, as our contact in the the company, a safe haven, to use Dr Ridley’s earlier Tripartite. They passed that information to the term, that the guarantee to depositors would be Bank of England extremely swiftly— terminated or limited? Mr Applegarth: I think that will be a matter between Q593 Jim Cousins: I am talking here about the any such party and the Treasury. Therefore I do not Treasury, the Government’s guarantee to think I am able to comment on that. depositors. What implicit understandings were reached between the Treasury, the Government and Q601 Jim Cousins: You submitted your business yourselves at the time that the deposits were plan to the Treasury at the same time as the guaranteed? guarantee to depositors was given but at that stage in Mr Applegarth: For the facility and guarantee to be your discussions with them, in the event of merger, in place we had to provide a viable business plan, break-up, takeover, call it what you will, no which is extremely closely monitored and indication was given that the guarantee to depositors scrutinised—that is where the “implicit” comes would be terminated? from—to make sure we are performing as per the Mr Applegarth: No. The form of words used was plan we had to provide to make sure we are viable “whilst the financial diYculties continued”. Processed: 30-01-2008 10:46:46 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG3
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16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Q602 Jim Cousins: Do you recognize there must be Therefore, I think the answer to the question is an early settlement of the future direction of the pursuing the revised strategy we put in place at the bank? end of June/start of July, even though it meant the Dr Ridley: The benefit of the second facility is that it share price went down because the profits were likely gives us until February 2008 to sort out the future of to be lower. 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 Q608 Mr Mudie: That just suggests lower growth. keep all our strategic options open and to discuss all What about the total lack of liquidity that you keep of the options, including sale of the bank, or sale of coming back to that caused your problem? Even part of the bank, or an independent future with a with a lower rate of growth that could still happen. V di erent funding arrangement. It has been put to you; no higher authority than Mervyn King has pointed out that you should have Q603 Jim Cousins: What is going to guide you? insured. You say you had some insurance. Dr Ridley: What is going to guide me? Mr Applegarth: We had some insurance. We had the equivalent of about $3 billion and it was plainly Y Q604 Jim Cousins: In the period between now and insu cient. I think an additional lesson to be February 2008, what is going to be the priority? learned is that we had already begun the process of What is your guiding light going to be? diversifying by geography and product all our Dr Ridley: My guiding light and the guiding light for funding streams. Had we had more diverse retail the Board is going to be responsibility for the funding, including in particular funding through a interests of the shareholders, the creditors, the branch within the euro zone, that would have employees and all other stakeholders. allowed us access to the ECB facilities and not simply to be dependent on the UK facilities. That is Q605 Jim Cousins: How many of your employees are an additional lesson for me. actually shareholders as well? Dr Ridley: Approximately 75%. Q609 Mr Mudie: That is something that I have some sympathy with. If you had realised earlier your Irish Q606 Mr Mudie: Since we are near the end, can I just connection to Europe, and used it, do you think if give you a last chance, certainly in my eyes, to come you had had the facility European banks had and away from denial, because even that eloquent speech which the Bank of England later on, after your run, of Sir Ian referred to things happening, lessons being actually gave British banks, would you have gone learned, and then he went worldwide. You can through this crisis? accuse us of hindsight. You now have hindsight. Mr Applegarth: It seems to have worked in Europe. What would you have done diVerently to avoid what happened? Within Europe there are a number of business Mr Applegarth: The trouble with hindsight is, if we models that actually have a greater dependence on had had it, other people would have had it too and wholesale funding than we do and they have not had you would not have had the events take place. As for the same issues we have had, so I would suspect so, the denial, I do not think the Board, certainly none yes. of the executives, are not in denial at all. We are deeply scarred by what has happened. Q610 Mr Mudie: Just let me go to something Jim and Philip raised, this question of when you realised you Q607 Mr Mudie: I know you are scarred and I know were in trouble in August, you said you looked, you regret it and I accept that you sincerely regret it. obviously, at trying to open up lines of liquidity, you The Chairman is distressed and I accept that and I started discussions with the Bank in terms of last accept the sincerity of it but what have you learned resort. Did you look for a market solution during and what would you have done? People looking at August? you would say—you must be used to it in Newcastle, the manager comes out: it is all somebody else’s Mr Applegarth: Yes, we did. In terms of looking for fault. At the end of the day somebody says to him liquidity, it was not simply— “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 Q611 Mr Mudie: No, I am really after a market Rock do? What would you do? What are you saying solution. Did you look for a market solution in to us as a Committee? What lessons have you terms of, as Jim referred to, takeovers and mergers? learned, not about the world, not about Europe but Mr Applegarth: Yes, we looked at two types of about Northern Rock? commercial solution. The first was using our assets Mr Applegarth: I think in essence it is to follow the to borrow and to get greater liquidity. I would revised strategy we announced to the market at the describe that as repo-ing and we did a limited end of June in terms of moving to a lower growth amount of that. The second was what I would model, because life has changed; you will not see the describe as corporate activity, trying to find a safe level of liquidity and pricing that you have seen over haven, and we started that on 16 August, so a week the previous decade be repeated going forwards. after the markets became dislocated. Processed: 30-01-2008 10:46:46 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG3
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16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Q612 Mr Mudie: Did you have any interest? Q621 Mr Brady: The Governor of the Bank was very Mr Applegarth: Yes. clear with us that the freedom of manoeuvre the Bank had was severely constrained by EC Q613 Mr Mudie: Could you enlarge? legislation, including the Market Abuses Directive, Mr Applegarth: Yes, there was one main high street the Takeover Code and some other things. Could clearer, which is why the question I was asked you talk us through the discussions you had with the before, if you were able to find a safe haven, in my Bank and the FSA specifically about the disclosure view, had it been an oVer—not a completed requirements relating to the lender of last resort? transaction but an oVer—from a major high street Mr Applegarth: We were in the process of taking clearer, I think you would not have seen the retail legal advice about whether such a facility would run, in my view. 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 Q614 Mr Mudie: Why did you not get one? You overt and the FSA told us that their view was the have told us how sound your business is, which I same. So both our legal advisers and the FSA came accept. You have a very largely sensible lending to the same guidance for us. policy. It was your borrowing policy that was to blame. You had a very good book. Why could you not secure a safe haven? Q622 Mr Brady: So you had both come to that Mr Applegarth: Primarily because the main high conclusion independently. It was not that Northern street clearer concerned would also have wanted it. Rock was saying “We will have to disclose this even Equally they could not tell, because it still has not if others want it to remain covert”? finished, how long the markets were going to be Mr Applegarth: I think that is fair, yes. 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 Q623 Mr Brady: Looking again at the question of cover the liquidity issues we had. 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, Q615 Mr Mudie: Who did they ask? if you had had those extra few days? Mr Applegarth: The central bank. Dr Ridley: Yes, the answer to your question is that had the leak had not happened and we had been able Q616 Mr Mudie: When? to announce on the Monday the facility with the Mr Applegarth: The corporate activity talks broke Bank of England in a measured fashion, with full down on 10 September, so I imagine just before 10 communication plans in place, undoubtedly there September. would have been some concern—a lot of concern— to many of our customers but we think it would have Q617 Mr Mudie: So specifically on 10 September the been considerably less than it was in the way that it bank—and I presume the Bank of England—said came about. Nonetheless, I think it is worth no? reflecting that all of us, both here and in the Mr Applegarth: That is what we were led to authorities, were surprised by the degree to which understand, yes. 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 Q618 Mr Mudie: Then seven days later they would about us being a solvent and profitable business did have said yes. not have a suYciently reassuring eVect on Mr Applegarth: We were on the night of the 13th, so customers. it is only three days later, going through the process Mr Applegarth: I slightly disagree with that. I think of putting the documentation in place in order to be there are three things that would have stopped the able to announce the Monday after, which I think is run. The first is had we found a safe haven with a a week after, yes. major retail brand and had that oVer in place. The second is had we been able to borrow using the same Q619 Mr Mudie: After the 13th, was your safe haven type of facility that we have used but general. So had still interested if they could have got the guarantee the facility not been bespoke to us but a general from the Bank? Did you keep lines open to the safe facility, I think that would have stopped it. Had the haven? bespoke facility been covert, that would have Mr Applegarth: The Bank made it explicit after the stopped it but I do not think that last one could have retail run had started, the facility to us would be happened. I think the chairman is right in that the transferable. Understandably, in the middle of a probability of a retail run would have been lessened Y retail run it is di cult to find a safe haven. had we been able to do the announcement as we had intended on the Monday, to be able to put facilities Q620 Mr Mudie: Specifically when did they tell you in place and also to actually improve our ability to that the facility was transferable? get the money to the customers. One of the things we Mr Applegarth: The Governor made it clear on that had intended to do over that weekend was to widen weekend, so that would be 15-16 September. the bandwidth on the internet account so you would Processed: 30-01-2008 10:46:46 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG3
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16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless not have had so much frustration from our internet Mr Applegarth: None outside our company. customers. We would have been able to get the money back to customers better. I still think it would Q628 Mr Brady: Do you propose to? have been unsettling for retail customers just based Mr Applegarth: I do not see how we can. on the language used. As soon as you have language used in terms of “lender of last resort” and “liquidity Q629 Mr Brady: Sorry, you said not outside the problems”, that would frighten me as a retail company. What steps have you taken within the customer. company? Dr Ridley: I agree. 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 Q624 Mr Brady: You say that a covert facility would cannot prove or disprove that somebody gave a not have been possible—not possible because of the verbal briefing. legal or regulatory requirements or not possible for the purely practical reason that it simply would have Q630 Mr Brady: Do you have a view as to where the come into the public domain by one means or leak did come from? another? Mr Applegarth: Other than I am pretty damn sure it Mr Applegarth: I think both of those. Firstly, the did not come from inside Northern Rock or our legal advice that we were getting that it was most advisers, no. probably announceable, and that was the FSA’s view as well, and secondly, and secondly, because Q631 Chairman: Could I just go back to Sir Derek there were so many people involved, in practical Wanless and ask about the Risk Committee which terms it would have leaked, and having seen what he chaired: did it have the specific policies for has happened since 13 September and what has got managing liquidity risk? in the public domain, I think that is a pretty strong Sir Derek Wanless: The Risk Committee is a probability. 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 Q625 Mr Brady: Albeit despite sensible clarification Committee monitored that on a regular basis at each of the position that the leak was not solely of its meetings. responsible for the run— Dr Ridley: I am sorry. I did not mean to imply that Q632 Chairman: Did you have an active at all. management policy for measuring liquidity risk? That is what I am asking you. Sir Derek Wanless: We have reports on liquidity risk Q626 Mr Brady: No, I completely accept that. Given which the committee sees. the clarification that took place, if the leak was not solely responsible for the run, it did clearly Q633 Chairman: If you had an active policy, why did exacerbate it; it did take some of that time away from it not work? The thing is, I want to get back to the you and clearly therefore it is a hugely important Bank of England and the FSA. The Bank of England factor in the way events developed. You said in said in April, “It is important that firms stress-test response to an earlier question that you are very and take those stress tests into account.” Secondly, confident, you know the leak did not come from you, the January 2007 FSA report says about risks for you are very confident, I think the implication was, firms and markets that “if economic conditions were did not come from Northern Rock. What kind of to deteriorate, this could lead to crowded exits, inquiry have you mounted within Northern Rock, draining liquidity from the market and causing including presumably your advisers, to establish erratic price swings in commodities, etc.” Did you as with absolute certainty that the leak did not a Risk Committee study those comments? originate there? Sir Derek Wanless: We looked as a Board at the Mr Applegarth: I do not think you can establish with issues of our funding strategy and what the risks absolute certainty that it did not, because you do not were. have monitored telephone calls and whilst you can ask to see written correspondence, that does not stop Q634 Chairman: I am asking specifically were the somebody briefing. Given that it was massively not FSA and the Bank of England reports discussed by in our interests or our advisers’ interests to leak it, your committee in terms of liquidity and how it and given the clear answers we have been given when could seize up? we asked the people concerned, because we kept it Sir Derek Wanless: Those reports were discussed as down to as small a bunch as possible within the part of the ICAAP work. For the whole of this company advisers who knew, as far as is certain, I period we were working with the FSA on our am sure that it did not come from us. ICAAP.
Q635 Chairman: So what did you do when the FSA Q627 Mr Brady: What steps have you taken to in January said that it could lead to crowded exits, establish where it did come from? draining liquidity from the markets? Processed: 30-01-2008 10:46:46 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG3
Ev 68 Treasury Committee: Evidence
16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Sir Derek Wanless: As we explained earlier, we— Q644 Chairman: You see, I put it to you that—and this was mentioned in one of the newspapers this Q636 Chairman: No, you see, your explanation is morning—when rival mortgage banks were scaling not suYcient because at the end of the day, you back their lending in 2007, you were accelerating found yourself in a position where no-one else in the yours. As the Daily Telegraph said this morning, UK found themselves. That is what we are talking almost one in five loans in the first half were about as a Committee, that this is unreal. What did provided by yourselves, and therefore that decision you do as a committee in terms of that liquidity? to expand aggressively is key to this situation. You Sir Derek Wanless: We were going through a process as a Risk Committee and you as the Chairman of the at the time of scenario stress-testing which involved Risk Committee did not do your job, Sir Derek. If looking at 20 scenarios which the Board had signed you had done your job, you would have brought to oV. Fifteen of those scenarios involved liquidity risk, the attention of the Board the comments of the FSA including two where securitisation became a in January, the comments of the Bank of England in particular problem. What did not happen was that April and then had a strategy early on in that year to we stress-tested the scenario of what has actually deal with the situation where you did not find happened, which is, as we said earlier, that there was yourself in the iniquitous position of being the only an unprecedented and unpredictable change in the bank in the United Kingdom to face this situation market basis. 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 Q637 Chairman: Can I ask then, in terms of stress your bank at the moment. tests, do you think stress tests should now include Sir Derek Wanless: The position is not like that at more extreme scenarios such as the one you that you all. The position is we were stress-testing, plausible have recently faced? stress tests— Sir Derek Wanless: Clearly, this now having happened to everybody will stress-test— Q645 Chairman: You were stress-testing but your stress-testing was not enough, because you ended up Q638 Chairman: So your stress tests were in this inglorious situation. insuYcient? Sir Derek Wanless: Our stress-testing was, as stress- Sir Derek Wanless: Our stress tests at the time were testing, plausible and— exactly what they should have been, that we agreed with the FSA— Q646 Chairman: This is unreal. Sir Derek Wanless: No. The position is, and it was Q639 Chairman: No, no, no. At the end of the day, confirmed to you by the FSA, who said no here we find ourselves in a situation where you are reasonable professional would have forecast the set the first bank to have a run in 140 years. Were your of circumstances that happened. They also— stress tests suYcient? That is the question. Sir Derek Wanless: Our stress tests at the time were Q647 Chairman: The FSA never said to us that no- suYcient. That is the point I am making. one could have found themselves in this position but Northern Rock, so the FSA did not come here and Q640 Chairman: So they were suYcient and you got give you support as Northern Rock so do not try and yourself into this situation. Why did not other banks kid us on that. in the country not get themselves into it? Why are Sir Derek Wanless: I am not. The FSA said, and you alone? This is the question we as a Committee others have said too, that what has actually are asking. Why are you alone here, Sir Derek? happened, the sequence of events, was not Sir Derek Wanless: What we are required to do is to something which was regarded as a plausible stress look at— 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 Q641 Chairman: Why are you alone, of all banks? course, since this has happened people will do Sir Derek Wanless: I think we went earlier through diVerent stress tests but the stress— the issue of what might have been happening in other banks. Q648 Chairman: The FSA said to us that they have to learn lessons on stress-testing. Implicit in that is Q642 Chairman: Why are you alone? That is the the fact that your stress-testing was not enough and question. Why do you stand on your own? Why are that is how you found yourself in this embarrassing you an orphan in the banking sector? situation, and you, as the chairman of the Risk Sir Derek Wanless: We do not know precisely what Committee, should have been alert earlier on in the the position was in other banks. Clearly, we are the year when the FSA and the Bank of England were only bank that has had a run. giving these warnings, and I put it to you that you were not doing your job. Q643 Chairman: You are the only one who went to Sir Derek Wanless: No, we have made it clear that the Bank of England. the stress-testing was tested against a tightening of Sir Derek Wanless: We are the only bank who have the credit markets, which we expected, and our had a run. That was crystal clear. strategy, as Mr Applegarth explained earlier, was Processed: 30-01-2008 10:46:46 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG3
Treasury Committee: Evidence Ev 69
16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless actually slowing down the growth of assets and happened in May, when we raised £4 billion through selling books, for example, the commercial lending a Granite issue, it was oversubscribed and at book. So we were taking action through the half- attractive prices. There was no indication at that year. We did not foresee the unprecedented and time, as late as May, that good-quality UK unforeseeable changes and the sequence of events mortgages, put into a securitisation vehicle, was that have happened. That is very clear. going to be a diYculty in terms of raising funds.
Q649 Chairman: So at the end of the day your Q655 Mr Fallon: So there was no increase possible in answer to us is unsatisfactory. You do not really the interbank rate that you did not stress-test? know how you got yourself in this situation where Sir Derek Wanless: We have not had a problem with you are alone in the United Kingdom. change in the interbank rate since August. The issue Sir Derek Wanless: No, we know exactly— certainly aVects profitability but that is not the issue we are here to talk about. Certainly our underlying Q650 Chairman: You, as the chairman of the Risk profitability is impacted by changes in margins but Committee, did not do your job. we had actually taken a good deal of action as early Sir Derek Wanless: The Risk Committee and the as January of this year to prevent any mismatch in Board did its job, in my view, properly through interest rates from hitting our bottom line. this period. Q656 Mr Fallon: It was your job and your Risk Q651 Chairman: It did its job and it ended up in this Committee’s job to assess properly the risk of hugely embarrassing situation, causing pain to illiquidity and to ensure the Board was prepared people in the North-East, not least your employers against it. You failed and that is why you have ended in the community. But you did your job. That is up dependent on £13 billion worth of public money. what you are saying to me this morning. Sir Derek Wanless: We take at each time, because we Sir Derek Wanless: What I am saying to you is there only have foresight, not hindsight . . . When we is a sequence of events that go through from sub- looked at our funding strategy and had a very clear prime problems in the States to the run on Northern strategy which said the first line of defence is good Rock which requires a good deal of careful analysis credit quality. The first line of defence is to make to find out what the issues are. sure we have available so we can securitise or put into covered bonds good-quality mortgage assets Q652 Chairman: You are out of step with every and that we have. Nobody has criticised, in fact other retail organisation in this country and you people have indicated to you, I think, that we have have no adequate answer to this Committee as to good-quality assets. That was the first issue, so that why you stand on your own. the markets would distinguish between what were Sir Derek Wanless: We were an outlier in terms of clearly very poor US sub-prime loans and good- wholesale lending in total, securitisation in total. quality UK loans. The first line of defence. The That is true and the figures show that. We were not second line of defence was to increase our retail an outlier in terms of maturity, the structure of the deposits, which we did both in the UK through a wholesale lending. diVerent product range and also in Denmark Chairman: You ended up in disgrace. That is the through opening a subsidiary there which was issue. successful in raising funds. We then opened up a securitisation covered bond and wholesale markets Q653 Mr Fallon: You have made it clear that you geographically round the world. To have tested the stress-tested some aspects of securitisation, Sir scenario which said that what would happen was all Derek. Because you were over-dependent on the of those markets and all of those geographies would wholesale markets, what you did not stress-test were close and be closed for a prolonged period—because movements in the interbank rate. That was the clearly we can cope with short periods of closure of position, was it not? This whole business model was those markets—was unprecedented and a gamble on interest rate movements. unforeseeable and therefore it was not in our stress Sir Derek Wanless: No, it was not and is not a tests. gamble in that sort of way. The issue that has happened is a complete drying up of liquidity, not an Q657 Mr Fallon: Do the four of you realise the issue about price. We expected the price would damage you have done to British banking? change in the marketplace and that the tightening Dr Ridley: We realise very acutely the pain and that the chairman referred to would be a tightening distress that has been caused to our customers and of pricing in the marketplace and therefore it would to others in the banking industry, yes. cost us more to raise securitisation. That was something we expected and it was something that we Q658 Chairman: Can I just ask Sir Derek again, to were planning for. follow that up, 75-80% of your business is depending on mortgage. Is that right? Q654 Mr Fallon: You mean you were ready for any Sir Derek Wanless: On securitisation, on non-retail. kind of increase in the interbank rate? Sir Derek Wanless: We were ready for foreseeable Q659 Chairman: These are public figures. Let us changes in our securitisation pricing. If you look at look at HBOS. They are the biggest mortgage lender the prices of our securitisation, if you look at what and only 20% of their profit is gained from it, so Processed: 30-01-2008 10:46:46 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG3
Ev 70 Treasury Committee: Evidence
16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless diversification is important. You were not Q665 Chairman: I am not saying. The point is, Sir diversified enough, Sir Derek. That was how you got Derek, they are saying that diversification is yourself as a company into this situation. It was important. too late. Sir Derek Wanless: We had a model which was Sir Derek Wanless: The company has had a very simple and well understood. It was sold to the successful strategy, which— 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 Q660 Chairman: You were not diversified the this year sold our commercial finance business. enough. That is the point I am making to you. There is a concentration on mortgage assets. That Sir Derek Wanless: The company strategy has been concentration was well known to all of those people very clearly articulated and it is to concentrate on with whom we do business. mortgage and— Q666 Mr Breed: Mr Applegarth, when did you Q661 Chairman: Exactly, so you were not diversified qualify as a banker? enough in the case of a crisis. Mr Applegarth: I am not a qualified banker. Sir Derek Wanless: No, that strategy has been a very successful strategy. 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 Q662 Chairman: You only had one well to go to V where other companies had a number of other wells, of policy, you sold o the commercial book, and you HBOS and others, and that is the situation, and that issued a profits warning. The Risk Committee is what you did not see as a company or you ignored seemed to carry on as normal; it did not have any as a company. You only had one well from which increased meetings. Everything was going along as if to drink. you thought it was normal. There was the so-called Sir Derek Wanless: That is simply not true, and close control of the FSA, which seemed to me those who comment on the shares, the analysts, talk anyway to be non-existent, and in the end you about our well-diversified funding stream. Retail, contacted the FSA on 13 August. During the whole wholesale, covered bonds, securitisation gave us of this period of time what discussions or meetings channels which opened up markets around the took place with your external auditors? world and nobody has foreseen that all of those Mr Applegarth: Our external auditors’ first point of markets would close at the same time. 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 Q663 Chairman: Sir Derek, again, this is unreal. You contact was much more frequent than that. depended for 75–80% of your business on mortgages. Other reputable companies were Q668 Mr Breed: So the external auditors were well diversifying and, as I say, in the case of HBOS, they aware of the situation on at least a monthly basis only depended on it for 20% of their profits. If you between March and August, yet it appears to me that had diversified, if you had sat with an ambitious they sent a letter expressing their concern about the chief executive and said, “Look, Adam, don’t put all liquidity and everything else, I think, on 11 your apples in the one basket because we are going September, which seems to be somewhat late. to end up in a car crash here” and things could Sir Derek Wanless: If I may, as the chairman of the have helped. Audit Committee, answer that— Sir Derek Wanless: That is simply not the way that we saw it or any— Q669 Mr Breed: So you are Chairman of the Audit Committee as well as the Risk Committee? Q664 Chairman: It is the way everybody else in the Sir Derek Wanless: Yes, I am. The auditors did the V way UK sees it. normal job in the interim results signing o . There Sir Derek Wanless: No commentators saw that. The were no liquidity issues which the auditors needed to model that we described for the business, which was pay special attention to at the time of the interim a concentration on mortgage business, was a very results in July. clear, transparent model— Chairman: Sir Derek, I have spoken to chief Q670 Mr Breed: So the auditors felt no need at any executives of major banks— time to alert the FSA or the Bank of England as such Jim Cousins: Which ones, Chair? about any concerns they might have had in the Chairman: I am not saying which ones. figures that they were seeing from Northern Rock? Jim Cousins: We have had 20 minutes grandstanding Sir Derek Wanless: You would have to ask the from you. Do you not think that is quite suYcient? auditors but I would be astonished if they did What other banks have you talked to, Chairman? because they did not alert us to any issues at that Chairman: I am saying diversification is important. stage. Jim Cousins: You are telling this Committee you have talked to other banks who are cleverer. Please Q671 Mr Breed: Do you think their letter of 11 tell this Committee what other banks they were. September was timely? Processed: 30-01-2008 10:46:46 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG3
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16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Sir Derek Wanless: I am not quite sure exactly which been told through the media. The rational view was letter you are referring to. “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 Q672 Mr Breed: Bearing in mind you had a liquidity being told by depositors who came for their money? crisis on 9 August, it seems about a month later they Mr Applegarth: I can understand readily the logic of decided to send a letter. somebody who has their life savings invested in an Sir Derek Wanless: The auditors were in contact institution and who sees pictures of people queuing with the company and knew well that the company outside the door and they go and join that queue. were keeping the Tripartite informed, as we That is quite a logical reaction. One of the problems mentioned earlier. with the depositors’ scheme was it is not simple to explain, in that the existing scheme was until recently Q673 Mr Breed: So they felt no need whatsoever to guaranteed up to £2,000 and then a certain express an opinion. percentage up to another. It does not lend to sound Sir Derek Wanless: You would have to direct that bites when you are trying to deal with customers to them. either on the telephone or queuing outside your branch.
Q674 Mr Breed: Who are your auditors? Sir Derek Wanless: PWC. 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 Q675 Mr Love: I am going to make a very big gathered any evidence from this process. It might assumption, which is that you, as the operators of help with the psychology of all of this. Northern Rock, understand Northern Rock Mr Applegarth: The first set of evidence we tried to depositors better than anyone else. What I am trying collect was what issues they were having actually to get to the bottom of is the psychology of what getting the money out. It was not just queuing happened on that Monday morning. I am going to outside the branches, because that was actually the make the assumption again that there is some least money going out, although it was the most evidence, that you have got your employees to talk visible sign of a retail run. It was what was to these depositors about why they were happening with internet withdrawals, what was withdrawing their money. I want to be clear first of happening with postal and telephone withdrawals. all, because there seems to be a diVerence of view The logic was at the time, and I perfectly understand between the chairman and the chief executive about it, “We have seen pictures. You have got our life whether or not the BBC leak was instrumental in savings. I want it back. I do not really want to what happened. I think you were saying Mr withdraw it and I’ll bring it back.” In fact, that is Applegarth that you thought that the diYculties you what we have seen. We have actually seen depositors would have had would have probably led to that returning cheques but I perfectly understand the although it might have been exacerbated by the reaction they took. I would have probably done the BBC. Dr Ridley, you said that you thought if you same thing if I was in their shoes. could have handled it, it would have been okay. Can we get clarity? Are we moving towards Mr Applegarth’s view of things? Q679 Mr Love: You talked about a safe haven. The Dr Ridley: Just be clear, I never said that if there had Governor of the Bank of England said to us that the been no leak everything would have been okay. I Takeover Code made it impossible to do what simply said, which was exactly what Mr Applegarth traditionally the Bank of England has done. Do you said, that the management of the communication on think it was an institutional arrangement like the the Monday morning would have enabled the shock Takeover Code or were there failures in the way that to depositors to be slightly less. the bank interacted with Northern Rock and the possible high street bank that you mentioned that could have taken over Northern Rock? Q676 Mr Love: You mentioned, Mr Applegarth, a Mr Applegarth: I think the Bank of England acted number of things that you thought could have remarkably smoothly within the constraints it had. helped. Let me ask you about one of the ones that Clearly, it would have been impossible to get a was raised by us with the Governor of the Bank of completed transaction over a weekend but it is my England and subsequently now by the Chancellor, view that, had you had an announceable oVer over deposit insurance, both in terms of time and in terms the weekend with a major high street brand, that of the coverage. Would that have made the would have provided suYcient confidence so a run diVerence? did not happen. 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 Q680 Mr Love: That did not happen. Was that withdrawals. That must be true. because of something that the Bank did or was it the Takeover Panel rules that precluded that from happening? Q677 Mr Love: How about the time? Were people Mr Applegarth: I understand in the first instance it coming to you? This is anecdotally what we have was because a facility similar to the one we got was Processed: 30-01-2008 10:46:46 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG3
Ev 72 Treasury Committee: Evidence
16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless not available to the main high street bank at the Q686 Ms Keeble: Earlier you said that the average time. It was subsequently made available in the first mortgage life on your books was three years. weekend of the run but, unsurprisingly, in the Mr Applegarth: Three years one month, yes. middle of a retail run it is diYcult to find a safe haven. Q687 Ms Keeble: If you say a third of them are very new, what is the profile for the rest of them? The Q681 Mr Love: The final thing I want to ask you is point is really the length of time that people hold a about whether it should be overt or covert. The mortgage before they either pay it oV or remortgage Governor told us it is a Directive from the European rather than the average lifetime of the mortgage as Union on market abuse. There are many reasons you have got them now. They are obviously two why we would want to make overt lots of things that diVerent things. would be covered by a Market Abuse Directive. Would you be suggesting, from your experience, Mr Applegarth: Yes, of course they are. The average that we should be thinking seriously about changing life of a mortgage product is three years one month. that and making it covert in the very specific The length of time a customer stays with us, circumstances that you were facing? however, is back up to seven years. Because, as the Mr Applegarth: I think a general rule that chairman said, we are very good at retaining our transparency is good I would sign up to, but there mortgage customers, the average life a customer is are occasions where discretion of being able to make with us is extended but his mortgage product is something covert might have helped. The problem short. So what you are finding is mortgage the bank would have faced even if it could have made customers are increasingly having two or three or it covert is in practical terms because, as proved by four products with us during their life before they the leak to the BBC, in practical terms, there will be leave us. The mortgage product—and it is the so many people involved in terms of advisers, etc, mortgage product that you are funding—has an that it would have got out and that in itself would average life of three years one month. have been damaging. If you think it is going to go out, you might as well try to manage the Q688 Ms Keeble: Perhaps we can have that profile communications well, and this is where I am in when we get the figures. The other thing is that you agreement with the chairman: the probability of a said much earlier on in the questions—and I might run would have been lessened had we been able to do not have got the wording exactly right—that you the full communication over the Monday morning had some more risky investments that you moved as intended as opposed to having to rush the oV-balance sheet. communication on the Thursday morning. Mr Applegarth: Yes. Q682 Chairman: Sir Derek, when you were Chief Executive of NatWest the Bank of England Q689 Ms Keeble: Can you just explain what that supervised you. What was the diVerence in approach was? It was just a throw-away phrase. between the Bank of England supervision and the Mr Applegarth: Of course I can. Under Basle II, FSA’s now? when you get your Basle II approval, the relative risk Sir Derek Wanless: The supervision in the 1990s was weighting of certain assets in your balance sheet a good deal more informal. The procedures which changes. So what we had, because of the quality of exist under the FSA tended not to be there at that the loan book, was you saw our risk weighting for time and there was a good deal more personal residential mortgages come down from 50% to 15%. discussion. That clearly required less capital behind it, so that links to why we were able to increase the dividend. Q683 Chairman: Would you say they monitored We had some assets whose risk weighting did not liquidity and funding more in the Nineties? change. Commercial lending is a good example. It Sir Derek Wanless: No. remained 100% risk weighted. Relative to the mortgages, which had gone down to 15%, they were Y Q684 Ms Keeble: I have a couple of questions. What therefore less capital e cient and therefore it made V percentage of your mortgages were taken out in the sense to remove that type of asset o the balance last couple of years, during your big expansion sheet. It also tied in well— programme? Mr Applegarth: We have been growing our assets by Q690 Ms Keeble: Can you just say again what they 20% plus or minus 5% for the last 17 years. were? I did not catch it when you went through it. Mr Applegarth: Commercial lending, unsecured Q685 Ms Keeble: If you could just say the percentage lending, commercial buy-to-let. Those were the by value, not by number, because presumably they three prime areas. are a bit larger now. Mr Applegarth: Yes. I would imagine over the last two years—and I will provide the exact number for Q691 Ms Keeble: Those you moved oV-balance you in writing—it probably accounts for around a sheet? third of our current lending.13 Mr Applegarth: Those we announced publicly that we were going to. We had only completed the three 13 Ev 233 parts of the commercial sale. Processed: 30-01-2008 10:46:46 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG3
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16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Sir Derek Wanless: We sold them. Mr Applegarth: That is not true. They had no knowledge that they had been named a beneficiary Q692 Ms Keeble: I see. You sold them. All of them, or potential beneficiary if there was a windfall from or you got through part of them? the master trust at some time in the future. Clearly Mr Applegarth: We sold all the commercial, and it they knew about us because the reason they were was in three stages, but clearly the market picked is that in 2001 they were one of our three dislocation has meant we have not been able to sell corporate charities. the unsecured or the commercial buy-to-let. As markets return towards normal, so we should be Q697 Chairman: You gave them £40,000. able to do that but that will take some time. Mr Applegarth: Yes, the staV raised £40,000.
Q693 Ms Keeble: Can I just ask because you said Q698 Chairman: What they are saying is they were “the unsecured”. Does that mean your new package not consulted about this. is included in the riskier portfolio? Can you just Mr Applegarth: It is not usual to consult them but I describe a bit about the buy-to-let and why that is have to say we have spoken to them and I have perceived to be riskier? written to apologise. 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 Q699 Chairman: Some would say it is identity fraud to get the first-time buyer product and there is stand- if you use a name and they do not know about it. alone unsecured lending. Our aim was to sell the Mr Applegarth: I would not go so far as identity stand-alone unsecured because the unsecured would fraud but I have written and apologised and they together perform so well. Its three months plus have accepted my apology. arrears are actually less than the industry average for secured lending. So we looked to move oV the Q700 Peter Viggers: One of the aspects of this aVair balance sheet, sell, the stand-alone unsecured and which has caused so much damage is the lack of a that accounts for 60% of that £7.8 billion. The risk clear, informed market for quite a long period, from weighting under Basle II did not go up. It was just 9 August, when you first knew of the liquidity the relative risk weighting versus mortgages which problems, through to 14 September, when you made came down. The same applies to the commercial your announcement. Obviously, the FSA and the buy-to-let. The commercial buy-to-let did not Takeover Panel have some responsibility for change its risk weighting, just relatively compared to ensuring that there is no false market, that there is an mortgages, which came down, made it look informed market, but the prime responsibility is therefore less capital eYcient. So it is good-quality yours, and there must have been many times during lending but it did not fit in a high-quality asset this turbulent period when you considered what balance sheet because we believed that high-quality public announcements you should make. Can you assets and transparency was the way to maintain please talk us through the narrative of that? liquidity. Wrong! Dr Ridley: Certainly. You must remember that on 9 August it was not as if there was a sudden change in Q694 Chairman: You mentioned special-purpose our profit forecast. This was the beginning of a vehicles. You have the Granite special purpose squeeze that, if it lasted only a short number of days, V vehicle. What is the purpose of that? would have no e ect at all. As it went on and it Mr Applegarth: Granite is our securitisation vehicle became clear that there would be an impact on the and accounts for roughly 50% of our funding. The profit forecast, we were keeping in very close contact way securitisation works is you borrow against a with both the authorities that you mentioned and pool of mortgages. The bond holders, the people also our own legal and other advisers, broking who are lending the money against it, they carry the advisers, about whether we needed to make an risk and therefore there can be no risk from those announcement. The other thing we had to take into loans to the PLC’s balance sheet, so even though it account was that we were by then in talks with the is shown in our balance sheet, it has to be a separate potential safe havens that have been mentioned. So legal entity. The separate legal entity is a master we simply took the best advice we could on when and trust. where we needed to make announcements and we made exactly as many announcements as we were Q695 Chairman: Just one point there. In the advised we had to make. agreement with Northern Rock the Law Debenture Corporation names a particular charity, Down’s Q701 Peter Viggers: Just for the record, can you Syndrome North East, but this charity has come out remind us of the share price performance during with a statement saying that they were not consulted. this period? Mr Applegarth: Indeed, and I regret that. We have Dr Ridley: There was a sharp decline in the markets spoken to them and I have written to apologise. The generally in the middle of August and some recovery master trust— after that.
Q696 Chairman: They say they had no knowledge of Q702 Peter Viggers: You took advice and made Northern Rock at all. That is what they said. It announcements when you were advised to make seems an extraordinary step that you took. announcements? Processed: 30-01-2008 10:46:46 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG3
Ev 74 Treasury Committee: Evidence
16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Dr Ridley: We were absolutely clear that we made Sir Ian Gibson: We do not know. every announcement that we needed to make when either we needed to announce a change of profits or Q711 Mr Dunne: You do not know what proportion we needed to announce discussions with other of your shares are held by your employees? parties, and while the discussion of the facility with Sir Ian Gibson: No. We know that 75% of employees the Bank of England was going on, that was also a hold shares. We will find out for you from the small relevant factor that we were told we had to take share register— into account. Q712 Mr Dunne: I am astonished to hear that no Q703 Peter Viggers: You maintained contact with member of the Board knows the proportion of the relevant authorities throughout? shares held by its staV, given the importance that you Dr Ridley: We maintained contact with the relevant place on employee ownership in the company. You authorities throughout. know 75% of your employees hold shares but you do not know how many shares they hold. Do you know Q704 Chairman: Dr Ridley, did you think it was V how many shares are held by the foundation? appropriate to o er a 14.2 pence dividend to Dr Ridley: The foundation does not own ordinary shareholders, almost £60 million in total, whilst the voting shares. What it owns is a stake that converts bank was under Treasury protection? into 15% of the company on takeover. 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 Q713 Mr Dunne: Does the foundation receive decision to not pay it. That was a decision that had dividends on those interests? to be a careful balance of judgement between on the Dr Ridley: The foundation receives in lieu of a one hand— dividend a covenant of 5% of pre-tax profits.
Q705 Chairman: Your announcement was Tuesday Q714 Mr Dunne: So the foundation had no interest 25 September but a couple of days before it you were in a dividend decision as such? still saying you were going to pay it out. There was Dr Ridley: That is correct. The foundation has had a bit of a brouhaha in the press that day. What £175 million from us over 10 years. changed your mind about paying it out then? Dr Ridley: We were taking continuous advice and Q715 Mr Dunne: Indeed, which is very impressive listening to all parties, including the FSA and others, and distressing to the foundation that that is now and we were having to balance the judgement going to seemingly come to an end. Are any between, on the one hand, paying cash out of the members of the Board directors of the foundation? business and, on the other hand, our obligations to Dr Ridley: No, currently no members of the Board shareholders. are directors of the foundation.
Q706 Chairman: Do you think it was appropriate to Q716 Mr Dunne: Will the foundation, given its pay out £40 million to preference shareholders, even contingent ownership position, have an ability on a though you had cancelled the payment to ordinary transaction with a third party to act as a blocking shareholders? shareholder in the event that a transaction Dr Ridley: That is simply a mistake that was made materialises? in the press. It was not a dividend to preference Dr Ridley: My understanding is that its stake shareholders; it was interest on a debt. converts automatically.
Q707 Mr Dunne: Following up on that, what Q717 Mr Dunne: Into 15%? proportion of the shares of Northern Rock are held Dr Ridley: Yes. by the Board? Dr Ridley: I do not know the answer to that question. Q718 Mr Dunne: Therefore it could have a blocking shareholding if the acquirer acquires 100%. Q708 Mr Dunne: Approximately? Dr Ridley: No, it converts once the acquirer has, Dr Ridley: Can we write to you on that?14 whatever the expression is, full control. Mr Applegarth: It is not blocking. It is a dilution. Q709 Mr Dunne: Is it a significant proportion or it is an insignificant proportion? Q719 Mr Dunne: Picking up the Chairman’s Dr Ridley: I should imagine it is a pretty comment about the decision to reverse the dividend, insignificant portion. did you have any discussions with the Bank of England which helped you change your mind? Q710 Mr Dunne: What proportion of the shares are Dr Ridley: No. The discussions about the dividend held by employees? we had were with the FSA and with other advisers. Dr Ridley: Seventy-five per cent. Sorry. It is the other way round. Q720 Mr Dunne: Were there any discussions with someone from the Treasury or the Chancellors 14 Ev 233 oYce? Processed: 30-01-2008 10:46:46 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG3
Treasury Committee: Evidence Ev 75
16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Sir Ian Gibson: On the day that the Board reached Q725 Mr Love: They can do that at any time, or do the decision not to pay the dividend there were they have to do it before the closure? discussions on a broad range of issues, including the Mr Applegarth: They have to do it at certain dividend, with the Tripartite group. The Treasury specified dates. was there, the FSA was there and the Bank representative was there too. Q726 Mr Mudie: I think there is general agreement that if we had a market solution it would have been Q721 Mr Dunne: So would it be fair to characterise better all round. Andy asked questions of the your decision that part of the contributory reasons Takeover Panel. Did your advisors indicate any to changing your decision on the dividend was diYculty in the safe haven deal being dealt with in a because you had been leant on by the authorities satisfactory timescale, in other words, not reaching that were providing the bank facility? the Takeover Panel? We got the impression from Sir Ian Gibson: No, it would not be fair to certainly the Bank of England that it was impossible characterise it like that. because of the Takeover Panel and the length of time and market disclosures, etc. Q722 Mr Dunne: How would you characterise the Mr Applegarth: You certainly would not have been nature of those discussions with the Tripartite able under the current legislation to actually members on the dividend? complete a transaction within a weekend but we Sir Ian Gibson: They wished to understand in detail would have been able to have an oVer of a what the Board’s thinking was at the point at which transaction, and it is my belief that the oVer of a we were having those discussions with them, where transaction with a well-known bank would have we stood on dividend, where we believed been enough to stop it. 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 Q727 Mr Mudie: You started discussions in mid- our regulatory capital. We explained our thinking to August and they came to a head in September. The them on those fronts and explained the process that chairman rang the Bank of England on 16 August. the Board was then going through in terms of its That was certainly a direct line then. Where were the review over whether or not to pay the dividend. FSA in terms of liaising, speaking, working with you throughout August into September? Q723 Mr Dunne: So the Board changed its view Mr Applegarth: We formally had two calls a day rather than was persuaded to change its view? with the FSA but I have to say that the number of Sir Ian Gibson: I think the chairman characterised it informal contacts were greater than that. So we were well, which is that we must as a Board or as a sub- in very close and continuous contact with the FSA committee of the Board have discussed the dividend and, of course, they are our lead contact for the payment almost daily—I do not have my notes with Tripartite and they garner information oVers for me but very frequently during that period. I noticed others in the Tripartite and they pass the Chairman of this Committee’s comments during communication across. So the FSA were kept right that period, for example. We looked at a whole up-to-date with everything we were doing on bunch of comments that were made. You said it was corporate activity. 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?” Q728 Mr Mudie: How up-to-date and how Dr Ridley: On the point about what proportion of supportive were they of this safe haven? our shares are held by employees, I do know that we Mr Applegarth: I think it can be generally have a very large number of small shareholders in characterised that everybody could see that it would comparison with the size of our staV and that is why be a potential— we know that it is a small number. The proportion of shares held by employees will certainly be less Q729 Mr Mudie: When you say that, can you than 10% and almost certainly less than 5%. confirm that “everybody”? It is certainly not the evidence that the Bank of England could be included Q724 Mr Love: On a related issue, I understand that in that “everyone”. the company continued to urge employees to buy in Mr Applegarth: That is a fair point. I am relying on the share-save scheme that you operate up till the feedback from the FSA, who are our key contact of end of August, when clearly there were some the Tripartite. It may be either the chairman or the Y di culties. In retrospect, do you think that was a senior independent in their direct contacts with the sensible decision? As I understand it, it came to an Bank got a diVerent view. 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 Q730 Mr Mudie: So the FSA in eVect were the lose significantly from the purchase of those shares? liaison point between you and the Tripartite, and the Mr Applegarth: The Save As You Earn scheme, the FSA therefore worked closely, I presume, on the safe money that is invested they can withdraw back as haven argument with you and regarded it as serious cash, so in terms of losing their money, no, that was enough to actually take to the Tripartite to ask them not the case. to consider. Processed: 30-01-2008 10:46:46 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG3
Ev 76 Treasury Committee: Evidence
16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Mr Applegarth: Yes. 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 Q731 Mr Mudie: Did they give you any stronger and were negotiating towards that. We were not part feeling than that? We failed to get Sir Callum, maybe of that negotiation. out of loyalty to the Tripartite, to say specifically that he supported it. I am at a loss. If his Q735 Mr Mudie: That was the thing that broke the organisation took it to the Tripartite, they clearly deal. Did you respond to the Bank of England in would not have wasted their time or wasted your terms of shock or anger or disappointment that the time in a pretty fraught situation by taking deal had foundered because of their decision, or did something that was lame at that point in the game to you just accept it? the Tripartite. Did you get the impression they were Dr Ridley: No. As I say, we continued to speak to supportive, that they thought it was a serious idea? anyone and everyone. Mr Applegarth: I think the hard thing we have in answering that question is clearly that we were not Q736 Mr Mudie: No, no. I am just asking. The party to the Tripartite discussions. We only know normal point would have been to pick up the the feedback from the FSA and they were telephone and speak to the Governor of the Bank of encouraging us to look at every opportunity to avoid England and say, “What the hell are you doing? We having to go to a lender of last resort. 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 Q732 Mr Mudie: Let me just ask you this, as a not? layman. Certainly you, Dr Ridley. As an ordinary Sir Ian Gibson: Could I comment? bloke who hears disaster being faced, you work with the FSA and you have another organisation willing Q737 Mr Mudie: No, let the chairman. I am just to take you over and save all the problems. The FSA V asking for a specific point of view from the take it o to the Tripartite and you get a decision no. chairman. The whole thing is in your hands, what Did you just accept this with aplomb or did you pick your company, your staV, your depositors are up the telephone and speak to anyone and say facing. Did you pick up the telephone and play hell “What the hell is going on?” I find it strange. with the Bank of England? Dr Ridley: We were only going to be in a position to Dr Ridley: We spoke to the Bank of England about V take or not take a decision when we had an o er. We all of this, yes, but— were doing everything we could behind the scenes, both with the authorities and through our advisers V Q738 Mr Mudie: I know you did but just answer the with other corporate parties to encourage an o er to question. When the decision came back “Sorry, they come forward in the interests of our shareholders, can’t agree the facility,” I am just as a layman creditors and other stakeholders. Yes, we picked up thinking anybody in this room would have said, “I’d the phone to anyone and everyone. better speak to the guy. He doesn’t understand how serious this is.” Dr Ridley: We were told that it was impossible for Q733 Mr Mudie: No, I am not making myself clear. them to provide the facility. 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 Q739 Mr Mudie: Okay, so you just accepted it. This of characterising it. It is for them to answer about is not a judgemental comment. You just accepted it. that but there was not a deal that was taken by the Dr Ridley: We did our best to put the position. FSA to the Tripartite group, as I understand it. There were continuous negotiations going on Q740 Mr Mudie: Sir Callum said, “I think it is between Northern Rock and the other party, incorrect to regard the private sector solution as V through advisers, and with the FSA talking to both being a firm, cut and dried o er. It was still at an Northern Rock and the other party and the Bank of exploratory stage.” It sounds to me that it was well England likewise. The eVorts being made were to past an exploratory stage, and it would have to be to find a deal that was acceptable to the acquiring give comfort to the depositors. Dr Ridley: A degree of exploration had obviously party, that was likely to be acceptable to ourselves V and required various forms of support from the taken place, yes, but no, there was no firm o er. We never had an oVer on the table. Tripartite authorities. Q741 Mr Mudie: No, but you would have got an Q734 Mr Mudie: Yes, that is the specific point, and oVer, you are strongly confident, if you had had that the Tripartite support was whether the facility that guarantee. was eventually oVered to you was going to be Dr Ridley: We cannot be sure of that. transferable. Was that a condition of the deal from the safe haven? I dislike calling Lloyds Bank a safe Q742 Mr Mudie: Your chief executive seemed to haven because they will use that as a slogan for indicate earlier that he would be content with that years: “Lloyds, the safe haven bank.” and that would have saved the problem. Processed: 30-01-2008 10:46:46 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG3
Treasury Committee: Evidence Ev 77
16 October 2007 Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Dr Ridley: Had an oVer come forward within a day why an announcement was delayed until the rescue or two on that basis then yes, we would have been in package was finalised on September 14, exactly a a better position but of course, you cannot be month later. What answer is there to that, Sir Ian? absolutely sure that an oVer is going to come Sir Ian Gibson: You have heard the answer, that first forward. of all, we were in a series of discussions with not just the one party that has been focused on right now but Q743 Chairman: Sir Ian, finally, do you think a number of potential acquisition partners, and relations between the Board and the shareholders of through that period, with the advice of the UKLA Northern Rock were suYciently transparent? and the FSA, as well as our lawyers, it was not Sir Ian Gibson: I think they were, yes. In fact, to pick suitable to put information into the market. We up a series of questions asked earlier, over the years were, by the way, continuing to fund, as has been Northern Rock’s overall approach has been to be pointed out, varying amounts diVerent days, but we extremely transparent about the simplicity and were always continuing to fund; we were always straightforwardness of its model because that has liquid. The profits that we are now forecasting for enabled it to disclose the quality of its book and ‘07 are in the market and profit warnings were issued therefore attract reasonably priced credit. That has at the appropriate times in all cases. Once we were in continued too with its shareholders. discussions with the Bank of England, our guidance from all involved, including clearance with the Q744 Chairman: The reason I am asking that is that UKLA, was that those discussions be not made lawyers for the UK Shareholders Association are public because there are circumstances, and we have now examining whether there is a potential class certainly seen the results of those circumstances, that action suit against Northern Rock for withholding mean it is not appropriate in the view of the listing crucial information that could have prevented authority or the FSA that certain of those discussions are taken to the market, and they might shareholders from losing millions of pounds. That is V a press comment. Do you feel that Northern Rock be for a di erent business. should have disclosed details of the risks to its Q746 Chairman: Finally, can I ask you to give us a business model sooner? Why did the Board wait a message in terms of the future of Northern Rock whole month before announcing crucial over the next six, nine months to reassure people. information to shareholders? Sir Ian Gibson: First of all, it is a bank that remains Sir Ian Gibson: On the first point, the risk in business, that is solvent, that is serving its information about its model was very clearly in the customers, that is paying its debts, that is paying its market and has been for a very long time. It is a very employees, and it continues to wish to do that and clear presentation of the company that is given in will strive in every degree to do that. Secondly, we our annual report. It is a very straightforward know we have the period essentially between now business. It is essentially a UK mortgage-only and the end of this year in which to work out the business, which some would see as a weakness, most appropriate strategy for the bank, for the others would see as a strength. It depends on your company, for its shareholders, for its creditors, for point of view. The data surrounding that has been its stakeholders and for its employees—we have all transparent to all for a considerable period, not just those groups to consider, and we will—and to bring this year but year on year. As for a secondary that to the Tripartite group and obtain what position, I think colleagues of yours, Chairman, consents and appropriate support are necessary for explored in great detail with the chairman and the whichever of the range of solutions that we end up chief executive just now the whole process that took choosing, and to do that in such a fashion that place from, I guess, 14 August onwards, where we people will say post that event . . . From my consulted legal advisers, the UK Listing Authority, viewpoint, I hope they say “They did the best that the FSA, later the Tripartite, in terms of what was anybody could,” because that is what I want them to appropriate to disclose at what point, either about say and I hope that committees like this are able to other party discussions or about discussions with the say, “In the light of quite unpredictable, unforeseen Bank of England or about the trading circumstances circumstances, they made a decent fist of it in the of the company, and we are fully satisfied that we did end.” follow the best advice and follow it to the letter. Chairman: We have a long way to go there because we are looking at the Tripartite agreement and to Q745 Chairman: I am mindful that the Governor of date not many people have taken responsibility, so the Bank told the Treasury Select Committee that he that is a conundrum for us which we want to was alerted to an impending crisis on 14 August. The examine over the next few months. Can I thank you shareholder group is saying they wanted to know for your attendance this morning. Processed: 30-01-2008 11:21:12 Page Layout: COENEW [SE] PPSysB Job: 386890 Unit: PAG4
Ev 78 Treasury Committee: Evidence
Thursday 25 October 2007
Members present
Rt Hon John McFall, in the Chair
Mr Graham Brady Mr Andrew Love Mr Colin Breed Mr George Mudie Jim Cousins Mr Sioˆn Simon Mr Philip Dunne John Thurso Mr Michael Fallon Mr Mark Todd Ms Sally Keeble
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 and it became clear from the middle of August welcome to the Committee. As you know, we are onwards that it was finding it increasingly diYcult to taking this session in two parts, the first on the issue do so. When that became apparent to the authorities of financial stability and transparency, which we in the middle of August, they did a number of things. hope to spend the first three-quarters of an hour or Firstly, the FSA worked intensively with the so on, and then on the issue of the PBR and the CSR. Northern Rock bank to try and resolve its liquidity On financial stability and transparency, we will be problems by helping it get access to more money, hearing from you again in January, at the conclusion helping it with the securitisation that it had planned of our inquiry, and it would be good if you could and which it depended upon. It also had discussions confirm in advance of your final report on deposit with, I think, two institutions which showed some protection and other related banking issues that this interest in acquiring either part or all of it but of would fit in with your timetable. course, unfortunately, these did not materialise and, Mr Darling: Yes, it would. as you know, Northern Rock found it progressively more diYcult to get funds even at a price that it was Q748 Chairman: Thank you. Could you please prepared to pay and eventually it had to come to the introduce yourself and your colleagues. Bank of England for specific support. Obviously, I Mr Darling: I can confirm I am the Chancellor. With am happy to go into further details there as you want me there is Clive Maxwell, who is the Director of but my view of this is that fundamentally the Financial Services and, with your permission, after structure we have in this country, where you have the we have finished the first part of the meeting, he will Financial Services Authority which is responsible withdraw since he is solely concerned with that area. for the prudential supervision of individual Nick Macpherson, the Permanent Secretary, you institutions, is right. We have the Bank of England know, as do you know Mark Neale, who is the which is responsible for the stability of the financial Managing Director for Tax and Welfare and system. I would take a great deal of persuading that Richard Hughes, who is in charge of the you should merge these two. I think that would be Comprehensive Spending Review. very problematic and certainly I do not think anyone would argue we should go back to where we were ten Q749 Chairman: Thank you very much and years ago when we had seven or eight diVerent welcome. Considering that we have had the first regulators. I think there are lessons to be learned in bank run in the United Kingdom for about 140 relation to the interface between the Bank and the years, how successfully do you think the Tripartite FSA. Both of those institutions, the FSA when they Authorities have handled this situation? came to see you a couple of weeks ago, and the Bank Mr Darling: There are certainly lessons to be of England in its Financial Stability Report which it learned. My starting point is this, that what published this morning, recognize that there are happened in the second part of August and early lessons to be learned in the way that we dealt with September was very dramatic. It started in the this in this country as well as there being United States; it rapidly spread from there to the rest international lessons of course as well. 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 Q750 Chairman: We will be having both the Bank of financial institutions became very reluctant to lend England and the FSA before us again before your to each other and there was an acute shortage of report, Chancellor. The Northern Rock run started liquidity. That aVected Northern Rock in particular on 14 September but the announcement to the because of its particular business model. It had changes in the depositor protection scheme for aggressively expanded its market share earlier this Northern Rock customers was only announced on year and was very dependent on being able to get 17 September. Why was there a delay in recognizing hold of wholesale funding on a very regular basis that additional action was required? Processed: 30-01-2008 11:21:12 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG4
Treasury Committee: Evidence Ev 79
25 October 2007 Rt Hon Alistair Darling MP, Mr Nicholas Macpherson, Mr Mark Neale, Mr Richard Hughes and Mr Clive Maxwell
Mr Darling: If we go back to the night of the 13th, Bank between the 15th and the time that ultimately that is, the Thursday night before the announcement Northern Rock had to come for specific lender of was made, you will recall that I think it started to last resort facilities. 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 Q754 Mr Fallon: But for a month the three of you market practice, at seven o’clock the next morning. could not agree on the safe haven option, you could The reason for that is the directors of Northern not agree on a covert rescue operation, and when the Rock had, understandably, decided they had to issue bank run started, you then took four days to put in a profits warning and that it would have been place proper saver protection. disingenuous not to have mentioned that they were Mr Darling: No, none of that is true. Firstly, in going to the Bank of England for facilities but the relation to what happened during that month, as the stories started to appear in the BBC and, of course, Governor told you when he appeared before the the queues started to appear outside some Northern Committee, whilst we were told there were concerns Rock branches the next day. I frankly do not think about Northern Rock at the first Tripartite that the issue of a guarantee or the extent of the Committee on the 14th and, as I said, the Treasury cover under the depositors’ scheme was an issue on and I were formally told on the 15th, at that stage it Friday. It suddenly became an issue over the was by no means certain that all was up with the weekend, which is why I decided that we would put bank. Northern Rock was able to get finance; it was Y a guarantee in place on the Monday. Guarantees, as finding it progressively more di cult but initially it you know, are by no means unproblematic and, as was able to get access to finance. That is why the 15 you have seen with Northern Rock over the last few FSA, as they have said in a memorandum to you, weeks, the nature and extent of the guarantee is quite were working closely with the Northern Rock bank a complicated thing. I think the issue of a guarantee to see whether or not they could help the or people’s concern about whether or not they could securitisation, they could help get additional funds. get all of their money out did not really become an On 29 August the Chairman of the Financial issue until over the weekend. Frankly, on the Services Authority, Callum McCarthy, wrote to me Friday—and indeed, it has been the case ever since— formally drawing my attention to the fact that he people could always get their money out of the bank, thought Northern Rock then had quite real as they can today if they want to do it, but I think problems. I think it was the following Monday that I was very clear by the weekend that, unless I went the Tripartite Committee, the Governor, the further than what I had been saying from Friday Chairman and myself, met. We agreed two things. through to Sunday, and said, to put the matter One is that, because of the systemic importance of beyond all doubt, “We will guarantee the retail and maintaining Northern Rock, we would have to also the wholesale deposits”, their problem would support that bank but, in addition, it was agreed that have continued but the guarantee itself was not an where it might be appropriate, generalised support issue on the Friday morning when those queues to the whole market would be made, and indeed a started to build up. 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 Q751 Mr Fallon: Chancellor, when did you great deal going on. The problem was that by the personally first hear that Northern Rock might be beginning of September it was widely known in the in trouble? market that Northern Rock was very exposed and Mr Darling: On 15 August. they were willing to pay to get the facilities but they were simply drying up. In relation to the covert Q752 Mr Fallon: So four weeks before the bank run. support, the safe haven point, by which I presume In this Tripartite system that you and Mr Brown you mean another company, there was one slight designed, of Governor, Financial Services Authority expression of interest from an institution but that and Chancellor, who was in overall charge? never came to anything. There was one more specific Mr Darling: In terms of the Tripartite Committee? 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, Q753 Mr Fallon: Who was in overall charge? we were clear from the time it became pretty certain Mr Darling: Ultimately it is the Chancellor. As I said that Northern Rock had severe problems that, if in the House of Commons a couple of weeks ago, I necessary, it would be able to get lender of last resort am pretty clear about that. There are discrete facilities. The problem was—and I said this in the responsibilities. As I said, the FSA on prudential House last week—that that I was always very supervision and the Bank in relation to financial sceptical whether or not you could do this covertly stability through its market interventions, but the simply because today’s market conditions are very whole point of having a committee is to allow all diVerent. 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 Q755 Mr Fallon: OK, but looking at the system as a specifically of Northern Rock on 5 August; a great deal of work was being done by the FSA and the 15 Ev 224 Processed: 30-01-2008 11:21:12 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG4
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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 whole that you put in place to protect us against this ultimately is responsible for these matters. I said the kind of fiasco, the plain fact is that you were told on same thing in the House of Commons last week. I am 14 August by Northern Rock that they were going very clear about that. What I want to do though is to run out of money. to make sure that we learn from what has happened Mr Darling: No, that is not true. here. I think there are changes that need to be made, particularly in the interface between the Bank and Q756 Mr Fallon: Through a triangle of indecision the FSA. There are changes too that we need to and dithering, four weeks later they did run out of make in relation to the deposit protection scheme, money. which is perhaps the third point that you mentioned Mr Darling: Northern Rock did not say on 14 in relation to the guarantee because much better August “We are going to run out of money.” What than a guarantee in future would be a system that happened was the FSA said on 14 August it believed would allow us immediately, in the event of a bank that, because of Northern Rock’s particular failing, to isolate the depositors’ funds and pay them business model, because of its exposure, it was the out as quickly as you reasonably can. Therefore concerned about it in general. That problem began there would be absolutely no reason whatsoever for to crystallise at the end of August, when it was clear a depositor with Northern Rock to be concerned that this was not just a generalised worry or a about whether or not their money was safe. As you suspicion but that actually Northern Rock was know, we are consulting on that now. running into quite substantial problems. As I said to Chairman: That is one aspect we will be actively you, during that period prior to the end of August looking at in our inquiry. and after that until the middle of September, extensive eVorts were made to try and resolve the Q758 Mr Simon: When I asked Sir Callum problem with Northern Rock. Remember, Northern McCarthy do you think the Tripartite arrangements Rock is and remains the property of its shareholders work, which is hardly a trick question, he said, “I and it is run by its directors. We were trying to work think that they do work. Each of us has discharged with them to try and resolve this position because as responsibilities.” He did not actually add time went on we became increasingly concerned “admirably” but that was definitely his attitude. about that. In relation to the general problem that Everybody who has been here has told us that the we faced, I said right at the start that I think there are Tripartite arrangements worked and it has all gone lessons to be learned, both in terms of the regulation, fine, and yet we had a run on the bank. There is a because if you look at Northern Rock, look at the huge reality gap which is baZing us all. exposure it had and realise just how dependent it was Mr Darling: Firstly, I do not think, as you rightly on being able to get funds on a daily basis, if that line say, anyone has used the word “admirably” or of funding dried up, as it did, what was its fallback anything like that. My starting point, as I said to Mr position? The answer in Northern Rock’s case is that Fallon a short while ago, is that I think having the they did not have a fallback position. Other FSA responsible for prudential supervision and the institutions like Countrywide in the United States Bank of England responsible for the general stability did have standby credit lines to banks. Northern of the market is the right model, and it is a model Rock did not appear to have that sort of safeguard. that most countries in the world are moving Work was being done but I am in no doubt that we towards. The Tripartite Committee is simply a need to learn from this, firstly, I have mentioned I mechanism for bringing those three things together think, better international surveillance. We have but when you ask was it able to stop Northern Rock international institutions which could be used far seeking funds, no, it was not, but I think it would be more eVectively, and that is something that we wrong in your analysis to say that if only the started work on when we met in Washington last Tripartite Committee was diVerent or it had weekend. In relation to the position domestically, functioned diVerently, this would not have the FSA have said, and it is right, that they do need happened. The big problem was the fact that to look at their procedures and how they regulate liquidity dried up following the failure of the sub- things. The Bank of England has said today that, prime market in the United States. That problem having regard to what happened over that period in aVected America, it aVected the Far East, it aVected August and September, it too needs to ask itself how Europe, there were problems in Germany, some in it would intervene, whether in a general sense or a France, as well as a problem with a particular bank particular sense, because it does worry me; I think here. In deciding what we do next, we have to be central banks do need to be able to intervene in ways clear about what the problem was in the first place that sometimes, in the public interest, are not overt. and I do not think it was the structure of the committee that was the problem. Q757 Mr Fallon: The FSA and the Bank have admitted their responsibilities, their failures. Why Q759 Mr Simon: Is it the problem that the structure will you not admit yours? You are in charge of the of the Committee was not suYciently able to system. This is the first bank run for 150 years. respond to the changing needs of a fast-moving You failed. situation, was not suYciently dynamically Mr Darling: As I said to you right at the start of this responsive to a crisis, and that a new structure needs session, I accept responsibility for what happens at to be thought of which is more responsive to these the Tripartite Committee. The Chancellor kinds of extreme pressures? 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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
Mr Darling: You can always improve structures and of England is doing similar work at the moment. you can always make changes but before you do, Thereafter I intend to publish my proposals, fitting you need to work out what the problem was in the in with your own timetable. I would find it useful to first place. The general problem was the fact that get your observations on these things before I liquidity dried up. The next problem was that you publish the Government’s proposals, which I were dealing with an institution, Northern Rock, understand, given the timetable that I think you are which was hopelessly exposed. Let us deal with those working to, would be perfectly possible but the two problems first of all. One is a generalised answer to your comment, Mr Simon, is that I think problem. I think there needs to be better there is always room for improvement. It would be international surveillance, there needs to be better nonsense to suggest that you could not improve the regulation to stop banks from hiding things oV- present situation. I think we can but I think we need balance-sheet, and there needs to be questions asked to be very clear what problem it is we are trying to on the precise role of what credit rating agencies do. fix. There are all sorts of things you need to do there. The second thing in relation to Northern Rock, I am Q763 Mr Dunne: Chancellor, just in response to Mr quite clear that regulators need to start looking far Simon you said that the big problem was liquidity more at liquidity and not just solvency. They tend to and that it had been identified and alerted to you be more concerned about solvency. Northern Rock that there was a liquidity problem in the markets is and was solvent and it is unusual. Mr McFall was early in August, at the beginning of this process. As asking about banks in the past. BCCI, for example, you have accepted that you have responsibility as was insolvent; Barings became insolvent. With this lender of last resort, the Bank of England is not bank that was not the problem; it was the fact that independent in this context. What were you advising you could not get ready cash. In relation to how the the Bank of England to do in response to the obvious bank and the FSA and ourselves react to those liquidity problem? things, yes, there are lessons to be learned. I think the Mr Darling: The position is that the Bank of FSA needs to have more visibility of what the England would provide lender of last resort facilities consequences might be on an institution like but you are right that I have to authorise it, because Northern Rock on the wider system and, as the ultimately the Treasury might have to guarantee Governor himself has said in the report published by that or it might have to support the Bank in doing the Bank of England this morning, the Bank of so. The procedure is that the Governor and the England needs to focus more on what happens if a Chairman of the FSA would recommend, as they particular institution gets into trouble on the wider did, that support to me. In relation to your other stability of the system. point, as I said, I think in reply to Mr Fallon, when at the beginning of September it was pretty clear that Q760 Mr Simon: Exactly, which the Bank has done whatever Northern Rock was trying to do, it did not this morning but the FSA certainly still has not look like it was going to work, we discussed both done. I understand that the best way to solve these general support in the market and I think it was a problems is to deal with the root causes and the core couple of days after that, probably the 4th or 5th, conditions and make sure that they do not occur that the Bank of England put about £4 billion into again. The question still remains, if you find yourself the market but we also agreed right at the start that, in a crisis like this, are the structures and the because of the importance to the stability of the institutions which consist of all the key actors able to financial system, the systemic importance, we would withstand and to respond to the pressure? We still have to support Northern Rock as an institution. have Hector McCarthy telling us each of us has discharged our responsibilities and the structures Q764 Mr Dunne: Can I take you back to the £4 worked. Plainly, they do not work. billion? You identified earlier that this problem was Mr Darling: It is Hector Sants, I think, and Callum a global problem and was aVecting markets in the McCarthy. United States, in Europe and in the Far East. The central banks in those jurisdictions were providing Q761 Mr Simon: They are as bad as each other. liquidity into the markets in August, not on 4th or Mr Darling: I know you have created a hybrid but I 5th September. You have not addressed my question think they might take exception to that. as to what advice you and the Treasury were giving to the Bank of England to respond to this situation, Q762 Mr Simon: I took exception to them, I can which was global. tell you. Mr Darling: We discussed this on a number of Mr Darling: I am very clear. This is ultimately my occasions and the Governor’s view was very firmly responsibility to make sure that the FSA firstly, is that it would be very diYcult to get suYcient money properly equipped to do its job and secondly, it is into the hands of Northern Rock without putting . . . very clear what the extent of its job is and where the Bear in mind that, as of about a week ago, they told boundaries are. Equally, it is my responsibility the committee they have had to borrow about £13 or ultimately to make sure the Bank also makes £14 billion from the Bank. To get that sort of money improvements. I said this to the Commons the other into the hands of one institution you would have to day: I have asked the FSA to let me have its put many more billions of pounds into the market proposals by the beginning of the year and the Bank generally. Given that the problem was not lack of Processed: 30-01-2008 11:21:12 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG4
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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 capital but was instead particular problems of taking out multi-billion-dollar facilities with the liquidity for Northern Rock, the Governor’s very Fed, or so it has been reported, in order to give firm view was that that was not the right thing to do. themselves back-up lines. If we had a diVerent Notwithstanding that, as I say, on 4 August, in an system applying in this country similar to either in attempt to try and free things up and to encourage the US or in the ECB, surely this situation could banks to start lending to each other, the Bank of have been avoided? England did provide that support. Mr Darling: There is always going to be an argument as to whether you should have general intervention Q765 Mr Dunne: I think that was 4 September. or specific intervention. One of the things that the Mr Darling: That is right. Bank of England has said in today’s report is that it clearly needs to look at that as a result of what has Q766 Mr Dunne: You said 4 August, I think. happened. You are asking me what discussions took Mr Darling: I am sorry; I meant September. place. The Governor, whose primary responsibility it is—one of the two core functions of the Bank is to Q767 Mr Dunne: Had the Bank acted in August in a maintain the financial stability of the system—was modest way and shown a signal that it was prepared very firmly of the view, as he told you when he to provide liquidity to the system, we might not have appeared here two or three weeks ago, and on other got into this problem. occasions too, was firmly of the view that he was not Y Mr Darling: I think it is impossible to say whether or convinced he would be able to get su cient money not that would be the position. into the hands of Northern Rock, and it was into those hands that money needed to go. Q768 Mr Dunne: This is what the ECB did and what the Fed did and they have not had a run on a bank. Q773 Mr Dunne: I have a specific question on the Mr Darling: Both in America and in Europe banks timing of the Northern Rock situation, if I may. You have got into diYculties. have told us that it became public knowledge, as we know, on the evening of 13 September. Where were Q769 Mr Dunne: But they have been able to handle you on 14 September? it in a covert way, and we have not. Mr Darling: I was in London. Mr Darling: It certainly was not covert, either what the ECB did or what the Fed did. Q774 Mr Dunne: Were you not at the ECOFIN meeting? Q770 Mr Dunne: But banks applying for facilities to Mr Darling: That was later that day. the Fed and the ECB have been able to do so without it becoming public. Q775 Mr Dunne: Do you think it was advisable to go Mr Darling: I think the diVerence is that in the outside the country when we were in the midst of the United States they did make money available. It did first run on a bank crisis we have had for 140 years? not stop three or four institutions from . . . I think in Mr Darling: Two things. Firstly, I was in London in fact three or four institutions have actually had to the morning. I think I left about 10 o’clock. The close down in the United States and have been taken reason I went with the Governor was because at that over by other banks. In Europe some of the smaller meeting I wanted to get European agreement to start German banks got into diYculties. So it is not just a looking at some of the diYculties we had problem for here. There are two things I would say internationally, to look at what we might do within to you. One is we did have these discussions. Money Europe itself, and subsequently there has been was put in, as I say, at the beginning of September. agreement that we need to do more. Frankly, Portugal is not the end of the world; it is possible to Q771 Mr Dunne: Too late. receive information and issue instructions from Mr Darling: No, I am not aware of any evidence that there, which I did, and I was back in London later we have that would demonstrate that had it been that evening. done a week or two weeks earlier, that would have sorted out Northern Rock’s problem. The problem Q776 Mr Dunne: Over that weekend you have just is Northern Rock would have had to have got this told us you changed your view about whether there money itself. The other banks, especially the larger should be a bank deposit guarantee. ones, were sitting on these things. The other thing I Mr Darling: Yes. would say is if you look now, two months later, it is interesting that, although the Fed and the ECB and Q777 Mr Dunne: When did you first start receiving the Bank of England here took diVerent positions, advice that this might be necessary? the overnight interbank rates are pretty close to each Mr Darling: We discussed it on a number of other, despite the fact that they took very diVerent occasions. The first time that I think the Tripartite approaches. Committee, the three of us, agreed it would have to be done was on the Sunday morning when we met. Q772 Mr Dunne: Northern Rock top management told us that had they thought about it early enough, Q778 Mr Dunne: When was the Bank giving you they could have used the ECB facility through their advice that it was something you ought to consider? Irish subsidiary. We have seen other UK banks now Did you have advice prior to the Sunday? 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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
Mr Darling: On the Sunday it was the Bank’s very Q781 Mr Breed: But two members of the Tripartite firm view that unless we did something on the Authority were concerned and they did not bother to guarantee, the problems were going to subsist and it tell the third part. is one that I agreed with. My recollection is that it Mr Darling: I think in the normal course of events was raised with me in more general terms prior to what the FSA and what the banks say is publicly that but I would need to check to be absolutely available. I do not think they were keeping it from precise. As I said to Mr Fallon right at the start, I do anybody. It was a more generalised concern. I think not think the absence of the type of guarantee that I what was unforeseeable when you think about it is announced on the Monday was the problem on the this: people start to default on their mortgages in one Friday morning. I think the problem on the Friday or two American states; within days it spreads morning was that, when you think about it, people throughout the United States and then across the were sitting at home, they saw on their television that world. I do not think that had been foreseen before. a fairly well-known bank in this country was going to the Bank of England for facilities and therefore a Q782 Mr Breed: Chancellor, you have been talking fairly large number of people went down to about the problems of debt and the problems that Northern Rock the next day to get their money out. some banks may have for quite some time. This was It was really over the weekend that especially a lot of obviously in the context of a background where comment in the newspapers and on television about there were concerns for a long time, yet apparently just how much money is guaranteed that the the Tripartite authorities did not actually have a guarantee really came into play. As I say, guarantees formal note from everybody all together until some themselves are diYcult. As you can see just now, I months after the FSA and the Bank of England had have given a guarantee which is giving Northern expressed concerns about the whole situation. How Rock the breathing space that it needs but none of could it be said that the Tripartite authorities are these things are problematic. I was quite clear by actually working in any meaningful sense between Monday that it was necessary to go further than about May and August? what had been said over the weekend and issue that Mr Darling: Firstly, you mentioned debt. I am not guarantee. sure whether you mean corporate or personal debt.
Q783 Mr Breed: Both. Q779 Mr Dunne: Did you get advice from Number 10 Downing Street on Sunday? Mr Darling: That actually was not the problem which confronted us in August. The problem that Mr Darling: No. I have said on many occasions in confronted us was whilst the institutions right across the last ten years, I am in regular contact with the the world had lots of money, they simply stopped Prime Minister for all sorts of reasons but no advice lending to each other. That is what was unusual in was issued on that point. 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 Q780 Mr Breed: Chancellor, earlier on in the saying is that in relation to one or two institutions— meeting you said that you first became aware at the and I think they had had discussions with Northern beginning of August of the problems with Northern Rock, as you might expect, about these things—they Rock, yet we were told by the FSA that they were had a more generalised concern. This is one of the concerned much earlier in the year, had issued a things, and as I said to you, questions do have to be warning about the business model, and indeed, had asked in relation to the regulator, the FSA, and all even put them under close supervision. Are you of us. When you get a general concern, how quickly saying that the Tripartite authorities had not been do you move from dealing with that general concern advised by the FSA of their concerns over Northern to actually saying, “Look, here are half a dozen Rock and that the first time they issued that to the things you ought to be doing”? other parties was the beginning of August? Mr Darling: I think 14 August was the first time that Q784 Mr Breed: In hindsight, would you have the FSA formally said when looking at this preferred that they had actually raised it with you problem—and remember, I think the week before, before 14 August? when problems had arisen in France, people started Mr Darling: Hindsight is a wonderful thing. 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 Q785 Mr Breed: I agree with that. Would it have are right that the FSA and I suppose more generally been preferable for them to have alerted you before the Governor of the Bank of England have raised 14 August? concern about these things. The only observation I Mr Darling: In hindsight, it would have been much would make is that, whilst there has been generalised better, would it not, if the FSA when first looking at concern expressed about this aspect of the banking Northern Rock had said, “Hold on, what exactly is system, I do not think anybody expected a complete your fallback position?” and when Northern Rock freezing of liquidity which, as far as I am aware, is said, “We haven’t got one” they did something completely unprecedented in modern times. about it? Processed: 30-01-2008 11:21:12 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG4
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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
Q786 Mr Breed: Do you think the Tripartite Mr Darling: No, I think they should be and they Authorities should have all been aware of the were proactive. I said earlier on that the FSA, concerns of at least two of them on one particular discharging its duty, was looking to see who might institution? be willing to acquire part or all of this business, who Mr Darling: They were not expressing concern might be able to help Northern Rock out. It was not about one institution at the beginning of the year. for the want of trying. It was as this situation developed. The market is a pretty small place; people Q787 Mr Breed: You just said that they were both knew Northern Rock had problems and, whilst expressing concerns about Northern Rock. there was an interest earlier on, as I have just been talking about, the fact that that particular Mr Darling: The Bank of England expressed a general concern. I think it was a speech the institution, after I think it was two or three days said Governor gave at the beginning of this year. The “No thanks” perhaps indicates the problem that we FSA had been talking to Northern Rock and were up against. The ideal solution—and I was very suggesting it did some stress-testing of its systems. clear about this—right from the time that I first When you think about it, at the moment the FSA became aware of this would be, if Northern Rock regulates hundreds of institutions. Some of those could either be acquired, merged with or find concerns they will raise, they will deal with and they another institution, because that would have been by will never come back and trouble anyone again. far the best option. If that had come along and we were able to help in respect of that, then of course we They have to exercise a judgement as to whether or Y not there is a particular concern that is so great, that would have done so. The di culty was that, as the is not going to be resolved, that then leads to a days went by, it was increasingly obvious that people systemic problem. just did not want to know. That was the problem. Q791 Mr Todd: The stories the BBC ran led to the Q788 Mr Breed: So their judgement was lacking in queues forming outside Northern Rock and, this particular case. Can I just turn very quickly to obviously, the bank was completely unprepared for the possibility of the so-called safe harbour or safe that event and had not prepared any communication haven, the other bid? You seemed to indicate that in strategy to tell its customers. Have you conducted fact there was not a substantial bid ever being able any leak inquiry into where that leak may have to be considered by the bank or anything else? come from? Mr Darling: That is right. Mr Darling: No, and I suspect, having had some experience of leak inquiries, it would be as successful Q789 Mr Breed: Mr Applegarth, the Chief Executive as every other leak inquiry that has ever been held. of Northern Rock, said to us that had a facility been It is of course open to you, if you wish, to summon granted to the bank, “I am led to believe that we people to ask them how it might have happened. would have had a good to consider and I suspect that, had an oVer been made with a big retail brand, Q792 Mr Todd: It clearly was not in Northern then the run would not have taken place.” Rock’s interest to disclose this information. Mr Darling: I assume you are quoting from him Mr Darling: I do not have the powers to summon when he said “I am led to believe.” It sounds as if the anyone that I might suspect and pin them against a thing was rather contingent but my understanding of wall and demand they tell me but it was clearly very what happened is this. There were actually two unhelpful and whoever did it, he or she has not paid institutions. One showed a slight interest but it never the price but others have. In relation to the more really progressed further than a general inquiry. general point, again, in retrospect, I think Northern There was a second interest which was raised with Rock could have perhaps managed those queues the FSA and at one point they asked what would we better than they did. The fact that there are only four do if they asked for support—and it was very branches in London and the fact that they are used substantial support; it could have been as much as to dealing with a very small number of people each £30 billion—to be given at commercial rates by the day means you do not have to have too many people Bank of England. Our initial reaction was twofold. coming into the place before you get the queues out One is that the Bank of England does not normally of the front door. provide, in eVect, investment help for a perfectly viable bank. The second point is that there would Q793 Mr Todd: Indeed, one of their problems was also be a state aid issue, I think. The third one is, if the rather small number of depositors they had. we were going to do this, we would almost certainly Mr Darling: I think I am right in saying they have have to say to banks at large, “If we are making this about 70 branches in the whole of the country and facility available, who else might be interested in there are only four in London. that?” However, in the event the matter was not pursued. Q794 Mr Todd: Do you think that one of the diYculties was that Northern Rock would have had Q790 Mr Breed: In that event, do you believe the to have disclosed anyway that they were receiving Tripartite Authority should be only reactive or do lender of last resort backing because this would have you believe they should in these circumstances be led to a profit warning? Is there some merit in more proactive? looking at whether, in these very specific Processed: 30-01-2008 11:21:12 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG4
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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 circumstances, some greater confidentiality might be issue a profits warning because the last profits applied, or do we just have to live with the forecast they had made had turned out to be wildly transparency and accept the consequences? optimistic and they have had to suspend payment of Mr Darling: I think that is a very good point and it a dividend in the meantime. The profits warning is one that aVects not just the central bank here but requirement drove that as much as anything else but across the world. I was very clear from the beginning my understanding is they would have had some of that week that, whatever happened, it would diYculty issuing a profit warning without almost certainly leak because that is the way of mentioning the fact that they were also seeking things, not necessarily from someone doing it quite facilities from the Bank. These are things we really maliciously but what was happening in the days do need do need to look at. We cannot have a before that is that people were phoning up banks situation where you can only provide support at saying “Have you been to the Bank of England?” Of such a cost that nobody is actually going to take it. course, the people who had not, were anxious to say That flies in the face of the whole concept of lender “No, no, never in a month of Sundays” and of last resort. gradually . . . It is rather like, as MPs, we are well Mr Macpherson: Further evidence of the diYculty of aware of the journalists’ round robin on a Friday keeping these things secret is provided by the general afternoon: “Have you or do you know anyone who standing liquidity facility which was available ever has?” and the minute you do not say anything, through August. You will recall that one clearing they finger you because you do not deny it. This is a bank had access to it. It was supposed to be secret problem. On top of that, in relation to Northern but it was in the newspapers the next day with a Rock, their legal advisers, as I understand, had told subsequent eVect on the share price. It is really, them they would have to issue a profits warning, not really diYcult. surprisingly, and they were also, I think, given Mr Darling: Can I just say for the sake of clarity that advice that, given the fact they had gone to the Bank the reason that bank got the facility is not because it of England or were about to go to the Bank of was in trouble but simply it was squaring its books England, they would have to disclose that. The at the end of the day. This is the point I was making, choice is whether you try and do that in an orderly that people did a phone round and only one person manner, and the only thing I was wrong about the said “I can’t comment.” leak was the timing of it, but it is a problem. As I said Chairman: In fact, the Chief Executive said it was to Mr Fallon, if central banks are to do their job, awash with cash. there will be times when they need to do things without people being aware of it for the greater Q797 Ms Keeble: Just to wrap up this last point, do public interest. you not think there is a fair point that, if people have their money in a bank and it is in diYculties of the Q795 Mr Todd: There is one other possible type that Northern Rock was in, actually people are framework, which is that the lender of last resort quite entitled to know what should happen about it facility could have been put in place rather more and what the prospects are for it having to go to the rapidly than it was, giving less time for a leak to Bank for a facility? occur. Northern Rock have claimed that it took Mr Darling: I thought you were going to make a some time to put this in place; they had a plan to separate point about the deposit protection scheme, communicate to their customers about it; that was which I think we are probably agreed on. I can foreclosed by the leak that took place. Another understand the point that you make in relation to approach, as I said, would be to concertina that that but I think there are times where if something negotiating process into a much narrower period. can be done to tide over a bank that might be in Mr Darling: We actually did it quite quickly. As I diYculty, that maintains its position and, said before, it is the directors who are running the importantly, the position of the whole banking bank and they did not actually come to the Bank of system, then that is justified. I would be reluctant to England and say, “Look, we actually now need get myself into a situation that if you had to make a facilities” until the week in question, and once they public announcement every time you did anything, had agreed to come, there was no problem you might actually make a diYcult situation that whatsoever. It was not like filling out a form for a much worse. I certainly would not want to see personal loan or anything like that. They were able queues outside every bank as a matter of routine. to get the facilities when they wanted them. The banking system is hugely important to us and I think it is probably far better that we can do things Q796 Mr Todd: They say they kicked oV on 10 . . . It depends on the circumstances butI think September and they were intending to announce a sometimes covert operations can be very much in the week later, which I must admit gives a huge public interest. opportunity for a leak. Mr Darling: My recollection is they did want a Q798 Ms Keeble: Can we move on to the Tripartite longer period but I think two things went against Authority and the Treasury’s role on it? You did say that. Firstly, it would have been astonishing if you previously that you had only known in August could have kept that quiet for a week. Secondly, about the problems with Northern Rock but both their own legal advisers—and directors have the FSA and the Bank had both talked in general fiduciary duties. This bank was trading. They had to about being aware of the general problems, which I Processed: 30-01-2008 11:21:12 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG4
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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 am sure you were as well. I wondered if you had done Q803 Ms Keeble: What are your relations now with any scenario planning in the Treasury as to what the the board? Do you have a Tripartite Authority implications might be of the fall-out of the sub- oYcial on the board of Northern Rock? prime market problems in the US. Mr Darling: No. Mr Darling: There are two things. Firstly, you are right that there was a generalised awareness of the Q804 Ms Keeble: Were you consulted about the problem but certainly not about specific institutions appointment of the new chairman? and certainly not about Northern Rock. I think the Mr Darling: In relation to your first question, no, we existence of and the consequences of people lending most certainly do not. It is very clear that the in the sub-prime market really only came to people’s directors are accountable to the shareholders and notice probably in about July. In relation to stress neither the Government nor the Bank of England testing, the Treasury has carried out exercises. If you nor the FSA are on the board. In relation to the new do not mind, I will ask Nick; it was before I came to Chairman, Bryan Sanderson, yes, I knew about it the Treasury. It did actually carry out a stress test but that decision was taken by the board; in earlier this year but that was in relation to a slightly V particular the senior director, Ian Gibson, was di erent scenario. It was more of a terrorist-based anxious that the board should be beefed up but that one. was his decision. It really is most important, as I said in the House the other day, the Government can help Q799 Ms Keeble: Could we have a note on it, but the Government does not own this company. V because I have some other questions. This company has to sort out its a airs. Mr Darling: Yes, if you want to have a note on it, I 16 will happily do that. Q805 Ms Keeble: But you have put a large amount of public money at its . . . You have given a large Q800 Ms Keeble: That would be helpful. Do you amount of support to the institution. have a named oYcial who takes the lead Mr Darling: Yes, and therefore we are working responsibility in relation to the Tripartite Authority, closely with the company but we do not have and who is that? somebody on the board. This company is owned by its shareholders and it is the directors that are Mr Darling: Yes. Here he is. responsible for it, not the institutions or the Mr Maxwell: I take part in meetings of the Tripartite Government. Committee and Stephen Pickford, my Managing Director, is also involved in doing that. Q806 Ms Keeble: You also said that there was going to be action over the credit ratings agency. I just Q801 Ms Keeble: You have maintained that wondered what progress you have made on that. consistently all through the crisis? Mr Darling: This is something that has to be done Mr Maxwell: We have cover. We ensure we have internationally, as well as in Europe and here as well. senior staV cover involving us and Nick as well and V I think the questions that really need to be asked are other senior sta whenever necessary. firstly, what precisely people believe their role to be, because a lot of institutions give the impression that Q802 Ms Keeble: One of the comments that you if the credit ratings agency says something is triple A, made earlier, Chancellor, was that you heard about that is fine and they do not make any further one thing, I think it might have been the decision to inquiries. I am pretty clear that credit rating agencies go for the facility, in the evening and you were told are there as simply one particular avenue of advice formally the next day. I did wonder about the lines and that first and foremost, the responsibility for of communication. Presumably, they are acted on maintaining the financial security of an institution immediately and you do not wait for a formal must lie with its directors. I am very clear about that. notification of something. The way in which credit agencies operate is Mr Darling: No, and in the normal course of events, something that I think we need to look at because it has some bearing on what regulators require of as a Minister, and particularly as the senior individual institution institutions when they take Minister, your oYcials keep you informed as and advice and the way in which they satisfy themselves when they hear things. I knew from what I was as to whether or not they are doing the right thing. 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 Q807 Chairman: Chancellor, on the issue of when the Tripartite committee met, they were aware Treasury staYng for financial stability, following up of it, and the Treasury was aware of this. What Sally’s question, I wonder if you could send us a note happened was the FSA actually rang up—I cannot on that because that is something of interest to us? remember whether it was you or Stephen Pickford— Mr Darling: On who it is or what? the next day and actually said, “Look, there is a Chairman: Treasury staYng of the financial stability problem here.” department. That would be of interest.17
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Q808 Mr Mudie: Chancellor, when the sub-prime Q815 Mr Mudie: As Mr Maxwell was saying, who issue arose in the States, the Fed and the ECB took handled from the Tripartite Committee, who was policy decisions on putting liquidity into the market. the liaison point with Northern Rock over these very The Bank of England took the opposite stance. Who sensitive negotiations that could have given a market took that decision? Was it solely the Bank of solution that would have saved all this problem? England or did they consult you and did you have a Mr Maxwell: In most cases during that period the say in that policy decision? contact with Northern Rock was carried out by the Mr Darling: As I was saying to Mr Dunne— FSA, its supervisor, and that is where the direct line of responsibility is. Q809 Mr Mudie: No, he asked but I hope I am not getting the same answer. I am asking you specifically Q816 Mr Mudie: The FSA did say they took a who took the policy decision not to put liquidity in position, a request, to the Tripartite Committee. the market in early August. Northern Rock say this was on the 10th and those Mr Darling: The decision was taken by the were the terms. I notice the Governor of the Bank of Governor but having spoken to me about it. I England says it was not a facility; it was a subsidy. It thought that is what I said to Mr Dunne. was the same facility that was awarded to Northern Rock three days later. Mr Darling: No, it was not at all. Q810 Mr Mudie: When I asked you in the House you said “I have many discussions.” Q817 Mr Mudie: You tell me. Plus interest rates. Mr Darling: I do, yes. Mr Darling: Can I deal with that, Mr Mudie? Firstly, I noticed that Callum McCarthy said to your Q811 Mr Mudie: Of course you do. Were you asked, Committee “I think it would be incorrect to regard consulted, or was he advising you of the decision? the solution as being a firm cut and dried oVer. It was We just need to know who took this decision? still at an exploratory stage and there were a number Mr Darling: He discussed it with me and I said what of other issues which had to be dealt with,” which is his belief was. We had a number of discussions about in terms what I was saying to Mr Dunne. What it but that was his firm view. I can be very clear about happened, as I understand it—and Clive Maxwell it: he took the decision but he consulted me and I will will add to this if he thinks it is appropriate—is that back the Governor. 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 Q812 Mr Mudie: No, but he took the decision, and possibilities, they said, “What would happen if we you will loyally back him. That is fine. asked you for”—it was not a firm prospect—“up to Mr Darling: He is responsible for maintaining the £30 billion from the Bank of England at commercial financial stability of the system but he does need to rates, in other words, not penalty rates or anything talk to me, as he needs to talk to Callum McCarthy. like that?” So in eVect, the Bank of England would I have explained what his views were. be providing the same sort of help as an investment bank might do for maybe up to two years and for Q813 Mr Mudie: Your loyalty is heartening. Let us quite a significant sum of money at prevailing take the one you do accept responsibility for, the commercial rates. chairmanship of the Tripartite Committee. You seemed to downplay the Lloyds TSB approach. You Q818 Mr Mudie: What was the amount they were see, Mr Applegarth told us that they were asking for? negotiating until 10 September but he got a final Mr Darling: I think it was up to £30 billion. decision from the central bank that they would not agree Lloyds’ terms, which were that the same Q819 Mr Mudie: What was the amount you agreed facility of £30 billion that was going to Northern with Northern Rock? Rock be transferred to them, plus they did not like Mr Darling: The lender of last resort. the rate of interest. Are Northern Rock telling us the truth? Q820 Mr Mudie: When they got the facility that they Mr Darling: Mr Applegarth, if he is saying that we still have, and they have now borrowed up to £16 reached . . . We were not at a stage where here was a billion of it, what was the total amount? V formal o er with hundreds of conditions and the Mr Darling: I will come on to that in just a moment only one that could not be sorted out was this. This but there is a world of diVerence between providing was a general enquiry from an institution who were public funds at commercial rates to a bank that was looking at possibly acquiring it. They did not come a going concern— to us and say, “Look, if we do this, we require a loan of this and these terms and conditions.” Q821 Mr Mudie: No, no, Chancellor. Rates we will come to and I understand that but it is the facility. Q814 Mr Mudie: Loyally again, we could not get the Mr Darling: The facility that this possible bidder was FSA, who seemed to be the conduit to the Tripartite asking for was to a commercially viable going Committee— concern. It was entirely diVerent to Northern Rock, Mr Darling: I think they raised it with them. which by the time it asked for lender of last resort Processed: 30-01-2008 11:21:12 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG4
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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 was in a much more diYcult position, and the lender Q827 Mr Love: In answer to a question earlier, you of last resort facilities, as Northern Rock have said, said that you as the Chancellor were ultimately they have drawn about £13 or £14 billion from responsible, and the Committee accepts that. Our that, that— diYculty has been in finding out before you entered the foray who was responsible amongst the Tripartite Authorities. Was anyone responsible and, Q822 Mr Mudie: What is the total you have agreed more importantly, should someone be responsible in with them? the future? Mr Darling: What we have agreed—and again, Clive Mr Darling: The answer to the question is I am Maxwell will set this out in further detail—is that always responsible. Even if one of my oYcials attend they have that facility but it is secured against the Committee, I am responsible for the actions of collateral. We have also guaranteed various deposits my oYcials. I am very clear about that. It is what but of course, we fully expect to be able to get that ministerial responsibility means. money back. Q828 Mr Love: You do not think prior to your Q823 Mr Mudie: Why will you not tell us the facility? involvement someone should have been taking Is it £30 billion? responsibility in the Tripartite, or do you assume Mr Darling: I can. I can tell you what it is. The terms that the Treasury takes responsibility? of the guarantee have been set out, I have written to Mr Darling: Maybe we are at crossed purposes here. both the Chairman of this Committee, so you should Whatever Treasury oYcials do on my behalf, I am all have the terms and details of it, as well as the PAC responsible for that. I carry the can. In relation to the see in the normal way, so you can see what the terms Tripartite Committee, obviously, as a matter of are.18 Because the money has not been drawn out of routine, oYcials—deputies, as they are called— the bank, it has not actually cost us anything yet and attend it because, if you look at the ten years it has I am confident it will not be because, apart from been set up, there will be many meetings that are anything else, we are taking collateral. 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, Q824 Mr Mudie: So it is £30 billion? sometimes the deputies attended, sometimes I Mr Darling: No, it is not. Not at all. I will be very attended myself but, whatever happened, I would clear about this, Mr Mudie, because you do need to have been told about it immediately so I knew be clear about this. There is a world of diVerence about it. between a loan of £30 billion to a commercial going concern and lender of last resort facilities, which are Q829 Mr Love: I am obviously not getting anywhere actually less than that, and what the Government is with this. Can I take it from a diVerent angle? There guaranteeing is the deposits. As the deposits are in are many that say, because the Bank has the bank physically at the moment, and as we have responsibility for providing liquidity into the market collateral against which they are secured, it is not the and also has overall responsibility for stability of the same thing as giving a bank £30 billion worth of system, that it is pre-eminent in the Tripartite credit. Just for the sake of accuracy, have I got arrangements. Would you agree with that? that right? Mr Darling: Its core responsibility to maintain the Mr Maxwell: I think that is absolutely right. stability of the financial system is set out in its objectives and that is a position, a job, that the Bank Q825 Mr Mudie: You are sacked if you say no! does day in, day out through its money market Mr Darling: It is me I am thinking about! interventions. I think I said in relation to Mr Mr Macpherson: The critical thing in the terms is the Mudie’s point that is its responsibility, yes. rate and also, to use the term of art, the haircut, i.e. However, the whole point of a Tripartite committee how much collateral you have to put up in exchange is because it recognizes that the FSA and ourselves, for the support. 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. Q826 Chairman: We all know what a haircut is but just explain it for the public. Q830 Mr Love: The Bank today published its Mr Maxwell: A haircut is the amount of discount financial stability report and it has been widely you set against some collateral that somebody interpreted in the media as suggesting a provides against a loan, so if you are making a loan strengthening of its pre-eminence in the Tripartite to somebody and you take an asset which on the face arrangements. Would you support that of it is worth £100, you might apply a haircut to that strengthening? so that you consider it as being worth £90 because Mr Darling: There are two things. One is, the way I you do not know how much it might be worth in the would interpret it, and rather more than that, the future. That is how a haircut works. way I understand it, is that the Bank is very clear that Chairman: A neat job! it too has lessons to be learned, both in terms of how it intervenes and also the extent of its interventions. 18 Ev 243 As I said right at the start of this, I think in answer Processed: 30-01-2008 11:21:12 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG4
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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 to the Chairman’s point, I think there are questions control, and I certainly think the communications that we have to ask ourselves in relation to the there could have been improved. Frankly, pushing a precise responsibilities, particularly at the interface leaflet through a letterbox to people standing outside of where the FSA and the Bank operate. I am pretty leaves an awful lot to be desired, and I certainly hope clear that firstly, I will not take anything away from this does not happen again anywhere but it needs to the fact that the Chancellor of the day is responsible be dealt with. I think also practical things like how for whatever happens but I think what we do need to you deal with people who come along asking for do is to make sure that both the FSA and the Bank their money, other places in other parts of the world have very clear responsibilities and that, if there is actually dealt with it a lot better than it was dealt any dubiety or any uncertainty as to who is doing with here. So communications are important. If what, that we sort that out. your question is should that be done by the Bank of England, the FSA or the government, I will look at Q831 Mr Love: You have talked on a couple of all these things and, if you have recommendations to occasions, and in answer to this question you make, I will certainly look at them but I think the mentioned the interface. One of the things that the first port of call, because so much is controlled by the Bank has admitted to is perhaps poor actual bank—remember, this bank was solvent; it communications between the Tripartite parties. Do was a going concern. It still is. It is the one that you think that is solely responsible for the problems primarily is responsible for communicating with that arose or is it more than just communication that what, after all, are its customers. They are not the needs to be looked at? Bank of England’s customers. Mr Darling: Communication can always be improved. As I said in reply to an earlier question, I Q833 Mr Brady: It was clear that the Governor of am not sure it was the Committee itself or the the Bank’s preference would have been to deal with structure of the Committee that was the problem. this through a covert intervention, and he was very We have to ask ourselves at each and every stage explicit when he came in front of the Committee that what are the problems that we need to try and fix? he felt his freedom to do that was hamstrung by four The problem I identify in relation to the Tripartite pieces of legislation. You on the other hand said that arrangements is that I think there does need to be you are sceptical that you could have done this some clarification as between what the Bank does covertly, I think you said because of today’s market and what the FSA does and the fact that there is conditions being very diVerent, so nothing to do inevitably an overlap between the two. The Bank of with the legislation. Can I take it you disagree with England is not responsible for the prudential the Governor’s assessment that it is legislation that supervision of individual banks. However, when a hamstrung him and prevented that action from problem arises in any individual bank, it could have taking place? wider systemic implications. That is one of the things Mr Darling: I will say again to you what I said, I that we need to look at and obviously, the converse think, on the floor of the House, that I will look at of that applies so far as the FSA is concerned. It is the four pieces of legislation he was concerned in that area, especially in relation to early warnings, about. One is the Market Abuse Directive, which is because obviously what we are trying to do here is to the disclosure of inside information. The other was stop this problem arising in the first place rather than the Takeover Code, which might, on one view, intervening, that we need to look at closely. I shall preclude something happening over the weekend. not repeat it at length but the other problems too are Then there is the insolvency legislation, which, I the international problems and also the fact that readily agree with him, is something that we need to every single director of every single financial look at, especially in relation to deposit protection. institution should really be asking themselves “What The fourth thing is the compensation scheme, which is critical to my business and if it goes wrong what again, not only do I agree with him but we are do I do about it?” If the answer is “I don’t know,” already trying to resolve that. What I did say, and I they should start thinking again very rapidly. said this on the floor of the House on 11 October, was that the issue before us prior to 13/14 September Q832 Mr Love: Finally, when Northern Rock came was not whether or not the Market Abuse Directive before us they said the leak had made a big diVerence said that we could not do something. The issue was to the way this had all panned out but they also twofold. One is the directors were being advised that admitted that, even if there had not been a leak, they they had to make a profit warning and also my think they would have been diYculties in explaining belief—and maybe because I am a politician I think this to the public. Can there be a role for just one of these things first—that someone is going to leak authority speaking to the public at any time in this and, as I say, sadly, I was right. I will look into relation to an issue like this? In other words, when all these things and if there is a problem with the you trigger the Tripartite arrangements, only one Market Abuse Directive and it could be that there is group should be speaking to them rather than all the a problem, that is clearly something we need to diVerent authorities? resolve but what I would say to you is, if there had Mr Darling: I think most people who deposit money been a realistic chance of rescuing this bank over a or do business with an institution want to hear from weekend, I would have done it and happily seen that institution as to what it is doing. Remember, a whoever was challenging us in court but that did lot of the things that were happening lay within their not arise. Processed: 30-01-2008 11:21:12 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG4
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Q834 Mr Brady: I recognise this is something you Q840 John Thurso: Earlier on in your comments to are still looking at but if there is a problem with the one of my colleagues you described Northern Rock Market Abuse Directive, do you think that is more as being hopelessly exposed and their business likely to have arisen in terms of obligations placed model as being extreme, which I think everybody on the company in terms of disclosure, or on the here would actually agree with today. A year ago Bank in terms of what it was able to do? Northern Rock was seen by the City as being a Mr Darling: I think that Directive bites on both. It highly successful business with an excellent profit is basically designed to stop people from doing record and well worth investing in. What is the things and hiding the full extent of what they are lesson for the City to take out of this? Do we actually doing to people that have a legitimate interest, like have a problem with our understanding of risk their shareholders but, like all these Directives, they generally? do not just bite on the company concerned; I think Mr Darling: I think in general terms I agree with a they bite on other institutions and almost certainly lot of what the Governor said in his speech in Belfast public institutions as well. If it is a problem, we a few days ago, and that is that he believes that all clearly need to deal with it. It is one of the things I institutions ought to carefully evaluate the risk to will cover when I publish my proposals at the which they are exposed. I have said before that beginning of the year. regulators should concern themselves not just with institutions that do not appear to be doing terribly Q835 Mr Brady: Finally, there is, I think, an well but also with institutions that do appear to be exemption in the Market Abuse Directive that seeks doing terribly well because, if they are out of line, it to give greater freedom of movement to central may be they are doing a very good job but they ought banks. Do you believe that is adequate? to just be sure that that is the case. What is going on Mr Darling: That is one of the things I have to look in the world at the moment is that people are re- at but, as I said to you and I have said before, I do pricing the risk and that is what is causing the not think that was the fundamental problem that diYculty. As the Bank says in its report today, and it was facing us in the second week of September. is very evident from discussions I had with my fellow finance ministers in Washington at the weekend, this Q836 John Thurso: Chancellor, the support given to process is still going on all over the world and people Northern Rock gives the impression that no bank do need to be far clearer about what risks they are V with retail depositors can be allowed to fail. Is that exposed to and what they have done to lay o that actually the case? risk by reducing it. Mr Darling: The position is as I set out in my statement of 11 October, which is that judgement Q841 John Thurso: Just following up on that last has to be exercised as to whether or not the failure of question, if I may, on lessons learned, I felt when the an institution, no matter what sort of financial board of Northern Rock came before us that the institution it is, would result in systemic damage to evidence given by the Chairman of their Risk and the financial system. It does not mean that we would Audit Committee indicated that really, the bank intervene in every case. For example, the Bank did itself had not looked at this risk and had not really not intervene in relation to Barings in 1994. properly worked out what they would do, which is, I think, very much what you are suggesting should Q837 John Thurso: I do not think Barings had retail happen. How do we get this through to companies, depositors. that risk and audit committees need to do more than Mr Darling: No, it did not but a view had to be tick boxes; they actually have to undertake the spirit taken—obviously, I was not there at the time—as to of what that corporate governance is meant to be whether or not the failure of that bank would have about rather than just the letter? an adverse eVect on the financial stability of the Mr Darling: I think in relation to financial system. institutions that must be the job for the FSA because it has to be a requirement on directors that they Q838 John Thurso: So the fact that the Northern understand the risks to which they are exposed, and Rock depositors are being protected on this in this particular case there is nothing inherently occasion is because not protecting them would have wrong with having a risk as long as you have that rocked the system? risk covered oV in some way or you can mitigate that Mr Darling: It is the system that we were concerned risk. Nothing is risk-free. For example, other about. Mr Macpherson has just reminded me of institutions that used this model and used to borrow course that BCCI did have retail depositors but the on the wholesale market either also had banks with judgement was taken there that it would not cause an investment arm so they had some other cover or the systemic problems that I believe would be caused they had standby credit facilities. Countrywide is a this time. case in point. Northern Rock did not have that, and earlier this year they quite aggressively pursued the Q839 John Thurso: So, to be absolutely clear, the mortgage market, it was very dependent on getting fact that it has happened on this occasion is not a a securitisation away at the beginning of September, precedent that any other institution should feel able which in the event they could not because, just at the to rely on? time they needed to raise the money, the funds Mr Darling: Each case will be assessed on its merits. dried up. Processed: 30-01-2008 11:21:12 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG4
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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
Q842 Jim Cousins: Chancellor, the guarantee going Q847 Mr Cousins: There has been no specific to depositors was rapidly eVective in calming the instruction or advice from the European situation. Is there a time limit on that guarantee? Commission that there is a clock ticking and an Mr Darling: We have asked the Northern Rock end date? bank to come back to us with its proposals by the Mr Darling: No. beginning of February and obviously, I am willing to review the situation at that time. We do have a state Q848 Mr Cousins: Have the Tripartite Authorities aid issue in that, as you know, there comes a point considered what they would do in the event of the where the Commission will say this is going on for bankruptcy of Northern Rock? too long. I am not sure that is an immediate problem Mr Darling: No because at the moment that is not but I really want to get across to the bank that they an issue. My concern would always be, in the event have a breathing space, if you like; they need to of the bank being unable to find some way out, that consider their options; they have a new chairman we protect the depositors. The opportunity is now now and they need to consider what the best course there to make sure that suitable arrangements can be of action is for the bank. That is their decision, they made. I very much hope the directors will use this are the directors, they own the company but we have opportunity to try and find a way to enable the bank given them that breathing space and we have said to to carry on in one shape or form but that has to be them “Look, you need to come back by the a matter for them at the end of the day. beginning of February.” Q849 Mr Cousins: Chancellor, just to sum up. There is no drop dead date—to use your own phrase. Q843 Mr Cousins: Of course the very phrase Mr Darling: Correct. “breathing space” which I do understand does imply a time limit, but you have given the Committee this Q850 Mr Cousins: The Tripartite Committee has not morning, I think, a very clear assurance that if the considered what action it would take in the event of time has to run further than the beginning of Northern Rock’s bankruptcy? February that would not necessarily be an obstacle. Mr Darling: Because that issue has not arisen. The Mr Darling: No, we are not saying it is a drop dead FSA have always said, and continue to say, that the date. To take it to the extreme, if they said, “Look, bank is solvent. What you said in relation to the drop we will come back to you in 10 years’ time” I think dead rate is absolutely correct, however, since I dare there might be a problem. say the bank will follow these proceedings with great interest, that does not mean that I do not regard it as Q844 Mr Cousins: Sure. being a matter of urgency and I think a matter of Mr Darling: I am reasonably confident they will weeks and months is what we are talking about. come back to us rather sooner than that. We have to They need to come forward with a proposal because get state aid clearance for this sort of support and the self-evidently they need to find a long-term solution state aid rules are quite clear, you can do this sort of for the problems they have got. thing to provide support in times of diYculty like Mr Cousins: People in the North East, Chancellor, Northern Rock but you cannot do it in perpetuity. I will be grateful to you for what you have said this said, when I did the statement in the House a couple morning. of weeks ago, I want to be as helpful as possible but I am afraid the bank needs to play its part too now. Q851 Chairman: Finally on the Northern Rock I am encouraged by the fact that perhaps with a new issue, when the Governor was here before us he told Chairman he will put a degree of not just expertise us that he had sent you a letter on 13 September but a degree of vigour into trying to sort things out which gave advice on further borrowing of Northern for them. 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? Q845 Mr Cousins: Have the European Commission Mr Darling: Yes. I have got your letter and I have advised you of any timescale in which they think the considered it carefully. I have looked again at what state aid restrictions would kick in? the Governor said to me and what the Chairman of Mr Maxwell: No they have not is the short answer, the FSA said. For the record, they wrote but there are diVerent ways in which you can apply recommending that I authorise the provision of for state aid approval and some of those approvals lender of last resort facilities. I do not believe that it have certain time limits on them. 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 Q846 Mr Cousins: And they are? confidential basis and has made it very clear that he Mr Maxwell: Restructuring Rescue aid, for would have concerns for the future if he thought example, usually has initial limits around six letters that he sent to me with his best advice were to months. be made public, at least in the immediate vicinity of Mr Darling: Usually— problems arising and also having regard to the fact Mr Maxwell: Usually it is very much as has been that the Northern Rock position is not yet clarified. discussed. I do not believe that I can release these letters. I am Processed: 30-01-2008 11:21:12 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG4
Ev 92 Treasury Committee: Evidence
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 sure that in future, whether it is me or any other future but my judgment—and it has to be my chancellors in the future, that both the Governor judgment on this—is that I do not think it would be and the Chairman of the FSA can write to me in in the public interest to release these letters at the terms which are more than a formality, that can moment. 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 Q852 Chairman: So it is relating to the immediate find myself in at the moment. environment, maybe at a later date you will. Chairman: Chancellor, can I thank you for the first Mr Darling: I am happy to revisit the position but I half of this session so we can release Mr Maxwell but will have regard to two things. One is the situation at it is not goodbye, we will see you some time later. the time a request is made but I also want to make Thank you very much. Processed: 30-01-2008 10:55:44 Page Layout: COENEW [SO] PPSysB Job: 386890 Unit: PAG5
Treasury Committee: Evidence Ev 93
Tuesday 13 November 2007
Members present
John McFall, in the Chair
Nick Ainger Ms Sally Keeble Mr Graham Brady Mr Andrew Love Jim Cousins Mr Sioˆn Simon Mr Philip Dunne Mr Mark Todd Mr Michael Fallon 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 seems to have been asleep on the job, not having Committee inquiry into financial stability. Professor noticed that the funding policy of Northern Rock Richard Portes, who was to appear with you this was high risk and also not expressing stronger morning, has indicated that he is ill so he has given concerns about the breakneck rate of expansion, his apologies. Can I ask you to identify yourselves especially in the last half year. I like healthy growth for the shorthand writer please. but it is hard to believe that the quality of the asset Professor Buiter: Willem Buiter. portfolio and the ability to vet the credit-worthiness Professor Wood: GeoVrey Wood. of your borrowers does not suVer when you take 20% of the net increase and 40% to 50% of the gross Q854 Chairman: Thank you very much for agreeing increase in activity in this half year period, so I think to come and give us your insight into the situation they were an organisation that was clearly engaged which was triggered by the Northern Rock Bank and in high-risk behaviour, and the fact that the FSA did the drying up of liquidity. We have witnessed the not call them back or felt they did not have the first bank run in 140 years as a result of that. With authority or the information (I do not know) is which, if any, decisions of the Tripartite Authorities worrying. Then of course I think the Bank of do you disagree most strongly? England made policy errors, even given the existing Professor Buiter: Well, there are quite a few. The framework, in its management of liquidity. Its very structure of the tripartite agreement was flawed demands for collateral were too strict—stricter than so I disagreed with the tripartite agreement before any other central bank that matters, much stricter they even started doing anything. The notion that than those of the ECB and stricter than those of the the institution that has the knowledge of the Fed—and its demands for collateral at its discount individual banks that may or may not be in trouble window, the so-called standing lending facility, were V would be a di erent institution from the one that has also way too strict. Basically they would discount the money, the resources, to act upon the only stuV that is already liquid: UK government observation that a particular bank needs lender of securities; European Economic Area government last resort support is risky. It is possible, if you are securities; a few international organisations’ debt lucky, to manage it, but it is an invitation to disaster, like the World Bank; and then, under special to delay, and to wrong decisions. The key circumstances, US Treasury bonds. All that stuV is implication of that is that the same institution—it liquid already so all the Bank oVered at its discount could be the FSA or it could be the Bank of England—should have both the individual, specific window was maturity transformation, not liquidity information and the money to do something about transformation, and that was absolutely no good. it. Given that, the decision to provide the support to When they created the Liquidity Support Facility Northern Rock—which was a joint decision and had for Northern Rock they created what the Bank’s to be authorised of course by the Treasury—was not discount window should have been all along— backed up at that point by a joint statement by all something that lends against illiquid collateral and the parties involved to tell the public that their also lends for longer periods, because the Bank money was safe. As I put in my note,19 they should discount window is only for overnight lending. The have had the Chancellor and the previous Bank has since retreated from its policy on collateral Chancellor and the Governor and the Head of the and they have also declared themselves willing to FSA and its Chief Executive all standing up saying, intervene more aggressively at longer maturities. At “Your money is safe”. If they were not quite least, they oVered to do so; when they did nobody convinced that the public would believe them—and came, partly because their promised interventions at in these days you cannot be sure of that—then the three-month maturities were at a penalty rate rather immediate creation of a deposit insurance scheme than at market rates. They are not quite there yet but that actually works and is credible would have been I think they have learnt and they are moving in the desirable. To wait three days was again an right direction. There was a whole slew of errors unnecessary delay. The FSA throughout all this from the Treasury, the current and previous incumbent, from the Bank of England and from the 19 Ev 310 FSA, and nobody comes out of it smelling of roses. Processed: 30-01-2008 10:55:44 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG5
Ev 94 Treasury Committee: Evidence
13 November 2007 Professor Willem Buiter and Professor Geoffrey Wood
Q855 Chairman: That was comprehensive. Professor Buiter: The private banks have a lot to Professor Wood? learn as well. They were foaming at the mouth right Professor Wood: I think I can be fairly brief, up to the moment that the crisis hit. The now Chairman. First of all, let me start by saying where departed Chair of CitiGroup, the American bank, I agree completely with Willem. I agree that the said in July that they were still dancing in the asset- structure was fundamentally flawed. It is simply a backed securities market, so they believed the party mistake to have responsibility lie away from would never end and they acted recklessly on both someone who can do something about it. I do not sides of their balance sheets, unlike Northern Rock think it would be possible to put the responsibility which seems to have acted recklessly only on one onto the FSA because the FSA is not a bank and it side of the balance sheet. The banks did act cannot provide liquidity. The FSA, as Willem put it, recklessly. How do you make them listen? What was asleep on the job; that is manifestly right. A very GeoVrey proposes might help but I doubt it. clear signal of a bank running a big risk is rapid Financial markets and financial institutions go expansion. Northern Rock was giving that signal through these bouts of euphoria where they really quite clearly; it really is remarkable that they missed believe that they know better than the authorities it. With regard to the support operation and the and that this time it is diVerent and we have new provision of liquidity, again as Willem said, there institutions and instruments that will make the risk should have been announcements that your money go away. That fallacy takes hold every so often and was safe. We might come back to that later in the there is very little you can do about it. context of deposit insurance. Walter Bagehot criticised the Bank of England’s behaviour in 1866 Q857 Chairman: So therefore we have just got to for its lending, as he put it, “hesitatingly, reluctantly dance to the tune of the banks and when they get into and with misgiving”. This prolonged the crisis and I trouble we forget about moral hazard and we bail think the same thing happened this time there was a them out because the whole financial system is at risk certain manifest hesitation and that made people and therefore we are in hock to them? nervous. A couple of issues where I do disagree with Professor Buiter: Not at all. Willem just a little bit. I think the Bank is right to take collateral. I think it should charge higher rates Q858 Chairman: So what do we do? on less good collateral, first of all to ensure that Professor Buiter: First of all when they do get into banks do not run risks confident that the Bank of trouble, when I said that the Bank of England England will bail them out and, secondly, of course, should have accepted a wider range of collateral, I to protect the taxpayer if some of this less good did not mean to suggest—in fact I explicitly do not— collateral does not eventually pay up. That the Bank that they accept illiquid collateral at face value. They was engaging in maturity transformation and not should be priced at a heavy discount and even when liquidity transformation is fine. I think it was the you think you have arrived at a fair price you apply right thing to do at that time. By and large, the further haircuts, further discounts to it, so it problems were in the structure, the division of becomes penalty collateral provision, over- responsibility and the lending hesitantly, reluctantly collaterising significantly if necessary. That can be and with misgiving. enough of a penalty. Secondly, I think that once deposit insurance was in place there was no reason Q856 Chairman: Both the Bank of England and the to allow the institution in question, Northern Rock, Financial Services Authority have claimed that they to be supported. The contagion eVect was contained warned financial institutions about the risk of by creating universal coverage of not just retail markets becoming illiquid. I think the FSA sent their deposits but also wholesale deposits and in fact all paper out in January and the Bank of England sent unsecured credit except subordinated debt, so all the their paper out in April 2007. I note from an deposits were safe, and at that point the support for interview that the Governor of the Bank of England Northern Rock could have been withdrawn. The had with the BBC last week that he said more could option there would have been to either let it go into be done in this area to ensure that financial insolvency or to take it into public ownership. That institutions listened to the Bank and the FSA would have been a very good discouragement of regarding their warnings and take action. What is future bad behaviour. your advice in that area? Professor Wood: The best way to make them listen Q859 Peter Viggers: There was a clear warning is to penalise them if they do not. It seems to me about liquidity not least in April from the Bank of therefore that the Bank of England’s behaviour in England, and when we asked Northern Rock what being very reluctant to take securities that they notice they took of that they told us that they would not normally take, except when the crisis got fulfilled all the stress tests which were agreed with the really bad, from Northern Rock and refusing to FSA. Nevertheless, the situation went badly wrong. accept them from other institutions for some Where would you allocate responsibility for this, on considerable time was exactly the right thing to do. the directors of Northern Rock? The casual lending on almost anything that the Professor Wood: Ultimately Northern Rock’s Federal Reserve and the ECB did almost failure has to lie with them, but the FSA was immediately seems to me to have been an error of charged, perhaps not terribly sensibly, with ensuring judgment and is likely to bring problems in the that the directors did things correctly. As I future. understand it, most stress tests in most banking Processed: 30-01-2008 10:55:44 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG5
Treasury Committee: Evidence Ev 95
13 November 2007 Professor Willem Buiter and Professor Geoffrey Wood systems focuses on capital adequacy. Bankers that the FSA does not seem to have carried out its generally have thought too little (central bankers job with the skill and diligence that one might have included) about liquidity for some time, and I think expected, but then again the Northern Rock board attention should shift back to that. There is the basic was not doing a wonderful job either. 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 Q864 Peter Viggers: Are there immediately any tests in good times you should think what is going to further powers that any of the Tripartite Authorities happen if times become not quite so good. need or do you think the system itself needs to be reviewed? Professor Buiter: They need the power to put banks Q860 Peter Viggers: Bearing in mind the Bank’s V warning about liquidity, was it surprising that the into administration e ectively without the deposits stress tests were not constructed to include liquidity? being frozen, as is the current situation, which is of Professor Wood: That is terribly diYcult because the course a terrible situation. They have to be able to availability of liquidity changes from circumstance ring-fence the deposits of banks that go into to circumstance. The stress tests have to deal with a administration. If anything they have to have FDIC- wide range of conditions and conjecture and that type powers of taking deeply troubled banks, where will be diYcult to do. I think one should simply you do not know necessarily where there are adopt a more conservative banking model rather liquidity and insolvency issues, into public than seek technical solutions that do not always ownership at no notice and to manage them as a work well. There are statistical problems—I am sure going concern, with existing obligations, existing Willem will confirm—in these markets because the exposures and no new business until things settle distribution of outcomes is not in a form that is down, and in the longer term a future for the readily handled by statisticians. institution can be found. The kind of open-ended Professor Buiter: One could have expected that they breastfeeding of a private institution that goes on at would have looked at the consequences of some of the moment is the worst of all possible worlds. the markets in which Northern Rock was funding Professor Wood: That is exactly right. The itself simply closing. What happened of course in the Comptroller of the Currency in the US coined the case of Northern Rock is that all of the markets in term “too big to fail” of Continental Illinois Bank which it funded itself closed, something which had when it failed. If you have proper bankruptcy laws never happened before, so you would have had to such as Willem has outlined then no bank becomes have an ultra stress test to capture that. However, too big to fail and they can bear the consequences of they seem to have done not even the kind of liquidity their actions. 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 Q865 Peter Viggers: We have had a forceful than about liquidity issues. That is the natural memorandum from the British Bankers’ province of the Bank. Association pointing out that liquidity regulation is the only remaining area of banking supervision that Q861 Peter Viggers: Does it surprise you that the is host rather than home state regulated. The British board of Northern Rock, with the exception of the Bankers’ Association has urged us to await decisions Chairman, are still in control of the company’s by the Basle Committee of Banking Supervision destiny, bearing in mind that some £30 billion of because banking liquidity and banking supervision public money is now invested through what is a is essentially an international matter. Do you think discredited board? we should await international developments or do Professor Wood: It is not clear to me the extent to you think there are steps we can take domestically? which they are actually in control. The company has Professor Wood: I have to say I have not read the to have directors but can they actually take decisions British Bankers’ Association memorandum but it without the Treasury or the Bank of England’s seems to me from how you summarise it to embody agreement? I really do not know. The company has a certain lack of clarity of thought. The home to have directors. country and only the home country can supply liquidity. If a British bank is short of sterling the Q862 Peter Viggers: Are you close enough to the Bundesbank cannot supply sterling; it has to be situation to know the extent to which the Bank of home country provision of liquidity. The only case England and the FSA are now eVectively controlling when that is not the situation is in the euro zone decisions? where of course you have several countries using the Professor Wood: No. You must ask them that. same currency. Professor Buiter: I must say I do not understand the Q863 Peter Viggers: Very well. To what extent do statement that you have just quoted at all. The bank you think the crisis of Northern Rock can be could be foreign owned but if it is registered in characterised as a failure of the FSA to regulate Britain then it is a British bank and it will have to be properly? supported by the Bank of England. That is how it Professor Wood: Again we come back to the fact works. It is not true for branches but it is true for that it is basically a failure of the regulatory system UK-registered banks and that is the only way to do as it was designed; it is a deficient system. Beyond it so, no, we do not have to wait at all for liquidity. Processed: 30-01-2008 10:55:44 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG5
Ev 96 Treasury Committee: Evidence
13 November 2007 Professor Willem Buiter and Professor Geoffrey Wood
Liquidity is provided at the level of the currency Q868 Mr Fallon: It follows from that that after area, be it the dollar area, the sterling area or the saying the deposits should have been guaranteed you euro area, so it sounds like this is confused babble. think that Northern Rock should simply have been allowed to fail? Professor Buiter: Yes. Q866 Mr Fallon: Just to be very clear then, you think Professor Wood: The word “fail” is a dangerous that responsibility for both general and individual term. liquidity should transfer back to the Bank; is that Professor Buiter: Sink or swim. right? Professor Wood: Sink or swim, put into liquidation, Professor Buiter: That is one solution. The other in that sense fail, but not simply collapse; that would solution would be to transfer provision for be foolish. institution-specific liquidity provision lender of last resort to the FSA by giving it an uncapped and open- Q869 Mr Fallon: What about the rescue operation ended credit line with the Bank of England itself; was the Treasury right to refuse the tentative guaranteed by the Treasury so it can just do the oVer from Lloyds TSB to carry out a takeover? lender of last resort bit. The market support will Professor Buiter: I do not know the details of the always have to be done by the Bank of England, and oVer but if it is true that they wanted up to 30 billion you may therefore wish to put the individual UK, as they would say in America, £30 billion, in institution support there as well. I think there are continued financial support to finance a takeover, tensions there with central bank independence then I think the Treasury and the Bank—this was a because especially individual institution-specific joint decision—were absolutely right to refuse it. support operations are always deeply and inherently This would be the socialisation of banking, and that political (with a very small “p”) because property might be a good idea but I do not think that is what rights are at stake and it is diYcult to have that done this was about. by the same institution that is meant to be non- political. If you were to give banking supervision Q870 Mr Fallon: So it would never be right for and regulation, including the lender of last resort government to lend on commercial terms in order to knowledge therefore, back to the Bank of England, protect financial stability? then you might want to take the MPC out of the Professor Buiter: They were not protecting financial Bank of England. stability. They would be protecting the shareholders of the company wishing to take over Northern Rock. Q867 Mr Fallon: Because we have learnt over the last few months, have we not, that the Bank is not quite Q871 Mr Fallon: But would it ever be right for the as independent as we originally thought. Even the Government to lend on commercial terms if they decision not to put liquidity into the market in thought there was a serious risk of financial August was referred to the Chancellor. instability? Professor Buiter: Independence, as I interpret it, Professor Buiter: Yes. Professor Wood: I think I would resist the feasibility applies only to interest rate decisions and that is why of that situation. If you have got proper lender of last I think it might be a good idea to take the MPC resort facilities in place, if you have an adequate (which all it does is set the Bank rate) out of the Bank bankruptcy procedure for banks, the question of England which can then do everything else, would not arise. including liquidity provision, at any maturity longer than overnight, foreign exchange market intervention, whatever. Q872 Mr Brady: Should the Bank of England have injected term liquidity into the financial system Professor Wood: I do not think it is necessarily before the run on Northern Rock? correct that we should want to give liquidity support Professor Wood: I think not. If commercial bankers, to an individual institution if the rest of the market as was the situation, could not price these securities, is in good order. That suggests that individual if they did not know what they were worth—I institution is fundamentally deficient and should be observed and Willem pointed out to me this morning closed. The lender of last resort operation should go that Morgan Stanley has written these things down to the market as a whole when the market is short of to zero, for example—if that is what they think they liquidity. If an individual institution needs it, and the are worth, it seems to me no more than an rest of the market is fine, there is something wrong impertinence to go to the Bank of England and say, with that institution. On the question of the “Use taxpayers’ money to buy these things from us.” Treasury being involved in this decision, there is a Professor Buiter: I disagree. There are times when it long history of course of the Treasury being involved is clear that, say, the spread of the three-month in these decisions simply because the Bank of premium of the inter-bank rate, LIBOR, over the England, even in the 19th Century, was a very small expected three-month policy rate, bank rate, is not bank and did not have much capital to lose. In the just a default risk spread but includes a liquidity risk 19th century it got other banks to help out. In the 20th spread, and when that goes together with a seizing century it has to go to its owner, the Treasury, to up of inter-bank markets, the Bank should ensure that the owner would provide more risk aggressively expand credit at that maturity or at capital if necessary. those maturities where there is, in their best Processed: 30-01-2008 10:55:44 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG5
Treasury Committee: Evidence Ev 97
13 November 2007 Professor Willem Buiter and Professor Geoffrey Wood judgment, such a term structure of liquidity spreads banks through the auctions they conducted relative as well as term structure of regular interest rates. to the size of the banking system they lent an average You cannot in general as a bank fix multiple interest of £230 million per bank whereas Northern Rock rates if markets are orderly but if markets are needed close to £25 billion. You tend to agree with disorderly you can indeed intervene at multiple the basis of that perception? maturities, and the Bank should have done so Professor Buiter: Yes, that is correct, but you could against the kind of collateral that the markets found have done it at the Bank’s regular discount rate for hard to price and then price it punitively, and in that Northern Rock. You could have done £20 billion way prevent moral hazard, yes, so they should have there. done so. Professor Wood: Calling it emergency lending was I Professor Wood: Maybe I could follow that up and suppose asking for trouble. 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 Q875 Mr Dunne: Can I just pick up one of the they could not trade at longer maturities is not usual responses you made to Mr Brady. During August but it was not causing any significant diYculties at was it not the case that the credit spread was the time. considerably higher in the UK than on the Continent and in the US? Professor Wood: When? 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 Q876 Mr Dunne: You are saying that has now made available to Northern Rock earlier it is quite narrowed? possible that it would not subsequently have needed Professor Buiter: They are the same. They are about to apply for lender of last resort facility, whereas the half a per cent in all three areas. Governor of the Bank made the point that because of the sheer volume of support that Northern Rock Q877 Mr Dunne: But the time of the crisis was needed—close to £25 billion—it was not possible to August. see how you would achieve that level of liquidity for Professor Buiter: It was higher in the UK, yes. Northern Rock simply by injecting it generally into the market. Would you comment on those two views? Q878 Mr Dunne: Indeed and was that not partly Professor Buiter: There are two problems. The fact because the central bank here was not providing any that Northern Rock needed £20 billion plus does not liquidity? mean that it could not have been provided at the Professor Buiter: That was my interpretation, yes. regular discount window. That is, after all, demand determined, subject to the availability of collateral; collateral is the constraint there. If the problem was Q879 Mr Dunne: Indeed. How can you therefore just that Northern Rock could not borrow, I would make the statement that had it provided liquidity it not have done so, but since the inter-bank markets as would not have had some beneficial impact on a whole, and indeed the wholesale markets and the liquidity throughout the system, irrespective of commercial paper markets were also seizing up, Northern Rock? there might have been a case for intervening, but that Professor Buiter: It would have had a beneficial is the same as the last question really, whether you impact on the system but I doubt whether it would could by restoring liquidity to the markets have have been enough to save Northern Rock. Northern prevented Northern Rock from going to the wall. Rock needed individual attention. That would take an enormous amount of money injections. We know for instance that despite all the Q880 Mr Dunne: There were many other issues money that the Fed and especially the ECB have put which you identified at the beginning which caused into these longer terms markets, the actual spreads the problem? of three months LIBOR and the euro equivalent and Professor Buiter: Yes, but banks generally were not the dollar equivalent over the expected policy rate is lending to each other, and that is never a good idea no smaller in euro land today than it is here, so it because that also means they are not lending to really may take a large injection of liquidity to get an households and to non-financial corporations. 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 Q881 Mr Dunne: We were told by the management Northern Rock would have been much help since of Northern Rock that they had an Irish subsidiary the problem, as we have seen, has been the shortage and had they been able to have a facility in place with of a large amount of liquidity, and so I think the the ECB through their Irish subsidiary in time, they FSA’s point is not valid. might have been able to secure some liquidity through that. Professor Buiter: Correct. 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 Q882 Mr Dunne: Do you think that would have been looking at what the European Central Bank lent to an appropriate thing to have done? Processed: 30-01-2008 10:55:44 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG5
Ev 98 Treasury Committee: Evidence
13 November 2007 Professor Willem Buiter and Professor Geoffrey Wood
Professor Buiter: Sure. been made clear in the past—that in times of Professor Wood: For Northern Rock, yes. diYculty they will accept a wider range of collateral than usual, but they should also give the warning Q883 Mr Dunne: I think you said earlier that the that they charge much higher rates of discount for it. currency for lender of last resort is critical but in this case had the liquidity operations been managed by Q889 Mr Dunne: The issue of providing a lender of the Bank of England in the same way as the ECB the last resort facility on a covert basis, which appears to pure currency risk was something presumably that have happened in the US and on the Continent, does could have been priced into the facilities? not appear to be capable of happening in this Professor Wood: You mean if they borrowed from country; can you explain why? their Irish subsidiary? Sure, they would have had to Professor Buiter: I think that particular statement of switch into sterling and if they were a well-run bank the Governor is not correct. There is nothing in the they would have hedged that risk. appropriately titled “MAD”—Market Abuse Directive—to prevent covert support to banks in Q884 Mr Dunne: Indeed. So would it be prudent trouble. On the day he said it, the statement was then for British banks today to ensure that they have contradicted by a spokesman for the Commission, facilities with other central banks in order to and every lawyer I have talked to since then says that maximise their prospects for liquidity if they need it? they have no idea where that interpretation came Professor Wood: I suppose if you are saying that from. If it is true then the Directive really is other central banks give out liquidity too generously appropriately named. We think we know, for (which I think they did) it would be prudent from the instance, that the ECB, which is a EU central bank, point of view of individual British banks, yes. I do has engaged in covert discounted borrowing which not think it would be prudent from the point of view really falls into that category and has gone beyond of the British banking system. But in any event, if all that, quite likely. Because it is covert we have the banks borrow abroad and switch into sterling, they issue of absence of evidence and evidence of absence. can only get that sterling from the Bank of England. But a) I think it is not true and b) if it were there So any one bank could protect itself by borrowing should be an enormous outcry against it, but it was abroad, but the system could not. not an issue, they could have done that. Professor Buiter: I think they should all do so, if they can, and of course not just in the Euro zone but in Q890 Mr Dunne: So you think the powers exist at the the United States as well because at the US discount moment and they have just misinterpreted it and got window you can discount anything, including cats it wrong? and dogs, in principle. Professor Buiter: Yes.
Q885 Mr Dunne: Indeed, and two of the major Q891 Chairman: The Governor made that point in British banks have taken out very substantial this Committee, Professor Buiter, and he said it was facilities with the Fed, have they not. four pieces of legislation acting together. Professor Buiter: Yes. Professor Buiter: The other pieces were by and large correct. The deposit insurance scheme is a shambles. Q886 Mr Dunne: Does this not raise questions of You cannot do under-the-table mergers or credibility about the regulation of the British takeovers—and that is absolutely correct, but that is financial services and banking industry? why you should be able to take banks into public Professor Buiter: We have a financially integrated ownership. That would be a solution for that global system and that means that liquidity can be particular thing on a short-term basis. And whatever purchased abroad as long as sterling is convertible. the third one was— I hope it will remain that way. Q892 Chairman: Insolvency. Q887 Mr Dunne: Do you see damage being done to Professor Buiter: Deposits get frozen, yes, that is the British banking industry in particular or do you also correct. Of the four things he said I only think this is not a peculiarly British problem? disagree factually with one which is the MAD. Professor Buiter: To me it was the way in which inappropriately restrictive British liquidity policy Q893 Mr Simon: All the people that we have had so could be mitigated by some banks, the ones who far—the Bank, the FSA, the Chancellor and were lucky enough to have subsidiaries abroad in the Northern Rock—have all explained to us that the euro zone or the United States that they could use. Tripartite arrangements work, whereas to most of us that seems a bit counter-intuitive because they do Q888 Mr Dunne: In addition to the points that you not seem to have worked very well. You are the made at the very beginning, what other lessons do adjudicator in this: do the Tripartite arrangements you think the regulatory authorities here need to work? learn to ensure that these liquidity problems do not Professor Buiter: I think we have already said that in recur in the UK? provision of liquidity they worked but did not Professor Wood: The regulatory authorities in a work well. sense did ensure that it did not occur in the UK once they dealt with the Northern Rock issue. What they Q894 Mr Simon: How do you think they could should certainly do is to make clear again—it has work better? Processed: 30-01-2008 10:55:44 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG5
Treasury Committee: Evidence Ev 99
13 November 2007 Professor Willem Buiter and Professor Geoffrey Wood
Professor Wood: Again Willem has made two Professor Buiter: Nor does it have the people. suggestions. One is that the Bank of England take Professor Wood: In addition I think it should be over the supervision for liquidity purposes of done soon simply because it is important to have individual banks. That would be a perfectly sensible these institutions run in before the next problem hits. idea. The other is to turn the FSA into a bank. I An example is in the United States where think that would be maybe sensible but certainly arrangements were changed and also some key diYcult. people had died just before the financial crash of 1929-31 and it was largely because of the absence of Q895 Mr Simon: Do you think there should be a experience that that turned into such a disaster. diVerent set of arrangements when a certain point of crisis is reached or passed? Q901 Mr Simon: Any more? Professor Wood: No, I think that would be Professor Buiter: No. misguided. It would be like having two pilots on the Mr Simon: Thank you. plane and saying this other one is going to take over when things get diYcult. When do they get diYcult Q902 Chairman: Professor Wood, can I take it from enough? We should have sensible arrangements your comments that the Tripartite system worked from the start. but failed? Professor Buiter: The Tripartite agreement needs to Professor Wood: That would be going too far, be changed along the lines that GeoVrey just restated Chairman; it worked but not too well. here. It did not work well and the reason it did not work well was not an accident, it was simply a Q903 Mr Love: Professor Buiter, you threw away a design fault. line earlier on suggesting that the Monetary Policy Committee should be taken out of the Bank and that Q896 Mr Simon: And you reckon with your two eVectively the functions of the FSA ought to be modifications or some version— merged with the remainder of the Bank. I think that Professor Buiter: Either of them—not both please, was the suggestion you were making. I just wonder just one. how Professor Wood would respond to that. Professor Buiter: Only the FSA’s liquidity Q897 Mr Simon: Obviously not both. One of which supervision function. is greatly more unlikely it seems to me than the other. You reckon that would have solved this Q904 Mr Love: I understand. I wonder if you would problem and this would not happen? respond to that because you have been suggesting Professor Wood: All I can say is in previous episodes that we could do one of two things. I would like to in the past in this country and elsewhere it did. press you on which of the two; do you think the Bank should be the major institution or should it be Q898 Mr Simon: What do you think are the chances the FSA? of them doing something like that? Professor Wood: Quite clearly the Bank should be Professor Wood: You should ask the Government the major institution in the provision of liquidity. that, not me. 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 Q899 Mr Simon: Obviously we did ask the is involved in only one set of decisions; it plays no Chancellor last week and he did not give us a very part in others. I think it is convenient full and accurate reply. administratively to have it in the Bank; and there is Professor Wood: Well, you can tell him from me that from time to time some connection between I think it is a good idea. monetary policy and financial stability policy, and Professor Buiter: We hope that after mature under such circumstances it is convenient to have reflection he will decide that change is the better part them together. of valour. Professor Buiter: One quick footnote to that. The problem at the moment is that the MPC only sets the Q900 Mr Simon: You are talking to all these people bank rate, but that is meant to be the target for the all the time. You must have a sense of whether there overnight inter-bank rate, and in fact the overnight is movement likely. inter-bank rate moves violently around. If you are Professor Buiter: They may simply limit themselves going to have this clearer separation, then the Bank to informal arrangements. I do not think you are of England should change its policy in the overnight going to see new legislation but the memorandum of market and actually peg the rate, at least the rate at understanding is just that; it is just a bit of paper, as which it repos, does its sale and repurchase somebody else once famously said. They may just operations, and it should always stand ready to repo have some clarifications in a footnote that says the at its target rate at any amount all of the time, as Bank of England will henceforth start looking at the opposed to its current practice of trying to target liquidity positions of UK registered banks and both price and quantity a little bit. They really have deposit institutions again. to change their operating procedures otherwise the Professor Wood: That would be a change because at liquidity management policy inextricably gets tied the moment the Bank does not have the resources to up with interest rate setting. You have to be fair to do that. the MPC. If they set the Bank Rate then they should, Processed: 30-01-2008 10:55:44 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG5
Ev 100 Treasury Committee: Evidence
13 November 2007 Professor Willem Buiter and Professor Geoffrey Wood except for a little default spread for the inter-bank Q910 Mr Todd: Do you think consumers are well rate over the policy rate, peg the overnight rate. That enough aware—and I think the evidence was in this requires a change in operating procedures at the crisis that they were not—where the current limit Bank. actually lay? I think most people thought that deposits either were not guaranteed at all or they Q905 Mr Todd: Can we turn to depositor protection. were guaranteed almost infinitely, and to hear there There is an argument for saying that depositor was a particular limit set on it was news to most protection introduces a moral hazard by people, so is there associated with this an important transferring risk but not straightaway. How do we function of public education so that people set appropriate depositor protection to ensure that understand clearly? that does not happen? Professor Buiter: Absolutely. Every bank should Professor Wood: You cannot do that; deposit have large signs when you walk in “Your deposits insurance inevitably creates some moral hazard. The are guaranteed up to . . . ” starting point has to be to think why do we want deposit insurance. It was introduced in 1933, if I Q911 Mr Todd: “Do not deposit more than recollect, in the United States in very special £35,000 here”. circumstances. The Federal Reserve had failed to act Professor Buiter: Or “do so at your peril”! 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 Q912 Mr Todd: Right, so the eVect of that would be was a substitute for a lender of last resort. Nowadays presumably to persuade consumers to spread risk so what we might call flighty liquidity—banks’ if they have large amounts of money to deposit they liquidity that disappears quickly—is in wholesale would deposit it in a number of institutions? markets, and deposit insurance, therefore, cannot Professor Buiter: Yes, that would be right. 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 Q913 Chairman: If I could come back to you on that. the banking industry the widow and the orphan, and There have been figures starting oV at £100,000 it should therefore be accessible immediately if a down to what the level is in the United States at bank closes, and it should be set at a fairly low level. 50,000, and the British Bankers’ Association have If it were set at a low level this would have the come in and said that £35,000 is an appropriate level incidental benefit that first of all large depositors, because 90% of the population would be covered by other banks, might pay closer attention to those they that. Could you give us an indication of where your lent to. Secondly, if it were set at a lower level it could sympathies lie in terms of the level? Would it be again continue to be financed by a mutual scheme 100% of that level protected? and thus the taxpayer would have less interest in Professor Wood: If we are protecting the widow and propping up banks. the orphan it has to be 100% since we cannot expect that such people would have the time or the Q906 Mr Todd: You are agreeing with that by the knowledge to police their banks. In terms of the level sound of things; is that right, Professor Buiter? it seems to me the British Bankers’ Association point Professor Buiter: Yes, but I would make a specific (which I had not heard before) was quite a good way point that it should only extend to retail deposits, of thinking about the question. that is deposits by natural persons, not wholesale Professor Buiter: A second reason for having 100% deposits or business deposits, unlike what we have is if you have anything less it is still an invitation to now. run. Unfortunately while co-insurance is a good idea for most insurance—you cannot have a run on your Q907 Mr Todd: So it has no purpose as a financial life insurance company but you can have a run on stability tool? the bank—I really would not recommend anything Professor Buiter: No. 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. Q908 Mr Todd: It is purely, as you have said, social policy? Professor Buiter: Yes. Q914 Jim Cousins: The Chancellor, when he spoke to us on this issue, said that the 100% guarantee that Q909 Mr Todd: Okay, if that is the case, what sort of was given by the Treasury was a case-by-case rate should it be set at? Is the current rate guarantee and each case would be assessed on its reasonable? There have been suggestions of raising merits, but the Governor in his very interesting radio it to £50,000, or is that just simply a political decision broadcast last week said something rather diVerent. to be made, you draw a line somewhere which seems He said that the existing system of deposit insurance fair at the time? we have trapped retail depositors—the word Professor Wood: Basically it is a political decision. It “trapped” was his and “that’s why we could not is linked to vulnerable persons’ deposits. In the allow Northern Rock just to fail.” Do you think that United States you can insure as much as you like the Governor in saying that has undermined the simply by opening enough deposits; it has to be Chancellor’s promise to us that this guarantee to individuals. depositors was only a case-by-case one? Processed: 30-01-2008 10:55:44 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG5
Treasury Committee: Evidence Ev 101
13 November 2007 Professor Willem Buiter and Professor Geoffrey Wood
Professor Wood: I am not quite clear what the it said that any bank that found itself in similar Governor meant by saying it trapped depositors. If circumstances to Northern Rock would get he meant that when the institution failed the Northern Rock treatment, both on the funding side depositors were then trapped because they could not and on the deposits side. There might well be get their cash out right away, that is right, but that individual fine-tuning if the banks have very has no bearing at all on what the Chancellor said. diVerent funding policies or very diVerent compositions of deposits but, as I understood it, Q915 Jim Cousins: I am inviting you, Professor eVectively the deposit risk for the entire British Wood, to see the implications of the Governor’s banking system has been socialised. remarks. He described retail depositors as being trapped by the present system of deposit insurance. Q920 Jim Cousins: I think that is a very important Professor Wood: That statement is to me only statement to make and I will just play it back to you meaningful if the Governor is saying after their bank so that we have understood its significance. You has closed they are trapped in the sense they cannot have said that whether or not the Chancellor so get their money immediately. intended, the entire deposit risk of the British Professor Buiter: I have no idea, I cannot make sense banking system was socialised, as you put it, when he of the statement. gave his deposit guarantee to Northern Rock? Professor Wood: Apart from that, I cannot see what Professor Wood: It is my understanding, as it is he means. Willem’s, that he said it would apply to any bank that got into diYculties, so in that sense, yes, he was Q916 Jim Cousins: You cannot make sense of the underwriting all the risk of the British banking Governor’s statement? system. I think he did back away from that Professor Buiter: Of the statement you are quoting. subsequently, much to my relief; it seemed rather a I did not hear the interview, I just read excerpts from lot of money to guarantee. it and that was not part of it. I find it hard to see what it could refer to. Q921 Jim Cousins: But is there not a real diYculty here that you are saying on the one hand that a Q917 Jim Cousins: What the Governor said was this: deposit guarantee was given in a form that socialised “We need a system in this country in which we can banking risk for retail depositors and then you are prevent the retail depositors from being trapped.” saying the Chancellor backed away from it, so where Professor Wood: That becomes much clearer. What does that leave us all? he plainly meant was that retail depositors should Professor Wood: It leaves us all with the Chancellor get their money out immediately if the bank fails having backed away from a 100% guarantee, and rather than being locked in for some months, which thank goodness for that! 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 Q922 Jim Cousins: Professor Buiter? referring to obviously. Professor Buiter: It leaves us, if indeed the Chancellor has backed away decisively from this— Q918 Jim Cousins: The point I am putting to you both is that the Chancellor said the guarantee he Q923 Jim Cousins: You are not so clear that he has gave to depositors in Northern Rock would not be backed away? extended anywhere else, it was a case-by-case Professor Buiter: I am not clear at all because I think system. The Governor’s doubts about the overall the statements, both the original ones and system seem to indicate that it must be more general. subsequent ones, are suYciently ambiguous that Professor Buiter: The Governor is talking about the they are compatible with almost any course of long-term reform—but hopefully it will be done very action. swiftly—of the deposit insurance system which Professor Wood: If I could take up that point—it should be one that allows you to get your money out takes us back to the Chairman’s opening questions immediately. It did not refer to this one-oV or ad hoc on why were things badly handled at the start—one (if there is more than one bank) series of individual of the ways in which it was badly handled were these bank deposit guarantees that the Chancellor created confused statements. for the purpose of this specific crisis. They are two diVerent things; there is no contradiction. Q924 Jim Cousins: Professor Buiter, in your evidence to the Committee—and I am following it Q919 Jim Cousins: Professor Buiter, while such a up directly because it is a right old shambles if you system, whatever it might be, is being put into place, are right—you said that national financial regulators which is not the case now, do you think it is credible in the European Union should go the way of the that we could say in the event of another diYculty in dodo? another bank that the 100% guarantee to depositors Professor Buiter: Yes. could not be extended if retail depositors are, as the Governor says, trapped? Professor Buiter: I do not understand the question. Q925 Jim Cousins: The evidence you have given to I was surprised by the Chancellor’s statement the Committee this morning rather bears that out, because as I understood his original announcement does it not? Processed: 30-01-2008 10:55:44 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG5
Ev 102 Treasury Committee: Evidence
13 November 2007 Professor Willem Buiter and Professor Geoffrey Wood
Professor Buiter: Well, one example does not prove stability, so I think there was probably very little the case. It is not really a matter of individual evidence, even if they had done the work, on which competence so much as the fact that we have this they could say what would happen if we suddenly regulatory race to the bottom when we at least could moved from stable to unstable times. neutralise the European element if we had a single European regulator. Capital is global and unfortunately governance is not and regulation is Q928 Ms Keeble: So people took risks they might not, but where we can operate in a larger area, not have done firstly because there had been a period especially if it includes a significant number of of stability and was it also not secondly because it serious financial centres, we should do so, yes; it just was oV balance sheet? simplifies the task of preventing the further spread of Professor Wood: Probably the first is more light-touch regulation. important but again— Professor Buiter: The level of transparency of the Q926 Ms Keeble: I wanted to ask a bit about the whole process is low. Many of the institutions have assessment of risk and the role of the credit ratings ended up holding them and dealing in them through V agencies. To what extent do you think the o balance sheet vehicles whose reporting complexity of the financial instruments has made it obligations are minimal, and so it became harder not very diYcult for investors to assess the true risk of just to understand the individual instrument, as the assets in which they are investing? Linked to that, GeoVrey just described, and how to price them but what do you think of the due diligence which they also it became hard to figure out who held them, so undertake? the knowledge on who owns what is still fairly Professor Wood: The instruments have got a bit patchy. 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 Q929 Ms Keeble: I just want to come on to the credit various qualities of borrowing. They were bundled ratings agencies. I think it was Professor Wood who up and people did not look inside these bundles. said that the concept of due diligence in this area was That may have been bad ratings agency work but it pretty meaningless. Would you agree with that, was also bad banking not to know to whom you Professor Buiter? were lending money. Professor Buiter: Yes, you cannot be duly diligent Professor Buiter: It is inherent in the process of for things that you really cannot understand. I think securitisation, which by the time you get to the the regulators and the Bank can help create ultimate investor, who is six transactions or more incentives for simplicity, for instance by the Bank of away from the originator of the loan, neither the England, in this particular case, announcing that buyer nor the seller has any idea as to the underlying they would take certain kinds of structures as risk characteristics of the security they are buying. collateral in repo operations at the discount window That gets worse when the securitised mortgage loans but not other more complex ones. That is one way of get packaged with credit card receivables, the square making simplicity attractive. root of car loans, and whatever else. The structure they have put together became so complex they probably were not even understood by their Q930 Ms Keeble: You have said that you think that designers. Due diligence does not mean anything if it would help if there were clearer reporting you cannot understand what you are dealing with, requirements. Do you think that it would also be and the rating agencies are in no better position to appropriate to look more carefully at the role of the know what the true value is, they did not go and credit ratings agencies and in particular their check individual addresses as to what the mortgages propensity for being able to advise on the structure were worth. of investments and then also do the ratings of them as well? Q927 Ms Keeble: There are two sides to that and I Professor Buiter: I have argued that they should want to come back on to the credit ratings agencies. become ‘monolines’, basically agencies just doing I could understand that a casual investor might not one activity, just doing ratings. You cannot manage look into the bundle to see what is there, but some of the potential conflict of interest involved in advising these investors are substantial and sophisticated and a client on how to design a structured financial one would have expected a degree of due diligence or product to get the best possible credit rating and that they would have required a greater then rate that same product. That is going to create transparency in the products. a conflict of interest so it should just not be possible Professor Wood: One would hope that but there to do that; you rate and that is it. actually is a diYculty because when you are putting these products together you are bundling together various categories of asset which had behaved Q931 Ms Keeble: Professor Wood, would you agree diVerently in the past, and you estimate what the risk with that? characteristics of the bundle is based on the Professor Wood: Absolutely. It slightly surprises me experience of these diVerent assets in the past. The that the agencies have not grasped that for trouble in the present situation was the past had been themselves and set up separate ratings agencies rather an unusual period, a period of remarkable because these would attract customers. Processed: 30-01-2008 10:55:44 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG5
Treasury Committee: Evidence Ev 103
13 November 2007 Professor Willem Buiter and Professor Geoffrey Wood
Q932 Ms Keeble: Professor Buiter, you have made Professor Buiter: Exactly the same point. comments about Basle II and the Credit Ratings Professor Wood: The same point. Agency. I wonder if you would just like expand on some of the comments you have made? Q936 Chairman: So we need a fundamental look at Professor Buiter: The credit rating agencies and their Basle II then? ratings play a central role in the first pillar of Basle Professor Buiter: Yes, back to Basle one and a half! II, the capital adequacy parts, and the other element of Basle II that I think deserves some scrutiny is the Q937 Mr Love: We will invite you back when we are use of internal models for marking to model the looking at Basle II. You both agreed earlier on that things that we cannot mark to market because there the Northern Rock crisis did not have any is no market for them, and that goes for most over- implication for the stability of the financial system. the-counter products, eVectively, not just for the Do you believe that any of the losses suVered by the ones that have temporarily become illiquid. So you much larger banks, such as Citibank, have any have two key pillars on Basle II: mark to model— implication for financial stability? turns out to be mark to myth in disorderly times— Professor Wood: They obviously make the and the rating agencies, which are deeply and institutions which have lost capital more fragile than inherently conflicted, and we are giving these rating they were before they lost capital, but one would agencies a semi-regulatory task through the Basle hope it also makes them more cautious in the future, Agreement. We cannot ask for the private provision which makes them less fragile. So, in the short term, of public goods like that. I think Basle II has to go yes, they are more fragile, in the longer term back to the drawing board before it is even out of the perhaps not. stable. This is a mixed metaphor. Professor Buiter: In the short term, by impairing their capital or at least reducing the margins, it will Q933 Ms Keeble: Can I ask one further point? Really make them more reluctant to lend, and that means the credit ratings agency should be capable of at least that the cost and availability of loans for the real guiding people as to where the risk lies in the system. economy is going to be more restricted in times to Why have they failed and what assessment do you come, so a net contraction on demand is imposed. have of exactly where the risk is, because there is quite a problem: the same investments are there, the Q938 Mr Love: Quite a number of the US banks same risk assessments, the same ratings are being have come forward with estimates of their losses. We undertaken, nothing has changed essentially, and have not seen that so much in terms of UK banks. there is a lot of people’s money tied up in institutions Should UK banks be more transparent about what which hold these investments. is happening to the balance sheets? One of the Professor Buiter: But the agencies did reasonably reasons they have given for that is the diYculty in well when they rated sovereign debt and quantifying what those losses are. Is that a corporations, large corporations. Remember, they reasonable excuse to give? only rate default risk and expected loss conditional Professor Buiter: The reason most of the big ones on a default occurring; they do not rate market risk, have not reported yet is that they are on a six- liquidity risk and everything else; so in some ways monthly reporting cycle, not on a quarterly one; so they would have been completely useless for the that is a straightforward reason. If you started current crisis in any case because there was a bringing in suddenly higher frequency reports, that liquidity crisis, by and large, rather than an would really put the wind up your sails. You have to insolvency crisis and we should not ask of them have a very good reason for doing that. I think as things that they do not promise to sell. But even in long as they stick to the regular cycle, that is fine, but the area where they are evaluating things, they they are going to have the same problem as their invented this new activity, rating fancy, structured American counterparts, in that they have on their complex products, but it is just very diYcult and books, or are exposed to, stuV that is really illiquid, basically impossible. has not been traded in deep, transparent markets for months now, some of them never, and therefore it is Q934 Chairman: Can I ask both of you in terms of very hard to establish a price. Yes, it is very hard, and it means also that there is non-uniformity in the the rating agencies, you both believe that they are V inherently and deeply conflicting? treatment of the same claims by di erent banks. My Professor Wood: Yes. view is that we really have no idea about what most Professor Buiter: Yes. 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 Q935 Chairman: Secondly, in terms of Basle II, John nothing; that certainly puts a clear floor under what Plender of the Financial Times was writing and he could happen, but very few other banks have been made comments that were along the same lines as willing to do that. yourself, Professor Buiter, but he is talking about Professor Wood: There is a big diVerence between Basle II, saying that it relies on the modelling some of the British and some of the US institutions. techniques that led to the sub-prime disaster and the Some of the US institutions are not strictly speaking new rule book also depends heavily on the credit banks. Banks have the option of carrying these loans rating agencies in whom investors have lost on their banking book rather than their trading confidence. book. They are not, therefore, required to mark to Processed: 30-01-2008 10:55:44 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG5
Ev 104 Treasury Committee: Evidence
13 November 2007 Professor Willem Buiter and Professor Geoffrey Wood market. Whether that is a good thing or not, banks therefore also riskier. I think you have to think of are allowed to treat these things very much like most of these vehicles as ultimately ending up on overdrafts. You do not mark overdrafts to market bank balance sheets. because there is no market. So there is an accounting diVerence, which can produce diVerent reports and Q941 Mr Love: Lack of transparency is a word used results. quite regularly both for oV balance sheet but also for perhaps a lack of adequate reporting of all of this, Q939 Mr Love: You mentioned Morgan Stanley and of course that leads to continued lack of suggesting that quite a lot of their paper is worthless, confidence in the market place. Should we be doing but we understand that quite a lot of them are still much more? Should there be more robust valuing at 90 cents in the dollar. If it all turns out to regulation, regulatory requirements, relating to both be worthless, as perhaps Morgan Stanley are already transparency and in a sense, therefore, to stability? admitting, would that shake their financial stability? Professor Wood: It was, of course, in a sense, regulatory requirements that led banks to put these Professor Wood: First of all, it would be a surprise V if it were all worthless, and I say that very seriously. things o balance sheet. Because the requirements When Continental Illinois Bank failed in the United were formal and in place, they knew that if they were States, it eventually paid out, I think, 93 cents in the not on the balance sheet they did not have to count dollar, or perhaps a little bit more, (but it took some against capital. So you have to think very carefully time). So it would be a surprise if these securities about the kind of regulation you have so as not to turned out to be worthless this time.. Secondly, if encourage that kind of behaviour. All regulation is every bank in the system took this big hit at once, it not good regulation; all regulation does not produce would indeed impose a severe contraction ratio on improvement. the economy. If they spread it out, sure, it would be Professor Buiter: There is a real problem about trying to prevent accountancy and auditing tricks or more diVused. Whether that is good or bad I cannot mitigating them by regulation that can be easily immediately answer; I would have to think about it. avoided. You really have to have principle-based bank regulation that basically says it looks like a Q940 Mr Love: What is the implication of holding bank, it lends like a bank, even though it may not V V quite a lot of this stu o balance sheet? Is there any take too many deposits, we will treat it as a bank for implication directly and, if they took it all back onto regulatory purposes. So you make an institution their balance sheet, would there be problems that pass the duck test when you decide to regulate it, but would arise from that? that is more easily said that done because the Professor Buiter: It depends on whether they are principle still has to be translated into actual required, either through legal obligations to do so, operational rules. The principle versus rules debate say through a credit-line or some other legal is a false dichotomy; both have always been commitment, also reputational considerations. If necessary. It is not easy, and you can do better than they are exposed, substantively exposed, then having we are now, but most of the activity that caused the them oV balance sheet is simply a smokescreen, it is trouble took place out of the view of the regulators. a way of hiding things. It is done generally for regulatory arbitrage purposes to reduce the capital Q942 Chairman: Can I thank you very much for you need to carry this stuV. Basically many of these your evidence this morning. It has been hugely vehicles are banks without capital or without helpful to us. reporting requirements and without governance, Professor Buiter: Thank you very much. It has been and so that is a lot easier to manage, but, of course, a pleasure. Processed: 30-01-2008 10:55:44 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG5
Treasury Committee: Evidence 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 Fre´de´ric 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 triple-A, some of you use lower case “a”, but you Committee’s inquiry into financial stability and always usually agree. How do you agree at the end transparency. Can you introduce yourselves for the of the day when you start oV with a diVerent base? shorthand writer, please, starting at this end? Mr Taylor: Actually we do not always agree; quite Mr Prescott: Charles Prescott, Financial the contrary in fact. There are two levels to this. One Institutions, Fitch Ratings. level is what you do not see in the public markets. So Mr Taylor: Paul Taylor, Fitch Ratings. each of the agencies has situations where they do not Mr Madelain: Michel Madelain, Executive Vice rate something because they disagree with the risk President of Moody’s. I am responsible for bank assessment that appears in the public market, but we ratings. also have diVerences in the ratings themselves. If you Mr Drevon: Fre´de´ric Drevon, I am Moody’s for look at the specific ratings assigned to diVerent Europe. I am also co-head for securitisation issuers, diVerent transactions, diVerent companies, business. I am London-based. banks, there are diVerences between the levels Mr Bell: Ian Bell, I head the securitisation business assigned. There is a lot of similarity as well simply of Standard and Poor’s in Europe. because of the fact— Mr Hancock: Barry Hancock, Head of European Corporate Ratings for S&P in Europe. Q949 Chairman: I am pointing out that Arturo Cifuentes, who is the Managing Director of RW Q944 Chairman: Maybe I can start by asking a Pressprich says, “In practice, however, the degree of simple question. What do rating agencies do and agreement category by category is extraordinarily what do your ratings mean? All your ratings mean high. This degree of agreement seems strange.” diVerent things in diVerent companies. Is that Mr Taylor: I am not sure it is extraordinarily high. correct? Maybe you can tell us, starting with Fitch, First of all, it is based on facts. The facts we all get what your ratings mean, and Moody’s, what your are the same. How we interpret those facts is down ratings mean and then yourselves? to our individual decisions and analysis. The facts Mr Prescott: Our ratings are measuring the are the same. So you would not expect massive likelihood of interest and capital being repaid in diVerences on a frequent basis, but there are terms of the conditions of the issue. diVerences. Mr Madelain: Our ratings speak to the risk of Mr Drevon: I should also add in the specific context default and recovery on securities issued in the of securitisation, arrangers who create these capital markets. transactions have a goal to achieve a higher rating, Mr Bell: Similarly to Fitch, our ratings are opinions typically a triple-A rating, so they will structure a as to the likely default, either on interest or principle transaction in a way that achieves the highest rating in a timely basis. possible; so it is not unlikely that diVerent rating agencies rating the same instrument will achieve the Q945 Chairman: So really your ratings reflect credit same highest rating. risks—that is the ability or willingness of a party to Mr Bell: In addition, in structured finance you also repay a debt—but they do not imply anything in have the fact that, even if there are diVerences in our terms of liquidity, potential for appreciation or analysis of a particular transaction because the volatility. Is that correct? people structuring the transaction wish to have the Mr Bell: That is correct. highest rating, they will simply take the most conservative position of the two or three agencies, so Q946 Chairman: So they do not do that for liquidity. enabling each agency to give a triple-A. Therefore, an investment decision based only on ratings can be misguided. Q950 Chairman: Do you agree with Mr Cifuentes Mr Bell: We have always been very clear that no that the rating agencies enjoy a power that goes investor should base a decision to invest or not invest beyond what regulators probably intended and, in any debt solely on the rating; this is one maybe even worse, understand? component of all the risks that that investor should Mr Madelain: I think that is an understatement. I take into account. think we are a provider of opinions on credit risk. There are many other providers, many diVerent Q947 Chairman: So the decision could be ways to form opinions, and we are one of such misguided? providers. Mr Bell: If based only on a rating, almost certainly, yes. Q951 Chairman: I will go on with what he is saying. He says whether a bond gets an investment grade Q948 Chairman: At the end of the day, you have rating or not is critical—in some cases it prevents diVerent quantitative models to rate the credit risk, certain investors from buying the bond, in others it but you usually almost always agree in terms of the forces the holders of the bond to sell it—but what is rating, triple-A or whatever else. Some of you use frightening, he says, is not only that the agencies Processed: 30-01-2008 10:55:44 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG5
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13 November 2007 Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Fre´ de´ ric Drevon, Mr Ian Bell and Mr Barry Hancock determine whether the bond meets the BBA Q962 Chairman: So you provide those services. standard or not is the fact that you define that Okay. standard. Is that not frightening? Mr Madelain: What is important is that those Mr Madelain: There are two things. There are services are unrelated to ratings. certain situations where ratings are embedded in regulations. This is clearly the case in the United Q963 Chairman: You agree with two of the three States; much less so in Europe. Second, we have points that Professor Buiter is making and, as a rating criteria that, indeed, lead to assigning certain result, he came to the conclusion, as Professor Wood rating levels, but those are fully transparent and did, that you are inherently and deeply conflicted. available to every user of ratings and actually may Mr Madelain: The issue of pay model, which is what default from one agency to the other. you have just described, is eVectively creating a potential conflict. What we do believe is that we do Q952 Chairman: In terms of the practice of the manage that conflict eVectively, as has been rating agencies, the appraiser in the rating process is demonstrated by our track record in this area and paid by the seller rather than the buyer. Is that also I think, as we have stated many times, by the correct? importance of our reputation for the viability of the Mr Madelain: That is correct. services we provide.
Q953 Chairman: The rating agencies provide Q964 Chairman: Why is your reputation under such technical assistance and advice on how to design scrutiny at the moment? Why are you getting structures that could attract the best possible investigated on Capitol Hill and you are considered rating— right at the centre of the sub-prime market? You Mr Drevon: That is incorrect. seem to be the architects of the rating of this and the fact that there are problems, in fact global problems, Q954 Chairman: —to the very issuers whose associated with it. You are perfectly decent guys. structures they will subsequently rate? Why did you get yourselves centre stage here? Mr Bell: That is absolutely incorrect. Mr Drevon: You know, we have been in the market for many years rating diVerent instruments and so Q955 Chairman: So, you agree completely with we are used to be being under scrutiny for the simple Professor Buiter? reason that we provide a very public opinion about Mr Drevon: No, we disagree completely. credit risk. It is very easy to point a finger at a rating agency because that public opinion is available in the Q956 Chairman: You disagree with Professor market place, and so we are used to having to defend Buiter? our opinions and we do that on the basis of our track Mr Bell: Yes, absolutely. record, which we publish, which clearly shows that our ratings have a very predictive power in terms of Q957 Chairman: Okay; that is fine. The rating diVerentiating credit risk. In terms of your specific agencies provide other financial services and comment, which was in relation to our role in the products than ratings or ratings advice? sub-prime market— Mr Madelain: We do not provide advice, as we have said. Q965 Chairman: I ask questions; I do not make comments. Q958 Chairman: Other financial services that you Mr Drevon: I am sorry. In terms of your specific provide. question in terms of our role in the US sub-prime Mr Drevon: We can speak for Moody’s. We do market, I think we have been quite clear also, and I provide some additional tools to the market but think we included that in our submission.20 We did those are done separately, they will be done not design the securities, we did not originate the separately from the rating agency. underlying mortgages, we are not investors; we provided one specific role, which was the credit Q959 Chairman: But you provide those services. opinion about credit risk. Mr Hancock: Exactly the same at Standard and Poor’s. Q966 Mr Fallon: Nevertheless, you are selling Q960 Chairman: Standard and Poor’s provide those services to the people you are supposed to be services as well. Do Fitch provide those services? regulating. That is the position, is it not? Mr Taylor: Actually, no. We are representing Fitch Mr Bell: Undoubtedly there is a potential conflict of Ratings. We do not provide those services. We have interest. It is well known to the market. a sister company, which is a completely diVerent company, a diVerent management structure. Q967 Mr Fallon: You are selling services to the people you are supposed to be regulating. Q961 Chairman: There are Chinese walls between Mr Bell: We do not regulate; we merely express you. opinions as to the credit risk. Mr Taylor: It is a diVerent company, who do provide those services. 20 Ev 280 Processed: 30-01-2008 10:55:44 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG5
Treasury Committee: Evidence Ev 107
13 November 2007 Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Fre´ de´ ric Drevon, Mr Ian Bell and Mr Barry Hancock
Q968 Mr Fallon: You are part of the regulatory Mr Prescott: No, it is obviously not because they system and you are selling services? were paying us. We look at every issue in its own Mr Madelain: I think we need to be clear on that right and we will decide what actions to take point. I am not sure what you mean by “selling depending on the circumstances and the information services”. that is available to us.
Q969 Mr Fallon: You take fees. Q980 Mr Fallon: But you did not take any action. Mr Madelain: The business model we have is that the You have written us a long submission here pointing fees are paid by the issuers of securities, yes. out how Northern Rock was over-reliant on wholesale markets, its funding mix was historically Q970 Mr Fallon: Let us just be clear about this. Did very skewed, and so on, but you did not change your any of you take fees from Northern Rock? rating of Northern Rock before the interim results, Mr Hancock: Yes. nor between the interim results and the final crash on Mr Taylor: Yes. 14 September? Mr Prescott: That is correct. Q971 Mr Fallon: You took fees from Northern Mr Hancock: I would add that at S&P we have over Rock? 2000 clients who are rated within Europe and the fee Mr Taylor: There has never been any denial of a from one of them is not going to influence a decision conflict of interest in the issuer pays models. There is that we would make on their credit standing. We nothing secret, there is nothing surprising, about would be driven entirely by our belief on the likely that. probability of default.
Q972 Mr Fallon: Then you will tell me Mr Taylor, Q981 Mr Fallon: But you are taking fees from all of how much fee you took from Northern Rock, if it is them, Mr Hancock, that is the point. You are the Y not a secret. tra c-lights being fixed by the speeding motorist, Mr Taylor: I do not know the number. are you not? Mr Hancock: We are driven entirely by our Q973 Mr Fallon: Roughly? reputation. If we lost our reputation, if anybody Mr Taylor: I do not know the number. doubted that we were driven by the fees we received from any individual client, that would be the end of our business model. Q974 Mr Fallon: How much a year do you charge Northern Rock? Mr Taylor: I do not know the number. 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 Q975 Mr Fallon: Does anybody else know what they September? charge Northern Rock? Mr Hancock: I think if you looked at the history of Mr Hancock: I could not tell you, no. the rating of Northern Rock, we had indicated that in the 13 years that we have been rating them they Q976 Chairman: Is it a substantial sum? were rated somewhat lower than many other Mr Taylor: In the context of our overall business, financial institutions within the UK. We certainly almost certainly not. I do not actually know the highlighted their increased, or higher, reliance on number. wholesale funding. Certainly we did not expect the repercussions of the US sub-prime market to have Q977 Chairman: Could you write to us with that and the impact and repercussions on funding of all UK give us a number so that it is a matter of public banks, but we have certainly highlighted the extra record.21 risks that were involved in their reliance on Mr Taylor: It is commercially sensitive. I am sure we wholesale funding. could let you have— Q983 Mr Fallon: I do not think you quite see this Q978 Mr Fallon: You told me it was all open and from the way we are seeing it. This is the first bank above board. run for 140 years. You are the people who are Mr Taylor: No, we do not disclose the fees paid by supposed to be flashing up the warnings about the individual issuers to us. likelihood of banks getting into trouble and then you come here and tell us you are being paid by the very Q979 Mr Fallon: The reason I am asking you this, same banks and you did not give the warning. Mr Taylor, is that the submissions you have all made Mr Bell: I think it is worth drawing attention to two to us make it very clear that, apart from the pieces of research or two investigations that have downgrade the day the interim results came out, taken place. As the potential conflict of interest is there was no change in your opinion of Northern well-known, we would like to draw attention to the Rock from 2006 until after 14 September. Why was fact that it has been researched in the United States. that? Was it because they were paying you? A few years ago the Federal Reserve Board asked a bunch of academics to investigate whether or not the 21 See Ev 264, 276, 285 conflict of interest did aVect the way the rating Processed: 30-01-2008 10:55:44 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG5
Ev 108 Treasury Committee: Evidence
13 November 2007 Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Fre´ de´ ric Drevon, Mr Ian Bell and Mr Barry Hancock agencies assigned their ratings. That academic Rock, what is the likelihood of you getting your research clearly came to the conclusion that they did money back? So, because of the strength of support not and that our reputational integrity was more that came in there, we did not have to change the important to us than the fees. In the same way, after rating, the rationale of the rating changed and was 2003 there was a quite legitimate investigation of the described by research issues by us, but the risk of the rating agencies by the Committee of European piece of debt did not change by that much if you were Securities Regulators as well as the European a bond holder. Parliament that was quite extensive, and they also reached the conclusion that our conflicts of interest Q986 Peter Viggers: When you were asked whether did not impact on the ratings we gave. So, although each of you drew fees from Northern Rock, Fitch we absolutely accept that these are legitimate and Standard and Poor’s said, yes; Moody’s was questions that should be asked, as there is a potential slightly less forthcoming. Can I assume that conflict we would like to draw attention to all the Moody’s also receive fees from Northern Rock? evidence that is accumulated in the case that that Mr Drevon: We do. conflict does not impact on the rating process. Q987 Peter Viggers: In assessing these fees (and we Q984 Mr Fallon: Let us focus on the evidence on would like you to let us know what the fees were) can Northern Rock. Why was it that none of you flagged you, please, also tell us whether these fees were up after July the real danger facing Northern Rock proportionate compared with other institutions from the closure of the financial markets? comparable to Northern Rock? In other words, were Mr Bell: I think the fact that needs to be borne in you remunerated in a manner which was perhaps in mind is that the crisis that unfolded in the excess of that which one would normally see from international capital markets in August was of a very such an institution? I would you like to put that novel kind, one never seen before, and it took the question to you, please, and I hope you will be able entire market by surprise, it took the regulators by to respond. You have been criticised for the speed surprise, it took the Fed, the Bank of England, the with which ratings adjusted to the sub-prime crisis. ECB, by surprise, it certainly took the investment Previously you were criticised for the speed with bankers by surprise and it took us by surprise. Our which you adjusted to problems with Enron. Were business is to express opinions. We do so based on you satisfied with the speed that you responded and our best understanding of how events are likely to what plans have you to improve the speed with unfold. Undoubtedly, if your business is, as our which you intend to respond? business is, to predict the future and try to see into Mr Madelain: I think actually we feel we did the future, there are times and there will be things eVectively respond to the situation in a timely that you do not see. We did not see the way in which manner. I would like to make two comments. The the sub-prime crisis would ripple through the capital first comment relates to what we have done. All over markets of the world and impact an English bank, the summer we had very intense activity around the like Northern Rock. assessment of the situation and the communication to the investors of the impact of the situation on the Q985 Mr Fallon: You all failed. bank we rated. We had weekly conference calls for Mr Madelain: I would like to give you my global investors, we published more than 25 research perspective on this situation. As has been provided reports through the summer on that very topic, so I think that the level of response and the expectation to you in various submissions, I think we made an V assessment of the liquidity situation and the risk of the investors at that stage were e ectively met. I guess the other question that one would have is what situation, the funding strategy of Northern Rock. I V think we felt that this risk was manageable. We had e ectively we were able to communicate. I think it is identified—. I think what is important to realise is very important that you understand that the that when you assign a rating you assign a rating to opinions we produce are based on the public a scenario which you think is the most plausible information that is available to us in the form of scenario for that institution. You do not assign a financial reporting as well as information that is rating to an extreme case. So, that is just to explain made available by the banks that we rate; and there is obviously a limit in what we can do and that limit what was the background for our rating. Moving V into the specifics, I think that we had obviously very is a ected by the amount of information that is early on measured the situation on liquidity that was available. aVecting the market, and our view was that Northern Rock was obviously exposed. We did Q988 Peter Viggers: But you are experts, otherwise engage with the bank on that situation and we it is just rubbish in, rubbish out. moved the rating when we were informed, Mr Madelain: But the expert is forming an opinion eVectively, of the decision of Northern Rock to seek using information that is made available to you. We assistance from the Bank of England. cannot create information that is not available to us. Mr Taylor: To answer your question directly, the rating did not change by much, the situation Q989 Peter Viggers: Switching to another point, to changed by a bit. Going back to your first question, Fitch, Fimalac claim that you warned investors which what is the rating actually doing, the rating is about the dangers of a sub-prime mortgage market addressing—. If you hold a security from Northern in 2005. Is that correct? Processed: 30-01-2008 10:55:44 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG5
Treasury Committee: Evidence Ev 109
13 November 2007 Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Fre´ de´ ric Drevon, Mr Ian Bell and Mr Barry Hancock
Mr Taylor: It is correct, yes. much worse than even our worst case assumptions— the deterioration in credit, the deterioration in Q990 Peter Viggers: What did you do about it? underwriting, the deterioration on the fraud side, the Mr Taylor: What did we do about it? One of the amount of fraud involved, and also a series of very challenges we have had as an industry over the last unusual and completely novel patterns of behaviour couple of years is when the markets have been so by sub-prime borrowers, things that had never been buoyant, as we have put out comments about maybe seen before in any other market. All of these credit deterioration or concerns in increasing combined to create a situation that was worse than leverage, for example, in transactions, many, many our worst case assumptions and also completely players in the investor community simply were not novel, not just to us but to the entire markets. As a viewing credit perhaps at the forefront of their result, with hindsight, if we had known exactly what investing decision. So, even though we can draw was going to unfold, we would have rated these attention to commentaries about deteriorating transactions diVerently. However, we maintain that credit risk, it was not being reflected in investor we rated them with all our knowledge and all our behaviour. A good way of describing that is the skill to the best of our ability. average ratings we have been applying, for example, in leveraged corporate transactions in Europe have Q993 Peter Viggers: But you are experts and been coming down on average for the last two years. presumably well paid. Did you study the initial sub- Until recently the price was coming down as well. prime market, notice the way they were The increase in risk as we reviewed it has not been collateralised and then draw conclusions to enable reflected in market pricing; so there was an you to warn people? imbalance between what we were saying, the Mr Bell: Absolutely. I think also one needs to direction of credit and the way the market was remember that we have been rating sub-prime responding to deals being placed. transactions since the early 1990s. This was not a new market for us. In 2001 there was a crisis in the Q991 Peter Viggers: Were you content that the then sub-prime markets, so we drew all the lessons information you were putting out reflected the that we could from this. What happened is that the reality that investors would probably want? crisis in 2007 was of a speed and amplitude much Y Mr Taylor: It is very di cult to say that, because greater, not just than in the past, but much greater what actually happened in the US sub-prime market than anything we had seen as a worst case scenario was very much unprecedented. We had not seen in the future. 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 Q994 Peter Viggers: Can I turn to Moody’s. Brian direction was clear, but it was not just us, many Clarkson from Moody’s said in the Financial Times commentators in the market were saying similar on 18 September, “A more uniform method of things. valuation is essential for eYcient and rational price discovery and to address future liquidity issues.” Q992 Peter Viggers: Do you at Standard and Poor’s Could you expand on that statement? and Moody’s accept that Fitch was ahead of you in Mr Drevon: I think it appears right now that one of warning of the dangers of sub-prime? the main reasons why we are in these very troubled Mr Bell: I am not exactly sure when their warning times is not necessarily linked to the credit risk we came out. We had warnings at roughly the same are seeing but more to liquidity-related issues and time. They may well have been ahead. I think one liquidity-related issues due to the fall in values we are has to remember two things. First of all, we did, as seeing on a number of securities. Why are we are did the other agencies, warn investors about the seeing this level of falls? First of all, it is very clear deterioration in sub-prime, but also one has to bear that these instruments are complex and require in mind how you rate structured finance significant amounts of time to fully understand and, transactions, which is that the criteria require a therefore, to try to find a tool for valuation. There is credit cushion. In order to have a triple-A you have no standardised solution to that. DiVerent banks to have a credit cushion so the pool of mortgages can will come up with diVerent solutions to value these absorb a certain amount of losses before there are securities and, by definition, this will result in any losses at the triple-A level. These cushions were diVerent methodologies across diVerent institutions very substantial in the case of sub-prime. They across diVerent markets. This creates generally reflect our analysis of past data. Those cushions are concerns that institutions may have more risk than not simply reflective of what happened in the past. they have been disclosing because they are using For triple-A ratings we simply do not say: “we diVerent methodologies. So there certainly is, I assume the future will be the same as the past; what think, a clear understanding in the market place that we do is we stress the past”. We look at how bad there needs to be more done in terms of agreeing on things got in the past and we say: “we will multiply solutions to have a more standardised approach for that level of rates to create a cushion that should valuations. From Moody’s point of view, this is not survive not just credit problems in the past but a an area that we are involved in at this stage. We much worse credit scenario”. What happened in the provide credit ratings, but we think it is an area case of US sub-prime, however, is that the future was which may benefit in the market in the future. 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Ev 110 Treasury Committee: Evidence
13 November 2007 Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Fre´ de´ ric Drevon, Mr Ian Bell and Mr Barry Hancock plan on developing tools to provide fundamental quite large, thousands and thousands of mortgages, valuations to help investors with valuing these they do respond fairly well traditionally to statistical securities. analysis. We have used that statistical type of analysis, taken quite a lot of information from the Q995 Peter Viggers: You have a unique status under pools, and we do a lot of due diligence in that sense, US security laws. You profit from your privileged over the 30 years. Our record shows that actually it status and it was Mr Bell, I think, who referred to has been extremely successful in predicting the your reputational integrity. Do you think you probabilities going forward. deserve this unique status in the US? Mr Drevon: Moody’s has generally been in a Q998 Ms Keeble: In this particular case it is not just position to say that we are not in favour of using that we had the first run on the bank and all that; a ratings for regulations. We have been very clear lot of people, a lot of my constituents, could have about that in all our observations. We think that lost a lot of money, all their money, so it is ratings are used for many things already, including desperately serious. How far down through the by investors, by issuers. They are used by investors structure did you actually prod to test how viable who buy whole issues, investors who trade, by these loans were and what this was built on? Not just investors who will short sell. We think that adding general mortgages, specifically these risky loans, regulations to that as an instrument that will be obviously risky because they are sub-prime, and it is using ratings is not something that we recommend, very clear that there was basically pretty much in fact. nothing there? Mr Bell: I would go further to say that, although Mr Bell: I think that is not actually correct. What undoubtedly we do commercially benefit from that you are seeing is a large number of down grades. status, we have always, at S&P, as well as Moody’s, Right now we do not know what the ultimate default been opposed to being part of regulation. We did not will be, but right now the defaults on these pools are ask for this status, we did not lobby for this status, very, very small; they are less than 1% of actual we disagreed with the SEC when they created this defaults. Those will almost certainly rise, but to say status and we have said ever since that it is a bad of something that was rated triple-A, for example, idea. We welcome the changes in the law that was downgraded to double-A or double-A minus provide more clarity about how this status is going that there is nothing there, in all likelihood those to be provided in the future. bonds will be paid out in full.
Q996 Chairman: If I can go back to another Q999 Ms Keeble: If you bundle things up and pass question, roughly speaking you all rated Northern them on and keep on doing that, it is just like pass Rock the same. the parcel: it keeps on going until somebody blows Mr Hancock: Not dissimilar. There were minor the whistle and it stops. What I want to know is how diVerences. far down did you go, not just saying they have not Chairman: Not dissimilar, and you all had business defaulted, the record is good, we have got 30 years with Northern Rock. I will be writing to you experience. What analysis did you actually do of formally on that regarding your relationship with what these securities were actually based on? Northern Rock and the income you have, and if you Mr Drevon: Again, our analysis is really statistically decide to write back to me and say it is confidential, based because we are looking at very large pools, in then it is going to be a matter of public record, but the case of US sub-prime we are looking it more than you will be getting a letter from me on that.22 Sally. 40 diVerent pieces of data on each loan to come to a conclusion, and that helped us to understand the Q997 Ms Keeble: I must say what it reminds me of level of risk in each individual loan and then, based is the children’s game, pass the parcel. You have got on that data, make assumptions about the credit risk some risk bundled up, it gets passed from pillar to of those pools. It is a very serious amount of work, post and, when the music stops, people open it and extremely detailed, and we make available to the find that there is nothing there, or next to nothing market place the models we use to analyse that type there. It makes me wonder how hard you actually of risk. We are very transparent about the process. looked at the securities that you were supposed to be rating: because once the information had come out Q1000 Ms Keeble: When it is peeled oV now, it is about the sub-prime market, it is hard to imagine quite clear that there was gross mis-selling, or what how anyone could have regarded them as sound would be deemed to be mis-selling—people could investments at all. I just wondered, if you listen to not repay, they did not have the income, all kinds of what the professors said as well, how far you look things—so how reliable can your statistical tools and scrutinised what you were rating? have been? I could understand that if you applied Mr Bell: We have 30 years of experience of rating them to middle income mortgages they might be structured finance and the first structured finance very reliable, but sub-prime is diVerent, is it not? transactions, both in Europe and in the United Mr Bell: It is, and that is why our rules for sub-prime States, were residential mortgages. The advantage of and the way in which we stress them is very diVerent. residential mortgages is that because the pools are We do not stress them at all the way we stress prime mortgages. Clearly there are lessons that we are 22 See Ev 258, 272, 280 going to have to learn about the US sub-prime. Processed: 30-01-2008 10:55:44 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG5
Treasury Committee: Evidence Ev 111
13 November 2007 Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Fre´ de´ ric Drevon, Mr Ian Bell and Mr Barry Hancock
Clearly we are looking at what went wrong and how triple-A rating. Do you actually take decisions on we could possibly learn from this and how we can the ratings that people get or do you have some change our criteria, change our tools of analysis. Are people who will assess a product, do all the reports there any items we should be looking at that we did and then a separate group of people who take the not look at before? Such crises are always an decisions on what ratings they should get? opportunity for us to learn. Mr Bell: The latter. Maybe it is easier if I just explain the way in which we operate. Our criteria are public Q1001 Ms Keeble: I want to ask you in a minute so that market participants know how we apply the about the lessons you have learned, but you have rules. They have provisions so that we can have also said repeatedly that your advice functions are diVerent criteria if we feel someone is gaming them, diVerent from your ratings functions and that you but basically our criteria is public. The client will have got diVerent structures, diVerent agencies. You approach us; an analyst will be assigned to a say that, but everybody else who is coming here (and particular transaction—that is the primary analyst. obviously we all talk to people informally too) says Sometimes on big transactions, complex there are conflicts of interest: that you advise and transactions, there may be two analysts. They will that you rate on the same products. How is gather the information; they will ask the questions everybody else so mistaken about what you are that they believe they should have obtain answers to doing? in order to achieve the rating. They will then, once Mr Bell: I cannot answer that. What I can say is that they have done this, go to a committee and they will we have a potential conflict of interest which is present the conclusions of their work to the known and managed. We simply do not provide committee. The committee will vote on the rating. advice. It is very diYcult for me to say anything more That is how we operate. than that. We do not have advisory functions, we do not have a consultancy function for structured Q1005 Ms Keeble: Do the assessors get information finance, our analysts are hired and our company is from separate sources or just from the client? hired to rate transactions. We do not have any Mr Bell: They will get assessment, they will get advisory contracts. information from all the sources they deem relevant, so they will get it from the client, they may get it from Q1002 Ms Keeble: Okay. You have sat here, Mr Bell, the press, they will get it from other market and you have talked about the cushion that is participants if need be. needed, this and that and the other, to get a triple-A rating. That comes perilously close to saying, if you Q1006 Ms Keeble: What happens if the client says, do this so we can tick these boxes, you can get a “If I tweak it here or there, will I get a triple-A”? triple-A rating. You have sat there and said it, and What do you do then? we will see it when the transcript comes out. How do Mr Bell: We basically answer the issue of our you actually make sure that other people do not criteria. So if a client says, “I thought I had followed listen to you, say “Oh, well, to get the triple-A, I have your criteria. I thought I would get a triple-A. I have to do X, Y and Z and then I will get it, and that is not got a triple-A. What is wrong? Why did I not get the model and that is all I need to do”? How do you a triple-A?” We will give them an answer and say the safeguard against that? criteria had not been followed. Mr Bell: All our ratings are done by a committee; all of our rated transactions and structured finance are Q1007 Ms Keeble: But before hand, I mean, when analysed. Because our criteria are transparent and you are doing the assessment? available to the market and available to investors so Mr Bell: This is what I am talking about. When we that they can understand how we rate, we are very are doing the assessment the client will sometimes conscious that there will be a tendency by investment come to us and say, “I do not understand; I thought bankers and market participants to game our ratings I had met the criteria”, and we will explain, “No, we and, therefore, the rating process is never a do not believe the criteria has been met”, and then mechanical one. We always look at each transaction they will decide whether they want to go ahead with and try to understand and try to see whether or not the transaction or maybe they want to change the anybody has tried to game our criteria. transaction.
Q1003 Ms Keeble: Can you say whether, as a result Q1008 Ms Keeble: How about the others? How does of this, you have actually tightened up things? Do what you have described compare with the other you actually sit on doing the final assessment or do agencies? you have a completely arms-length group of people Mr Drevon: I think the committee process is who get all the data, a bit like the MPC, I suppose, probably somewhat similar. One thing to note which and look at it all and then think, “Right”? I think is important is that the reason why we have Mr Bell: DiVerent from whom? Because we do not transparent methodology being made available to have an advisory function. the market is because we think it is good practice. We were being accused a few years ago of being Q1004 Ms Keeble: You have sat here and described black boxes: a client, an arranger comes to us and how we could go about—. You have described asks us to rate a transaction, we give the rating but briefly some of the things that are needed to get a we do not explain the rationale for that rating. We Processed: 30-01-2008 10:55:44 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG5
Ev 112 Treasury Committee: Evidence
13 November 2007 Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Fre´ de´ ric Drevon, Mr Ian Bell and Mr Barry Hancock have taken many steps over the last few years, in Mr Taylor: No, I am Fitch. I do not think it is wrong fact, to become much more transparent and make actually. A lot of this is nuanced, to be honest. For available our criteria to the market place. From a an investment grade security the impact of recovery policy point of view, I think this was the right track assessment is very limited, because if you are taking to take. a healthy, strong investment company and saying, “Let us predict what it is going to look like as it is Q1009 Mr Simon: Going back to the extent to which about to go down the pan”, there is hardly any you agree or not and why, you started oV by saying purpose for doing that, there is no value we can add. that the ratings that you issue measure diVerent We actually do this for our ratings at the lower end things, they are not all the same; so S&P measures of non-investment grade; we build in the assumption default probability, Moody’s measures expected of recovery. So we are actually doing the same thing, loss. Then, the next thing you said is that it is not true but we are saying, as you start getting down to the that there is an extraordinarily high degree of much riskier levels of assessment, we think it agreement between the things that you rate. So far therefore adds value to talk about recovery that would make sense. If you are all measuring prospects as the risk becomes greater. diVerent things it is not surprising that there is not an extraordinary high degree of agreement, although it Q1014 Mr Simon: So you are only measuring very is surprising that there are people in the market slightly diVerent things? saying that there is an extraordinary high degree of Mr Taylor: In practice, yes. agreement. Then Mr Taylor told us that the reason there is an extraordinary high degree of agreement is Q1015 Mr Simon: The facts are the same, and you that the facts are the same, at which point I am are all talking to the same people and using similar starting to lose it. The facts are the same, so there is procedures to establish the facts, so it is not an extraordinary high degree of agreement, but you surprising that you all come up with the same are all measuring diVerent things, so it is not answers all the time, which you obviously do even surprising that there is not an extraordinary high though you do not like admitting it. In which case, degree of agreement. If there is an extraordinary going back to the fees that you charge and receive, high degree of agreement, what is the point of having if I am a typical participant in this market would I three of you in a normal market where the product normally be attempting to have a relationship with is the same and the price is roughly the same? What all of you: I pay you all and you all rate me. would be the point of having three providers if you Mr Madelain: It depends. are not in any competition, if you agree about everything, even though you are measuring V Q1016 Mr Simon: I know that sometimes you di erent things? decline to rate. I know that you do not all rate Mr Madelain: Let me answer the first point, which is V everybody every time. that we are measuring di erent things. When you Mr Madelain: Exactly, yes. talk about investment rate security, the diVerence between measuring expected loss and default probability tends to be very small. The reason it is Q1017 Mr Simon: If I want to make a good very small is because the diVerence is made up by the impression, would I not want to be rated by all three expected recovery, eVectively. of you? Mr Hancock: There will be a number of clients who are rated by all three, there will be a number who are Q1010 Mr Simon: What are you adding to the rated by two and there will be some who are just V market by measuring these things di erently? What rated by one. There is diVerent market practice in is the point? Why do you not measure the same diVerent countries and sectors of the market that we thing? operate in. 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 Q1018 Mr Simon: Roughly how would that break ultimate recovery, pay-out, eVectively, that he can down? Would two be the most common, would expect from the investment he is making. you say? Mr Hancock: Yes, probably. Q1011 Mr Simon: So you think that is the best way. Q1019 Mr Simon: Why is that? Speculate a little You need to measure the loss, not just the from a very informal position as to what I as a probability of default? punter gain by being rated by two of you when you Mr Madelain: That is correct. almost never disagree with each other and you are measuring the same things and the same facts? Q1012 Mr Simon: And you are Moody’s? Mr Madelain: The point is we can disagree. Mr Madelain: Yes. Q1020 Mr Simon: I know it is possible. Q1013 Mr Simon: S&P, you think that is wrong. Mr Madelain: And we can disagree sometimes on You think that you only need to measure the things that are very important—the cut oV point probability of default? between investment grade and non-investment Processed: 30-01-2008 10:55:44 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG5
Treasury Committee: Evidence Ev 113
13 November 2007 Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Fre´ de´ ric Drevon, Mr Ian Bell and Mr Barry Hancock grade, for example, or special situations where we Mr Bell: I think the more educated, informed may take a view and other raters may take a very opinions there are, the more— diVerent view. Q1028 Mr Simon: So it would be better if there were Q1021 Mr Simon: We have been hanging this ten of you? around the Northern Rock situation. Give us an Mr Bell: Absolutely. example in the Northern Rock situation of such a nuanced disagreement and the positive impact that Q1029 Mr Simon: Good. it had? Mr Bell: If none of us existed, it depends which Mr Madelain: At the moment, I understand— markets you are looking at, but in markets which are structured finance, which are global markets with Q1022 Mr Simon: No, no, I am talking about the run fairly complex instruments, it is diYcult to see how up to the run on this bank, which none of you sussed such markets could meaningfully exist without a out in advance. To be fair, nobody else noticed it series of independent opinions that looked directly either and it is obviously not your fault—I am not at the transactions. 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 Q1030 Mr Simon: Why cannot we just have a diVerent way and thereby sent a subtle signal to computer model? Everybody knows what these the market? criteria are. Why can we not just have a programme Mr Madelain: We had a higher rating for Northern and everybody runs it through at their desk? Rock than Fitch and S&P. We had a double issue Mr Madelain: They are available today. rating on Northern Rock, and the reason we had a higher rating was because in our rating methodology Q1031 Mr Simon: Why do we need you then? Why we do assign a higher weight to systemic support to do we need to pay you to do that? bank ratings. Mr Bell: Because the thing about computer models is they are very inflexible and, therefore, they are Q1023 Mr Simon: But that does not really make any subject to gaming. There are a lot of very highly paid diVerence, does it? It is a diVerent methodology, people in banks whose job it is to try to figure out a everybody knows that, everybody knows what the better mouse trap, and if you have an inflexible methodology is, so unless you are actually going to model with no human element to actually see how be making decisions in a diVerent way, unless you the model is being gamed, you will get yourself into are going to be forming views diVerently— a lot of trouble fairly quickly. Mr Madelain: We formed a view, which was that eVectively we are rating the bank higher. 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 Q1024 Mr Simon: That is because you always rate do not quite agree?”, nobody says, “We disagree those higher banks higher than they do, and because we have added a little bit of human element everybody knows that, so what is anybody learning into this, because we made a slightly diVerent from this? judgment.” The only reason you disagree is, “Oh, we Mr Hancock: It comes back to the users of ratings have got a slightly diVerent criteria”? value a variety of opinions. In this case Moody’s Mr Madelain: It is not. It is human judgment. That took a diVerent slant on the likelihood of state is exactly what it is. intervention in the case of Northern Rock. These are opinions, there is no right or wrong, and clearly our Q1033 Mr Simon: You could write that into your users value having a variety of opinions. model? Mr Madelain: No, it is not a model, it is actually a Q1025 Mr Simon: Very briefly, Mr Bell, two view we form over time for bank ratings. We assign hypotheticals. If one of the three of you did not exist, a higher element. would it be a big problem for the market? Secondly, if none of you existed, would it throw the markets into crisis? Q1034 Mr Simon: In all cases; in every instance? Mr Bell: If one of us did not exist, it would narrow Mr Madelain: No. and reduce the number of opinions that investors can turn to. Q1035 Mr Simon: “In these cases we assign this rating”—that is not a warm, human, touchy Q1026 Mr Simon: That is called a truism. judgment. You could write it as an algorithm. Mr Bell: Yes. Mr Madelain: Well, eventually you can, but how you came to that conclusion is exactly the image, and V Q1027 Mr Simon: If one of you did not exist, there that is what you di erentiate as. would be one fewer of you than there are now. I understand that. I would like a little bit of Q1036 Mr Simon: That is another truism. These are interpretation, which is what you do for a living all human judgments because the algorithms are after all. written by humans. Processed: 30-01-2008 10:55:44 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG5
Ev 114 Treasury Committee: Evidence
13 November 2007 Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Fre´ de´ ric Drevon, Mr Ian Bell and Mr Barry Hancock
Mr Bell: Let me give you an example outside of each mass shooting in the United States, “There is Northern Rock which I think is useful. Both blood on the floor but it really is not anything to do Moody’s and us rate structured finance transactions with us.” in emerging markets, including Russia. They are Mr Hancock: We are certainly aware of these not, you will be glad to know, rated triple-A. concerns and issues and we go to great lengths in However, we have formed quite diVerent views trying to educate investors and others on how to about the nature of the risk of sovereign interference use ratings. in Russia on various asset classes and Moody’s view of their analysts based in Russia, knowing the Q1042 Chairman: You have not done very well so market and knowing the Government, about what is far? more likely, an interference with a mortgage Mr Hancock: By way of example, we have an event transaction or an interference with a consumer loan every working day of the year somewhere in Europe, transaction, is the exact opposite of ours. We have and part of the eVorts of those events is to get clarity our view; they have their view. As a result we rate on these issues. We are investing a huge of amount of those transactions diVerently and we explain why we time in trying to invest in the market more generally. 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 Q1043 Chairman: But after the Northern Rock happening. Moody’s staV in Russia have a diVerent situation it does not seem as if there has been much understanding. I am not saying I believe ours is success here for all three you. better because I am S&P, but I think it is of value to Mr Madelain: I am not sure what is the link, what is investors to be able to see those diVerent ratings, to the statement that you made. understand why they are diVerently assigned, to understand the subjective element behind them and Q1044 Chairman: Some investors use your debt then, as an investor, to make their own view as to ratings as a green light to invest. They have invested whether they feel Moody’s is right or whether we in Northern Rock and at the end of the day, as Mr are right. Fallon said, you did not downgrade your ratings until September, so some people are going to find Q1037 Chairman: You mentioned about value to themselves on their backside as a result of that and investors to see the diVerent ratings. Would you take you are then going to turn round and say, “It is it then that some investors can mistake a good credit nothing to do with us, mate”, because this is all to do rating for a green light to invest? with credit risk. But we are here as the interface Mr Bell: My experience of investors over the 20 between Parliament and the City and the community years that I have been in the structured financial and trying to get some handle on the situation, as Mr market is that the spectrum of investors in structured Fallon has tried and Mr Sioˆn has tried, but it is no finance is huge. At one end it is composed of use you then turning round to us and saying, “It is extremely sophisticated funds that have their own— 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 Q1038 Chairman: My question is a very simple one, in a certain way? Again, I think we have done a lot Mr Bell: do you think that some investors can to try to communicate on that and maybe that is not mistake a group credit rating for a green light to enough. We have in fact been looking at providing invest? more information to investors on other risks. We Mr Bell: I think some investors may well have done have been looking at terms of— that, yes. Chairman: I think this Committee, from the evidence you have given us this morning, would think that Q1039 Chairman: You would all agree on that? you have really failed hopelessly on that situation Mr Bell: Yes. Philip.
Q1040 Chairman: So the fact that you have all given Q1045 Mr Dunne: I would like to take us a bit above roughly a good credit rating to Northern Rock to the Northern Rock situation to look at the impact of investors and they invested on that basis, you would particularly the new financial structured products come back to them and say, “Oh, it is nothing to do and your relationship with the explosion of issuance. with us because it is only about creditworthiness”? Could you start by telling us, somebody, a volunteer, Mr Madelain: We are very clear in our how many triple-A rated sovereign credits there are? communications in what the meaning of the rating Mr Taylor: It would vary by agency. is. Q1046 Mr Dunne: In order of magnitude: one dozen, one hundred? Q1041 Chairman: Back to my point earlier that some Mr Taylor: Thirty maybe, 30, 40. 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 Q1047 Mr Dunne: How many corporates globally reminds him of what the gun manufacturers say after triple-A rating? Processed: 30-01-2008 10:55:44 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG5
Treasury Committee: Evidence Ev 115
13 November 2007 Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Fre´ de´ ric Drevon, Mr Ian Bell and Mr Barry Hancock
Mr Hancock: A handful. comes in which has virtually no track record, it would be very diYcult for us to come to a Q1048 Mr Dunne: Banks? conclusion. Mr Hancock: A handful. Q1057 Mr Dunne: Does that mean you do not oVer Q1049 Mr Dunne: Any? rating or you do oVer rating? Mr Hancock: There is the Rabobank in the Mr Drevon: No, we may decide there is not enough Netherlands which remains triple-A rated. It is the information or enough data made available to assign only one in Europe without public support. a rating. That is quite possible. It is certainly the case in some emerging markets, it may be the case for a Q1050 Mr Dunne: How many structured financial new type of asset class, but typically, again, if you products are triple-A rated? look at some of the large asset classes which have Mr Taylor: Thousands. 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 Q1051 Mr Dunne: Can you give us some idea of the obligations, have been around for approximately ten volume of issuance which is rated by you. I think one years now. 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 Q1058 Mr Dunne: After what point do you start to of what proportion of that is triple-A rated? issue ratings? Mr Bell: Totally or just structured finance? Mr Drevon: There is no specified point in terms of—
Q1052 Mr Dunne: That you look after, that you rate. Q1059 Mr Dunne: Let us take collateralised debt What proportion is triple-A? obligations, which have been going for ten years. Mr Bell: I genuinely do not have that number. I How long did it take before you started to provide would say 50 to 60%. ratings? Mr Hancock: We can certainly revert to you with Mr Drevon: Collateralised debt obligations, they that. started with the repackaging of corporate debt, so we had a lot of information on the underlying risk, Q1053 Mr Dunne: It would be very helpful if we which is a corporate debt. So, we could have could have an analysis, Chairman, by rating assigned these instruments very rapidly, again, on category, by type of issuer, the volumes and the the basis of the underlying data. I think we have to number of issuers? look at what also goes in the structured fund’s Mr Hancock: Certainly.23 instrument.
Q1054 Mr Dunne: That would be very helpful. How Q1060 Mr Dunne: That is a good line. How carefully long has each agency been rating the diVerent types do you look at what is going into the individual of structured financial products? I think you products as they are evaluated? Let us look at a mentioned 30 years. complicated one. How about a first default basket? Mr Bell: About 1976, I think. How closely do you get into what comprises the first default basket? Mr Drevon: The analysis would be on each Q1055 Mr Dunne: And is that the same for Moody’s individual instrument that goes into that and Fitch? transaction, and we would take a view on what is the Mr Drevon: Yes, approximately. It should be the likelihood of default of that specific instrument, same thing. what is the correlation between those diVerent instruments, model that and come to a conclusion. Q1056 Mr Dunne: But that is just for mortgage bank securities. Mr Bell, as you were saying earlier, there Q1061 Mr Dunne: If we take something else, a CDO are some very ingenious minds generating new square, which is new expression to me, that products all the time, so can you give us some sense essentially is a CDO vehicle investing in pools and for the longevity of the historic track record that you tranches of other CDO instruments? look at when you come to approach a new Mr Drevon: That is correct. 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 Q1062 Mr Dunne: Do you go down to the sits within the rating structure? underlying individual asset across a pool? Mr Drevon: It is in fact very simple. The more Mr Drevon: That is correct, yes. We do what we call information there is, the more track record there is, a “look-through”, so we go, in fact, not at the first the clearer we have a view of what could be future level, but we go for the underlying assets, which is performance and we can evolve models around that. the corporate risk. To the extent that there is a new instrument that Q1063 Mr Dunne: Is the issuer able to provide access 23 See Ev to the underlying data in every case? Processed: 30-01-2008 10:55:44 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG5
Ev 116 Treasury Committee: Evidence
13 November 2007 Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Fre´ de´ ric Drevon, Mr Ian Bell and Mr Barry Hancock
Mr Drevon: In most cases the underlying corporate Mr Hancock: I would just add, it is exactly the same names are rated; so we use the rating information. on the corporate and government side. We have an enormous number of phone calls from investors and Q1064 Mr Dunne: Let us suppose we are not dealing other interested parties questioning our opinions with corporate names, we are dealing with packages every day and, as a matter of policy, we put the of securities which do not have to issue accounts and names and phone numbers of the analysts on each do not have to issue public statements. piece to encourage that. Mr Drevon: Typically those instruments would be rated by us and we would use the rating as an input. Q1072 Mr Dunne: Do you publish your methodology in relation to individual instruments Q1065 Mr Dunne: So you rely on your own rating of and your model? Can somebody actually come in an underlying instrument. and look at your model? Mr Drevon: That is correct, yes. Mr Bell: Yes. In CDOs, for example, our model is available for free on the website. I believe that is the Q1066 Mr Dunne: Without necessarily going in to case for the other agencies. 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. Q1073 Mr Dunne: Do any regulators overlook your methodologies or models? Do you have discussions Q1067 Mr Dunne: How frequently do you reassess with them at all? ratings of individual instruments? Particularly I am Mr Bell: We have had discussions with regulators interested in the financial products rather than the where they have asked questions about our corporates, which have a natural publication cycle. methodologies. Mr Drevon: It is on-going work at Moody’s. The day we assign the first rating is also the first day we start Q1074 Mr Dunne: Any question of whether it is monitoring the rating; so there is no specific day in valid, or was it more to do with the conclusions that the year we decide we are going to review the ratings, you have come to for a particular instrument that it is an on-going review. they are interested in? Mr Drevon: I believe the regulators have been Q1068 Mr Dunne: Once a year, once every two years, looking more at the conclusion than the once every three years? methodology itself. Mr Drevon: It really is instrument specific. In some Mr Taylor: The experience that I have had is just instruments we will review them every week because that they are trying to understand how we look at there are very specific events surrounding that things, how the process works. 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 Q1075 Mr Dunne: So they are looking ultimately at monitoring is going to be on an annual basis. how you arrive at the outcome, but they are not seeking to question whether the methodology itself Q1069 Mr Dunne: Who monitors the monitors? Is is correct or appropriate? there any independent assessment of any of your Mr Taylor: Correct. methodologies? Perhaps I will ask somebody else. Mr Bell, you are nodding. Q1076 Mr Dunne: Can you explain why it is that Mr Bell: The independent assessment is basically diVerent credits with the same rating have such conducted by the investors. Our criteria are public. widely diVerent spreads in the market place? To give Therefore, it can be conducted by anyone who you an example which was given to me the other day, wishes: the regulators, CESR, the investors. if you take an emerging market, Peru 2016, which is trading this spring at 96 basis points above the Q1070 Mr Dunne: Do any investors in your relevant US treasury and you compare that with a experience ever analyse your methodology, other US corporate dollar bond, say General Motors, than in relation to questioning your decision? Do 2031, which had a 250 basis point spread over they go back to first principles? Do they ask for all Treasury, whereas a foreign corporate dollar bond, of your data to cross-check with their own models— KazCommerce Bank 2013 had a 263 basis point Mr Bell: Yes. spread, that is a significant diVerence, all of which have got a double-B plus rating, I think it was from Q1071 Mr Dunne: —in relation to that instrument. Moody’s in that case, so perhaps Moody’s can Mr Bell: Certainly in Europe I have come across a answer. Why is it that the spread is so significant if number of investors. Also we do do exactly that. If the rating is the same? the information that we have received suggests that Mr Madelain: I think the spread speaks to more than we should change our criteria, we will often request just credit risk but also to the liquidity of the a comment from the investors. We sometimes get instruments, and there may be also some diversions quite vociferous comments for or against any of view between our perspective on the credit risk as proposed change, so is there an on-going debate with a suitable security and the general consensus of the the investor community. market. Processed: 30-01-2008 10:55:44 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG5
Treasury Committee: Evidence Ev 117
13 November 2007 Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Fre´ de´ ric Drevon, Mr Ian Bell and Mr Barry Hancock
Q1077 Mr Dunne: So the credit rating is not a guide what the rating was one year, two years, five years to an investor as to the performance of the before the default, so there is absolutely zero underlying instrument, it is merely a guide as to incentive to do that, and it will be seen through by whether it is going to repay at the end of its maturity. the users, who have access to all of this information. Mr Madelain: If you define performance as return, Mr Madelain: I think what is important to note is the that is correct. performance of the rating. There is a very high degree of transparency about that. I think all Q1078 Mr Dunne: What about the default rate of agencies publish a huge volume of statistics, either at diVerent types of instruments? What has the the aggregate level or at the asset class level, actually experience been of that? tracking the performance of our ratings. So, it is Mr Drevon: We published a very significant amount certainly an area where transparency is very high. 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 Q1082 Mr Dunne: Have you read Peter Warburton’s structured finance ratings, in fact, are in line with the report? This is language which you may disagree performance of other bonds, such as corporate with, I expect. It says, “The final trick that rating bonds. 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 Q1079 Mr Dunne: That is interesting, because there downgrading a nearly bust bond a few weeks before was an article in the FT in August that suggested its final demise, the agencies can claim that it that actually the performance of CDOs was ten defaulted as a C-rated bond rather than a DD-rated times riskier than corporate bonds, and that was bond which it was when the bad news hit? from a Moody’s study? Mr Hancock: Can I just reinforce that the user of all Mr Drevon: I think you always have the possibility our ratings has all of the data available to identify if to drill down and say, if we look for a period of six that behaviour is prominent. months at a specific asset category and specific rating Mr Bell: I would also say, if you look, for example, level, there will be diVerences—that is absolutely normal—but the work we do is based on long-term at the table that we include in our submission of the statistical data and when we look over the long-term default rates in the US RMBS, they are from initial horizons, there is a high degree of convergence in rating not from final rating. terms of the performance of the ratings on the structured final side and the corporate side. Q1083 Mr Dunne: I think your best defence to that charge actually is what happened with Northern Q1080 Mr Dunne: If I can quote to you from this Rock, because you failed to downgrade them and article, it comes from a Bloomberg’s market report perhaps you should have seen the warning signs a bit in July which said that corporate bonds rated BAA, earlier. A couple more questions, if I may, the lowest Moody’s investment grade rating, had Chairman. One is in relation to the information that now reached 2.2% default rate over five-year periods is available to you as a rating agency in the US from 1983 to 2005, according to Moody’s, but from compared to Europe. You routinely receive 1993 to 2005 CDOs, which have only been going that information not generally available to the public long, with the same BAA grade, suVered five-year markets from issuers, but in the US information on default rates of 24%. Are you going to suggest that underlying collateral is generally available to that CDOs have much higher default rate with the investors, whereas it is not in Europe, and a charge same rating than corporate bonds over their life? has been made that during the summer crisis prices Mr Drevon: No, it does that in general. It does it in of securities began to show investors perceiving risk specific rating levels, and I think you commented on well ahead of the rating agencies in the US. That did one rating level for a specific horizon, but even not happen in Europe because the information was within the CDO categories there are a number of not available. Would anybody like to comment on V V di erent types which will have di erent that? performances. Mr Taylor: I do not think we have any problem at all with greater transparency in the markets. We Q1081 Mr Dunne: Can we turn for a moment then to have no problem whatsoever with the market seeing how you decide at a certain point that credit is absolutely what data we get. 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 Q1084 Mr Dunne: You would be quite happy to see in. Is it the case that you tend to reduce grades of information made available to investors in Europe debt that you see heading towards default shortly in the same way as it is in the US? That does not before the final default in order to improve these happen at the moment. performance statistics that we have just been Mr Bell: Yes, absolutely, in fact we welcome it and talking about? we have been, in some cases, urging, particularly in Mr Hancock: Certainly not. Indeed, the way the this crisis, our clients to make that information statistics are actually published, you can look available, because we think it is good for the market through that, so the investor is quite able to look at that it should be available. Processed: 30-01-2008 10:55:44 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG5
Ev 118 Treasury Committee: Evidence
13 November 2007 Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Fre´ de´ ric Drevon, Mr Ian Bell and Mr Barry Hancock
Q1085 Mr Dunne: Do you see any parallels with Mr Hancock: It is certainly something we will be what is happening in the US banking sector: losses looking at. being generated by investors, particularly in these CDOs, between other market failures such as the Q1088 Chairman: Why do you need a working party Lloyd’s insurance market? If you take the example in the light of Northern Rock? Why do you not just of the Piper Alpha loss of one billion dollars, go ahead and ensure that you assess liquidity? For because the way the reinsurance arrangements God’s sake, you have all given Northern Rock a worked, that translated into a 16 billion dollar really good rating, the disaster happened and now Lloyd’s reinsurance loss. Do you see investment in you are saying, “We are going to set up a working CDOs by CDO funds as creating a spiral in a similar party because we never assessed liquidity.” Why do way to that, or potential risk of a spiral? you not just say here and now you are going to assess Mr Bell: I think you need to distinguish between a liquidity? credit loss and a mark to market loss. The credit risk Mr Hancock: Certainly within the rating of never disappears, but neither is it necessarily Northern Rock we did assess liquidity. Now clearly magnified by being repackaged, it is just moved our assessment of liquidity did not withstand the around. In terms of credit losses, the credit losses repercussions— 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 Q1089 Chairman: So they failed. announced by all the banks are mark to market Mr Hancock: I think what Philip was referring to— losses. Undoubtedly, if you have many transactions, tell me if I am wrong—was some sort of separate including in this synthetic area, then you have much indicator for liquidity in addition to the probability greater value of issues out there, and on a mark to of loss indicators. market basis you clearly have a greater chance that the losses will be magnified. In terms of credit losses, Q1090 Mr Dunne: My question is how do you do there is no magnification because the loss does not that if you are not participating in the market? get magnified as it gets moved around. Mr Taylor: We are looking at it. We are investigating it because market participants are Q1086 Mr Dunne: Until somebody defaults, and asking if we can provide that kind of service. We will then it does get magnified. investigate and do the best we can to look into it and Mr Bell: Sure, but there is no magnification. The see if we can put something together. Maybe we need ultimate default, the borrower in the sub-prime who to buy in new expertise, new tools and new data. borrowed 25,000 or 100,000 dollars, can only default There is no guarantee we can come up with that kind to the 100,000 dollar tune even if that loss has been of product, but it is work in progress. repackaged in an RMBS or a CDO. It has been Mr Bell: The decision to do such a process is fairly moved around, but he cannot default more than easy to take; the creation of such a scale is actually 100,000 dollars. The losses that you are now quite complex. witnessing in the system are mark to market losses as Chairman: Okay. these securities’ values have been marked down, and I think this is one thing that is worth bearing in mind. Q1091 Jim Cousins: Looking at the events of this In terms of the magnitude of those mark-downs, we, summer and, indeed, the autumn as well, would you for example, looked at one triple-A prime UK expect a bank approaching the Bank of England’s RMBS bond that traded at 80 cents in the dollar or credit facility to inform you? 80 pence in the pound. That loss, taking into account Mr Hancock: We would not be at all surprised if they the credit enhancement already in the bond, did not, given the hugely sensitive nature of that assumed that the person who sold it at 80 pence in discussion. 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 Q1092 Jim Cousins: You seemed to imply earlier in the UK would fall by 40%. I do not think that on that you would have such an expectation? any valuation theory, other than Armageddon, Mr Madelain: What I said is that—. I said earlier anybody believes that eight out of ten UK borrowers that— are going to default on their mortgage and the price of houses in the UK is going to fall by half. What you Q1093 Jim Cousins: A lot earlier. My memory is are seeing in the market today, all those enormous quite good. mark to market losses, does not reflect credit Mr Madelain: I said earlier that we were expecting deterioration, they also reflect a clear element of systemic support to be made available to the bank, panic. yes.
Q1087 Mr Dunne: Are any of you considering Q1094 Jim Cousins: No, you said that Northern liquidity and introducing a measure of liquidity as Rock had told you that they had approached the part of your rating methodology? bank. Mr Prescott: We are setting up a working party to Mr Madelain: No, I did not say that, or if I said it I look at liquidity in financial institutions. should have— Processed: 30-01-2008 10:55:44 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG5
Treasury Committee: Evidence Ev 119
13 November 2007 Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Fre´ de´ ric Drevon, Mr Ian Bell and Mr Barry Hancock
Q1095 Jim Cousins: If you did say that— us if they had, means that, frankly, the public cannot Mr Madelain: I do not think I meant to say that. have a lot of confidence in anything you say or do, can they? Q1096 Jim Cousins: You did not mean to say it? Mr Hancock: I think certainly information that we Mr Madelain: No. are hearing on a confidential basis and retained confidential within the rating agency, we incorporate into our rating opinions, but we do not Q1097 Jim Cousins: Would you expect a bank necessarily disclose that information on behalf of approaching the credit facilities of the Bank of the client. England to tell you? Mr Prescott: I think they would only do that at the very last minute. 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 Q1098 Jim Cousins: They would only do it at the the United States to increase that, why are you very last minute? telling us that you neither know, nor would you tell, Mr Prescott: Yes. if a bank approached the credit facilities of the Bank of England when it is an obvious, important Q1099 Jim Cousins: How many banks have in fact contribution to the markets? told you that they have approached the credit facility Mr Bell: We are bound by confidentiality with our of the Bank of England? You have just said to this clients and of course follow the code of conduct. Committee that you want very high standards of transparency. I have asked you a rather simple and Q1107 Jim Cousins: If you are bound by obvious question and you are dumbstruck? confidentiality then all your ratings are suspect? Mr Madelain: No, I think the answer to your Mr Taylor: I do not agree with that. One of the question is— guiding principles of the IOSCO Code of Conduct that was applied to us was how we treat confidential Q1100 Jim Cousins: How many banks have told you information and how we keep that information to that they have approached the credit facilities of the ourselves. So, in complying with the IOSCO Code of Bank of England? Conduct, we would not be able to answer the Mr Hancock: I think, certainly from S&P’s point question on a specific-name basis. We answered it by of view— saying nobody has approached us, we have not had any information that that happened, so we have Q1101 Jim Cousins: How many banks have answered your question, but if it was confidential approached S&P’s to tell you that they have information we could not do it. approached the credit facilities of the Bank of England? Q1108 Jim Cousins: In your case nobody has told Mr Hancock: I think that would have to be you that. something, if we even have the information, that Mr Prescott: Yes. would have to remain confidential, given the sheer sensitivity and confidential sensitive nature of Q1109 Jim Cousins: What is the case with the banking. other two? Mr Madelain: I would make two comments. Q1102 Jim Cousins: Do you take the same view, Moody’s? Q1110 Jim Cousins: We have actually been told no- Mr Madelain: We also take the same view. one has approached them. Has no-one approached Moody’s? Q1103 Jim Cousins: You would say the same thing Mr Madelain: I cannot make such a comment. to the French Finance Minister, would you? Mr Madelain: I am not sure I understand your Q1111 Jim Cousins: So we do not know whether question. anyone has approached you? Mr Madelain: What I can tell you is two things. Q1104 Jim Cousins: Christine Lagarde, do you tell her that it would be confidential if a bank told you Q1112 Jim Cousins: Fitch are willing to tell us that that they had approached the credit facilities of the no-one has approached them; you are not willing to Bank of England? You would tell her that too? tell us that no-one has approached the credit Mr Madelain: We would, yes. facilities of the Bank of England? Mr Madelain: It is not that I am not willing. I am not Q1105 Jim Cousins: A brave man. You do see the informed in a way that I can tell you that. point I am making. If such a simple and obvious point as the one I am putting to you is lost in these Q1113 Jim Cousins: You would not come to this mysteries so that you neither know whether some Committee today and not know whether a bank had bank has approached you to approach the credit approached the credit facilities of the Bank of facilities of the Bank of England, nor would you tell England and they had told you. Processed: 30-01-2008 10:55:44 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG5
Ev 120 Treasury Committee: Evidence
13 November 2007 Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Fre´ de´ ric Drevon, Mr Ian Bell and Mr Barry Hancock
Mr Madelain: I believe it will be the responsibility of Q1123 Chairman: Some submissions have indicated the Bank to communicate that. to us that the credit ratings side of your business has quite a high margin, something like 50%. What Q1114 Jim Cousins: What is all this stuV about margins does the credit rating side of your business transparency and “we welcome it” and “we want have? more of it”, when I ask you a very simple question Mr Taylor: I do not actually have—. It is a disclosed and total confusion and mystery comes? number in our public accounts. I am more than Mr Hancock: I would repeat what Fitch said, that willing to provide it to you. we operate the IOSCO Code of Conduct, and that is very specific on what we can say and cannot say in Q1124 Chairman: Roughly. terms of confidential information. Mr Taylor: It is certainly less than 50%. We have a diVerent business model, perhaps, to our Q1115 Jim Cousins: If your code of conduct prevents competitors. you from telling the market such a simple and Mr Drevon: Approximately 50%. V obvious issue about whether a bank has approached Mr Bell: Unfortunately, di erent from the other the Bank of England credit facility (and I have not ratings agencies. Standard and Poor’s is part of asked you who, I have just said how many and you McGraw Hill, which is a listed US corporation, and are not willing to say), then I do not think your unfortunately McGraw Hill does not break out that ratings are worth anything? number, so under US securities laws I am informed Mr Madelain: Our ratings will reflect that that I am not at liberty to disclose that information. information. Q1125 Chairman: So if I wrote to you, could I get Q1116 Jim Cousins: If you had had such that information: the credit business side of your information, it would be reflected in the ratings? business? Mr Hancock: We reflect all relevant information Mr Bell: The McGraw Hill Corporation, if it were to that we have in our ratings, even if we do not disclose disclose that number, would have to do it in confidential information. accordance with the regulation FD on selective disclosures. I am not an expert in American securities law. Q1117 Jim Cousins: But you are not willing to tell the Committee whether a bank has approached you to tell you that? Q1126 Chairman: Moody’s you are 50%? That is the Mr Hancock: Correct. only answer we have got. Mr Drevon: Approximately, yes. Q1118 Jim Cousins: You are not willing to tell the Committee whether you would expect a bank to Q1127 Chairman: Okay. On Basle II you heard approach you and tell you? Professor Buiter saying that no-one any longer trusts Mr Hancock: I think, as I said in the earlier the rating agencies’ judgment of the question— creditworthiness of complex structured instruments and, therefore, that puts a huge hole in Pillar 1. Do you agree with that? Q1119 Jim Cousins: Would you expect a bank to tell Mr Drevon: No, we do not. There is no, I think, you that? proof that investors have lost confidence in rating Mr Hancock: I would not be shocked if they did not, agencies. In fact, over the summer we have done a given the nature— number of outreaches to investors, including very large conference call conferences, and there is still a Q1120 Jim Cousins: In that case, how can you tell us large degree of interest from the investor community it is reflected in your ratings? on our opinion about credit risk. On Basle II, Mr Madelain: The rating reflects information that is perhaps I can refer to our earlier comment, which is made available to us. that we are not in favour of using ratings in regulations. Q1121 Chairman: Let us move on. As a general rule, can we say that rating agencies do not change a Q1128 Chairman: You are all aggressively now rating until something happens? In other words, you related with downgrading mortgage-linked use historical data. securities. I think it is because of that that Professor Mr Hancock: I am sorry, could you repeat that? We Buiter has made his comment. It seems that it is a could not hear. legitimate comment that he has made. Mr Bell: I think it is a legitimate comment, but I Q1122 Chairman: Rating agencies do not change a would echo the words of my friends from Moody’s, rating until something happens; in other words you which is that during our interaction in Europe with use historical data to assess the ratings. investors, what we have found is that there is a sense Mr Hancock: No, not necessarily so. We certainly that, yes, the ratings in the US sub-prime did not go have our opinions about the future and we the way they were expected to go, but that has not incorporate our opinions for the future into our led them to lack confidence in all our work in ratings. They are forward-looking instruments. structured finance. Equally, with Basle I, as Processed: 30-01-2008 10:55:44 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG5
Treasury Committee: Evidence Ev 121
13 November 2007 Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Fre´ de´ ric Drevon, Mr Ian Bell and Mr Barry Hancock
Moody’s have always said, we were not in favour of Q1136 Chairman: I would suggest maybe to people being incorporated in Basle I, we did not think it was in the market that could come across this that there appropriate. is a hint of arrogance in that answer, but there we are. The Bank of England Financial Stability Q1129 Chairman: At the moment, in terms of Report, October 2007, says that it is unclear whether Y complex structured products and the downgrading the ultimate bearers of risk have su cient you have, do you think you still have the confidence information of an underlying credit risk in the of the market in terms of your judgment of product, in particular, the more complex instrument creditworthiness of these structured instruments? in which they invest, and investors may have become Mr Bell: I think that the market, quite legitimately, over-dependent on rating agencies’ assessments of is asking questions which I think it is incumbent risk and also could have misinterpreted ratings, upon us to answer. 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 Q1130 Chairman: So it does not have full confidence England’s statement there? in you? Mr Bell: We have always been very clear as to the Mr Bell: I think the market is diverse. I think some nature of our ratings. people continue to have trust in us. Q1137 Chairman: I am asking the question: do you Q1131 Chairman: Largely speaking—we are agree with the Bank of England’s statement here? addressing the generalities—you think that the Mr Bell: We believe that certainly some investors—. market does not have full confidence in you at the We do not believe that the investors misunderstood moment? the rating, i.e. we do not think that investors actually Mr Bell: The market is not one single entity; believe that a rating was trying to encapsulate a price therefore it is not a binary answer. or liquidity component. However, we think that, in the absence of any other indicators, undoubtedly a Q1132 Chairman: But a large part of the market does number of investors used the rating as a proxy for not have full confidence in you. Is that right, liquidity or pricing components. Moody’s? Mr Drevon: No, in fact if the market did not have confidence or was not interested in ratings, it would Q1138 Chairman: So the Bank of England are on to ignore completely our downgrades. It has been the something here then. opposite. The downgrades have a significant impact Mr Bell: I think, yes, but I do not think it is a on the market and therefore— 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 Q1133 Chairman: You are keeping this whole close as we could get”. confidence in the market. You are coming here and telling us that? Mr Drevon: Again, I think the proof will be in the Q1139 Chairman: Do you disagree when the Bank of future. England say that investors may have become over- dependent on the ratings agencies’ assessment of risk? Q1134 Chairman: I am really asking you for the Mr Bell: That is entirely possible. We have never present. We get lots of submissions into the advocated that investors should buy— 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 Q1140 Chairman: What about Europe when you have the confidence of the market? look at the Bank of England? Mr Taylor: Actually I think we do. A comment I Mr Drevon: With respect to the last point, yes, I made earlier was that investors had not been focused think we agree that it is quite possible that some on credit over the last couple of years. Sub-prime is investors took the rating as a proxy for the risks. We a very specific situation. It is about 3% of the credit do not disagree with that. market, to keep it in perspective. Do you want me to answer the question? Q1141 Chairman: Fitch? Mr Taylor: I agree. It is a valid point. Q1135 Chairman: Of course? Mr Taylor: So investors have not been focused on Q1142 Chairman: The Bank of England has some credit. I think in the last few months they have suggestions for improvement in the Financial refocused massively on credit. We have never been Stability Report, saying that it is in the rating busier in terms of dealing with investor inquiries, agencies’ best interests that investors have a good investor discussions, so I absolutely think they still understanding of what ratings mean, and to that see value in what we do. It would be completely end, for example, agencies could publish expected arrogant to say we cannot learn lessons from what loss distributions of structured products to illustrate has been going on, but I do think investors continue the tail risks round them. Would you agree that is to value the core product of what a rating is. worth taking up? Processed: 30-01-2008 10:55:44 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG5
Ev 122 Treasury Committee: Evidence
13 November 2007 Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Fre´ de´ ric Drevon, Mr Ian Bell and Mr Barry Hancock
Mr Drevon: I think it is something that we would be Q1145 Chairman: Agencies could adopt the same ready to provide and we do provide in some cases. scoring definitions. Converging in a single measure The problem is that the market also is looking for would reduce the risk of misinterpretation by simple messages. If we start providing complex investors. answers, very statistically based, I am not sure it will Mr Bell: We take the view that there is benefit in necessarily respond to the investor needs. having diVerent agencies trying to encapsulate diVerent kind of risks because it provides a greater spectrum. Q1143 Chairman: Okay. The second one: agencies could provide a summary of information provided Q1146 Chairman: So you do not agree with a by originators of structured products. Information single scoring? on the extent of originators’ and arrangers’ retained Mr Bell: No. economic interest in a product’s performance could also be included, and that may satisfy investors that Q1147 Chairman: You do not agree? incentives were well aligned or encourage investors Mr Bell: We do not think that it will help investors. to perform more thorough risk assessments. Do you agree with that? Q1148 Chairman: Rating agencies could score Mr Taylor: I think it is a call for the originator of the instruments on dimensions other than credit risk. transaction, as opposed to us. What information is Possible additional categories include market sent out to the market is really a function of the liquidity, rating stability over time or certainty with person originating that transaction. It is a a rating that is made? confidential information issue again. We would be Mr Drevon: Possibly. We are looking into that. We happy to see it. are not sure if everything is feasible. Chairman: Those are suggestions from the Bank of Q1144 Chairman: Agencies could provide explicit England and I would suggest, given that they are probability ranges for their scores on probability of from the Bank of England, the rating agencies default, and that would provide a measure of the should take this seriously and maybe, rather than set uncertainty surrounding their ratings. up a working party, come back with your views to Mr Bell: It is an interesting idea. I think the problem this Committee on these suggestions from the Bank is that, expressing an opinion about the future of England, and we will let you do that, so that we likelihood of default, if you try to encapsulate it in a have that information in public as a result of your two decimal point percentage, it is probably submission. That is all. Thank you for your evidence providing spurious scientific fact. this morning. Processed: 30-01-2008 10:59:40 Page Layout: COENEW [SO] PPSysB Job: 386890 Unit: PAG6
Treasury Committee: Evidence Ev 123
Tuesday 4 December 2007
Members present
Rt Hon John McFall, in the Chair
Nick Ainger Mr Andrew Love Mr Graham Brady Mr George Mudie Jim Cousins John Thurso Mr Philip Dunne Mr Mark Todd Mr Michael Fallon 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 instruments. That means investors while searching the Treasury Committee’s inquiry into financial for ever higher yields lose sight of the risks involved. stability and transparency following the Northern Mr Palmer, do you agree with the governor? Rock situation. For the record, will you please Mr Palmer: Over the past few years, as is now well introduce yourselves? known, we have lived through a period of stability Mr Mills: Mr Chairman, my name is William Mills, and low interest rates which has led investors to I am the Chairman and Chief Executive of City search for high yield. That search is often quite Markets and Banking for Europe, the Middle East legitimate. Institutions have their own clients and and Africa. liabilities in the form of pension fund-holders or Lord Aldington: I am Charles Aldington, Chairman policy-holders and as intermediaries the banking of Deutsche Bank in this country. I should also say sector has sought to satisfy that demand, and the to the Committee that I do not sit in the House of housing market in the US provided opportunities to Lords. do so. Mr Corrigan: I am Gerald Corrigan, Managing Director at Goldman Sachs in New York. Q1154 Chairman: Is that your answer? Mr Palmer: I am Jeremy Palmer from UBS. Mr Palmer: Yes.
Q1155 Chairman: If I may start again, do you agree Q1150 Chairman: Do you agree with the recent with the Governor that you have developed a range comments of Peer Steinbru¨ck, the German Minister of increasingly opaque and complex financial of Finance, that the snooty attitude of bankers who instruments that mean investors while searching for believed they were cleverer than everyone else is every higher yields lose sight of the risks involved? largely to blame for the credit crisis? Mr Palmer: I believe that in all cases the investors Lord Aldington: Mr Steinbru¨ck’s comments were were sophisticated and given all the information made in the context of what has been happening they required. recently in Germany. Q1156 Chairman: Therefore, you do not have Q1151 Chairman: He spoke about the global crisis. opaque and complex financial instruments? Lord Aldington: Yes. I am sure that it was intended Mr Palmer: Complexity is a fact of life and it has largely for a domestic audience. The developments resulted from people searching to satisfy their which we have seen over the past few months are the particular needs. result of things that have happened in the economy over the past few years and are not the fault of Q1157 Chairman: Therefore, you have not lost sight bankers. of the risks involved? Mr Palmer: The information that was available was considered at the time to be normal. 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 Q1158 Chairman: Mr Mills, has Citigroup lost sight element of humility. While I do not want to associate of the risks involved? myself with the particular remark to which you refer, Mr Mills: Mr Chairman, I would just emphasise that I think humility should be a central part of the way the end-buyers of these complex instruments were we approach our business. 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 Q1153 Chairman: The Governor of the Bank of to losing sight of the risk, with the benefit of England said you had developed a range of hindsight there were some stress scenarios that increasingly opaque and complex financial maybe should have been reviewed further. Processed: 30-01-2008 10:59:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG6
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Q1159 Chairman: Citigroup has lost reportedly Q1166 Chairman: I come back to the complex between $8 billion and $11 billion. The former chief products. Last week we had before us Professor executive, Chuck Prince, said, “We have to keep on Buiter, a former member of the MPC and a dancing.” Are you keeping dancing? In other words, distinguished economist at the London School of you just keep going in the market and when the Economics. He said of the process of securitisation music stops you will see where everything falls out? that “by the time you get to the ultimate investor, Mr Mills: Mr Chairman, I believe that our former who is six transactions or more away from the chairman’s comments were in relation to leveraged originator of the loan, neither the buyer nor the finance and in relation to the . . . seller has any ideas as to the underlying risk characteristics of the security they are buying. That Q1160 Chairman: They were in relation to risk. He gets worse when securitised mortgage loans get kept dancing. Has Citigroup now stopped dancing? packaged with credit card receivables, the square Mr Mills: Sir, as you mentioned, we have taken our root of car loans and whatever else. The structure fair share of losses on this. they have put together became so complex they probably were not even understood by their designers.” Do you recognise that sentiment and, if Q1161 Chairman: You all come before us. Citigroup so, do you have some empathy with it? lost between $8 billion and $11 billion. UBS has lost Mr Corrigan: Speaking for myself, I certainly do. $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 Q1167 Chairman: Mr Palmer, do you agree with that down by 19% to ƒ1.4 billion. Goldman Sachs’ sentiment? flagship hedge fund fell by 12%. The BBC reported Mr Palmer: Things have undoubtedly become more that its losses caused by the subprime ran to about complex. 1 £12 billion. I asked you about the comments of the Bank of England. Have you lost sight of the risks Q1168 Chairman: Do you have empathy with that involved? It seems here as if you are flying in the face sentiment, Lord Aldington? of reality. You have not lost sight of the risks Lord Aldington: I certainly recognise that sentiment. involved and everything that you are doing is somebody else’s fault. Mr Corrigan: Let me take a stab at that. There is no Q1169 Chairman: Mr Mills, do you have empathy question that over recent years the inner workings of with that sentiment? the financial system have become enormously more Mr Mills: I do recognise the complexities, Sir. complicated and complex. Q1170 Chairman: We have heard of CDOs-squared Q1162 Chairman: We are getting somewhere, Mr and CDOs-cubed. Lord Aldington, can you explain Corrigan. to me what a CDO-squared or CDO-cubed is? Mr Corrigan: In addition to that, the structure of the Lord Aldington: I have not come before this system has tightened further the linkages between Committee as an expert on CDOs. 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 Q1171 Chairman: But your organisation is involved our understanding of this highly complex in collateralised debt obligations? environment. Unfortunately, I think it is also Lord Aldington: That is true. My organisation is inevitable—it is a trait of human nature—that when involved in a very broad range of products and I markets are strong and ebullient there is a natural would not claim to be an expert on all of them. 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, Q1172 Chairman: You cannot tell me what a CDO- unpleasant as it may be. squared is? Can anybody tell me what it is? Mr Palmer: A CDO-squared is a derivative structure Q1163 Chairman: Nobody wants to get caught with designed to give investors exposure to a CDO. 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? Q1173 Chairman: Mr Corrigan, can you try to Mr Corrigan: I do not want to associate myself with explain it to us in simple language? comments about dancing. 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 Q1164 Chairman: A split already! securities, institutions package up a family of Mr Corrigan: But I think we need to recognise that individual mortgages into what is a fairly plain there is here a basic element of human nature. vanilla mortgage-backed facility. I think it is entirely fair to say that when those mortgage-backed Q1165 Chairman: In other words, the herd securities are issued the disclosures associated with mentality? the issuance of those instruments are quite Mr Corrigan: That is correct. wholesome. Processed: 30-01-2008 10:59:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG6
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Q1174 Chairman: What does “wholesome” mean? products which will go the way of the dinosaur. Mr Corrigan: A CDO carves out of a plain vanilla Experience over the past 18 months or so has shown mortgage-backed security certain credit tranches of that in some classes of instruments there will that security and reformulates them in what is called probably be a permanent retrenchment in these a structured credit product into a particular class of kinds of activities credit standards aVecting those particular mortgages, not the full pool of mortgages. That is Q1180 Mr Dunne: Are you admitting that it takes a called a CDO. When you take a CDO and then roll shock of the kind we have just had for the banks to it into a second CDO that is called a CDO-squared; recognise that there is something inherently wrong in other words, it is a CDO made up of other CDOs. with the structure? Mr Corrigan: Unfortunately, that is a fact of life Q1175 Chairman: If you put in another one it is which I cannot dispute. a CDO-cubed? Mr Corrigan: Thank God, we have not got that far Q1181 Mr Dunne: Did any of your institutions take yet. heed of the warnings that were issued in this country by the FSA in January and by the Bank of England Q1176 Chairman: At the end of the day it is in April about the consequences of this spiral of such becoming more complex and opaque, is it not? sophisticated instruments running out of steam? Mr Corrigan: It is certainly complex. Lord Aldington: The comments of the Bank of England and the FSA at similar times were very Q1177 Chairman: Professor Buiter cannot sensible observations about what was going on the understand it. If Lord Aldington cannot explain market. We read those and factor them into our what a CDO-squared is what does that mean for processes, as we do other opinions. ordinary people? Mr Corrigan: With all due respect, it is important to Q1182 Mr Dunne: Who within your organisations recognise, as I am sure you do, that the CDO looks at the fundamental building blocks of these product, much less CDO-squared, is clearly one that products? The rating agencies who came before us is aimed at sophisticated institutional investors. It is the other day claimed that their models were not aimed at retailer investors and in my judgment constantly being validated and challenged by the should not be. investment banks, but models do not price as well as markets, so there is a failing somewhere either Q1178 Chairman: But you have insurance between the rating agencies or within your deal companies and others putting their money into these teams in working out where the flaws are in the things and the pensions and insurance of ordinary models. Is any of the witnesses close enough to the people are involved in them, so at the end of the day practices of his deal teams to know whether or not the ordinary man can lose? the models have validity? Mr Corrigan: That is true. Mr Mills: I would answer that the models are based on historic precedents. What all of our due diligence Q1179 Mr Dunne: There has been an explosion of has not taken into consideration is the impressive issuance of structured finance instruments over level of delinquencies and defaults. I think that we recent years. We were told by Fitch that there were are in a period that is a scenario that should have now only 15 industrials, 32 financial institutions and been tested more rigorously but, frankly, we were 16 sovereigns with triple A-rated debt paper. Would basing most of our decisions on what the rating any of the witnesses care to hazard a guess as to how agencies referred to as depression-type scenarios. many structured finance products there are with Secondly, I would also just mention thatin terms of triple A-rated status? I can tell you that it is a trick the guidance from the FSA and the Bank of question and I know the answer. There are 8,409 England, one thing that we did not anticipate was compared with a handful of real companies with the liquidity crisis—we did not anticipate that the triple A-rated paper. Clearly, that has been a liquidity would dry up to the extent that it did in bonanza for all of your firms and investment banks. August and that, frankly, added on to the issues. Who would like to comment on the impact of the explosion of issuance on financial stability? Q1183 Mr Dunne: Most of us are not here to beat Mr Corrigan: For starters, it is important to you around the head but to try to find some recognise that in a very real way the fundamental solutions to make sure it does not happen again. If driving force that goes a considerable distance in we are looking at historic data and carrying out explaining the explosion of structured credit regression analysis without suYcient risk-testing of products—I agree with that characterisation—was what may go wrong going forward, how do we come the long period during which there were abundant up with better models or methodologies for pricing amounts of liquidity on a worldwide basis and very product that takes these things into account so this low nominal and real interest rates. To a significant does not happen again? degree it has been the reach for yield on the part of Mr Corrigan: As some Members of the Committee institutional investors in particular that goes a may know, two years ago I was chairman of an considerable distance in explaining this very rapid industry group that looked at the subject of complex growth of structured credit products. In my products, among others, which included institutions judgment there will be at least some classes of such not only in the United States but in the UK and Processed: 30-01-2008 10:59:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG6
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Europe. We devoted a lot of attention to the Mr Corrigan: I think and hope the answer is yes. question you have just raised. I think the answer has Since you have made reference to the statement that a couple of components to it. First, you are precisely I submitted to the Committee, which I hope accurate when you suggest that models by definition Members have found useful, one of the points I are backward and not forward-looking. That is a emphasise is that, having myself lived through more reality that we all have to deal with. The way we try of these financial disruptions than I would like to to deal with it, with a great deal of impetus from the admit to over 40 years, the fact of the matter is that regulatory side, including the FSA in London, is by all of us need to continue to devote relentless energy trying to enhance scenario analyses, stress-testing to learn from these experiences when they occur in and things like that to allow us to try better to look at the process of what I call strengthening the so-called what we call the tails of these frequency distributions shock-absorbers in the financial system. which are the essence of these models. I think we Unfortunately, it is sad but true that in the nature of have become better at that. Do I think we are as things these periodic disruptions will occur. When good as we could be? No. If you look at the recent they do so we have to learn from them and step back example of the subprime situation in the United and rebuild certain elements of things we have done States with its unfortunate and tragic consequences in the past as with, say, the question of rating clearly almost no one anticipated the combination of agencies. But I think we must also be honest with factors, including the bubble in the first place and ourselves and recognise that as hard as we work at then declining home prices superimposed on a this in some point in the future another surprise rapidly changing credit environment. will occur.
Q1184 Mr Dunne: But in the US you had identified Q1186 Nick Ainger: But, looking at your analysis, post-Enron a deficiency within the rating structure with which I agree, it seems so obvious that if these and legislation was introduced to regulate the rating CDOs were so opaque—one American academic agencies. Clearly, that has failed in this case. Are described them as “too clever by half”—there would there lessons we can learn internationally about how be a major reckoning at some time. If you are buying rating agencies are essentially used by investment a product and do not know what the risks are banks to validate a product which does not do what throughout its life surely that is reckless. it says it will do on the tin? Mr Corrigan: I have a lot of sympathy with what you Mr Corrigan: You are right that in the post-Enron say, but in fairness I would simply observe that for environment in the United States substantial eVort sophisticated investors the disclosures associated was devoted to taking a fresh look at the rating with CDOs were pretty good. Could they have been agencies which resulted in legislation. That was better? Yes. I think the question of opacity must be finally passed in 2006, I think. That goes some kept in a little bit of perspective, because even for distance in terms of reform in the way the rating very sophisticated investors if you took the trouble agencies operate. In addition to that, international V security regulators as a group eVectively instructed to read the disclosures and the o er documents at a the rating agencies in 2006 to adopt formal best minimum you should have been able to start asking practices, codes of conduct and ethics. I think those the right questions. Unfortunately, I suspect there things have helped but obviously they have not fully are cases in which the amount of diligence that went resolved the issues to which you refer and as part of into looking at and thoroughly studying these the normal post mortem from this episode we need disclosures was probably not always what it should to revisit that question. One thing I would like to have been. Speaking from personal experience—I do see—others may not agree—is a joint eVort by a not consider myself to be exactly feeble-minded— relatively small group of highly professional and you have to work at it. Those documents are not sophisticated investors to work in collaboration bedtime reading. with the rating agencies themselves to come up with a fresh cut at a framework of best practices, Q1187 Nick Ainger: But an awful lot of people in all including the question of how better to manage your organisations are paid extremely well to read potential conflicts and interests. To get top quality the detail of those products. Mr Mills, was institutional investors involved in that review is a Citigroup reckless? very constructive way to think about how to we can Mr Mills: As it relates to distributing product, I do make still further progress. not believe that we were reckless but I believe we gave all the appropriate disclosures and I believe Q1185 Nick Ainger: Mr Corrigan, reading your that we were dealing with what we thought were submission to the Committee24 it seems that sophisticated institutions. We thought that from the everyone is now wise after the event, but I am sure point of view of suitability these were instruments that Members of the Committee and the British that they could analyse and understand. In response public expect bankers to be cautious rather than to your earlier question, I think the issue around the reckless. With hindsight, do you think that a number subprime and sub-structured product occurred of financial institutions to the degree that they much earlier in the chain and I think that had to do became involved in CDOs were reckless? with basic lending to borrowers and as to whether or not they were creditworthy or appropriate to lend 24 Ev 332 money to. Processed: 30-01-2008 10:59:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG6
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Q1188 Nick Ainger: But errors made in the sale of a Q1195 Chairman: Do you have some sympathy for mortgage to a householder in Chicago should not those who view it as a black box? end up with the crisis that we face in this country Lord Aldington: I would not view it as a black box with Northern Rock. Admittedly, the contagion at all. The information is available if one chooses to started with the mis-selling of a mortgage in seek it. Chicago, but it was your institutions and the linkage through CDOs that caused that contagion. If you Q1196 Mr Love: I want to ask about the had done your job properly and deeply examined consequences for the individual financial these products, as Mr Corrigan says should have institutions that have suVered loss whether there are been done, perhaps that contagion would not have any knock-on eVects on other financial institutions. occurred. Clearly, that was not done, was it? I start with Lord Aldington. Mr Mills: I think that people used the best analytics Lord Aldington: What type of financial institutions available to them. I think that with the benefit of are you talking about? hindsight, you cannot disagree with your conclusion. Q1197 Mr Love: I am referring to those that have suVered loss through this process. Q1189 Chairman: Lord Aldington, one of your Lord Aldington: And the consequences for others? analysts, Mike Mayo, is quoted as saying that the V whole question of CDO exposure and o -balance Q1198 Mr Love: What are the consequences for sheet vehicles is such a black box in many ways but others in the marketplace? “that is investing in financials”. Do you agree with Lord Aldington: Some of the large investment banks him? have to varying degrees taken losses and those have Lord Aldington: Chairman, this discussion is really been absorbed within their capital base and loss about the way—- reserves. Speaking for my own house, we are in a healthy position and will move forward. Q1190 Chairman: I am asking about Mike Mayo’s comment about the black box? Q1199 Mr Love: Mr Corrigan, do you have anything Lord Aldington: Do I agree with Mike Mayo? to add to that? Mr Corrigan: I have two thoughts. First, as you Q1191 Chairman: One of your analysts at Deutsche know well, very substantial losses have been Bank, Mike Mayo, has said that the whole question incurred by a broad cross-section of financial V of CDO exposure and o -balance sheet vehicles is institutions over the past several quarters. I observe such a black box in many ways but “that is investing that in some ways it was a testimony to the work of in financials”. Do you agree with your own analyst? those institutions over the years, including the Lord Aldington: I would not have chosen those supervisory community, that they were able to words. This is a serious topic and sometimes analysts absorb those losses as well as they did. As far as I are a little provocative in what they say. What we are know, despite the size of these losses in the major talking about here is the way in which the financial institutions none appears to threaten their viability. markets for a sophisticated products work and what I go back to one observation by the Chairman a little is acceptable in terms of information is something earlier. We know that on a smaller scale there are that is developed between the arrangers and other classes of institutions, including pension funds distributors and the sophisticated investors. for an example, that have undoubtedly experienced some losses. I believe that major financial Q1192 Chairman: If you had agreed with him I institutions—I can speak only for one—have an would have gone on to ask another question, but it aYrmative responsibility to work with pension is more alarming that you do not agree with him. funds, foundations and institutions like that to try to You have people in your organisation saying to the help them better understand the nature of some of financial community that this is a black box and you these investments. On behalf of Goldman Sachs in come here to say it is not. Whom do we believe? This particular, I have spent a great deal of time over the is a person who is on the street every day, if you like, past couple of years doing exactly that. I have telling the financial community that it is a black box worked directly with these institutions to help them and you disown that. enhance their own risk management and due Lord Aldington: We are all aware of the role that diligence capabilities. I consider that to be an analysts play in our organisations. inherent responsibility of major financial institutions in this area. Q1193 Chairman: Should you review the way analysts play their role? Q1200 Mr Love: Mr Palmer, are there any Lord Aldington: Analysts have always been required consequences for financial stability from the losses to have an independent voice; indeed, in most suVered by the larger institutions? countries in the world that is now legally enshrined. Mr Palmer: So far, despite the losses suVered by some major institutions the overall consequences Q1194 Chairman: He describes CDO exposure as a have been fairly well contained. Of course, the black box. How would you describe it? process is never finished. We have seen the larger Lord Aldington: The process of investing in CDOs? institutions which have taken losses adapt and We have just been addressing that. modify. 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4 December 2007 Mr E Gerald Corrigan, Lord Charles Aldington, Mr Jeremy Palmer and Mr William Mills they take responsibility and eVorts to adjust and valuations they make? Is there any assumption that improve risk management systems which are clearly that is happening in the marketplace at the present very important as we move from this backward- time? looking way of thinking which in the past has driven Mr Palmer: I can speak only for my own firm. risk analysis to a much more forward-looking stress Obviously, we are driven by the natural principles of analysis-type situation. From what we have seen so transparency. Frankly, I think it is in everybody’s far all of those things mean that the institutions that interests to drive towards transparency as soon as are adapting reasonably well up to this point. possible. Of course, the rules determine what we can say and when we can say it. Q1201 Mr Love: Why is it that a lot of the banks have failed to quantify the exact losses? Q1205 Mr Love: Lord Aldington, how long before Mr Palmer: I think that is a matter of opinion. At we overcome this problem? any one time the banks must assess, first, what their Lord Aldington: The key to that lies in the answer to exposures are, second, the likely losses and, third, the question you posed earlier: people retaining respond to their legal requirements in terms of what confidence in the value of what is on their books. they can and cannot say at any one time. As we move That is the most important thing that must happen. into next year and see the audited full year results Markets have to be confident in the values that are coming from a lot of the bigger institutions that are there. involved we will have a much clearer picture of exactly what has happened. Q1206 Mr Love: I understand that, but how long Q1202 Mr Love: Mr Mills, one investment banking will it take—three months, six months, a year? institution assumed that its exposures were now Lord Aldington: I would say we have made a very worth 63c/ on the dollar while other suggested 90c/ on good beginning. One can always be a little the dollar. Why is there such a huge variation in the optimistic, but the start of a new year has its own quantification of the losses being suVered? eVect. I hope that we see things settling down in the Mr Mills: What occurred in August and September first half of next year. 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 Q1207 Mr Love: Mr Corrigan, companies report inventory and their positions based on the visibility quarterly in the States. In this country that does not of other trades that are taking place in the happen yet. Everyone tells us that all should be open marketplace.So, for a period of time—roughly two and transparent about what the losses are. Why is no or three weeks—investment and commercial banks one doing that? had to come up with a diVerent methodology for Mr Corrigan: With all due respect, I am not sure I establishing values on their portfolios and agree with that characterisation. On the whole, what fundamentally had to deconstruct these complex we have seen so far, certainly compared with earlier securities, look at the underlying collateral and come experiences, suggests that loss recognition at up with a valuation. So, there was a period of time individual institutions has been pretty good. when there were significant diVerences between Another observation directly germane to your line institutions as it relates to that. I think that most of of questioning is that one of the single most those have converged at this point. I believe that important things we should look for in major given the level of disclosure that has been financial institutions is the true independence within forthcoming through the month October that those those organisations of the people who are price distortions should not be as great as they were responsible for price verification. That is usually in September. found in something like the controller’s division. How it is labelled across individual institutions probably varies, but when inevitably there are Q1203 Mr Love: The 63c/ that I quoted would be diVerences of judgment as, for example, a sales considered pessimistic by some. Mr Palmer, how person and a controller’s person about the best does UBS come to that conclusion? possible valuation of a particular trade or item in Mr Palmer: First, the fact is that every institution inventory naturally there should be discussions, but has diVerent types of exposure; they are not always at the end of the day the controller’s judgment strictly analogous. Second, everyone has to make his should prevail. That independence as the basic own estimate of what he thinks the future impact of principle of corporate governance is the single most the economic environment will be and so there is important thing we can do to help ensure the best bound to be an element of subjectivity in these possible job is being done in response to the question things. Unfortunately, it is very hard to arrive at a you phrased. In the international supervisory common number. The nature of every organisation community, certainly including the FSA in the UK, is diVerent, not just by degree but in terms of the a renewed and aggressive eVort is being directed at details of the actual exposure. that issue. Q1204 Mr Love: If you look at your competitors, would you assume there are any decisions taken to Q1208 Chairman: Mr Palmer, my colleague asked admit only to a small amount of loss but to drip feed you about the figure of 63c/ on the dollar. Given that it over a period rather than be more realistic in the the market for many credit instruments has frozen Processed: 30-01-2008 10:59:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG6
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4 December 2007 Mr E Gerald Corrigan, Lord Charles Aldington, Mr Jeremy Palmer and Mr William Mills up, thereby making it impossible for the banks to Q1217 Chairman: To go back to my question, Mr mark their assets to either model or market, are these Mills has given eight in the range of one to 10. What figures not largely pie in the sky? do you give? Mr Palmer: Obviously, the biggest problem is that Lord Aldington: I can only repeat what I have said. there is no visible benchmark in the market which is We stand by the valuations we have on our books. normally from where you start. When that does not exist you have to use your best eVorts through Q1218 Chairman: Therefore, you do not give any statistical analysis. range at all? Lord Aldington: A valuation is a valuation, and it Q1209 Chairman: It is a guesstimate? has to be supported by the accountants. 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 Q1219 Chairman: Mr Corrigan, what do you say? element of judgment in it. How fast will the US Mr Corrigan: Let me respond at two levels. First, I economy decline? How bad will delinquencies be on make it my own personal business to review in great mortgages? These kinds of things are very diYcult detail the procedures and policies that we as a firm to assess. follow in the area of price verification. I have spent a lot of time kicking the tyres, if I may put it that Q1210 Chairman: Mr Mills, do you agree that these way, to try to satisfy myself as best I can that what figures are pie in the sky in light of the frozen we come up with in terms of valuations is state of the art. To answer your question, on a scale of zero to 10 market? 3 Mr Mills: No Mr Chairman, I would not I would say it is 94 based on my experience and the V characterise them as pie in the sky but as a fairly amount of time and e ort I have put into the task. sophisticated eVort to try to determine the value of the underlying collateral. Q1220 Chairman: You have flown across the Atlantic. Here there is a BBC programme called Q1211 Chairman: Just explain to us in simple Strictly Come Dancing which has a scale of one to language how, if it is impossible for banks to mark 10. On that basis you are doing well. Mr Palmer, their assets to either model or market, there can be what was your figure? an accurate assessment. Mr Palmer: I did not give a figure. 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 Q1221 Chairman: That is why I am asking. benchmarks that you can look to, you have to look Mr Palmer: I am not going to give a figure. We do at the underlying collateral and look at the the best job we possibly can. underlying cash flows of that collateral, because they are performing, and determine through diVerent Q1222 Chairman: Are you sure it is 10 out of 10 if it statistical analyses. is 63c/ on the dollar? Mr Palmer: It is 10 out of 10 in terms of eVort and Q1212 Chairman: On a scale of one to 10 how integrity. History will prove whether we are right accurate do you think they are? or wrong. Mr Mills: Mr Chairman, what I can benchmark for you is when we announced our earnings warning we Q1223 Chairman: You have taken the Cistercian gave a range. We said that the losses we would incur vow of silence? would be in a range of $8 billion to $11 billion. Mr Palmer: I am telling you that as far as we are concerned to the best of our ability we performed the Q1213 Chairman: I am a simple chairman looking task of independent verification. for a range. Mr Mills: I just wanted to clarify my comments. We Mr Mills: I would say it is 80% to 90% accurate. gave a range of $8 billion to $11 billion in terms of what we could anticipate as losses. That was the Q1214 Chairman: Lord Aldington, what do you say? number I gave you. In terms of our books, records Lord Aldington: A valuation is a valuation and I and in terms of our disclosures, we make our think to say that it is only 90% accurate is always a absolute best determination; we do that to a diYcult thing to say. standard of 100%. Chairman: Looking at it from a simple point of view, Q1215 Chairman: You say it is nine? if the banks cannot mark their assets to either model Lord Aldington: We arrive at our valuations and or market to try to understand where we are in this Y attach huge importance to what Mr Corrigan has situation is very di cult. said, what our IPV (independent price verification) people say and then there are the accountants. Q1224 John Thurso: I turn to the question of oV- balance sheet vehicles. Perhaps I may start with Mr Q1216 Chairman: What valuation do you give? Mills because his group has about $141 billion of Lord Aldington: We stand by the valuations that we exposure at the moment. What is the purpose of have on our books. hiding assets and liabilities oV balance sheet? Processed: 30-01-2008 10:59:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG6
Ev 130 Treasury Committee: Evidence
4 December 2007 Mr E Gerald Corrigan, Lord Charles Aldington, Mr Jeremy Palmer and Mr William Mills
Mr Mills: I would not characterise it as hiding assets understand the assets in these vehicles, is that these oV balance sheet. I think, these vehicles have been vehicles are in the process of orderly unwinding. The appropriate in the sense they have helped facilitate vehicles have sold . . . the raising of capital for various endeavours. We have a number of . . . Q1230 John Thurso: You are saying that you do not have an exposure? Q1225 John Thurso: What is the financial purpose of Mr Mills: There is the moral hazard issue as to not having it on your balance sheet? If it is an asset whether or not from a reputational point of view if it makes you look good and if it is a liability you we do not step in and support these vehicles it will ought to disclose it, so what is the purpose of not somehow hurt our reputation in the market. having it on the balance sheet? Mr Mills: The vehicles that you are referring in our Q1231 John Thurso: But as far as your stated public instance are arm’s length transactions. We have not balance sheet goes there is no asset or liability on you invested any equity in these vehicles and do not have involved in these things? any obligation to make sure that we support these Mr Mills: Right now, Sir, we have supported the vehicles. We have helped the sponsors of these vehicles. I can get back to the Committee with an vehicles by raising capital for them, but we are not exact number, but it is somewhere in the equity investors in these vehicles. They have been neighbourhood of $8 billion. somewhat misclassified as vehicles that we have provided. Q1232 John Thurso: Mr Palmer, I put the same basic question to you. It is my understanding that there Q1226 John Thurso: What do you need to bring are assets and liabilities that are oV-balance sheet. them back onto your balance sheet now? That has been stated in a great deal of press Mr Mills: We have made a public statement that we comment and there are various filings and other are not going to bring them onto our balance sheet. things to indicate that. The evidence of Mr Mills is that it is oV-balance sheet because there is no asset Q1227 John Thurso: Other institutions do. Why is or liability and no exposure. Is that also true of your institution not bringing them onto the your firm? balance sheet? Mr Palmer: As a general rule, my firm does not have Mr Mills: I cannot comment on other institutions. any activity in oV-balance sheet vehicles of this kind. From our perspective, these have all been arm’s length transactions set at commercial terms. Q1233 John Thurso: Lord Aldington, does Deutsche Bank have oV-balance sheet items? Q1228 John Thurso: You have an arm’s length Lord Aldington: We do have oV-balance sheet transaction in which you have invested nothing and vehicles. The original purpose of those vehicles for which you have no liability. Can you explain why which remains is to provide a service to clients on you have an exposure of $141 billion? both sides of their balance sheets, that is, clients Mr Mills: I think the numbers that people are wanting financing or a slightly enhanced return. throwing round are somewhat exaggerated and they That is the origin of these vehicles; in other words, it are, frankly, more along the lines of what we would is of perfectly proper commercial origin. As a matter potentially be supporting in the commercial paper of fact, under IFRS they have to be consolidated market and what would be the potential exposure if and, further, under Basel II they would be subject to we chose to bring these vehicles onto our balance prudential regulatory control.25 sheet. Q1234 John Thurso: Mr Corrigan, for completeness Q1229 John Thurso: I am now thoroughly what is your response? perplexed. You have something that is not an asset Mr Corrigan: I think that most financial institutions or a liability; it is classed as an exposure by other have at least some form of oV-balance sheet people. If you did bring it into your balance sheet it activities, typically in the form of special purpose would have an impact but you do not intend to do vehicles. In the context of these so-called SIVs some so. Can you help me? institutions have them; others do not. We at Mr Mills: I will do the best I can. The facts are: we Goldman Sachs do not. The important point here is have sponsored vehicles that have outside investors that there are fairly clear standards of accounting in that have provided the equity to support these USGAAP, ISB here in the UK and in Europe that vehicles. Those equity investors have an economic stipulate the ground rules under which any interest in these transactions. The exposure arises from the fact that from a business model point of 25 Note by witnesses: a) Whilst DB has structured oV balance view they are funded short term and their assets are sheet vehicles, in answer to this question I was specifically referring to ABCP (IE asset backed commercial paper) long term. What the market is trying to estimate is, conduits rather than all oV balance sheet vehicles. b) The if, in fact the liquidity crisis continues, will we, vast majority of these conduits have to be consolidated Citigroup, provide the liquidity to fund these under IFRS. As of 30 September, DB had EUR 32 bn of vehicles so they do not have to go into an asset sponsored conduits of which EUR 5 bn were not consolidated under IFRS. c) Under Basle II, the exposure disposal mode, especially in an environment where of the Bank to these vehicles will need to be reflected in a people feel that that would just add more fuel to the more risk sensitive manner, which may trigger higher fire. What we have said, particularly because we regulatory capital charges. Processed: 30-01-2008 10:59:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG6
Treasury Committee: Evidence Ev 131
4 December 2007 Mr E Gerald Corrigan, Lord Charles Aldington, Mr Jeremy Palmer and Mr William Mills instrument may qualify for oV-balance sheet Lord Aldington: Yes. I add that in all of my banking treatment. At the risk of considerable over- experience the issue of what should be on and oV- simplification, the defining principle in making this balance sheet always comes up for discussion. determination is whether the purpose of the instrument in question and the risks associated with Q1239 John Thurso: I think Mr Corrigan has given it have been transferred to that vehicle such that the me his answer. What do you say, Mr Palmer? sponsoring organisation unambiguously is not at Mr Palmer: I agree, and I think it is already risk by virtue of that instrument or vehicle. As we happening. have learned, it is not always quite as easy in practice to determine whether or not the risk has been fully Q1240 Peter Viggers: When banks were in the world transferred to that vehicle, but that is certainly the of buying securities and taking on mortgages in principle. order to hold them they would have a vested interest in making sure that the security was solid. As banks Q1235 John Thurso: Perhaps I may ask for have moved to a diVerent model of originate to clarification for my simple Scottish mind. It always distribute and put together or buying packages seems to me that the risk should be relatively clear, which they know they will pass on, I put it to you inasmuch as I lend you some money and am taking that they do not have the same vested interest in a risk. The level of the risk is whether or not you will ensuring that the security is completely solid. I am pay me back. What you are saying is that these are thinking here of subprime mortgages in the United elements where the risk I have taken has somehow V States in particular. Do you agree that there has been been laid o . a loosening in borrowing and lending standards? Mr Corrigan: That is correct. Mr Corrigan: I think the evidence is overwhelming that in the origination process in the subprime Q1236 John Thurso: That is done in such a manner markets in the United States the answer is yes. It is that if you fail to pay me back I do not take the hit. however important to recognise that the If that is 100% true then it is oV-balance sheet, but development of the subprime mortgage market was the problem is that these things are so complicated a noble idea, because what it sought to do was and complex that I may think I have laid it oV but in provide access to home ownership on the basis of reality I have not. individuals and families who by historic standards Mr Corrigan: I have some sympathy for what you never had any realistic hope of being able to own have just said. I fully expect that as a result of some their own homes. Unfortunately, that novel idea fell of the things we have seen in the recent past asunder in part because it is unambiguously true that accountants and others will take a fresh look at the the credit standards particularly with regard to some precise criteria that satisfy the conditions of that sort of these exotic and complex mortgages have not of risk. been what they should have been. That is something we have to fix. As I suspect you know, there is Q1237 John Thurso: The exposure of Mr Mills has legislation pending in the US Congress that will go to do with the potential loans he may have to make some very considerable distance to try to repair that to fulfil the obligations that may or may not be in problem, but there is no question as far as I am those vehicles. concerned that at the origination point the standards Mr Corrigan: With all due respect, Mr Mills made a of diligence, credit checking, marketing and point that should not be ignored. Even if it is true, as promotion some of these mortgages got out of hand. I expect it probably is in this case, that the risk diVerentiation is clear enough it still does not solve Q1241 Peter Viggers: I put it to you that when such the reputational risk problem. Over the decades and mortgages, loans and other commercial paper are centuries we have seen cases in which financial collateralised or securitised at the first cut of institutions have made a determination that even if securitisation, as it were, the individuals would have they are fairly confident that the legal and a good understanding of what is involved, but I put accounting risk is clear considerations of reputation it to you that when they have been repackaged may leave them with little or no choice but to step up several times the people who make the investment do anyway. The reputational and financial risks have to not know exactly what they have. Can each of you be thought out in juxtaposition to each other. look at your loan books and the CDOs you have taken on and unpick them? Can you pull pieces out Q1238 John Thurso: Ultimately, on the grounds that of the tapestry and know exactly what the value is of the objective of a balance sheet is truly and fairly to what you hold on your books? state the assets and liabilities of an entity with a view Mr Palmer: There is a well established process of due to the outside observer being able to have proper diligence of portfolios of mortgages and the view of net worth, do you agree that we need to take securities that arise out of them. The process is to a long hard look at oV-balance sheet vehicles and be look at a sample of the mortgages within each a lot more rigorous about them? Perhaps we can bundle, as it were. There is also a stage when the have quick answers from the panel. portfolio is held for a period so see the delinquencies Mr Mills: I think that the answer clearly is yes. I and defaults in the first few months. There are well- would say that in response to your point, the equity established processes for getting as much market is already assuming that risk when it looks at information as possible and providing that to the the valuation of the stock. buyers of the securities. Processed: 30-01-2008 10:59:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG6
Ev 132 Treasury Committee: Evidence
4 December 2007 Mr E Gerald Corrigan, Lord Charles Aldington, Mr Jeremy Palmer and Mr William Mills
Q1242 Peter Viggers: Lord Aldington, are you that consider whether rating agencies were unduly confident in your involvement? influenced by issuers and underwriters who paid for Lord Aldington: As I said earlier, I am not an expert credit ratings? in this industry, but I support what Mr Palmer has Mr Corrigan: I do not like to monopolise the just said. conversation. First, in the United States legislation was passed in 2006—it may have been in 2005—that Q1243 Peter Viggers: Mr Mills, when after was essentially an outgrowth of the earlier Enron- management changes there is an £11 billion write-oV type events. That put in place a fresh oversight within Citigroup some commentators were function as it pertained to the rating agencies. concerned that many of the losses were in the £43 Among many other things the provisions of that legislation established new standards for record- billion of oV-balance sheet exposures. Does this keeping, authorisations and so on. In addition, follow through from what has been said before? The V word “sophisticated” has been used quite international securities regulators in e ect told the frequently. While sophisticated investors rating agencies in 2006 that they had to come up with understand the distinction between a bank’s own formal statements of best practices and codes of assets and oV-balance sheet items, the fact is that you ethics and behaviour, which has been done. I have have suYcient reputational risk to require you to looked at one of those codes of conduct for at least make financial commitment to oV-balance sheet one of the rating agencies and it is pretty good. Is it vehicles? good enough? We are in the process of learning. Mr Mills: The specific reference I made was to an $8 Recent experience suggests that there are still billion to $11 billion potential loss that would be further things. crystallised in the fourth quarter. That directly related to assets that we have on balance sheet, so Q1247 Chairman: But is there a need for this? that is directly related to our mortgage-backed Christopher Cox wants to probe whether they have exposures. As it relates to oV-balance sheet been unduly influenced by issuers and underwriters exposures, we do have some exposures to some very who have paid for credit ratings. distant third-party investment conduits that we are Mr Corrigan: I think that is fine. supporting from a commercial paper point of view. As it relates to our own sponsored conduits, we have Q1248 Chairman: Does everyone agree with that? not disclosed or made any provisions in terms of Lord Aldington: Yes. losses. Those conduits are in the normal course of business selling down assets to meet their funding Q1249 Chairman: Is there an inherent conflict of targets and have plans in place to have an orderly interest in the fact that rating agencies are paid by unwind. The good news for us, Sir, is that those the same banks whose products they provide conduits have very good assets and so they do not ratings? rest in any subprime product. Lord Aldington: This debate about rating agencies has been going on for years and years and nobody Q1244 Peter Viggers: Do you discuss this with your has yet found a better solution as to how to pay or auditors? compensate the rating agencies. Certainly, in the Mr Mills: We discuss it with our auditors and our “lessons learnt” department in all of this it would be regulators on an ongoing basis. very sensible to bring that question into it.
Q1245 Peter Viggers: Mr Corrigan, you have $65.5 Q1250 Chairman: There could be a conflict of billion worth of activities related to collateralised interest here? debt obligations, real estate investment, mortgage- Lord Aldington: We all have to manage conflicts of backed bonds and principal-protected notes. interest, but it is a sensible thing about which to ask According to the Financial Times of 8 November, a question. auditors will be looking very closely at this area. Are all of you discussing these issues with your auditors? Q1251 Chairman: Does everyone agree that there is Mr Corrigan: Absolutely. I do not recognise the a conflict of interest here? number you cited, but we can deal with that Mr Corrigan: There is certainly a potential conflict separately to the extent you wish. The auditors of interest. carefully review the preparation of financial statements. I should also acknowledge that in this Q1252 Chairman: Mr Corrigan, as to the depositor area the supervisory authorities have spent a great protection scheme it has been suggested to us by one deal of time in recent weeks and months looking at US commentator that the Northern Rock crisis the same questions. Whether it is auditors, internal could have been avoided if the UK had adopted the management or supervisory authorities, we can say US model of depositor protection. Do you share without the slightest hesitation that all of these issues that view? are under our microscope, and they should be. Mr Corrigan: Certainly, I agree that deposited insurance is a prominent and necessary element of Q1246 Chairman: Do you agree with Christopher the so-called safety net that surrounds financial Cox, chairman of the Securities and Exchange institutions in all countries. Whether there is Commission, that in his opinion there is a need to anything absolutely unique and magical about the Processed: 30-01-2008 10:59:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG6
Treasury Committee: Evidence Ev 133
4 December 2007 Mr E Gerald Corrigan, Lord Charles Aldington, Mr Jeremy Palmer and Mr William Mills
US system as opposed to the current or a newer eye—I have not done the arithmetic—my sense is system in the UK is a judgment that you and your that on balance we have probably made some colleagues have to make. money.
Q1253 Chairman: I just wanted a US perspective, Q1258 Mr Mudie: Can you give us some idea of the because the issue of adequate legislation and instant timeframe? This started in the States. When did you return of moneys is important. I shall be going to start to go to subprime in such a massive fashion and Washington next week to speak to the FDIC. begin to securitise it? Mr Mills and Mr Palmer have Mr Corrigan: There are two observations I oVer. said they think they have lost money; Mr Corrigan One is that the US deposit insurance system has a fee believes he may have made money. It would be system applied to the depositary institutions that is interesting to discover what period of time we are risk-based; in other words, not all institutions pay talking about. the same fee. It is diVerentiated based on the risk Mr Corrigan: As an approximation, our assessment characteristics of individual institutions. I think that of the underlying conditions in that segment of the is a pretty good idea. market was in the timeframe of our second quarter which ends in May. Q1254 Chairman: It is an upfront payment model? Q1259 Mr Mudie: I do not mean that. When did Mr Corrigan: Now it is an upfront payment model, subprime lending in the States take oV in a but what institution A pays may not be the same as noticeable way? How many years are we talking institution B based on the risks characteristics as about? determined by the FDIC. The other point I make for Mr Corrigan: The key benchmark for that would be your consideration is that the payout provisions the approximate timeframe of 2003–04. There were should be very simple and straightforward; in other elements of it before that. It really emerged as a words, in the United States the payout provision is major business in that timeframe. $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 Q1260 Mr Mudie: You are saying that in those three a little concerned that that may be a bit of a or four years you did not make enough profits to structured product in its own right. 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 Q1255 Mr Mudie: Listening very closely to your involved in terms of the origination of the product evidence, you seem very regretful about it. I put a and we were not involved, in the early years, in the question that perhaps the ordinary man in the street structure and distribution of the product. We put might ask. You have declared interim losses, but in together a team 18 to 24 months ago and got the course of the business you have been conducting involved. for several years in this field—the subprime market—do your profits exceed your losses; in other Q1261 Mr Mudie: You got in too late? words, although you are all very sorry that you have Mr Mills: With the benefit of hindsight, yes. been left with this exposure you have certainly made Mr Palmer: I have not done the math, but the huge a lot of money over the years in this field, have you growth of subprime lending in the US is a relatively not? recent phenomenon. Mr Mills: I can answer for Citigroup. Our losses greatly exceed the profits that we made in this field. Q1262 Mr Mudie: We have had it for three or four years, so how long have you been in? Q1256 Mr Mudie: Over what period? Mr Palmer: Over that period of time, but I think the Mr Mills: Several years. huge growth came about in 2005 and 2006. Mr Corrigan: I am not sure, but I suspect that in the case of Goldman Sachs on balance we have made Q1263 Mr Mudie: Why have you not made money if money over the period in question. you were in at the beginning and you have had three Mr Palmer: To be honest, I am not sure. My good years? Have the good years not compensated suspicion is that it is in the same direction as Mr for you being caught with late exposure? Mills. I have not made the calculation, but I think it Mr Palmer: It is pretty clear that diVerent decisions is going in that direction. were made in diVerent firms at diVerent times and they have led to diVerent outcomes. Q1257 Mr Mudie: Why do you think you are diVerent from the others? Q1264 Mr Mudie: Lord Aldington, I have left you Mr Corrigan: That is a good question. First, part of out. What about your position? it is that Goldman Sachs is not involved in the front Lord Aldington: I do not know whether anybody has end of this; in other words, we are not in the even done that piece of math. It is an interesting residential credit origination space or the servicing question. space. Second, we have had a measure of success—I do not want to overstate it—in hedging some of our Q1265 Mr Mudie: Why would you not do it if you exposures in this space in the recent period. When I were running a firm? If you have a product and are try to put the whole thing together in my mind’s suddenly caught with this exposure the one defence Processed: 30-01-2008 10:59:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG6
Ev 134 Treasury Committee: Evidence
4 December 2007 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 market by any standard are quite extraordinary. has made brass out of it over the years. Why have There were obvious breakdowns in the credit you not got that figure? origination process. Lord Aldington: I did not say that we had not done it; I said I did not know whether anybody had done Q1273 Chairman: I understand, but I go back to the it. We certainly have not made it public. My guess, point about garbage in, garbage out. just based on the provisions we have taken, is that we Mr Corrigan: I would not characterise it in that way. would be more in the Goldman department than in Who would have anticipated that in key segments of the other, but I honestly cannot tell you. the residential mortgage markets in the United States house prices, which have not declined in Q1266 Chairman: Mr Corrigan, you stand out from absolute terms in over 30 years, would do so by 5% the pack here by making money. Is it not the case or 6%? You can characterise that as “garbage” if you that you have done that because you bet the other will. Freely admitting that mistakes were made, I way from these guys and you saw this could end in would not go as far as to characterise it as “garbage tears? in, garbage out”. There are opportunities and Mr Corrigan: Approximately in the timeframe of situations in which people make mistakes. our second quarter which ends in May we sensed that deterioration particularly in the subprime space Q1274 Chairman: In your opinion, were investors was mounting. In that timeframe we began to hedge sophisticated enough to understand what you were our exposures in ways that turned out reasonably telling or selling them? well from a financial point of view. Mr Palmer: There are two things happening here: first, the complexity of the instruments and the Q1267 Chairman: In summary, is it fair that decisions to invest in them; second, the unforeseen collectively you say you provided all the information marketplace conditions. You have to remember that needed to enable an institution to buy a complex both of those things are happening at the same time. product from you and analyse such risks that might Q1275 Chairman: Lord Aldington, were they ensue from that purchase? sophisticated enough to understand what you were Mr Corrigan: You use the word “all” and that telling or selling them? always makes me nervous. I do not think I would Lord Aldington: We have always treated our want to be wed to that word, but certainly a investors in this as if they are professionals and we systematic aggressive eVort was made to provide take steps to satisfy ourselves that that is the case. adequate disclosure to help investors make informed One must say that in certain isolated cases—I can decisions. think of a couple in Germany which have been in the press—it is not clear that the investors fully Q1268 Chairman: What about you, Mr Mills? understood what they were buying or that they took Mr Mills: I think we made adequate disclosures and advantage of the possibility to do their homework.26 I think we have tried to assist. Mr Mills: Mr Chairman, I think that there are diVerent classes of investors—those who Q1269 Chairman: So that people knew the risks? V participated directly in the purchase of CDOs, I Mr Corrigan: Real e ort was made to provide think, were given all the information and all the adequate disclosure. analytic tools to make a decision. I think some of the investors, particularly investors in commercial paper Q1270 Chairman: Lord Aldington, what do you say? that were buying commercial paper that was rated Lord Aldington: I support what Mr Corrigan has A1 and P1, and not necessarily understanding some said. The key to all of this is making the information of the underlying assets probably did not have available. suYcient information.
Q1271 Chairman: Mr Palmer? Q1276 Chairman: As a result of this crisis do you Mr Palmer: Information was provided, but I do not agree that you have suVered reputational damage? think anyone can pretend that the types of market Mr Mills: I believe that we have suVered conditions were foreseen. reputational damage, yes. Lord Aldington: I do not think so. Q1272 Chairman: I come back to the question asked Mr Corrigan: Sure we have. by my colleague Mr Ainger about the mortgage in Mr Palmer: We have. Chicago. If there are information problems early on Chairman: The UK stands alone. Thank you very about, say, the sale of a mortgage in Chicago is it not much for your evidence this morning. 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 26 Note by witness: The comments and the cases to which I impression that I defend every single thing that was referred were observations based solely on press reports, and I have had no personal involvement with the relevant done. There is no question that mistakes were made, matters, I have no have personal knowledge that any but it is also true that the conditions that have investors that purchased products from Deutsche Bank materialised especially in the subprime mortgage failed to understand them. Processed: 30-01-2008 10:59:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG6
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 Q1283 Mr Fallon: Why is there nothing in the 2006 the session. Please introduce yourselves for the report or interim report pointing out the risk of record. illiquidity? Mr Sexton: I am Richard Sexton, head of the UK Mr Sexton: The audit opinion in both the annual Assurance practice of PricewaterhouseCoopers report and interim review covers the financial which includes our audit practice. statements. The financial statements set out in very Mr Hitchins: I am John Hitchins, a banking audit detailed note disclosure, as required under IFRS, partner of PricewaterhouseCoopers. information on the liquidity profile of Northern Rock. Q1278 Chairman: What are the aims of an auditor when auditing a company? Q1284 Mr Fallon: Were you content with the Mr Sexton: The audit is performed in accordance liquidity risk? with standards and regulations in the UK now Mr Sexton: Our opinion explicitly covers the issued predominantly by international bodies. It disclosures required under international financial seeks to provide comfort about historical financial reporting standards in connection with the historical information as embodied within the financial information. statements included in a company’s annual report. That is the role of the statutory audit. In the UK we Q1285 Mr Fallon: That does not answer my do perform other work at times at the request of question. Were you content with the liquidity risk companies predominantly in connection with that Northern Rock was running? interim announcements. That is also performed in Mr Sexton: Our job is to look at the presented connection with guidance issued by the Auditing historical information and whether it represents Practices Board in the UK. fairly the actions of management and the board in managing the assets and liabilities of Northern Rock Q1279 Chairman: Does auditing a bank present any in this case. That is what is presented in the notes to additional problems compared with a non-financial the account on which we have expressed an opinion. company? Mr Hitchins: The only extra requirement placed on Q1286 Mr Fallon: Northern Rock told us that at 30 us when auditing a bank is our statutory duty to June, 73% of its total liabilities were in wholesale report to the FSA if we become aware of anything funds. Excluding the main banks, no other mortgage that is material to the exercise of the FSA’s lender comes anywhere near that. The nearest would functions. be Alliance & Leicester at 55% or Bradford at 53%. Were you aware of the extent to which there was such a liability? Q1280 Chairman: In the independent auditor’s Mr Sexton: I should say that I am not directly report on Northern Rock’s 2006 accounts you state involved in the audit of Northern Rock. I oversee that “you are not required to consider whether the that audit and I have therefore regular contact with Board’s statements on internal control cover all risks all of our audit partners, so the answers I give are in and controls”. Given what has happened to that context. The information presented by Northern Rock, do you think this is a possible area Northern Rock clearly set out its portfolio of of reform of auditing standards? mortgages. Yes, it is diVerent from others. The Mr Sexton: That statement is derived specifically accounting standard on which we base our opinion from the combined code which requires us to look at requires that information to be disclosed. controls over financial information, not the operational risks. I suspect that it would be a matter Q1287 Mr Fallon: Did it not occur to you that this therefore for those responsible for the combined was something of an extreme business model, as the codes and others to consider that issue. At the FSA chairman described it? moment we are explicitly not required to look at Mr Sexton: The information required to be audited those aspects. was thoroughly audited and presented in the financial statements for all to see. Q1281 Mr Fallon: You are required to look at the operating and business review, are you not? Q1288 Mr Fallon: Why did you approve the peculiar Mr Sexton: It is correct that we have a duty to trust status given to Granite Finance whereby 70% consider the operating and business review to ensure of Northern Rock’s mortgages were placed oV- that it is not inconsistent with information presented balance sheet in a separate vehicles? on which we express an opinion in the financial Mr Hitchins: First, I should make one correction. statements. They are not placed oV-balance sheet. You will see that all of those mortgages and the related Granite Q1282 Mr Fallon: But the operating and business funding are disclosed in the annual report on review of Northern Rock had three or four Northern Rock’s balance sheet. Securitisation is a paragraphs on liquidity risks, so you reviewed those normal structure in the market whereby notes are paragraphs presumably? issued to note-holders who have recourse only to the Mr Sexton: They would have been reviewed by the pool of mortgages that backs those notes. They are audit team as part of its duty. placed into a special purpose vehicle which Processed: 30-01-2008 10:59:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG6
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4 December 2007 Mr Richard Sexton and Mr John Hitchins eVectively ring-fences the pool of mortgages for the subsidiaries which has to be disclosed separately; benefit of the note-holders. They are not taken oV work as the statutory auditor in connection with the balance sheet because accounting standards still regulatory responsibilities that my colleague require that vehicle to be consolidated as if it was a mentioned; and work that we provide as auditors in subsidiary of Northern Rock. Overarching that is an audit-related sense on the oVering circulars for the Granite master trust that owns those vehicles securitisation, that is, comfort letters on the financial and that is itself also part of the special purpose information in those circulars. That is normal vehicle structure. That has nothing in it other than a practice and is required by the banks.27 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 Q1294 Mr Fallon: The problem is that you were company and typically that money is given to earning in fees three times as much from consultancy charity eVectively in the form of a legacy. advice which further securitised Northern Rock’s borrowing as you were getting for checking whether Q1289 Mr Fallon: Are you aware that a charity had or not that securitisation was placing the been nominated without its knowledge to be the organisation at risk. There was a conflict, was beneficiary? there not? Mr Hitchins: We were not aware that the charity did Mr Sexton: With respect, I do not believe that it was not know, but in securitisation it is quite normal for three times our audit fees as statutory auditors. I the residue to be given to charities. In some cases it believe the number is £1,100,000 if you include the is just left as a charitable trust with the charity to be three relevant disclosures, and the other fees are in decided at the time the money is available; in other the nature of audit-related activity providing audit V cases it is specified just as a testator in his will directs and comfort letters on o er circulars which amount that an amount of money is to be given to a charity. to £700,000. There is no requirement to notify the charity. Q1295 Mr Fallon: The non-audit fees are listed at Q1290 Mr Fallon: Do you not think it is somewhat £1.3 million. improper not to notify the charity? Mr Sexton: As I have explained, the non-audit fees Mr Sexton: Neither of us was involved in the detail are a categorisation under UK law which includes of that review. As auditors we were interested in the statutory audit responsibilities around whether the structure was properly consolidated subsidiaries and regulatory reporting in the case of into the balance sheet of Northern Rock and the a bank. 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 Q1296 Mr Fallon: Do you see nothing wrong in the matter that is relevant to the presentation of those same firm doing the audit and checking whether the assets and liabilities properly in the financial bank is liquid and at the same time charging statements. consultancy fees for arranging securitisation that increases the risk of illiquidity? Q1291 Mr Fallon: Did PricewaterhouseCoopers Mr Sexton: We did not charge fees for consulting on advise on the two securitisations in the current year? the creation of further securitisation. Our fees were Mr Sexton: We did not advise on the securitisations. in connection with very specific comfort letters in The work of PricewaterhouseCoopers has been to relation to historical financial information that provide comfort letters on historical information appears in those documents. Our audit covers the included in the prospectus oVerings, as is normal for historical financial information in the annual report. any such oVering in the United Kingdom market and around the world. Q1297 Mr Fallon: Altogether last year you took fees of £1.8 million and probably £1 million or so already Q1292 Mr Fallon: Therefore, you were an adviser? this year. The taxpayer has now had to lend Mr Sexton: We provided comfort letters as auditors Northern Rock £19 billion. Do you not think you and reporting accountants on information in a should repay your fees to the taxpayer? prospectus, in the same way that as auditors we Mr Sexton: All I can say is that fees were charged in provide short form reports on IPOs. connection with the work we performed and the annual report and accounts and the presentation of Q1293 Mr Fallon: Last year you charged Northern the historical information therein and subsequently Rock an audit fee of £500,000 in addition to non- in providing comfort in connection with audit fees of over £1.3 million. Do you think that securitisation oVerings and in relation to specific ratio is appropriate? financial information. 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 Q1298 Mr Fallon: You have audited and provided manner in which we disclose them in buckets is comfort to the biggest banking disaster for 150 mandated. The numbers you quote include: work as years. statutory auditor, the first number, for Northern Rock group; work as the statutory auditor of the 27 Ev 339–40 Processed: 30-01-2008 10:59:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG6
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4 December 2007 Mr Richard Sexton and Mr John Hitchins
Mr Sexton: We have provided audit services in Mr Hitchins: No. connection with auditing standards and guidance from the UK Auditing Standards Board and the Q1305 Mr Todd: Looking at Granite, you have said International Auditing Standards Board and that it is a small vehicle. To what extent did you audit performed the duties required of statutory auditors. 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 Q1299 Mr Todd: Have subsequent events caused the so-called Granite structure appear on the you to revisit your audit practice in this particular balance sheet of the group accounts and, therefore, bank; in other words, do you think there is they were subject to audit. something to be learnt from your contribution to this disaster? Q1306 Mr Todd: Did you examine the risk that Mr Sexton: Perhaps I may answer that on a general obviously was faced in the end by Northern Rock basis and then ask my colleague to pick it up that it would not be able to securitise through the specifically in relation to the banking sector. The vehicle it chose and obviously that was a material auditor is always cognisant of market developments factor in the eventual collapse of the bank? Was the in order to understand all of the information scenario that securitisation opportunities would available to it to give those opinions that it does give eVectively dry up one that you examined? on that historical financial information. We are Mr Sexton: A specific requirement of auditing reviewing and thinking about the market standards is to consider the work that management information now available to us and how that might and the board have done in connection with their influence the level of audit evidence we might require ability to continue as a going concern. The primary and the nature of our procedures in today’s reason for that work is to ensure that the assets and circumstances. liabilities are properly valued, but as part of that work we look at all the information available. Q1300 Mr Todd: Do you think this episode has enhanced your ability to win audit business in this Q1307 Mr Todd: You have not quite answered the particular sector? question. Bearing in mind that the vehicle of Granite Mr Sexton: I think our ability to win business is and the securitisation of loans were absolutely dictated by our ability to deliver a quality audit in critical steps in the ongoing operation of Northern whatever market. Rock, did you examine a circumstance in which this would cease to be a functioning alternative? Mr Sexton: The audit team would have considered Q1301 Mr Todd: Therefore, you think it has done no the availability of continuing funding based on reputational damage at all? historical trends. Mr Sexton: I believe that the audit process as judged by reference to the specifics of Northern Rock in the Q1308 Mr Todd: Do you imply that because it had annual and interim reports—our opinion on the not happened before they did not think it was a risk latter was signed on 25 July—discloses very accurate worth considering, because it is an historical information about liquidity and other structures function looking back? within Northern Rock. 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 Q1302 Mr Todd: Financial institutions do not have historical performance and the ability to raise funds. to get their audit from you; there is a competitive It was in February that we issued our report. marketplace here. You think it has made no V di erence and the market believes that you have Q1309 Mr Todd: When eventually the Bank of performed a technical task to the best of our ability England found itself having to support this and you are a good provider of these services in institution, not surprisingly people wanted a clear future? picture of the assets and liabilities of the bank. It Mr Sexton: I believe that to be the case. appeared that that picture was not readily available to any of the tripartite partners. Was the preparation Q1303 Mr Todd: Good! I am glad you are so of an appropriate picture of the assets and liabilities confident. I turn to events in April when the bank of Northern Rock at that point something in which chose to alter its lending pattern, at least so it told us, you played any role? to reduce the level of new loan activity. Did you have Mr Sexton: For the purposes of discussion with the Bank of England in September? 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 Q1310 Mr Todd: Yes. of audit services to Northern Rock, but to the best Mr Sexton: I do not know the answer to that of my knowledge, no. question. Q1311 Mr Todd: Could you ask your team? I am Q1304 Mr Todd: Mr Hitchins, do you have anything slightly surprised that you have not had more useful to add to that? Were you closer to this? detailed conversations with the team involved in Processed: 30-01-2008 10:59:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG6
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Northern Rock before coming here, because you process. Can you provide us with a summary of how have qualified a number of your responses by saying you worked with Northern Rock on the that you were not directly involved and you are not assumptions of impairment that they produced? too sure exactly what happened. Mr Sexton: What we will more than happily do is Mr Sexton: I believe I have said that I oversee the provide you with a commentary on the nature of the audit. I have spoken to the audit team about the key information we sought that the company had put elements of our reporting dates, both the annual and together in January for the purpose of its review.28 interim reports. I cannot answer your very specific question in relation to that matter. Q1317 Mr Todd: The other aspect I am interested in is your role of the September process in trying to sort Q1312 Mr Todd: Presumably, a critical issue in out the valuation of Northern Rock and its assets valuing the assets and liabilities of Northern Rock and liabilities at that particular time when, very because it is a mortgage institution is the assumption understandably, public authorities were wondering about the future housing market in the UK. Is that quite what they were getting themselves into. You reasonable? said you were not too sure what happened then. Mr Sexton: I would imagine that to be the case. 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? Q1318 Mr Todd: Will you also provide a note on that? Mr Sexton: I am slightly confused. The implication 29 of your question is that we gave them advice on Mr Sexton: Yes. valuing their loan book. Q1319 Mr Love: It has been reported that the big six Q1314 Mr Todd: Presumably, you tested whatever accountancy firms, if I may call them that, have its assumptions were to see whether or not they were produced a report on valuing bank holdings. The reasonable? getting together of the big six is unprecedented. Why Mr Sexton: That is correct. In February as part of is this being done? the going concern review for the annual report we Mr Sexton: It is not unprecedented. From time to would have looked at its forward-looking time the so-called big six do get together when there assumptions for the purposes of the balance sheet is a matter of public interest. We feel that we can be presentation, and for the purposes of our 25 July helpful to the markets in general in encouraging opinion we would have updated those again people to think about particular issues. A short basically by reference to management discussion as paper has been produced which reiterates largely the required by the APB guidance notes. existing accounting standards in connection with the Mr Hitchins: It is important to bear in mind that the calculation and presentation of value-based assets. mortgages are in the balance sheet of Northern Rock That is the paper to which you are alluding and the at cost with the amortisation of relevant fees and one to which the Financial Times article referred. 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 Q1320 Mr Love: As I understand it, as reported that context as one element we look at what assumptions takes a very tough line on the use of market prices management has made as to the future trend in UK for making that valuation. We have just heard from house prices. Another element is the percentage of four of the large institutions. Do market prices exist cover—the loan to value ratio—that the mortgage for the particular vehicles we are talking about? has. All of those factors are looked into. It is not Mr Sexton: We have not gone through the audit really a valuation, but we are responsible for period of 31 December 2007 which will undoubtedly auditing management’s impairment allowance. be a challenging period in relation to obtaining appropriate evidence. The market values would have been looked at as at 31 December 2006. That Q1315 Mr Todd: What was your take on that at the market did exist. The models to which you refer and time you conducted it? Obviously, one of the current the nature of the paper refer to the fact that the first speculations is that Northern Rock’s loan book may port of call ought to be market value. When market not be quite as resilient as it might have appeared in value does not exist or there is no reasonable liquid the past because of the expectations in the UK market one needs to look to models to establish what housing market. if any value can be placed on the assets. Mr Hitchins: I cannot comment on the details of it Mr Hitchins: The paper was intended to be a because, obviously, I did not do that piece of work companion to a similar paper produced in the US myself, but in principle we signed a clean opinion in under USGAAP. Basically, it put together into one February and so we would have had a look at it and paper all the references in the accounting literature satisfied ourselves. on how to prepare fair value accounts for financial instruments. It therefore goes through the fair value Q1316 Mr Todd: I have been a bit frustrated by the absence of much detailed knowledge of what PwC 28 Ev 336–7 actually did for Northern Rock during this audit 29 Ev 341 Processed: 30-01-2008 10:59:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG6
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4 December 2007 Mr Richard Sexton and Mr John Hitchins hierarchy. If you do not have a quoted market price of interim auditing purposes. Why has there not what do you then do? What other sources of been a large-scale move among financial institutions evidence do you obtain? to bring in auditors to look at the valuations? There is a great deal of talk among all of them about the Q1321 Mr Love: One of your colleagues, Pauline need for transparency but a total lack of Wallace of PwC, who is leading the production of preparedness to be transparent themselves. Why is this report has said that it was there not to provide that happening? guidance but context. What does she mean by that? Mr Sexton: The only way I can answer that is to refer Mr Sexton: Pauline Wallis is one of our technical to the amount of disclosure that is mandated under specialists in that area in PwC. The intent of her international financial reporting standards IAS 39 comment is that it is there to alert the market as a and IFRS 7 as recently reissued which are required whole to this being a significant issue and to to be put into the financial statements. The banks of reinforce the need for people to consider the their own accord will go about their valuations and valuations very carefully. employ a lot of people to do them. Mr Hitchins: It is not intended to provide new interpretations of accounting standards because that Q1326 Mr Love: I am minded to ask you for a value is not the job of the big accounting firms. If that is judgment about international financial accounting needed it should be done by those who set standards because that seems to be the response to accounting standards. all of these questions but I shall not do so. Have you been advising your clients on the need for Q1322 Mr Love: I am interested in the view transparency and suggesting to them that they might expressed about the so-called model-based wish to undertake some interim auditing procedure calculations. If you were here earlier and listened to in order to get out into the marketplace the best the discussion you would have heard that there are estimated true valuation of some of their vehicles? obviously very diVerent models, assumptions and Mr Sexton: We have encouraged all of our audit calculations. To what extent will this paper bring teams to talk to their clients over the period about consistency to that? the need to look at the valuations of their assets and Mr Sexton: We cannot dictate to the market or those liabilities, be that in the banking or corporate who prepare those models what assumptions they environment. 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 Q1327 Mr Love: As I understand it, for most firms supportable information wherever available. 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. Q1323 Mr Love: The obvious question to arise from Are you giving your firms any advice on bringing that is whether you can find yourself auditing two forward valuations in order to get them into the diVerent large financial institutions with very similar V marketplace? vehicles which have used very di erent assumptions Mr Sexton: Perhaps I may answer that in two parts. and models and therefore have arrived at very V First, you are absolutely correct that the tradition in di erent valuations and you then agree with their the financial services world is to have a 31 December decisions on these matters? year end. Typically, they would issue preliminary Mr Sexton: Whether or not we would agree with results reasonably early in January through the them is a matter for the future, but we can certainly month of January. Indeed, if one uses Northern come across the circumstance where diVerent V Rock as an example its interim announcement in institutions use di erent models, as they do. That is relation to 2006 was on 24 January and for most absolutely the case. financial institutions the audited financial statements followed approximately a month later. Q1324 Mr Love: How confident are you that by the There are also continuing obligations under use of this report we will get more confidence and regulation in the UK for all listed institutions to trust in the marketplace? There is a lot of concern keep the market informed of material developments. that there is not just a lack of transparency about the That is outside the scope of the work of auditors, but V valuations but where there are valuations they di er it is a continuing obligation on those companies. so much that nobody can have any confidence in them. Do you think this will make a contribution towards restoring confidence? Q1328 Jim Cousins: How much do you charge for Mr Sexton: I think that if financial institutions writing a comfort letter? ensure they provide appropriate and detailed Mr Sexton: That depends very much on the nature disclosures where they use those models it will and volume of the information required. provide greater transparency so everybody can understand exactly what is going on. Q1329 Jim Cousins: You appear to have received fees of £500,000 for auditing Northern Rock and Q1325 Mr Love: You mentioned earlier in response £700,000 for writing comfort letters. How much per to Mr Fallon that a lot of the work you do is not comfort letter did you charge? concerned with just standard auditing procedures; Mr Sexton: As I have explained, that depends you are brought in by companies for a whole variety entirely on the scope of the specific comfort letter. Processed: 30-01-2008 10:59:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG6
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Q1330 Jim Cousins: How many comfort letters did Q1338 Jim Cousins: In the tripartite discussions that you write? you had with the FSA, about which you have not Mr Sexton: There were a number of comfort letters really been able to tell us anything, where did your in 2007. duties lie? Mr Hitchins: I do not know whether there was a Q1331 Jim Cousins: How many? tripartite meeting. They do not happen every year Mr Sexton: No more than 10. but only at the FSA’s request.
Q1332 Jim Cousins: You charged £70,000 for a Q1339 Jim Cousins: Did any happen? comfort letter. Therefore, there is more money in Mr Hitchins: I do not know. writing comfort letters than in auditing the company? Q1340 Jim Cousins: Can you tell the Committee Mr Sexton: When we are requested and required to whether they did happen about Northern Rock? provide things like comfort letters we provide that Mr Sexton: Yes.30 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 Q1341 Jim Cousins: In your relationship with the on their level of activity in relation to those FSA where do your duties lie? Do they lie to particular matters. 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 Q1333 Jim Cousins: You have to agree that in the on regulatory returns to the FSA where we have a wider world it would seem pretty extraordinary that duty of care to both the company and FSA. 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 Q1342 Jim Cousins: Could you spell out what your a statutory disclosure in connection with the fee for duty of care is to the FSA? auditing the company Northern Rock Plc. There are Mr Hitchins: In terms of regulatory reporting, our additional subsidiary companies within Northern duty of care is to make sure the information in the Rock that are subject to audit and regulatory regulatory returns is consistent with the information responsibilities that fall on the company that must we have audited. be fulfilled. If you take those numbers together what you see is that we charged fees of £1.1 million as Q1343 Jim Cousins: Did you ever draw to the FSA’s statutory auditors to Northern Rock and £700,000 attention that in terms of assets and liabilities over in connection with comfort letters and three months Northern Rock’s liabilities were four securitisation. times its assets? Mr Hitchins: I do not know whether we specifically Q1334 Jim Cousins: In your discussions with the did so. FSA about Northern Rock what did you tell them Mr Sexton: That information is included in the that was material to your function as auditor? regulatory returns and therefore is brought to the Mr Sexton: I do not have a transcript of the precise attention of the FSA. comments made to the FSA by the audit partner at the tripartite meeting. Q1344 Jim Cousins: It is up to the FSA to spot it? Mr Sexton: The FSA has a very well developed Q1335 Jim Cousins: Just give us the general flavour. procedure. When you talked to the FSA what sorts of things did you tell them? Q1345 Jim Cousins: You are not under any duty to Mr Hitchins: The first point here is that which I point it out? referred to earlier in terms of our duty to report Mr Sexton: Not explicitly, no. 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. Q1346 Jim Cousins: What is your duty as auditor to the depositors? Q1336 Jim Cousins: Did you report anything to the Mr Sexton: Our duty as statutory auditors to any FSA about Northern Rock? UK plc is primarily to the shareholders; it is they Mr Sexton: We would have had normal with whom we contract through their board. conversations as part of tripartite meetings with the FSA, with Northern Rock management and the Q1347 Jim Cousins: So, you do not have any duty of regulator. care to depositors? Mr Sexton: We have no duty of care to depositors. Q1337 Jim Cousins: Could you charge £300,000 for that? Q1348 Jim Cousins: What are your fees so far for Mr Sexton: The work that we provide to the preparing the documents for the sale of Northern regulator as statutory auditor is mandated by the Rock? FSA and subject to the very competitive marketplace to which you have referred. 30 Ev 341 Processed: 30-01-2008 10:59:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG6
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4 December 2007 Mr Richard Sexton and Mr John Hitchins
Mr Sexton: I do not know that number. It is an statements on internal control cover all risks or form ongoing process and as the bid process proceeds as an opinion on risk and control procedures. Do you auditors we will almost certainly be involved in think you should be required? providing opinions on historical financial Mr Sexton: The requirements of the combined code information predominantly in relation to periods which drive the work we do and do not do have been already reported. subject to repeated review involving all market participants—regulators, companies and standard- Q1349 Jim Cousins: Perhaps you could let the setters—and the conclusion they have reached is that Committee know in due course what those fees are. the best use of auditors is to focus upon financial Mr Sexton: Those fees will be thoroughly disclosed reporting controls, which is what we do, not provide in the annual report and the prospectus. an overall opinion on internal control in the way the American environment has moved. Q1350 Jim Cousins: Can you let the Committee know what the fees are so far? Q1357 Jim Cousins: I was asking you, not them. Do Mr Sexton: Those fees will be thoroughly disclosed you think it would be right for you as auditor to under regulatory requirements. report on the risk and control procedures of the bank? Do you think you should be required to check Q1351 Jim Cousins: In preparing those documents out the board’s statements on its internal controls obviously your duty is to the board of Northern on risks? Rock. Mr Sexton: What I am saying to you is that the Mr Sexton: The duty in preparing a prospectus- regulators dictate the work we do as statutory related document will be to the shareholders of the auditors, so if your question is directed to us as company—we contract with the company—and to statutory auditor I can answer only as to the nature the purchaser to the extent we contract with the of what the regulators might require us to do. purchaser. It will depend entirely on with whom we contract. Q1358 Jim Cousins: This is dissembling. I am asking for your view about this. Do you think it would be Q1352 Jim Cousins: One of your former colleagues, sensible if you were required to report on these risks? Rosemary RadcliVe, was a director of Northern Either you do or do not. Rock and served on the audit committee. Mr Sexton: I think that firms like my own can add Mr Sexton: That is correct. value when they look at all kinds of control. It is one of our areas of expertise, so we could certainly add Q1353 Jim Cousins: Did you raise any issues about value to companies if they requested us to do that that? work. 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 Q1359 Jim Cousins: To be very clear about what you the regulators that her independence was not are saying, that would be additional to your work as impaired, she having left our partnership in 2001, auditor and it would be a specific new task for which did she go back onto the audit committee.31 you would charge an additional fee, presumably. Mr Sexton: If it were requested by the company Q1354 Jim Cousins: Therefore, you sought the outside statutory regulation that would be the case. assurance of the regulators that it was perfectly proper for her to be on the audit committee and she Q1360 Mr Brady: You have been very particular in went back onto that committee? responding to one or two colleagues to make clear Mr Sexton: She did. The specific arrangement is that that the proportion of your fee income derived from she steps out of any discussion involving audit-related activity is higher than has been PricewaterhouseCoopers and its appointment to suggested. Do you think there is an acceptable and Northern Rock. unacceptable ratio between those two things? Mr Sexton: The purpose of the disclosures of fee Q1355 Jim Cousins: What about her involvement ratios is to ensure that users of financial statements with the regulatory returns that you prepared? are aware of the amount of work we do. We take Mr Sexton: I am afraid that is a matter for the independence incredibly seriously and look at every company. I do not know the answer to that. piece of work, whether or not it approaches some Mr Hitchins: We do not prepare the regulatory sort of magical ratio, to see if it can possibly impair returns and eVectively we provide an assurance our independence. We decline to act where we feel opinion on them. 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 Q1356 Jim Cousins: In your reporting to Northern look at each individual piece of work and be Rock shareholders in the annual report you say that comfortable that it has no impact on independence. you are not required to consider whether the board’s
31 Note by witness: For completeness, the regulator I was Q1361 Mr Brady: In the past accounting period referring to in my reply was the Securities and Exchange what has been the ratio of fees as between audit- Commission. related services and other services? Processed: 30-01-2008 10:59:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG6
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Mr Sexton: In all companies? Mr Sexton: I am afraid I do not know on what facts KPMG based that report. Presumably, it would Q1362 Mr Brady: In Northern Rock? have been a private report commissioned by the Mr Sexton: In Northern Rock it is disclosed in the bank or other parties. I do not know the information accounts. The ratio in terms of our role as statutory behind it or on what they would have based that auditor and the work we have to do is less than one conclusion. to one. Q1368 Mr Brady: But in your dealings with Q1363 Mr Brady: What ratio would give you cause Northern Rock or your statutory audit function for concern? there was no point which would have caused you to Mr Sexton: I merely observe what the market raise concerns of a similar nature as to whether or analysis as a whole shows. If one looks at the not the model was sustainable. FTSE100 analysis in the 12 months broadly to 31 Mr Sexton: I think that what you describe is a December—you will appreciate that year ends are specific piece of work that KPMG as consultants to diVerent for diVerent companies—the ratio is of the the bank were engaged to do on behalf of that order of 1.1 to one. institution. We cannot act as consultants to our audit clients. Q1364 Mr Brady: Looking at some of the fee income that you have received for assurance services in Q1369 Mr Brady: I accept that, but during the relation to securitisation transactions, it appears to course of the work that you undertook in terms of me that a significant amount of it was dependent your assessment of the bank’s practices as statutory upon the particular business model being pursued by auditor there was nothing that led you to have Northern Rock. concerns of a similar nature. Mr Sexton: It was a fee income reactive to the Mr Sexton: For the purposes of looking at the transactions that they performed. annual accounts, the interim report and preparation of our opinions thereon we would have looked at all Q1365 Mr Brady: So, the more securitisation pertinent information, including the liquidity in the transactions were performed the more letters of markets at those points. assurance you would expect to provide? Mr Hitchins: I think it is important to remember Mr Sexton: That is correct, but under our ethical how liquid those markets were in the first half of standards we cannot provide any kind of 2007. In May, June and July there was over $30 management input to a company to encourage it to billion of residential mortgage-backed security perform one transaction or another. That is issues. completely forbidden under our ethical standards. We cannot create a transaction flow in order to Q1370 Mr Brady: I accept that. My point however is charge fees; it is purely a reaction to the level of that albeit KPMG may have been acting in a diVerent transactions that a company may or may not choose capacity for Sachsen LB two years ago when there to undertake. was significant liquidity in those markets it was cautioning that the strategy was based on the premise Q1366 Mr Brady: When Northern Rock decided to that markets never malfunctioned. pursue a business model which led to a great Mr Sexton: As auditors clearly we have been expansion of certain types of transactions clearly conscious of the fact that for a number of years that provided an increased flow of fee income for valuations have been rising in respect of various asset PwC. classes. Therefore, part of our work has been to focus Mr Sexton: Northern Rock’s entry into those carefully on the values based on the information that transactions has that consequence given market we have available at the time we do our work. That practice that typically requires the audit firm to encompasses a whole load of facts. Our opinions at provide comfort. that moment in time are based on the best information available to us, so we would have been Q1367 Mr Brady: There seem to be some parallels cognisant of that kind of issue for the purpose of between what happened to Northern Rock and the looking at annual financial reports. German bank Sachsen LB which in some ways was pursuing similar business models, particularly Q1371 Mr Brady: You would have been cognisant of through its Irish subsidiary. There was a report in that presumably not only for the purposes of the the Financial Times on 23 November which financial report but also in relation to letters of commented that KPMG had undertaken a review of assurance relating to securitisation transactions? the activities of Sachsen’s Dublin-based market Mr Sexton: During the first half of 2007, yes. The last business. The FT reported that as early as 2005 securities issue that Northern Rock entered into of KPMG had cautioned, presciently, that the Dublin which I am aware was in June. strategy was based on the premise that markets never malfunctioned and it warned that the bank Q1372 John Thurso: First, is it right that neither of could be forced to sell assets if investors stopped you was involved in the audit of Northern Rock and buying the bonds being used to finance the various neither of you is a client partner or anything like that? funds. Was KPMG able to see something that PwC Mr Sexton: We are both client partners but not of could not? Northern Rock. Processed: 30-01-2008 10:59:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG6
Treasury Committee: Evidence Ev 143
4 December 2007 Mr Richard Sexton and Mr John Hitchins
Q1373JohnThurso:Inotherwords,youarenotinthe Mr Hitchins: I do not believe that would necessarily direct client relationship chain? be a weakness. Mr Sexton: That is correct. MrSexton:Oneofthechallengesis thattherearepros and cons. Obviously, on the positive side they are aware of both aspects of that part of the management Q1374 John Thurso: Clearly, I understand that an of the business, but, frankly, the downside is the audit is really about establishing the veracity of what amount of work involved to do both jobs. Therefore, has happened in the past rather more than about the one has to balance the two. As with all committees of sagacity of the actions that have been taken. I want to the board, they are acting on behalf of the board as a turn to the questions that my two colleagues have whole, so there is a role for it. been asking about the relationship between the audit committee and risk committee and the auditors. It Q1376 John Thurso: My worry is that the audit seems to me that the core failure of Northern Rock committee’s job is basically for the independent was the fact that the risk committee failed to see the directors to ensure the audit is being done correctly risk of an illiquid market. When they came before us and you as client partners have been given the they said that it was unforeseeable. From the opportunity to meet with the audit committee conversations that have just been going on it seems without any members of management. All of that is that others, including KPMG, foresaw it, so maybe it designed to try to make things as robust as possible. was foreseeable. Asking you not as this company’s But if you have exactly the same chairman and people auditors but as serious practitioners in this field, what on the audit committee as are on the risk committee can be done to improve the performance of a risk the chances are that the same problems can occur as committee of a financial institution and the way in between the audit committee and the full board. whichitinteracts withanauditcommittee? Oneofthe Mr Sexton: Having variation in committees and V V points which struck me was that the chairman of the di erent people looking at di erent aspects is a good risk committee and audit committee was the same thing, and we see that today in many of our client person and mostly the same independent executives companies. They will select their independent non- were involved. Is there anything that you would like executive directors for specific skills and deploy those in particular ways. to see done in that part of the mix of corporate Mr Hitchins: Today some banks still have combined governance? audit and risk committees. Mr Hitchins: Banks tend to have risk committees at V di erent levels. There is usually a management risk Q1377 Chairman: From the questions put by a committee that manages the business day to day. number of my colleagues it appears they are not Many banks have now established risk oversight particularly satisfied that you have adhered to committees as committees of the board. The reason general principles, for examplethe issue of regulatory for their establishment is that the workload of audit returns raised by Mr Cousins. In light of those committees has become too great for the committee comments I shall be writing to you for further details itself to handle both audit and risk oversight. What and I hope you can reply as quickly as possible, say, one needs is a clear link and common membership, within a couple of weeks.32 not exactly the same. Having common members is an Mr Sexton: We will certainly do that. We did come in important way to ensure that the audit committee is the spirit of answering questions on financial stability aware of what the risk committee is doing. rather than Northern Rock specifically, so I hope we have been able to help you.
Q1375 John Thurso: Would you think it a wise Q1378 Chairman: Northern Rock is the elephant in precaution to say that the risk committee chairman the room, is it not? should not be the same individual as the audit Mr Sexton: I understand that as well. committee chairman? Chairman: Thank you very much. Processed: 30-01-2008 10:59:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG6
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. Mr Montagnon: Our members are quite large Perhaps you would introduce yourselves for the investors in the corporate bond market but they do record. not have a huge amount of asset-backed securities. Mr Montagnon: I am Peter Montagnon, Director We have asked them. What comes back is of Investment AVairs at the Association of something in the region of 0.5% of their portfolios. British Insurers. We have not been particularly large in this and it Mr Sears: I am Guy Sears, Director, Wholesale, is diYcult to know why others have gone into it. Investment Management Association. Our impression is that a lot of the paper we have Mr Pitt-Watson: I am David Pitt-Watson from been talking about has been bought by banks Hermes and I am Chairman of their Equity around the world, not necessarily by traditional Ownership Service. long-term institutions. There has been some buying Mr Hitchen: I am Chris Hitchen, Chairman of the by such institutions to diversify risk and get the National Association of Pension funds and Chief right risk/return balance in the portfolio, and Executive of the Railways Pension Trustee clearly there has been some push down the risk Company. 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. Q1380 Chairman: What factors explain the rise in Mr Sears: Generally, with asset managers we have demand over the past decade among investors for about three point something trillion pounds under a range of higher-yielding but riskier financial management. We act for others; we do not do products, including US subprime residential proprietary trading. A very small part of that will mortgage-backed securities? be in this infected stuV. There will be some pockets Mr Hitchen: Certainly, from the perspective of of stress, but they are a very small part. pension funds our forays into the areas you mention have been relatively limited. We try to run Q1382 Chairman: Do investors have a suYciently diversified portfolios. But the secular change over good understanding of credit ratings? Does more the past 10 years among UK pension funds is that need to be done on that? they have increasingly been maturing and marked Mr Montagnon: As provided by the credit-rating to market by accounting standards, et cetera. They agencies? are now brought onto company balance sheets. Therefore, there has been a desire among pension funds to de-risk their investments and move Q1383 Chairman: Yes. towards more bond-like investments which might Mr Montagnon: I think they do, at least insofar as be closer to their liabilities. The problem is that the they understand the limitations of a credit rating. yields on long-dated bonds are very low and there When I talk to our members who are large may be a supply/demand imbalance there. It may institutional investors they regard the credit rating be that some investors look for instruments which as only one factor in their investment decision; they appear to have the characteristics of bonds but do not rely on them. Sometimes their clients give perhaps have a slightly higher yield. them a criterion which requires them to invest in Mr Pitt-Watson: In looking at the issuance of this paper above a certain credit rating—an investment paper one needs to look at the supply as well as the grade—and that aVects their behaviour, but in demand. Clearly, banking regulation made it very terms of individual ratings they like to make their attractive for people to dis-intermediate loans and own judgments. They take note of a credit rating package them up as high yield securities. but do not rely on it completely. Obviously, people want as high a yield and return Mr Hitchen: I reiterate that. Certainly, the bond as they can possibly get and this can be achieved managers we have employed in our scheme would because special purpose vehicles do not have the make their own credit assessment. The credit-rating same capital requirements that would be required agency rating would often be something that they if they were held on the balance sheet. could use in a way to gain an advantage over the Mr Sears: I think there are three points. With low market by assuming that other investors are relying interest rates people look for yield. There is the on it, if you like. I believe that the credit-rating originate and distribute model that has been agencies provide to the market a good basic level pushed. There is also a matter that has not been of information. mentioned by the investment banks. Part of the Mr Pitt-Watson: I would put a caveat on that and explosion was caused because mathematicians consider where the question is coming from and started to put together better models on which some of the Committee’s earlier questions. People people could rely to assess joint risk. do use external credit-rating agencies in thinking about value, but the bond market like the equity market, is characterised by trading rather than Q1381 Chairman: Do you think there are better ownership. You will probably remember Keynes’ models, Mr Montagnon? description of professional investors. He described them as those who try to guess who it is will win 32 Ev 342 a beauty contest, which requires not just knowing Processed: 30-01-2008 10:59:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG6
Treasury Committee: Evidence Ev 145
4 December 2007 Mr Chris Hitchen, Mr Peter Montagnon, Mr Guy Sears and Mr David Pitt-Watson which person you think is beautiful but which one those who set capital treatment. This conflict also you think the other person thinks is beautiful. appears in the context where there can be a massive Therefore, when people trade bonds what they look diVerence between, say, getting investment grade at is how it is they beat the market, whatever it is and not getting it. There is a very high risk area of that the market does. That means that the conflict as well as just generally. 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 Q1386 Mr Dunne: Mr Montagnon, you said just a relatively short period of time, you can manage now that you believed your members held a very to out-perform the other actors in the market in small proportion of asset-backed securities. The which you are trading. 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 Q1384 Chairman: Is there an inherent conflict of banks did so. Who knows where this paper is? How interest in the fact that rating agencies are paid by do we get to the bottom of this? If you are the the same banks for whose products they provide institutional investors and you do not hold it and ratings? the banks do not have it where has it gone? Mr Montagnon: Yes. We have been aware of and Mr Montagnon: That is a very good question and concerned about the conflict of interest particularly one of the reasons why this present moment is so in some of the structured finance products where Y the credit-rating agency is involved both in assisting di cult. Nobody really knows where the risks have the bank prepare the product and in rating it. That ended up and who hold them. I repeat that our impression is that a lot of this paper has found its is a source of concern. We do not however believe V at this stage that it needs to be addressed by formal way into banks. It is slightly di erent from regulation. We would prefer that it be done traditional lending, but you have seen a couple of through a robust code of practice, probably under German banks where there have been problems. It the sponsorship of IOSCO, rather than formal has definitely been a banking rather than a long- regulation because we believe that the latter may term institutional problem. All we can say is that have some unintended negative consequence with we cannot trace a lot of it back to our members. regard to competition and choice. Mr Sears: I am not sure either. We have not gone Mr Pitt-Watson: Some of you may know that last through all the clients of all of our firms to work year I wrote a book entitled The New Capitalists: it through. I certainly think that the percentage How Citizen Investors are Reshaping the Corporate across some of the institutional funds may well be Agenda which raises precisely this question. above 0.5%, but it is certainly not significant. Clearly, if you are paid by somebody there is an Perhaps some is sitting inside hedge funds. I think inherent conflict of interest. that in particular the enhanced yield money market funds, not the constant net asset ones, will be Q1385 Chairman: I have read it. carrying some of it as well. Mr Pitt-Watson: I will add that as a blurb on the back of the second edition! It is not just the Q1387 Mr Dunne: That is a very interesting point. payment for the credit rating; it is also that they Is that not where the public at large may get hurt (the ratings agencies) will provide additional by this? There may be more sophisticated financial services to the companies they are rating. The three products created to provide a pooled money credit-rating agencies are a protected oligopoly and market fund that holds instruments which, there may be a question about whether or not that although they have been rated triple A, are is a constructive thing to do in terms of having contaminated and may start to unravel. Is that not appropriate competition in the market. where the man in the street can get hit but so far Mr Hitchen: The way credit-rating agencies get it is hidden? paid is nothing new, but the job has become more Mr Sears: There are two ways in which the man in complicated. Despite the fact that clearly they do get paid for providing the ratings, my perception the street may be hit. To explain, there are money market funds and money market funds. The French as an outsider is that their business model is not V as robust, say, as that of investment banks, ie they enhanced-yield ones are somewhat di erent from cannot pay for quite the same level of talent as the the institutional money market funds that will be issuers of paper. There might be something there triple A-rated. They will have quite a small that we need to think about. percentage of this asset-backed security, and Mr Pitt-Watson: But they did get Worldcom, certainly over the past couple of months they have Enron and Parmalat wrong, and that is why they been exiting that. One of the advantages is that the are mentioned in The New Capitalists. Now they maturities are very short so you can get out. There have got this wrong. There are some things that are two very diVerent products out there: treasury- perhaps we should dig up by the roots this time, type products in the form of institutional money and sort out. market funds and more investment-type products. Mr Sears: We have been talking about the conflict I believe that those do have infection and mainly of interest in this area for years and years, but in institutional people have gone into them, but they this context sometimes credit-rating agencies are are in France and across Europe. You are almost given a special role by the regulators or absolutely right that through repackaging, whether Processed: 30-01-2008 10:59:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG6
Ev 146 Treasury Committee: Evidence
4 December 2007 Mr Chris Hitchen, Mr Peter Montagnon, Mr Guy Sears and Mr David Pitt-Watson it is direct or through secondary eVects, with loss marking to model (as people were already doing of liquidity, retail people will be hurt, as we all will perhaps because that helped with the bonus at the if this continues. end of the year, if it appeared markets were going up). The accountants simply do not know how to Q1388 Mr Dunne: Do you agree that we are only give a market value when there is no market. That a short way through the process? The contagion knocks back on all your banking ratios. People eVect of the potential of other funds being unable start to get scared about credit. The banks hold on to price because one risk goes wrong is yet to be to their credit and the interbank lending market that works any longer. The man in the street is very unravelled. It has happened. How long will the V process take before it becomes apparent how firmly a ected by this. Did sophisticated investors widespread it is? know what they were doing? Yes, they did and they Mr Sears: I think it is spread across the whole were trading; they were trying to beat the market. economy. When we get to the year ends, In my view what sophisticated investors were not construction companies may worry about getting doing to the extent they should have done, was their facilities renewed. How long will it take? I do behave as owners, like the old bank manager would not know, but there will be a certain critical points. have done when he took on a mortgage. He would I believe that the interim results that come out in ask, “Does this person have a secure job and will January will be another moment of confidence and he be able to pay back the mortgage? Do we have perhaps crisis of confidence. a house that has security?” That was what failed. It Mr Hitchen: Commentators are now talking about went straight through the system. The credit-rating maybe two years for the full eVects to become agencies and the accountants did not do their job apparent, but if you go back less than one year and as a result we have this problem today. given that the market was not focused on these Mr Hitchen: Pension fund trustees will have a issues much at all I suspect that may be an varying level of understanding of these things, but underestimate. I agree with Mr Sears that if we get what they are not doing is trading in the market an economic downturn as a result of the credit day to day. What they do is appoint professional crunch it may be much more long term. 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 Q1389 Mr Dunne: Mr Pitt-Watson, do you believe refers. that investors understand the relative pricing of investment grade and non-investment grade tranches of some of these CDOs? Are they relying Q1390 Mr Dunne: Perhaps this is a question for Mr entirely on what the rating agency says or because Montagnon. Are your professional investors not they are so sophisticated are they looking behind relying on the credit rating as their primary that? determinant not just of the creditworthiness of the Mr Pitt-Watson: More sophisticated investors instrument but whether or not it will have liquidity? know what is going on but are typically motivated Do they use a separate measure to determine to try to trade in the market rather than be good liquidity? owners in the market. The person whose Mr Montagnon: Our large investment members investment money they are investing is the ordinary certainly do not rely solely on the credit rating. The man in the street. You asked who has lost from credit rating does not in itself say anything about this. Clearly, the pension funds that own Northern liquidity. That has been a problem. In some parts Rock have lost up to £4 billion. I would guess that of the market they may not have been properly public sector pension funds have lost between £250 understood. What our members believe is that million and £300 million simply as a result of the sometimes the information they need to assess the fall in the value of Northern Rock since this crisis issues they get—this applies more generally across began. Lord knows how much they have lost the bond market—is not as available, accessible or through their equity holdings in the banks overall. readily forthcoming as it might be. Certainly, with Clearly, the banks did have these investments regard to structured products they need (subprime CDO’s) because they have been writing information about collateral in order to be able to them down; that is where the losses have come assess the risk they are taking. They would like to from. Pension funds with lots of hedge fund know more about the models underlying these investments will not even know what those hedge transactions and sometimes that is not so easy to funds are invested in. I checked for Hermes. I was get at. The investment banks said it was there. It told they are not entirely sure about the many may be there but in a format that is not at all hedge funds in which the British Telecom pension digestible. That is diYcult sometimes when one has scheme is involved but they know that one of them to make quite quick decisions. 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 Q1391 Mr Dunne: Do you believe that the treasury the money of ordinary people is directly aVected by departments of local authorities, for example, who what is happening here. We do not know the value may be deciding where to plant their cash deposits of these things. Accounting standards have focused through the year have the capability to look behind on mark to market rules instead of prudence, the credit rating and do anything other than take principles. When the market dries up and we start it just because it is investment grade? Processed: 30-01-2008 10:59:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG6
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4 December 2007 Mr Chris Hitchen, Mr Peter Montagnon, Mr Guy Sears and Mr David Pitt-Watson
Mr Pitt-Watson: Obviously not. The credit ratings Q1395 Nick Ainger: Mr Pitt-Watson, earlier you are often used to give the mandate. Funds are referred to the issuing of mortgages and the image allowed to invest in bonds that have got a certain of the old-style bank manager. Do you think that credit rating. That is why getting good credit rating within their organisations the banks have old-style is worth so much to the issuer, because it means bank managers? the interest rate is lower, and the amount of money Mr Pitt-Watson: No. It is not being done in that it raises can be a lot higher. 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 Q1392 Mr Dunne: If we look beyond the confines obtained. One of my colleagues in the States is a of the CDO market we see liquidity starting to dry director of a bank which got out of subprime in the up across the economy. Today we read in the past year. He told me that one of the numbers he newspapers that property funds are starting to looks at is the first payment default on auto-loans. impose non-redemption periods because of issues A person buys a car and does not make the first aVecting the property market. Do you see evidence payment, let alone the second or third payments. of contagion spreading into other financial These defaults have gone shooting up in the United instruments? States. Those sorts of indicators simply mean that Mr Sears: As I read in the FT this morning, the people have been giving out injudicious loans and property funds which imposed in this 12-month the market has been happy to accept them because period are institutional funds. Because of the way it has not been thinking of itself as the owner of the FSA rules work, you cannot for a retail fund those loans but as the trader of them. I do not impose a 12-month period, so the ones that have criticise trading; it is very important that we have been announced have been the institutional side of it, but if we trade without ownership and move it. Are people seeing stress everywhere? Yes, they from the old bank manager system, to loans being are. Certainly, as far as asset managers are monitored by traders on Wall Street, without concerned the diVerence at the moment is that anything else taking place, ultimately it is the compared with the period prior to the summer pension funds, insurance companies and little people now manage this full-time. People are savers who lose because the market collapses, as it exiting and becoming more liquid as time goes on. has done this summer. I suggest that that is a very diVerent dynamic from Mr Sears: We talk about sell and buy side firms. I V six months ago when some of the signs were there. think it is a very di erent dynamic. All of our firms will be remunerated by performance over time. There are two lifestyles, one of which is Q1393 Chairman: I asked the banks about transactional: people are paid transaction by problems with a mortgage in Chicago. I asked transaction just to sell something. The other whether it was a matter of garbage in, garbage out activity is performance-oriented. These are two if they did not have the market information. How very diVerent ways to approach the market. I think do you view that? that is the modern analogy to your bank manager Mr Pitt-Watson: When suddenly the very basis on and the salesman. which securities are traded and valued is called into Q1396 Mr Mudie: That is what worries me. I shall question it is quite dangerous. That was the ask about pension funds. The answer is that they problem with the credit-rating agencies to whom are not in these products, but those products that you talked. I go on to say that there is a continuing would deliver money. If you are benchmarking you problem—Mr Cousins has focused on it in some of would not your advisers be pushing into that field? the things he has written in the past few years— Why are you not in it? with the way in which accounting standards are Mr Hitchen: I can speak only for the pension fund developing. Accounting standards are based which I run. We set guidelines for all our external considerably less on the principles (on which they professional fund managers; we set not only a used to be based) than they on market prices. That benchmark but the rules of the game that they play is another continuing issue. 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 Q1394 Nick Ainger: I asked the banks whether they have told our managers they cannot invest in them. considered their actions to be reckless or cautious. If they want to do so they must come back and You seem to be saying from the way you react to make a very reasonable case to us. We have CDOs that you are being cautious. Do you think adopted the same approach to most other the banks have been reckless in the way they investments. became involved? Mr Hitchen: The banks operate in a diVerent Q1397 Mr Mudie: I read your submission.33 You environment and over very diVerent timescales. We say that only 1% to 2% are involved but it still represent in the main institutions that invest very represents £60 billion which is a lot of money. That much for the long term and that colours the way is just your estimate. Does that estimate also we think about things. We are naturally cautious include private equity, for example? about getting into areas of which perhaps we do not feel we have a perfect understanding. 33 Ev 330 Processed: 30-01-2008 10:59:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG6
Ev 148 Treasury Committee: Evidence
4 December 2007 Mr Chris Hitchen, Mr Peter Montagnon, Mr Guy Sears and Mr David Pitt-Watson
Mr Hitchen: Pension funds tend to take the equity Q1400 Mr Mudie: You are a bit more realistic or part of private equity investments. They will have pessimistic than Mr Hitchen whose submission says some investments in the loan part of the deals, but there is nothing to worry about whereas you have they are mainly in the equity piece. Clearly, that said there is a lack of transparency and there are brings its own risks, but we accept that when we real worries. invest in equity we do so for return and we have to Mr Hitchen: To clarify, I was not trying to give the take it on the chin if a particular equity goes wrong. impression there was nothing to worry about.
Q1401 Mr Mudie: Are you going to be more pessimistic? Q1398 Mr Mudie: When we have investigated Mr Hitchen: No. Certainly, there are things we do private equity we were particularly worried about not know yet and in two years’ time we will find your industry in terms of pils in returns and then that more pain is being borne. But what we tried something happens and you have real problems in to say in our paper was that pension funds are terms of paying pensions. You are quite relaxed in likely to be less aVected than some other investors terms of the amount of money invested in these because of our more cautious and diversified particular financial instruments. How firm are you approach. on that 2%? Mr Pitt-Watson: Let me also be very optimistic. Mr Hitchen: It is the best estimate we have at Capital markets do and have done a fantastic job, present. 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 Q1399 Mr Mudie: You spell out your investment equities market, namely that credit markets will not policy or strategy which is apparently coming out be successful unless you have someone who takes of equities and going into bonds. In your paper you ownership responsibility. In the equity market Mr Hitchen and Mr Montagnon in particular have complain about the shortage of bonds, so where is been leading lights in making sure that in the UK your money going? we do have ownership. I think we need to learn that Mr Hitchen: You hit on a very good point. There lesson from this credit crisis too. 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 Q1402 Mr Mudie: If I were an individual approaching my pension and listening to you I approach that we have tended to take as pension would ask: are we learning just the theoretical funds is to diversify as much as we can into lessons or will we have some pain from this? Will diVerent kinds of assets. We still have large there be pain in the pension industry? amounts of money invested in quoted equities; Mr Pitt-Watson: We do not know what the real certainly, my fund of £20 billion has about half in world economic eVects will be from this credit quoted equities diversified around the world. For crunch. I was talking yesterday to a retailer who the other half we have tried to invest in as many V was terribly negative about what was happening. di erent kinds of assets as we can. We simply do not know. If you are the Bank of Mr Pitt-Watson: We do not know how much England by how much will you reduce interest rates pension funds have invested directly, but both Mr to try to keep the economy going? Hitchen and I say that, as large pension funds, we both have a large hedge fund programme. We are Q1403 Mr Mudie: That is not very reassuring, is it, not quite sure in what those hedge funds will have because you are in hedge funds, private equity and been invested, but we know that one and possibly securitisation and yet you come before us and say two are coming back to us to say they have “short you are okay? positions”. They have been short and have made a Mr Pitt-Watson: I am sure that people’s pensions lot of money in the past three months. Typically, in 25 years will be okay at the end of the day, but the ones which will have been long in this market if what we are looking at is what is likely to happen will not be picking up the phone to tell us how in the immediate term there is a real problem. We badly they have been doing. When you ask whether do not know. There were CDOs, special purpose pension funds are investing here we need to be vehicles issuing paper and inadequate accounting careful. This is a very complex market where rules. The economy particularly in the United money, securities and investment start with the States bubbled. The bubble burst and we now have individual but end up with a hedge fund manager. to hope to can bring it down slowly without it At the end of the day it is to do with railway aVecting people’s livelihoods and jobs. It could workers’ or telecom workers’ pensions, but it is aVect their jobs. often being managed in a way that is at several layers distant from that pension fund. The people Q1404 Mr Mudie: In the individual areas we have who manage it tend to try to make their money by mentioned the fundamental issue is transparency. trading and the concern is that there is no one In your memorandum you talk about a sitting there saying, “Hang on a minute! I want to government review and the current tripartite make sure the security in this company is as strong discussion. In the same sentence you go on to talk as it ought to be.” about whether greater transparency can be Processed: 30-01-2008 10:59:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG6
Treasury Committee: Evidence Ev 149
4 December 2007 Mr Chris Hitchen, Mr Peter Montagnon, Mr Guy Sears and Mr David Pitt-Watson achieved in the market for structured investment Mr Hitchen: There is certainly a risk of that. vehicles. Am I reading that wrong? Are you expecting government to deliver transparency or do Q1407 Chairman: On the question of reporting, the you just make a plea for it? If it is the latter tell me other day I read an article which said there were how we will get it. It seems to me to be the thing five or six diVerent ways to report losses in that is missing from the whole exercise. accounts. It may be that some banks are just drip- Mr Pitt-Watson: I think I am making a plea for feeding this, so perhaps there is a need to look at responsibility and ownership. To take one example, reporting losses in greater detail. in the area of accounting rules we have had a Mr Montagnon: One area where we do need more momentum towards international accounting rules. transparency is the reporting of this business in Most of the world has adopted American standards financial institutions. We need to know with much which very much value things to market. We have greater clarity what is on, what is oV, and what has talked about those problems. That move continues. potential to come back onto the balance sheet than It is up to investors to make sure that we first slow perhaps we did in the past. As investors who hold this process and consider what is happening in this shares in financial institutions this is something that country, but also if we have a body called the should be looked at closely. In addition, we also International Accounting Standards Board should want to have a close look at the role of audit not investors be in the majority on that body? committees and risk committees in managing these Should we not be asking that pension funds set risks and deciding how they should be reported. aside some part of the enormous fees they pay to That is one area of transparency that we would like fund managers for trading, to make sure they have to see improved as a result of this. the necessary resources; so that when we do get Mr Sears: Some of the investment banks said they international accounting standards they are not might take this back on because of reputational ones that break under stress? That is the sort of risk. If we start to go to reputational risk as being thing we can do and is a good lesson for the future. the reliance for a covenant, in the past people may In my memorandum I make one or two other have relied on that reputational risk because things have been too big to fail. I think there are things suggestions about things we could do. 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 Q1405 Mr Mudie: When we listened to the banks be too big. We have already seen a distinction in earlier I am not sure they did not deliberately the approach of some investment banks. 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 Q1408 Peter Viggers: Following that precise point, V it might be better to be an investment bank that their books and are scared sti because they do not V know what they have. If they cannot analyse it how has survived having sloughed o its non- attributable, non-balance sheets assets rather than on earth do they expect someone advising you to one that still finds diYculties having taken on be able to tell you the risk? In other words, it was board those liabilities. deliberate. Mr Sears: It is an invidious position for them. I do Mr Pitt-Watson: I do not pretend that we can make not suggest that I would like to sit in their seat but this perfect. What would I rather have in future? that in designing the structure going forward we Do I want people who start with accounting have to take account of the fact that we should not measures that fundamentally are based on be in this situation be making such decisions at a prudence or accounting measures that time when there is lack of clarity. fundamentally are based on market value? Who would be more likely to protect pensions and Q1409 Peter Viggers: I asked questions of the savings? I make the assumption that prudence investment banks about the securitised assets held might be quite helpful here. on their balance sheets which had been through Mr Hitchen: You have a good point. I think various stages of collateralisation. I was reassured investment banks will tell you anything you want by bankers who said that there were recognised to know about a product they are selling to you, models for testing a section of these CDOs as assets but ultimately they are in the transaction business and it was possible to evaluate them. Are you and their job is to get the transaction done. It is a similarly sanguine? Do you believe it is possible to fact of life that there are brighter brains working at value such securitised assets? First, is it possible to investment banks than elsewhere in the food chain. put a value on them? Second, does liquidity aVect That is just the way the economics work, so the rest their value? of us have to be pretty careful about the way we Mr Sears: I do not believe that in the end the deal with them, but the watchword has always been models work. You heard from others who gave caveat emptor. 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 Q1406 Mr Mudie: Does it not come down to the happened to see that the models could not cope old saying that if it is too good to be true it is with working out all the complexities of the things not true? connected to them. As another example of models, Processed: 30-01-2008 10:59:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG6
Ev 150 Treasury Committee: Evidence
4 December 2007 Mr Chris Hitchen, Mr Peter Montagnon, Mr Guy Sears and Mr David Pitt-Watson the interim results of Northern Rock—I make no Mr Montagnon: One thing we have done at the ABI criticism of its board—give their Basel II statement. together with other bodies it to talk to the credit- That is entirely proper, but in that statement the rating agencies about putting into their own waiver they get on 30 June which allows them to assessments more reference to the covenants and move onto internal models and such like would greater explanation in shorthand terms of what is result—to be fair, they say there is some asset there, not necessarily their evaluation which would realisation as well—in a release of £300 million to present them with legal problems. We would need £400 million to shareholders over the next three to and hope to go further in that direction. 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 Q1412 Peter Viggers: I raise a specific point on think that raises questions about what the internal pension fund investment. A recent Citigroup survey models are and how much you are allowed to rely showed that 85% of pension fund managers plan to on them in these risky areas at the end of the day. raise their allocation to alternative assets in the next I believe that in certain other areas the modelling three years, with private equity being the most is very good, but for the new frontiers the models popular area of prospective investment. Do you do not work. I believe that this morning we have think that figure still carries weight or has there heard from very responsible investment banks that been a rethink? they feel the same. Mr Hitchen: I am sure that the figure still carries Mr Hitchen: The models do not deal very well with weight because pension funds tend to operate in the world from which the data which populate quite a gradual way, but we go back to a point I them have come. They may very well reflect the made earlier. Pension funds are looking to diversify past five, 10 or even 20 years depending on the into as wide a range of assets as possible. That is model. I always try to remember as a sense check really our primary defence against any particular that maybe these instruments did not exist in the problem that emerges in a section of the market. 1930s, but what would have happened if they did? I am sure we would like to invest not a large but Think about a scenario which could clearly happen significant amount of our assets in private equity, in the real world but which might not have been so hedge funds, property and various other alternative evident in financial markets in the recent past and assets. I suspect we will find it quite hard to build therefore not modelled. our exposure to private equity in the near future because I do not believe that as many deals will be Q1410 Peter Viggers: To move closer to your areas done in that sector of the market. and look at the risk associated with private equity Mr Pitt-Watson: If you ask what investors can do, and highly leveraged deals, have lenders to private it comes back to how it is investors will ensure they equity been exercising due diligence in respect of are providing that ownership discipline. We have loan issuance and have they been alert to the risks the principal/agent problem and we keep passing associated with weaker loan covenants? Is this an the security on and on. By the time it has been incipient risk? passed to a hedge fund that is trading in Mr Hitchen: To be candid, we invest with a number derivatives, of some CDO originated from of general partners and often take the equity piece wherever, there are several principals and agents. of private equity deals. Those partners have in the Somehow we have to get investors as a group to recent past until the summer found it increasingly work together, for example as Mr Montagnon easy to get loans for the deals they want to do. I would do for the ABI, on a much more significant do not go as far as to say that the providers of those scale than historically, to make sure that the loans have not been doing due diligence, but it is ownership disciplines exercised by the old-style certainly the case that credit has been very easy bank manager who said, “Yes, I think you will over the past two or three years and it is now repay the mortgage”, are there. We need that more markedly more diYcult. The same general partners urgently when dealing with alternative investments now have to accept more diYcult terms for loans because once you have them in your hedge funds or in some cases do equity-only deals. There has what you are investing in is quite complicated. been a complete turnaround in the way underwriters look at private equity deals. Q1413 Peter Viggers: Might there be the emergence Mr Montagnon: In a seller’s market—it is a seller’s of new forms of vehicles with much more emphasis Y market—it is quite di cult for the buyers to on transparency and certainty? demand the kind of covenants that they might Mr Pitt-Watson: That is certainly something we at wish. We have been through a period until quite Hermes would be keen to promote for ourselves recently when better protection might have been and among other investors as well. wanted but it has been very diYcult, if not impossible, to negotiate. If you seek such protection you will not get any investment. Q1414 Chairman: That reminds me of an inquiry we conducted into split capital investment trusts a Q1411 Peter Viggers: If investors in the past have few years ago. We had before the Committee one perhaps been over-reliant on summarised risk of the architects of such trusts. He admitted to us assessments by other organisations what can they that he really did not understand the model. It was now do to be more specific and certain they are good for the environment in which he used it but taking risks that they fully understand? when it went into the outside world it blew up. Processed: 30-01-2008 10:59:40 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG6
Treasury Committee: Evidence Ev 151
4 December 2007 Mr Chris Hitchen, Mr Peter Montagnon, Mr Guy Sears and Mr David Pitt-Watson
Mr Pitt-Watson: That is exactly the sort of Q1417 Jim Cousins: Of course, the implication of problem. Clearly, there are lessons to be learnt that is that rather more banks will go bust because from this issue, but if we think about what may be it will be easier to make them go bust if retail the problem in the next war it will be the same thing depositors are protected. I want to ask the insurers happening again. People will be trading but not about Mr Sears’ earlier point about toughening the owning and we will have lost control of where the reserving requirements on banks with the idea of ownership function is. Then everybody, right preventing them going bust in the first place. across the market, loses out. Ultimately the railway Mr Montagnon: Clearly, it is better if banks do not and BT pensioners suVer. go bust in the first place. The problem with Mr Sears: However good the model is, one will Northern Rock was essentially a matter of always have human fallibility. 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 Q1415 Chairman: But it is frightening when the therefore presume that in future people will be architect of the model says he does not understand paying such attention. Even if you have the best it, is it not? protection or prudential supervision in the world Mr Sears: I do not disagree with that. sometimes there will be cases when you have problems. If when a problem arises the retail Q1416 Jim Cousins: I want to turn to the insurers. customers know that their own money up to a The Governor of the Bank of England made it very given limit is safe and they can have access to it clear that he wanted a change to the solvency when they want at least you are spared the risk of arrangements for the banks to prevent retail a run because there will be less need for customers depositors from being trapped, as he expressed it. to go immediately to the bank to try to take Do you favour that? everything out. It is from that point that one gets Mr Montagnon: We believe that we need a robust the risk of contagion. system of deposit protection but we think that it Mr Sears: Equally, the bank is put into needs to be very carefully crafted in such a way as administration if it needs to be. not to distort the savings market as a whole. The danger is that if there is over-protection of Q1418 Jim Cousins: I have understood the written depositors it will act as a disincentive to other evidence of the insurers to mean that they would forms of saving. How one gets there is quite not favour much higher limits of depositor complicated. It may be we need to look at the way protection than we currently have. the insolvency laws operate to ensure that savers Mr Montagnon: That is correct. The question is not can get their money or deposits out of banks whether the limit needs to be increased but rather quickly in the event of a bank failure. One of the how the system works and whether one can have problems with the present system is that it seems confidence in it. If one takes a limit of £35,000 that to get a long time to get the money out. That may covers 98% of all savers who have their savings mean it is probably helpful to have some adjustment to the insolvency arrangements. only in cash and about 80% of all individual savers, so one will capture the bulk of the most vulnerable Mr Sears: While this is not particularly an IMA people in that protection. If one increases the view, like Mr Pitt-Watson I am the author of two chapters of Tolley’s Insolvency on regulated bodies amount one tends to distort the market for savings and financial market insolvency. I worked on the because in view of the guarantees one makes bank Credit Institutions Reorganisation and Winding deposits more attractive relative to products that Up Directive in Brussels. I think the issue is not do not have the same guarantees. That is not whether or not depositors ultimately get their necessarily good for the savings industry and the money back. The innovative thing people can country’s overall propensity to save. consider in looking at it again is whether or not there is a way to ensure people can keep getting Q1419 Jim Cousins: Where does that leave the so- their cash notwithstanding an administration or called bank assurance model in which the bank is collapse. Given that most people take money also a portal into other kinds of savings products? through a cash point I presume it is not beyond the Mr Montagnon: I do not believe it necessarily wit of man somehow to plug into the cash point aVects the model. What we would like to see is a system so people can still withdraw money while market for savings where choices are not distorted. there is an insolvency up to the limits of the If we can oVer products across that range we are protection. A lot of the discussions have been about very pleased to do that. One of the things we are how much money people should get. As your concerned about in terms of bank deposits is that constituents will know far better than I, telling the way the protection scheme is funded should not people that for example after Christmas they will involve cross-subsidisation from insurance to get their money back if there is an administration banking deposits to protect the latter because that of Northern Rock is not something they need. would tend to distort the position. 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 Q1420 Jim Cousins: Where should the money into it at moments of crisis up to some limit. come from? Processed: 30-01-2008 10:59:40 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG6
Ev 152 Treasury Committee: Evidence
4 December 2007 Mr Chris Hitchen, Mr Peter Montagnon, Mr Guy Sears and Mr David Pitt-Watson
Mr Montagnon: Essentially, from the banking My view is that it could be huge if we do not system if the banks are the ones whose customers respond to this sensibly and with judgment. It are being protected. aVects all savers.
Q1421 Chairman: Has there been a change in the Q1423 Chairman: Do you think that bonus and profile of hedge fund investors with institutional option policies in Northern Rock and in general investors increasing their presence in the market? encourage executives to take too many risks? Mr Hitchen: That has certainly been true over the Mr Montagnon: Sometimes that may be true. In the past few years. My fund has invested directly in case of Northern Rock the ABI felt that its bonus hedge funds for perhaps the past four years, and policy was too generous and we had flagged it. it may be Hermes is quite similar in that regard. What that reveals may also be a system whereby Essentially, we went to hedge funds in search of the balance on the board is not necessarily security. Hedge funds provide capital protection in operating terribly well because the executives are a way that the equity markets cannot. We have a able to persuade the non-executives to award them need for real returns and that is just one way of too generous pay increases. That may say quite a getting them with less downside risk. lot about the relative balance and the way risk is approached and accountabilities on the board. Q1422 Chairman: Banks have reported very large Mr Hitchen: We do always try as far as we can to losses on derivative holdings. The question for us promote this, but the basic problem I suppose is is: how much more has been lost by clients? You that whereas we are trying to invest over 20, 30 or referred to insurers who bought similar products 40-year periods and be owners you cannot really sold earlier by the banks. Do you have any ballpark expect an executive to take such a long timeframe figure? Is it a significant multiple? into account. Mr Pitt-Watson: I think the question is: where does Mr Pitt-Watson: The answer is yes and it is the contagion start? Do you take just the CDOs exacerbated by marking things to market and that are absolutely bankrupt, the ones that are marking things to model. Therefore, in the years marked to model, or the ones that are marked to when things look good you can take your bonus market, or do you take the knock-on eVect on the and hope that that is still in the bank when things bond market? Do you look at what has happened go bad. Of course, the original investment is from to bank shares and then add in what happened to other people’s money. Northern Rock? Do you then think about what has Chairman: I do not think you have any messages happened to economic confidence overall? These left unsaid. It has been a long session. Thank you were the kinds of issues Mr Mudie explored earlier. for your evidence. Processed: 30-01-2008 11:07:36 Page Layout: COENEW [SO] PPSysB Job: 386890 Unit: PAG7
Treasury Committee: Evidence Ev 153
Tuesday 11 December 2007
Members present
John McFall, Chairman
Nick Ainger Mr Andrew Love Mr Graham Brady Mr George Mudie Mr Colin Breed Mr Sioˆn Simon Mr Jim Cousins John Thurso Mr Philip Dunne Mr Mark Todd Mr Michael Fallon
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 terms of the limit of protection on the deposit to your colleagues. We have met before. Can I ask encourage the financial institutions to manage its why you are pushing ahead with reforms to the aVairs responsibly and not recklessly? FSCS funding ahead of the Government’s Sir Callum McCarthy: First, I do not think that this consultation on the future of the entire deposit is a science. There is no algorithm we can apply to protection scheme? give you the right answer; it has to have elements Sir Callum McCarthy: Chairman, because for a of judgment in it. We are looking at this very long time we had in train changes, changes carefully. The present £35,000 probably covers designed to make the scheme more resilient and to something like 95% of individual depositors; it give it better funding power, and we thought that probably covers something like 50% of deposits, whatever changes come about from the legislation and getting that balance right so you get the right the Government plans to introduce next year, it protection for individuals but do not encourage would be sensible to make those changes in the irresponsible behaviour by institutions is what the meantime because we did not think there would be judgment has to be. any conflict between improvements we are planning to make and had planned for some time and Q1427 Mr Todd: Do you think that the current whatever comes out of that legislation. 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 Q1425 Mr Todd: In the discussion over the FSCS understand the level of protection that is oVered, there has been debate over how to define the and I think I would not have been alone in not boundaries of it and the implications in terms of knowing the details of this until Northern Rock moral hazard, both for the depositor in not perhaps filled our screens—and I tend to take the view that being fully aware of the products they are I am a reasonably well-informed consumer. There purchasing and the method of protecting their must be many, many who knew nothing about it, deposit, and also the financial institutions that they and did not know the limits or any co-insurance have placed their deposits with. How do you element within it? address those? Sir Callum McCarthy: That is true, and I think one Sir Callum McCarthy: The moral hazard question of the questions is how to explain the reality and was particularly predominant at the very early that reality is both a question of the amount of stages of the scheme. When the scheme was first coverage, when this no longer applies when there introduced in the 1970s it was a 75% deposit is co insurance, and also the speed with which an insurance, and it only went up to 90% relatively individual can expect to receive a payment under recently, and it is only post Northern Rock that we the deposit insurance. have increased it to 100% for the first £35,000. The Ms Minghella: It is important that consumers diYculty is forming the right judgment on that understand the protection that is available to them because, for example, if you look at the experience in the event of a failure, and that is why when a in the US during savings and loan problems, it was business does fail we take steps to inform every quite clear that that resulted in some distortion of consumer who is aVected that they have a right to behaviour and some serious moral hazard. claim on the scheme. We also do work with a number of stakeholders, Consumer Advice Centres, Q1426 Mr Todd: So what advice do you give, Money Advice Bureaux, journalists, and MPs, to because you have said there is a question of balance try and bring the scheme to general attention in to be struck here, is there not, in addressing how advance. to design this, both in terms of the concept of co-insurance, of the depositors bearing some Q1428 Mr Todd: Do you not think there should be proportion of the risk and therefore incentivised to a clear obligation on a provider of a deposit-taking understand what they are involved in, and also in service to communicate regularly with the person Processed: 30-01-2008 11:07:36 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG7
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11 December 2007 Sir Callum McCarthy, Mr Hector Sants and Ms Loretta Minghella having that deposit the limits of a scheme of this essentially that this was a matter of social policy, kind? Without wanting to spread alarm about it really, and had no particular role in terms of they can couch it in appropriate terms of “in the financial stability. Would you agree with that? unlikely event” and all the other things, but surely Sir Callum McCarthy: I am not sure if I would there should be an absolutely clear obligation completely agree with that because I think if there placed on a business to do that, and that has not is greater understanding of the position of been done. individual depositors, if they know they are 100% Ms Minghella: I would agree with you, Mr Todd, covered up to a certain amount, if they know they that a firm should have an obligation to get very rapid repayment, it is much less likely that communicate with its customers; it does have that there will be a retail run, and that has implications obligation at the point of giving any explanatory again for financial stability. So I think it is not just information about a product, and I think that a question of the social aspects of this, though those could be further enforced. are important—
Q1429 Mr Todd: What about the research into Q1432 Mr Todd: It is consumer confidence— institutions which might be safer than others? To Sir Callum McCarthy: Yes. what extent do you think humans are able to make reasonable judgments to spot, if you like, the Q1433 Mr Todd: —which, if it is absent, certainly Northern Rock circumstance and say: “Well, I has an eVect on financial stability. would perhaps rather not place my money there but Sir Callum McCarthy: Yes. 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 Q1434 Mr Todd: But the primary aim of this does not, should the Financial Services Authority scheme I think was described as widows and not be providing that? orphans. It certainly extends to a lot more than Sir Callum McCarthy: First, unlike, say, the FDIC widows and orphans but the principle is of people which does have a pre-funding basis and where the of relatively modest means having their savings contribution from the diVerent institutions is properly protected so they need not worry about adjusted according to the assessment of risk given them, and providing a scheme which, for example, by the FDIC, we do not do that, partly because we encompassed the deposits of businesses or relatively do not have a pre-funded system. One would have wealthy individuals should not be an objective. Is to be quite careful about that process because it is that reasonable? not self-evident that one wants all the time to be Sir Callum McCarthy: Broadly I would agree with marking institutions up or down, and there would that. The basis is it is unreasonable to expect have to be a considerable degree of care in how any ordinary individuals to assess matters. approach was taken to that. Mr Sants: We might add that in making the Q1435 Mr Todd: Fair enough. Lastly, obviously a decision to go to the 100% of the £35,000 we were depositor protection scheme of this kind cannot reflecting a belief that it is probably unrealistic to protect against all possible circumstances of failure, expect the consumer to have the necessary and there is a recognition that if a very major information and ability to judge funding risk I financial institution failed then it would not be think possibly that would be asking too much of adequate to cope with that circumstance. How the consumer. I certainly think in our view it would should that be expressed? obviously be something we could discuss and take Sir Callum McCarthy: It is important that, even if views on as we go through the next stage of the there were a very large failure, people should know process, but our current thinking, and it certainly that the guarantee that they had received would be was behind the 100%, is that it is a little too met, but that essentially would have to be met in ambitious to expect the consumers to have detailed the last resort by Government. understanding of funding risk. Q1436 John Thurso: Prior to October this year the Q1430 Mr Todd: You do not think even a scheme would only cover 90% deposits between rudimentary information provision would be of £2,000 and £35,000. I understand the rationale for value? deciding upon an upper limit figure but I do not Mr Sants: I think that is highly debatable, to be understand the rationale for an intermediary band honest. We have discussed in this group before, of of only 90%. What is the rationale behind that? course, the complexities of the events that overtook Sir Callum McCarthy: The rationale was a view of Northern Rock, and I think a rudimentary the moral hazard and the importance of some description of funding issues might well cause degree of co-insurance, in a sentence. more issues. Q1437 John Thurso: Do you think it is appropriate Q1431 Mr Todd: I think I can appreciate that. We that the individual depositor at the under £35,000 had a discussion with two academics on the issue level should be obliged to partake in that moral of the role that depositor protection might have as hazard, given clearly the Government have decided a financial stability tool, and their view was since October that is not the case? Processed: 30-01-2008 11:07:36 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG7
Treasury Committee: Evidence Ev 155
11 December 2007 Sir Callum McCarthy, Mr Hector Sants and Ms Loretta Minghella
Sir Callum McCarthy: In answer to a previous Ms Minghella: It is not bust; it has not gone bust; question I explained that the background of the and we only levy for firms that we believe are likely introduction of this scheme started oV at 75% then to come our way for pay-out. went up to 90%. Originally it did not have any fixed element at all and if you look at the development Q1444 John Thurso: Do you think anything will of it you can see where it started from and where go bust? it has moved to. Ms Minghella: Based on our past experience we can anticipate a number of failures. We have since we Q1438 John Thurso: UK banking generally over took our power six years ago declared 1,800 firms the last 12–15 years has enjoyed a long run of very in default and, based on that pattern, we can strong profits, and it may be not for me to guess foresee— where the markets are going but there was reason to suspect they might be going into a cyclical Q1445 John Thurso: But none of those are major downturn. The compensation scheme appears to deposit holding banks? lack funds to do its job. Is that correct? Ms Minghella: Absolutely not, no. In the deposit Ms Minghella: The compensation scheme has a taking area we have only had 29 credit union very strong levying power, and it has been further failures, and that is it, and they are small. improved by the Financial Services Authority’s recently announced changes so that from 1 April Q1446 John Thurso: In your forecasts do you next year we will be able to levy £4 billion per year forecast that any major deposit taking institutions according to need. We are not constructed, the are up to fail? Statute does not allow us to be constructed, as a Ms Minghella: Not at present, no. pre-funded scheme, we can only levy on a pay-as- you-go basis, but the £4 billion a year we believe will enable us to deal certainly with a wider range Q1447 John Thurso: So in fact, if you come down of failures than we can now and will be suYcient to the major banks and the principal secondary to deal with the sort of failures we would banking institutions, you are not forecasting any normally expect. failures and therefore you are not going to be raising any funds, in fact? Ms Minghella: Not in advance, that is right, so we Q1439 John Thurso: That levy would normally levy according to need, and should the need arise have a degree of ex ante in it as opposed to ex post mid-year we would levy at that point. funding for the future? Ms Minghella: It will not be an ex ante levy mechanism because we will just levy each year for Q1448 John Thurso: Thank you for that. One of the failures we can see ahead on the basis of our the problems with the protection system or the forecasts. 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 Q1440 John Thurso: Can I just have a go at your unsecured and therefore take their chances crystal ball? What failures do you see ahead next following what the receiver or administrator will year that you are going to be raising money for? do, whereas that is a politically unacceptable Ms Minghella: We are in the process of preparing situation and therefore governments step in and our forecasts for next year at present— have schemes. Is there any merit in considering changing the legal status of depositors such that Q1441 John Thurso: But you are forecasting that they are in a secured creditor position so that it there will be failures and you will raise money? changes the balance of moral hazard? Ms Minghella: Yes, that is right, based on our past Sir Callum McCarthy: Clearly the Government experience and on the information available to us could, if it wished, change insolvency law. You at the time of the levy decision. If a failure were to would have to be very careful in approaching those occur that was not in our forecast we would levy changes because it would also change the relative for it at the time, and the industry would be obliged attractiveness of advancing money in other ways to pay our levy invoices within 30 days. for the funding of banks, and before making a particular change it is very important to consider John Thurso: That is such a wonderful minefield of V information that you have given us there that I do the overall e ect on the banking system. not think the Chairman would let me prosecute all of the possibilities – Q1449 John Thurso: The fundamental point here is Chairman: Try your best! 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 Q1442 John Thurso: One begins by saying was scheme or rescue always in place, so what the Northern Rock in your forecast? banking industry are asking us to do is to publicly Ms Minghella: No, it was not. underwrite that. If you change the structure of the law, you put that cost and that responsibility back Q1443 John Thurso: So what confidence can I have on to the banking system earlier in the process. in the forecasts you have got? Does that not have some merit? Processed: 30-01-2008 11:07:36 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG7
Ev 156 Treasury Committee: Evidence
11 December 2007 Sir Callum McCarthy, Mr Hector Sants and Ms Loretta Minghella
Sir Callum McCarthy: I would point out that it is have in America it necessarily makes it easier to not the case that all banks in all circumstances have take a decision not to save institutions. I think it been saved. I can understand the merit of the is still a diYcult decision. argument but I also think it has to be weighed Mr Sants: Indeed you could argue it might have carefully with the continuing need to make banks been the converse because, taking your earlier point attractive as institutions to either invest in or to that the Tripartite would have been more confident lend to. 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 Q1450 John Thurso: The Governor of the Bank of balanced call. England admitted that our system for dealing with insolvency of banks and depositor insurance is markedly inferior to all other countries. What Q1455 Chairman: What constraints does the changes could we make in particular to the release Deposit Guarantee Schemes Directive, Sir Callum, of depositor funds in the event of a bank failure impose on the design and operation of the UK that we could learn from other countries. scheme? For example, would a US style system be Sir Callum McCarthy: I would not agree with that permissible here if so desired? statement in comparison with “all” other countries; Sir Callum McCarthy: My understanding is that it I am not sure if the Governor intended it as such. represents minimum levels, and does not constrain us.
Q1451 John Thurso: I think he was selecting his Q1456 Chairman: Are any changes afoot on the countries. European Commission’s Deposit Guarantee Sir Callum McCarthy: I think there are certainly Scheme Directive that you are aware of? things we can learn from the US experience where Sir Callum McCarthy: Not that I am aware of, no. they have the ability to deal with a failure rapidly and in a way which enables them to take powers Q1457 Chairman: How should the UK deposit to deal with a failing bank. insurance system deal with the issues of home versus host regulation? Q1452 John Thurso: So you would share John Ms Minghella: The way it works now is that if a Bovenzi’s view that, had the UK had a system UK deposit institution were to fail it would be for rather like the US model of depositor protection, the UK as a home state to look after the depositors, the Northern Rock crisis could have been avoided not only the depositors in the UK but the in the UK? depositors of any EEA branch, and if a EU bank Sir Callum McCarthy: It would have undoubtedly from overseas passports into the UK, it is for the been of real help in preventing the retail run. 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 Q1453 John Thurso: The final question, if I may, a number of banks have done. That is basically the and it really goes back to what I was touching on, is way it works under the Directive. this. If we had had an eVective depositor protection scheme and a more suitable insolvency regime in Q1458 Chairman: Sir Callum, the Chancellor place at the time, would the Tripartite Authorities assured this Committee that the 100% guarantee simply have allowed Northern Rock to fail? And given by the Government to the depositors of maybe I should not ask the question “would” they Northern Rock did not extend to any other have, but “could” they have? Would it have been institution; rather “each case will be assessed on its easier? merits”. How credible is that assurance? Sir Callum McCarthy: I honestly do not know, I Sir Callum McCarthy: I see no reason to doubt it, am sorry. I understand the question but I am not Chairman. It was a statement made to you sure if I can deal with the hypothetical seriously by the Chancellor. circumstances. The issues that would have been involved would have been serious and I do not Q1459 Chairman: So it is 100% credible? know the answer, is the only truthful answer I Sir Callum McCarthy: I absolutely believe that the can give. Chancellor meant what he said.
Q1454 John Thurso: I am probably asking you to Q1460 Chairman: What a fine answer, Sir Callum! speculate, then, but do you think there are any I am asking you, is it 100% credible? Would those banks that are simply too big to rescue? very words have come out of your mouth, if you Sir Callum McCarthy: No. If you look at those were in that position, in other words? instances where there have been very big banking Sir Callum McCarthy: I should make clear that the failures, the Swedish experience, for example, only person who can make that guarantee of 100% people have been rescued on a very large scale. of deposits is the Chancellor, and that has always Going back to the other question, just thinking been the case. about it in terms of the US experience, I do not think the answer is self-evident, that if you had a Q1461 Chairman: We understand that, but I am deposit insurance and the insolvency regime you asking you, Sir Callum, is it credible? Processed: 30-01-2008 11:07:36 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG7
Treasury Committee: Evidence Ev 157
11 December 2007 Sir Callum McCarthy, Mr Hector Sants and Ms Loretta Minghella
Sir Callum McCarthy: I think it is. 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 Q1462 Chairman: 100% credible? adjustments? Sir Callum McCarthy: Yes. Sir Callum McCarthy: I think it holds but we have always been concerned to make sure that the Q1463 Chairman: What factors might make a distribution of risk is real rather than apparent, and Y financial institution less deserving of a 100% one of the things that is di cult is to make sure we guarantee than the Government assessed Northern can identify the channels by which that distributed Rock to be? risk may become reconcentrated. Sir Callum McCarthy: Sorry, Chairman, I am not Mr Sants: The other aspect that we have talked sure I am qualified to answer the question. 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 Q1464 Chairman: But you understand the focus of the regulatory community is clearly on the question? major transmission mechanisms to make sure they Sir Callum McCarthy: I understand it. If I were the are in good health, namely the core banks, and Chancellor I might have addressed my mind to it therefore it is important going forward that those but since I am not the Chancellor I have never core banks are operating in a very transparent way. addressed my mind to the question. 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 Q1465 Chairman: You are a lucky man, you are not the core transmission mechanisms are able to work the Chancellor. On the issue of financial stability, in a transparent way. Sir Callum, what are the financial stability implications of the shift we have seen towards an “originate and distribute” business model, and is Q1467 Chairman: I notice that Josef Ackermann, that irreversible? Chairman of Deutsche Bank, as a member of the Sir Callum McCarthy: I think they have very Institute of International Finance made the point substantial implications and they do not all go in that a number of structural problems need to be addressed and included in that: improved risk the same direction. First of all, the “originate and V distribute” model, as the shorthand suggests, it management, review of the role of o -balance sheet distributes risk much more widely, and that in itself conduits and special investment vehicles, the is attractive because it stops risk being concentrated valuation of complex products, the examination of in highly geared banks. The questions that go the credit agencies, and improved transparency. I do other way, which we have always been conscious not want you to go through every one of them, but of, as have other regulators around the world, is it is that a reasonably comprehensive list to you? makes it much more diYcult to identify where risk Sir Callum McCarthy: Those are the major items. lies. There are also two major questions that the “origination and distribute” model has to address Q1468 Chairman: And you would agree with those? more clearly than has been addressed: the first is the Sir Callum McCarthy: Yes. standards of underwriting by the originator, where Chairman: Good. failures in those standards have been one of the fundamental causes of the sub prime problems, Q1469 Mr Mudie: Would you please tell me what and, secondly, it is important that those who invest, the core transmission method means? those to whom the risk is distributed, understand Mr Sants: One of the key issues here is, if we are what they are investing in. It is clear that there has having disruptions in the financial system, is that been a degree of complexity of product which has going to then aVect the real economy, your been distributed, and not everybody who has constituents, the man in the street. From the bought those products properly understood them. regulatory perspective one of the key ways of Mr Sants: Just to add, if I may, and to develop that managing and assessing that risk is through making theme a bit further, what we are thinking is clearly sure that the mainstream banks which, as it were, the structure of the market place will change as sit on the interface between the financial system and reflected in your question, and that those complex the consumers, are in good health. The structures which were previously part of that transmission mechanism is another way of distribute model are not going to find favour with describing the large banks. investors going forward because of the issues we have seen. So we see a disappearance, or certainly Q1470 Mr Mudie: I suppose that answer deals with a significant diminution in the use of complex the bigger question of stability, but what about structures, but not necessarily a disappearance investor protection? What we have are securities altogether of a distribute model. It is more that the that were contaminated. I think some of the banks will have to think about distributing through bankers did not know what the hell were in them, clearer and simpler processes, so we see the model and they more or less said: “We were selling them, evolving but not disappearing entirely. But, of they were buying them, nobody was worried course, these are all crystal ball forecasts and it because we were all making money from them”. could go in other directions. Did you at the Financial Services Authority ever Processed: 30-01-2008 11:07:36 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG7
Ev 158 Treasury Committee: Evidence
11 December 2007 Sir Callum McCarthy, Mr Hector Sants and Ms Loretta Minghella
flag up, ever analyse, the various securities with a foresaw, the precise set of circumstances which view to saying whether you should be warning have arisen since, and that includes the liquidity investors about the possible risk? It is one thing to crisis. look at the wider stability but I am just thinking why were these allowed to pass through for such Q1473 Mr Mudie: I understand that, and we can a length of time without anybody in the Financial all be wise after the event. I am just asking, as Services Authority—well, perhaps you did. Did somebody in the street might ask, as a pension fund you? might ask, and maybe a pension fund with no great Mr Sants: Just to remind ourselves, of course, the resources because we heard last week about how buyers of these complex instruments are deep the analysis would have to be, how deep you institutions, not the consumer in the street. The would have to go in to see the make-up of these consequences, however, of that development of the things, and a lot of purchasers—even if they are not financial market has ultimately been to cause individual and are institutions—are not going to disruption to the consumer in the street— have those resources so they are depending on you, amongst others. What comfort can you give us in Q1471 Mr Mudie: But, Hector, just stopping you, the future? we had the pension funds in here and it was an Mr Sants: I think we were clear in our advice as to interesting session. What you are saying is: “Well, the risks inherent in complex derivative products, I blame the buyers”, but one of the things that I and we have made clear in a variety of our would take comfort from as a buyer is you. After publications, the complexity and potential liquidity all, the industry is paying a lot of money—not to risks that accrue to credit derivatives. What you personally but to the Financial Services obviously is the case is that on top of that, in Authority—to give that regulatory structure and addition to the liquidity point I have made, we have comfort. Now, your answer seems to be: “Well, you seen a failure with regard to the income stream should know better”. accruing from the US sub-prime marketplace Mr Sants: It is a two-part answer, actually, and which has then led to those securities falling that was the first part. It is the case, nevertheless, significantly in value. If you are asking whether we I think we should remind ourselves, that are placing ourselves in a position where we would institutions are meant to be sophisticated enough be looking to make all the commercial judgments to make good judgments, but having said that the that we think mainstream institutional investors Financial Services Authority and the Bank of should be making, no, we are not seeking to put England as well, have repeatedly over the previous ourselves into that position, but I do think in terms few years warned of the risks of the evolution and of a structural observation on the market we were the development of the credit derivative and related clear on the risks that the increased complexity in complex securities market, and a variety of our the marketplace was creating for institutional publications have highlighted those risks to the investors, but we placed the onus on them then to institutional investors— 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 Q1472 Mr Mudie: Let me take your latest one—we process here and the type of marketplace that the have a later one but it is less relevant—of January community is looking for. 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 Q1474 Mr Mudie: So, to bring that all together, a last financial stability crisis”. Nothing about the pension fund that finds itself losing money and individual securities. If you were regulating in a looking to you will find on record the clear parallel industry: say supplying blood, I would warning: “Be careful about these products”. want you to assure me if I were in hospital facing Mr Sants: About the inherent liquidity and a transfusion, that the regulation was working and complexity that these products—credit derivatives that the blood supply was not contaminated. This or related products—carry. is what is happening in terms of these securities. These securities were coming in bundled up to Q1475 Mr Mudie: It is all about transparency. Did avoid people seeing the real risk and the real you feel these products were transparent enough? original basis of the loan, and you were letting them Mr Sants: I think I have said before here— come into the market, traded, with people making money from them. Now, it is not that we are Q1476 Mr Mudie: Yes or no. Did you think these looking for you to say you made a mistake: we are products were transparent enough? looking for some comfort for the future. Did you Mr Sants: I think they are transparent enough to think, first of all, you recognised the dangers and, those who have the right level of competence and if you did, did you adequately tell the market about the time and the resource to look at them. I think the dangers? there is a risk that because they are highly complex Mr Sants: I think this takes us back a bit to the not all institutions have devoted the necessary time comments I made to the Committee earlier, that we and resources, and have chosen to make absolutely acknowledged and made clear in our last assumptions, be over dependent on the rating appearance that we did not foresee, and nor do we agencies, which has proved to be unwarranted and think any other market commentators or regulators inappropriate and not wise in the circumstances, Processed: 30-01-2008 11:07:36 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG7
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11 December 2007 Sir Callum McCarthy, Mr Hector Sants and Ms Loretta Minghella but in principle, if you choose to and you take the Financial Stability report in April, have you any time and you have the expertise, you can unpick evidence that the institutions that you regulate did these structures. anything to address the problems that you and the Bank had highlighted only months before? Q1477 Mr Mudie: Are you intending, are you Mr Sants: We certainly do have evidence that some working on, are you investigating, any fresh of the institutions were taking steps to manage their approach to these securities? Or are you lying in financial aVairs on the assumption that market the sand? Is that your industry? Are the Financial conditions would get more diYcult, yes. Services Authority doing anything further to give comfort that this sort of thing will not happen Q1481 Nick Ainger: “Some”? All? again? Mr Sants: Not all. As I mentioned before in the Mr Sants: Well, of course, as we mentioned before, July press conference we re-stated our concerns the market place will itself adjust as it does in the that we thought that not all institutions had event of circumstances— properly anticipated the possibility of an abrupt change in market liquidity and ratings, which I Q1478 Mr Mudie: I am asking about the FSA, think was a quotation from myself at a press though, Hector. conference at the end of July, so we have been Mr Sants: —but I think on top of that there are a concerned that not all institutions had properly variety of initiatives that the worldwide regulatory anticipated the possibility or the likelihood of a community— significant deterioration in credit markets.
Q1479 Mr Mudie: No, Hector. Again, Q1482 Nick Ainger: I asked a question last week “worldwide”. I would be very interested, because I of the investment banks that came before us, about think it is key, that the Financial Services Authority whether they felt some of them had been reckless should be operating worldwide, but what are you rather than cautious. In the spectrum between doing as the Financial Services Authority? reckless and cautious, do you think some of our Anything? financial institutions have been on the reckless side Mr Sants: Yes, indeed, and I was telling you that. of the spectrum? I was just making the point that as the Financial Mr Sants: If you define “reckless” as endangering Services Authority on our own we would not the corporate entity in a way which was identifiable generally be able to solve these problems as a and which could have been seen as probable by the national regulator. Having said that, we will take management, then that is not a statement I would the lead in and be fully active in looking at a be making about the mainstream institutions here number of the issues which includes the credit in the UK. rating agency point which has already been mentioned, which is an important aspect of Q1483 Nick Ainger: What has surprised me from providing the right information and a clear the evidence we had last week from the investment understanding of how those organisations operate; banks was their basic admission that they did not we certainly do have our initiative with our know the extent of the risk involved on the CDOs institutional community to encourage them to give they were trading. Surely that is reckless? If you are consideration to the lessons they can learn and the going to spend many, many millions, perhaps actions they should take; and we will also be billions, of pounds on these packages and you do obviously looking carefully around the issue of not know what the risk is, is that not reckless? transparency, which is a point mentioned earlier by Mr Sants: I do not particularly want to get drawn the Chairman, around these special purpose into commenting on individual institutions. In vehicles and related points. All those initiatives are general we have said that the UK large banking part of the list that was mentioned earlier, and we community, and as the Chairman has said this a will pursue those nationally and internationally number of times, it is well capitalised and has gone with vigour. into this downturn in generally good shape. We are talking here about our UK regulated banks. Q1480 Nick Ainger: Mr Sants, you have told us of the warnings that the Financial Services Authority Q1484 Nick Ainger: Mr Mudie was asking you gave, and also the Bank of England were warning questions about lessons that were learnt and so on. about the complexity of these packages. Specifically Do you think that you will now be regulating in January you say: “The financial markets have diVerently our financial institutions, particularly in become increasingly complex since the last financial relation to credit risk assessment and also liquidity, stability crisis, which implies a transmission of bearing in mind what has happened in the past mechanism for shocks, have also become more six months? complicated, and possibly more rapid. Market Mr Sants: Yes. There are two elements to that, as liquidity remains abundant, but it is still important we have touched on before. There is the question of for market participants to consider how they would ensuring at the coalface that our supervisory teams operate in an environment where liquidity is rigorously pursue our current framework, which restricted”. Remarkably prescient, if I may say so. already includes a requirement for comprehensive Between that warning that you gave in January and and eVective stress-testing by institutions, and the warning which the Bank also gave in its specifically with regard to Northern Rock we have Processed: 30-01-2008 11:07:36 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG7
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11 December 2007 Sir Callum McCarthy, Mr Hector Sants and Ms Loretta Minghella mentioned here before that we think it is a matter their appearance, is to measure credit risk as we should properly review and publish the opposed to liquidity risk, and it is important that conclusions of in March, but I think it is reasonable is done in as comprehensive and transparent way to say that a more rigorous on-the-ground as possible and ideally in a way which is easily supervisory engagement could have been made. understood by investors and allows people to have Then there is, of course, a wider question. I think confidence in similar methodologies being used by you have to take a global perspective, of this all agencies, so I think the first group of points talk unusual set of events in the round. It is right and to that aspect and we fully support that. We are proper that we should also then be looking at that part of IOSCO, as you know, which has recently liquidity regime and seeing how we should introduced a code of conduct for credit rating modernise and learn from the experience in the last agencies and we are very active in encouraging few months. We are committed to publishing a IOSCO, which I am sure they will do, to revisit that discussion paper shortly on the issue of liquidity code to look at exactly those sorts of issues. The framework, both looking at the national element of fifth point is an interesting point in that clearly an it and the international element, which will be out element of the problem that has occurred here has before the end of the year, and we will engage in been institutional investors choosing to use a rating a rigorous debate with the community in terms of agency’s process as a shorthand way of potentially improving the framework. evaluating liquidity as well as credit, and that has not been helpful and is not, indeed, what the Q1485 Nick Ainger: That is in relation to liquidity, agencies were intending their measurements to be but what about credit risk assessment? Is that a role addressing, so it does open the question, given you should be playing as a regulator, do you feel? liquidity is clearly as important an issue as credit, Looking at the particular performance of some of and in the current circumstances more important these institutions some have acted quite markedly though it can depend on the set of circumstances, diVerently from others in their exposure to these should they not also be bringing forward liquidity risks. measurements. We know from our conversations Mr Sants: It is already part of our framework that with them that they are considering it; it is quite institutions obviously should have a proper complicated; so I think what I would say about that controlled framework which includes a proper fifth point is, if it could be done in a way that was credit control framework and an analytical credible and robust and simple to understand, then approach. We will obviously continue, as I think that would be a good idea, but I think we have to we already do, to have that as a key focus of our leave it to the agencies to see whether that is really regulatory engagement. I have made the something they can deliver, and to be fair to them observation already with regard to the large UK they are commercial organisations and they have to also decide whether that is commercially banks headquartered here in the UK that they are V well capitalised at the current time, but clearly that worthwhile o ering to make. But it is vitally is an area of supervisory focus and needs to important going forward that people understand continue to be so. Just to be clear, we do also think the limitations of the service that a credit rating we should engage with the credit rating agencies, agency delivers, and do not use it as a shorthand who are a key part of that mechanism by which way of avoiding their obligations to look properly people make credit judgments. at the structures and the risk they are taking on.
Q1486 Mr Dunne: That leads very nicely to my Q1487 Mr Dunne: You also identified the conflict question. We had the credit rating agencies in front of interest that the issuer pays the agency who of us last month and you have just made the point provides the rating. Do those proposals help to you would need to engage with them. Could you address that problem? give us your views on the Bank of England’s five Sir Callum McCarthy: Just before we deal with proposals which they think should be considered in conflicts of interest, could I reinforce what Hector relation to the credit rating agencies, and I can said? One of the comments I think made correctly remind you what they are if you have not got them is that people have relied too much on the rating at your fingertips. The first was that they should agencies rather than doing their real analysis of publish expected loss distributions of structured whether “This investment is something that I products to illustrate the tail risks surrounding understand”. It is somewhat ironical that one of the them; secondly, that they should provide a responses is to try and seek from the rating agencies summary of information provided to them by the even more work and even more assessment not just originators of structured products; third, that they of credit but of liquidity, and I, like Hector, think should provide probability ranges for scores on that is an idea that has to be subjected to a lot of probability of default; fourth, that they should thought before simply signing up to it. adopt the same scoring definitions between them; Mr Sants: On the matter of conflicts, obviously it and, finally, that they should consider scoring other is a conflict and that is an uncomfortable position aspects of the products such as liquidity, stability for those organisations to be in and, as regulators, and so on. when we see a conflict we rightfully are concerned Mr Sants: The first four are eminently sensible and as to what consequences might flow from such a are all around the point that the principal purpose conflict. The conclusion that has been reached in of the credit rating agencies, as you will know from the past, and at the moment there is no reason to Processed: 30-01-2008 11:07:37 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG7
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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 Sir Callum McCarthy: I suppose the risks would be without that model the credit rating agencies would the same risks that would apply to many be able to continue to thrive commercially and institutions: an abrupt decline in the asset values exist, so we are in a position where that conflict has or—yes, I think that is probably the biggest risk. to be managed rather than removed because if it was removed the service probably would not exist Q1493 Chairman: When did you last look over the as well and we do need to be pragmatic. But I think books of Northern Rock, or are you doing that we need to revisit again, and that is part of the right now? IOSCO initiative that we just referred to, whether Sir Callum McCarthy: I am not quite sure what you or not we are addressing conflict management as mean by “look over the books”. We are not rigorously as we should. auditing Northern Rock but we have detailed certainly weekly, if not daily, discussions with Q1488 Mr Dunne: Briefly, you touched on the Northern Rock. international ramifications of this global crisis and increasingly internationally sophisticated Q1494 Chairman: What role is the Financial organisations. The EU Commissioner was here last Services Authority playing, if at all, in facilitating week—not before this Committee—and said there a takeover of Northern Rock? are 45 banks with cross-border activities engaged Sir Callum McCarthy: Our principal responsibility, in Europe, and the challenge for the regulators is when there are particular bidders for Northern determining who takes responsibility if one of these Rock, is to make sure we subject them to the major cross-border organisations fails. What role is normal regulatory challenges and we are doing there for a supranational regulator, or the IMF or that—that is the question of change of control as some other such body, to help with bank far as a change of control is concerned, supervision? authorisation of individuals, and a view of any Sir Callum McCarthy: I do not believe that is the proposal and whether it meets our threshold right solution. There is a major task to identify the conditions. responsibilities and rights of home and host supervisors for these major institutions, and we Q1495 Chairman: How would you respond to the have set out our views on and we are working suggestion that a false market has developed in the closely with other regulators and central banks to shares for Northern Rock? try and find practical solutions. I do not believe the Sir Callum McCarthy: We do not believe that a right answer is to move towards some form of false market has developed. We believe there are supranational supervision. considerable uncertainties which account for the sometimes very considerable variation in the UK, Q1489 Chairman: Sir Callum, I believe there is an both in the volume of trading and in the share individual designated as a grey panther at the price, but we do not believe that any of the Financial Services Authority for banking asset conditions that are necessary to be met for us to management insurance and markets, and that suspend trading have been met. individual is on the Challenge Panel preparing Mr Sants: Volatility is, in itself, not a reason for supervisors for Arrow visits. Is that correct? suspension. Sir Callum McCarthy: There are a number of grey panthers who do the things you describe. Q1496 Chairman: Some suggest that there is a case for a new team to run Northern Rock as soon as Q1490 Chairman: And they ask questions like: possible, and that changes need to be made with “Are you supervising the right area? Are you asking speed. Mention has been made regarding the right questions?” Given what happened to the nationalisation. Do you see any merit in Northern Rock share price earlier in the year, nationalisation being used to break the log jam? In should that have flashed a red alert with the other words, to stop any parties being a legal Financial Services Authority and taken Northern impediment and have legislation in the House of Rock out of the normal procedure of Arrow visits? Commons, and indeed the House of Lords, over Sir Callum McCarthy: One of the matters we are the period of a couple of days with a new team looking at in terms of the examination that is being already identified, so they can get on with the done of how we supervise Northern Rock up to the business of reviving this institution? time when these risks crystallised, is to answer Sir Callum McCarthy: We have at the moment, questions exactly like that, but overall I do not Chairman, two proposals which do not depend on think that we paid enough attention to various that, and it is important that those two proposals signs. are investigated and pushed through to find out whether they will work or not before intervention through legislation. Q1491 Chairman: Is Northern Rock still solvent? Sir Callum McCarthy: Yes. In our judgment. Q1497 Chairman: I understand but if speed is not of the essence here then we could find ourselves Q1492 Chairman: What risks are there to the with further problems, so would you say you have continued solvency of Northern Rock? any sympathy with the notion of having Processed: 30-01-2008 11:07:37 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG7
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11 December 2007 Sir Callum McCarthy, Mr Hector Sants and Ms Loretta Minghella nationalisation to ensure over the period of a day Q1504 Mr Fallon: Will that include the possibility or two that we get everything up and running of somebody else supervising liquidity? quickly? Sir Callum McCarthy: No, this is to do with the Sir Callum McCarthy: I agree that speed is highly question of how the FSA discharged the desirable. That is why we would like to be in a responsibilities it had up until August 2007. position so that the board and the Government can, as quickly as possible, come to a view on one Q1505 Mr Fallon: I thought we were pretty clear of the two proposals that are on the table, and it now that you did not discharge your would be better to see whether those can be responsibilities. We have had the worst banking advanced before discussing nationalisation, or any crisis for 140 years. Somebody failed. legislation. Sir Callum McCarthy: I repeat, we are looking at the lessons that we are going to learn. Q1498 Chairman: It is not oV the table, perhaps? Mr Sants: We have already said quite clearly that Sir Callum McCarthy: I think the Chancellor made we think the supervisory process with regard to clear that everything remains. Northern Rock in the period prior to July should have addressed the liquidity issues through more Q1499 Chairman: Within the public sector, where aggressive engagement around the question of are the resources needed to manage a nationalised stress testing and ensuring that the board, whose bank in the interests of taxpayers and consumers? primary responsibility is ultimately to run the Sir Callum McCarthy: If that eventuality occurred institution, fully understood its business model and it would be necessary to find a team to do so. 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 Q1500 Mr Fallon: Sir Callum, if Northern Rock to ask the questions as to why that did not take cannot find the funding it needs to finance its place and what lessons should be learned from that. operations without nearly £29 billion worth of That is about our application of our regulatory support from the taxpayer, how do you still regime as it then was. There is then a second describe it as solvent? question as to whether or not the regulatory regime Sir Callum McCarthy: Because we have looked at should be modified which will be looked at through the assets it has and the demands on those assets the combination of the liquidity discussion paper and believe that those assets meet those demands. and, of course, if there are any issues relating to the The amount that has come from the taxpayer is tripartite review, that will be handled through the secured against the assets of Northern Rock. tripartite review. We are in no way not acknowledging the fact that our supervisory Q1501 Mr Fallon: But if it is not able to finance its engagement with Northern Rock prior to July future liquidity, how can you regard it as solvent? should have looked into these scenarios and it Sir Callum McCarthy: Because there is a distinction would appear on the reading of the file to date not between liquidity and solvency. to have done so. 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 Q1506 Mr Fallon: If you were charged with England. 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 Q1502 Mr Fallon: But you still think it is solvent? the bank? Mr Sants: Yes. In clear accounting terminology, Mr Sants: I think we need to look at a couple of threshold conditions is regulatory terminology and points here and they will come out in the review. we have answered the question. There is a question as to whether or not the overall regulatory proposition is in some way flawed and Q1503 Mr Fallon: Yes. I think you have also in addition whether the narrow engagement of that explained to us exactly what has been happening. group of supervisors with that institution not You have said there are regulatory lessons to be properly discharged. It would be wrong to prejudge learned here and you are going to publish a the conclusion of these various reviews, but my discussion paper on liquidity. Is that right? preliminary thoughts would suggest that the Sir Callum McCarthy: No, there are two quite approach we were taking in terms of emphasising diVerent things and let me explain what they are. stress testing in principles-based regulation was One is a paper on liquidity as a general set of issues right. I do not think that events here undermine the and, as Hector said, we plan to publish a discussion basic regulatory philosophy of principles-based paper on that before the year end. The second and regulation, the crux of which is about asking quite diVerent aspect is that we have undertaken to management to take responsibility for the do a review of the way in which the FSA discharged outcomes and consequences of their decisions and its responsibilities in relation to Northern Rock you could well argue here that is something the during the period up until August and we have board should have been doing more rigorously undertaken to do that and publish the results of than it was. I do not think the philosophy of that in March and that is not a discussion paper, regulation is undermined here, there may well be it is a quite forensic investigation. questions, I think there are questions, as I have just Processed: 30-01-2008 11:07:37 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG7
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11 December 2007 Sir Callum McCarthy, Mr Hector Sants and Ms Loretta Minghella indicated, about the particular engagement with That test is that a business can meet its obligations this particular company. As to the question of within the normal course of its business and whether or not it would have made any diVerence therefore looking forward, including in Northern if administratively those supervisors had reported Rock’s case, of course, the repayment of £25 to 29 to the bank rather than to the FSA—Sir Callum billion—whatever it is—of taxpayer’s money, and I may wish to comment—I do not think there is any understand that is in place until February, do you, evidence at all if the reporting line of that therefore, believe at this moment in time that supervisory department had been moved that Northern Rock is solvent on the basis that it can would have made any diVerence to the set of meet all its obligations within the normal course of circumstances which transpired prior to July, nor its business, including that taxpayer’s loan to it? would it have made any diVerence to the Sir Callum McCarthy: The answer is yes. We would information being passed over to the relevant part not deem it solvent unless we believed it could do of the bank with regard to monetary operations that. The fact that it is getting liquidity from the during the course of August and September. Government is undoubtedly the case and without Sir Callum McCarthy: Could I just add one point, that liquidity the bank would have failed. which is I think that the idea of transferring banking supervision separately from insurance and Q1510 Mr Breed: It is totally dependent upon the security supervision is an idea that has severe Treasury contribution which lasts until February disadvantages. according to the Chancellor. By February, when the taxpayer may expect to have all its money back Q1507 Mr Fallon: It is a pretty severe disadvantage which would be in the normal course of its current with the background and all the damage we have business, you expect that to happen which is an seen to British banking as a result. You seem to be assessment therefore of its solvency today? simply defending your empire. The supervision of Sir Callum McCarthy: No, I do not think we are liquidity was done perfectly well by the Bank of necessarily saying that we believe the taxpayer will England until you started it in 1997. have all the money which has been advanced Sir Callum McCarthy: People can have diVerent returned by February because I think if you look views on the ability of diVerent supervisory regimes at the Chancellor’s statement he said February or historically. I would point out that if you look at the time at which other events have been reached. the problems that the events have caused, they have It is clear that the Treasury, in discussions with the caused severe problems in Germany, where bidders, has been prepared to discuss timetables for banking supervision is shared between BaFin and repayment which go beyond that. All that is in the the Bundesbank, so the idea that making bank public domain, I am saying nothing new. supervision the responsibility of the Central Bank is the answer to these is not necessarily supported Q1511 Mr Breed: You consider that suYcient to by the facts. consider that Northern Rock remains solvent? Sir Callum McCarthy: We do believe that Northern Q1508 Mr Fallon: You think you are still the best Rock remains solvent. people to supervise banking liquidity? Sir Callum McCarthy: I believe that it is impossible Q1512 Mr Breed: Could I ask finally then, when is to take the question of banking liquidity from Northern Rock’s next trading statement to be overall supervision. There are questions, as Hector published? has absolutely indicated, about whether we did that Mr Sants: The next trading statement would come suYciently well, but I do not believe you can take with the final results. bank liquidity supervision from other aspects. Mr Sants: Also you have to ask the question, what Q1513 Mr Breed: Is there not one due in the middle particular benefit do you think would accrue from of December? aligning a supervisory group with a money markets Mr Sants: That would be its pre-close and then it management group; a central banking liquidity would have to make a full statement by the spring. function? There is no particular evidence that the issue with regard to Northern Rock would have in Q1514 Mr Breed: We are now 11 December, so any way been changed by that alignment. I think within the next few days you would expect you do have to ask the counter-factual question Northern Rock to produce an interim trading what is it you think would have been brought to statement? this issue that was not brought to the issue as a Mr Sants: Coming back to the quoted company result of making that organisational change. point you have just made, I think it is clear to investors that without the support provided by the Q1509 Mr Breed: Could I return to your view on Bank of England at the current time then Northern the solvency of Northern Rock. I think you said Rock would not be able to continue in its current that there is a diVerence between solvency and form. There has to be a presumption, as Callum liquidity. Of course, one of the tests of solvency is has already laid out, that support would remain in all to do with liquidity and, indeed, the vast place unless an alternative mechanism can be put majority of businesses that go bust go bust because in place, to justify continuing the meeting of the they have not got cash, not because they have not threshold and conditions, and that analysis is got assets, so liquidity is a fundamental of solvency. correct. In a narrow sense we are clearly dependent Processed: 30-01-2008 11:07:37 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG7
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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 Q1520 Mr Dunne: If Northern Rock is assertions we have made and that is absolutely nationalised, will Granite have to be nationalised right and any statement by the company will have too? to reflect that. Sir Callum McCarthy: I am sorry, it is a hypothetical question and I do not know the answer at all. Q1515 Mr Breed: Just to repeat, you are expecting Mr Sants: Granite is, as you know, an on-balance the company to make its interim trading figures sheet vehicle in that sense. I know the obligations available by the middle of this month? which are carried by Northern Rock to Granite Mr Sants: It would make a pre-close statement and would have to be carried through the then a statement after the end of the year. nationalisation process, I would imagine.
Q1516 Mr Breed: You are expecting that to Q1521 Mr Dunne: That would survive? Events of happen? default would not be triggered or it could be Mr Sants: In order to fulfil its listing conditions it organised so they did not trigger through a will have to so do. nationalisation, do you envisage? Sir Callum McCarthy: It is diYcult. It would Q1517 Mr Breed: If it does not, then its listing depend on the details of the Granite trust. might be in jeopardy? Mr Sants: It would depend. I have a view, but I am hesitant to express a definitive view. I could Mr Sants: Its listing could be in jeopardy. send you a note on it. I am pretty sure that it could be organised in such a way, but I hesitate to be Q1518 Mr Dunne: With hindsight, should the absolutely definitive. lender of last resort facility have been extended to Mr Dunne: If you could send a note, that would be Lloyds TSB in order to have allowed a private appreciated, Chairman.34 sector solution? Y Sir Callum McCarthy: I think it is very di cult to Q1522 Mr Brady: When we took evidence from form a judgment on that because, as I think I said Northern Rock it was not readily suggested that last time I was before this Committee, it was not the first contact specifically about the liquidity quite as cut and dried as I think it has been problems between the FSA and Northern Rock suggested that there was a complete proposal on was initiated by Northern Rock and not by the the table. It was the case that it was made clear FSA. I think, Mr Sants, you were interviewed for slightly later than that that the facility which had V V the File on Four programme. You gave the opposite been o ered to Northern Rock would be o ered to answer and said it was the FSA that initiated other bidders, ie they could take advantage of it, Y that contact. but it is a di cult set of circumstances to take a Mr Sants: Sorry, I have got a very bad cold. I view on even in hindsight. actually could not hear the question.
Q1519 Mr Dunne: You just explained that you do Q1523 Mr Brady: Who first contacted whom not believe it would be appropriate for liquidity regarding the liquidity problems at Northern supervision to be separated from regulatory Rock? Was it the FSA contacting Northern Rock supervision and the regulatory supervision restored or vice versa? to the bank. Do you think there is an alternative Mr Sants: My understanding of the events—I scenario in which the liquidity supervision should think, as always in these things, it is a question of be brought into the FSA so it is brought under a how you perceive them—from our point of view, common roof? we contacted them first in the sense that, just to be Sir Callum McCarthy: No. There is a question clear, we always understood the funding model of about whether the only route providing finance Northern Rock, as I think I have explained before, should be via the Bank of England or whether the so from the moment that market conditions Government should have other agencies that it deteriorated and we set up our special process from could use. I think that is something which is a 10 August and so forth, if you remember the earlier possible route. I should make clear that I am not discussion, we were proactively engaging with the arguing for the FSA to have a very large balance firms that we perceived as carrying risk and that sheet. That is the last thing I want. includes Northern Rock. Northern Rock may have Mr Sants: We obviously have a mandate to been answering the question in the sense that facilitate private sector solutions and, as was clearly, as the company, it would be their judgment demonstrated by the retail bank point you just as to when they had a serious problem, so in that made, you could argue that is a diYcult mandate sense they might have rung us and said, “We now to discharge when the FSA has no locus with do oYcially think we have a serious problem”, but regard to providing funding with regard to from our perspective we were contacting and institutional specific situations. That is a question proactive with Northern Rock as an at risk firm that could be reasonably considered but, as the once market conditions had deteriorated from 9 Chairman indicates, there are diVerent ways that mechanism could be considered. 34 Ev 227 Processed: 30-01-2008 11:07:37 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG7
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August. I believe, as I said on the programme, that and something which very little could be done we were proactively engaging with Northern Rock about at all, which was the physical layout of the and that was the case. branches. One of the problems in these circumstances is because of anti-money laundering Q1524 Mr Brady: That dated from 9 August? requirements, if somebody comes in and says, “I Mr Sants: I think from 10 August actually. wish to withdraw £20,000”, it takes something like Sir Callum McCarthy: Could I make a distinction a quarter of an hour to go through all the necessary between after the events crystallised on 9 August steps. If you have a small branch with two and before I think it would be a misleading counters, you only need ten people and you have impression to suggest that the first time we had ever a queue. There was a whole series of things that discussed liquidity, those issues, stress testing, was were diYcult, some of which with more favourable 9 August. timing we could have overcome; some of which we Mr Sants: Yes, I did not think that was the could not. Also, I think in retrospect it would have question. I think I made clear earlier that in July been better to have emphasised the positive aspects we had already started to point out to the firm, rather than the negative aspects of lender of last recognising that we could have been doing this resort. before, that we were very unhappy with their stress testing scenarios and asked them to do “further Q1528 Mr Brady: Did the FSA advise the distinct liquidity tests and scenario tests” and give Chancellor that there should be the guarantee put greater consideration to the impact of accelerated in place at the same time as the lender of last resort? cash flows from a trigger event in a liquidity crisis, Sir Callum McCarthy: No, we did not, nor did so that communication was already taking place anybody else, nor would I have wished to have with them in July and that was proactively initiated given that advice because it would clearly have been by us. better if the lender of last resort facility had been put in place and had worked without a general Q1525 Mr Brady: What advice did the FSA give guarantee. to the Chancellor about the need for an immediate depositor guarantee after the lender of last resort Q1529 Mr Brady: Again, I think I am quoting operation was leaked? correctly from the File on Four programme, Mr Sir Callum McCarthy: The announcement was Sants, on this subject you said—I think this refers made on the Friday and, as you say, it was leaked to the FSA and the Chancellor collectively—“We on the Thursday night. Over the weekend there was obviously had made the judgment that it wasn’t an a series of conversations with various Treasury announcement we wanted to make at the same time oYcials and the Chancellor in which the need to as the facility”. That implies this was at least give an explicit government guarantee was discussed. discussed and the decision was taken on the Mr Sants: To be fair, I think this particular Monday afternoon. programme is an edited programme, not a live programme, so I am not sure I can particularly Q1526 Mr Brady: What advice did you give? recall the question to which I was responding or, Sir Callum McCarthy: The advice was that if the indeed, can be sure from the transcript what the run that was taking place continued, the only way question was I was responding to. I was not of stopping it was an explicit government involved in everyday conversations with the guarantee. Chancellor but I concur with the analysis the Chairman has given. I do not think we specifically Q1527 Mr Brady: Could I also then ask about the gave any advice with regard to the 100% guarantee advice that was given prior to the leak or the prior to the news breaking. announcement being made. The Governor has pointed out there was no easy way to predict the Q1530 Mr Brady: As you say, the programme is response of the customer, but is it not really edited but in the transcript I have got in front of common sense that in those circumstances without me, your actual words in response to this point 100% guarantee there would be a state of panic were: “We certainly discussed the possibility, but created? we obviously made the judgment that it wasn’t an Sir Callum McCarthy: No, I do not think it was announcement we wanted to make at the same time obvious. I think that a whole series of things as the facility”, so it was the possibility of it. conspired. It was extremely unfortunate that the Mr Sants: My recollection of the discussions, I information leaked because it meant that instead of have to say these were not specifically with the this being put in place as, “This is a solvent Chancellor, was that they were about alerting the institution which has a cash flow problem and the FSCS i.e. we were talking about the way in which Government is stepping in to make sure that it is this announcement would interact with the saved”, it became a panic measure or a response to compensation scheme. We were, of course, aware something that was already in the making. Panic of the limitations of the scheme and, indeed, as we was how it was seen. I think that it was unfortunate said before in our consultation paper, which was a that the administrative arrangements within precursor to the changes we have announced, and Northern Rock were not better developed, both in the Chairman mentioned at the beginning, we made terms of the Internet access which was inadequate clear the scheme was not structured to address a Processed: 30-01-2008 11:07:37 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG7
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11 December 2007 Sir Callum McCarthy, Mr Hector Sants and Ms Loretta Minghella large scale failure in the banking system. This is the supervising the Bank of England or any subsidiary point we had already made in public. What I was of the Bank of England, so if an institution became seeking to reflect in that comment, I believe, from a subsidiary of the Bank of England, we would not memory, was the fact that we had been talking supervise it. If it were a freestanding, if I can use about those issues, but we had not given specific that expression, nationalised bank, we would advice as to whether the matter should be supervise it. addressed prior to the announcement. Q1536 Jim Cousins: Is this something that has been Q1531 Mr Brady: You did not give advice one way discussed by the tripartite committee, how its own or the other? workings would be aVected in the event of the Mr Sants: Not personally to my recollection, none nationalisation of a bank? of us did. Sir Callum McCarthy: I am not aware of any Sir Callum McCarthy: My recollection is that the discussions. I have not taken part in any question of the guarantee only arose after the discussions. I am not sure if there have been any. queues began to develop. Mr Sants: I am not aware of it in the way I think you are asking. The Chairman has already Q1532 Mr Brady: Yet it was discussed before that? answered in terms of understanding the supervisory Sir Callum McCarthy: Hector has explained the framework, but in terms of the specific tripartite context in which he made that remark. question, I am not aware of any discussions. Mr Sants: The compensation scheme was discussed beforehand. The issue of 100% guarantee was Q1537 Jim Cousins: You are obviously aware, Sir certainly not discussed at the principals’ level. I Callum, that there is a campaign to downgrade the think I may have some vague recollection of it value of the assets in Northern Rock and force it being mentioned by some working group into nationalisation, that campaign has been in discussion, but that is the extent of it. front of the Committee this morning. What regulatory consequences do you think there would Q1533 Mr Brady: Do the Tripartite Authorities be if one of the members of the tripartite committee have a communication strategy for coping with a itself became the owner of a bank? bankrupt? Sir Callum McCarthy: Sorry, I should make clear Sir Callum McCarthy: I would say a better one now that I do not understand the reference to than we did some time ago. downgrading the assets. 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 Q1538 Jim Cousins: I am not suggesting you have way the Tripartite Authorities communicate done that. around these types of issues, both the terminology Sir Callum McCarthy: I am not sure in terms of the tripartite arrangements if there were a nationalised and the way we handle the release of the news. We V have already started to learn from those lessons and bank whether that would have very great e ects on continue to so do. the tripartite arrangements overall.
Q1534 Mr Brady: One final point. If I could come Q1539 Jim Cousins: If a nationalised bank were to back to Ms Minghella. How involved were you at seek to wind up its operation rapidly by selling its the time all of this was going on and how confident, assets in the market in a short time frame, would in particular, were you that the FSCS could cope that be something that would come before the with the failure of Northern Rock had that tripartite committee? happened? Sir Callum McCarthy: Were there a nationalised Ms Minghella: We were not involved in August bank, whoever was running that nationalised bank with the discussions with the Tripartite Authorities would have responsibilities, it would have when they were going on. We became aware of the responsibilities presumably under the Act of problems of Northern Rock in particular in Parliament that had led to the nationalisation. In September. I think a point that has been made terms of the FSA’s regulatory responsibilities we earlier with Mr Todd was that we were not would be concerned, as with any institution, about designed to deal with a failure of this size, so it was systems and controls, adequate management, all not a surprise to us that these discussions had been those things, but it would not be for us because we going on in advance of our being informed. By the would not be the shareholder—the shareholder time we found out the lender of last resort facilities would be the Government in some form or other— were already in mind and that seemed to us to be to decide on the commercial strategy of that appropriate in the circumstances. institution.
Q1535 Jim Cousins: Sir Callum, if a bank were to Q1540 Jim Cousins: But in your discussions at the be nationalised, how would that aVect the workings tripartite committee if you did have concerns, you of the tripartite committee? would be expressing them in front of other parties Sir Callum McCarthy: I think that it would depend who might themselves be the owners of the on who was the owner of any nationalised bank institution whose management you have some because we do not have responsibility for question about. Processed: 30-01-2008 11:07:37 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG7
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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 Sir Callum McCarthy: Could we come back? of these are hypothetical circumstances, but you should assume that we would discharge our Q1544 Chairman: Definitely. Karin Forseke, a non- responsibilities with the same independence that we executive member of the FSA board, was a CEO of adopt towards any institution for which we have the Swedish investment bank Carnegie until March responsibilities. 2006. The Swedish regulators found that Carnegie’s 2005 and 2006 annual reports presented incomplete Q1541 Jim Cousins: One of the issues, looking back information and punished the company with the over the Northern Rock aVair, is the failure to maximum financial penalty, also insisting on anticipate things. Now I am not myself going over multiple board changes. In these circumstances, that ground, the Committee has gone over that have you considered whether it is appropriate for ground. The issue of nationalisation is not now a her to remain a non-executive member of the theoretical one, it is something that is being actively FSA board? advocated by a large number of influential people. Sir Callum McCarthy: Yes, Chairman, I have Are you really telling me that, yet again, we have considered it very carefully. I discussed the matter a failure to anticipate consequences and that there extensively with the Swedish financial regulator and has been no discussion either at the FSA or at the took advice on the report and at rather tripartite committee as to how the regulatory considerable expense had the report, which is only system we have for banks would be aVected in the in Swedish, translated into English so we could event of a bank nationalisation? I find that look at the evidence in detail and formed a view, extraordinary. which I formed after consulting the past and future Sir Callum McCarthy: I would say that I do not Deputy Chairman of the FSA, that it was find it extraordinary. I do not find it extraordinary appropriate for Karin Forseke to remain a because at the moment we have got two proposals member. 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 Q1545 Chairman: As a Committee, we visited convinced that were there a nationalised bank what Sweden in the last couple of weeks and we read the are the real problems that this would present for regulatory report in English, so it was no problem the tripartite arrangements. If there were significant for us, but it was quite a censure that the regulator ones we would deal with them, but I do not think gave. In the light of your answers, I think for the that I am convinced there would be diYcult public record I would like you to write to us on this problems. the issue in detail as to why you have confidence Mr Sants: To your point, we are clear—the in her as a non-executive director and the reasons Chairman has answered the question—what our for that. Sir Callum McCarthy: I would be delighted to, regulatory responsibilities as the FSA would be for 35 that entity and it would be our role to discharge yes. those in our capacity as an independent agency, so I think we are clear about our regulatory Q1546 Chairman: Last question. Do you think that responsibilities, there should not be a either you as the regulator or the market have a misunderstanding about that. proper understanding of the size of the tail risk in money or credit markets? I say this in light of the Q1542 Jim Cousins: The Governor and you, Sir evidence that we have looked at from Paul Callum, would look the Chancellor in the eye, if he Ormorod and Bridget Rosewell. were to find himself the owner of a bank, and raise Sir Callum McCarthy: I think the analysis of tail criticisms about it? risks is an extraordinarily diYcult issue. By Sir Callum McCarthy: If there were a question, for definition you are saying that you expect events example, of inadequate systems and controls within which happen very infrequently, that is what you a nationalised bank over which we had supervisory are examining, and anybody who claimed they had responsibilities, I would have absolutely no a full understanding of the risks associated with tail diYculty in doing what you suggest. risks would be open to appearing misleading. Mr Sants: I do not think it is possible to have a Q1543 Chairman: Sir Callum, a couple of final full understanding of tail risks. questions. In 2006 Northern Rock appointed Rosemary RadcliVe, a former partner of PwC, to Q1547 Chairman: We understand that, but what their audit committee and their auditors last week they are saying is a gap between the Bank of mentioned that they raised concerns about this but England’s base rate and the three-month Libor is withdrew them following the receipt of what they an indication of unusual conditions in the market called an “explicit clearance” from a regulator. and really their conclusion was it should not be Were you the regulator involved and, if not, did assumed that the historical data on this gap follows you express any views on the matter? a normal statistical distribution as many have done. Sir Callum McCarthy: I think no views were Are you alert to that and, for instance, is there expressed on the matter. some justification in suggesting that the tails of the Mr Sants: I think we were the regulator involved, but I know of no views being expressed on that. 35 Ev 266 Processed: 30-01-2008 11:07:37 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG7
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11 December 2007 Sir Callum McCarthy, Mr Hector Sants and Ms Loretta Minghella distribution of spread between the three-month statements we made in the earlier part of the year Libor and the base rate may be fatter than which are even more appropriate now than they conventional analysis might suggest? were, that firms need to seek to run full scenario Sir Callum McCarthy: It is certainly the case that tests, understand the circumstances under which there has been a very substantial divergence their business models have come under pressure between the three-month Libor and the bank rate, regardless of whether or not that type of modelling that is manifest in the UK, the Eurozone and the looks particularly probable from a tail risk United States. It is exacerbated at the moment by analysis. They should run their businesses to take the year end pressures, so that is undoubtedly the into account those risks and, as we said earlier, we case. do not feel that it was the case that all institutions Mr Sants: It is also undoubtedly the case with were taking that approach to risk management in regard to financial markets, as others have said to the early part of the year. We believe that recent you, that relying solely on historical statistical events and supervisory engagement mean that they analysis as a method of predicting the future via are much more focused on this point, but it is still modelling is not a suYcient way to discharge your a key factor that they need to properly focus on. responsibilities as a board of directors. You do Chairman: On that technical point, could I thank need to take into account the likelihood that the you, Sir Callum and colleagues, and wish you a future will not reflect the past and circumstances merry Christmas and a peaceful new year, starting will not repeat themselves in the way they have in with your reappearance at this Committee shortly the past. That is why we continue to reiterate the thereafter. Processed: 30-01-2008 11:11:00 Page Layout: COENEW [SO] PPSysB Job: 386890 Unit: PAG8
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Tuesday 18 December 2007
Members present
John McFall, in the Chair
Nick Ainger Ms Sally Keeble Mr Graham Brady Mr Andrew Love Mr Colin Breed Mr George Mudie Jim Cousins Mr Mark Todd Mr Philip Dunne Peter Viggers Mr Michael Fallon
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 institutions with deposits of only $10 million/$20 the Committee. You are both very familiar with the million/$50 million, much smaller than the sort of Committee, but could you introduce yourselves for circumstances we are talking about in the UK at the the shorthand writer, please. moment. What tends to happen with the larger Ms Knight: Angela Knight, I am the Chief Executive institution in the States is that the depositors do of the British Bankers’ Association. become creditors of an institution owned and Mr Coles: I am Adrian Coles, I am Director General controlled by FDIC, so again the answer to your of the Building Societies Association. question is, yes, this could be arranged if there was the desire to do that in the United Kingdom. Q1549 Chairman: As you know, this inquiry is Chairman: We hope to finish by half past ten so we largely about financial stability, so my first question are going to ask brief questions and receive brief to you is: is it possible to design a system where answers so that we will get the maximum out of this payouts are made from a failing bank within days or session. Peter? weeks of a failure rather than months or years as at present? Is work going on on that? I notice that a Q1551 Peter Viggers: In your memorandum36 you representative from the IMA has suggested plugging commented on the amount of liquidity made the Bank of England into the ATM network in order available by the Bank of England and contrasted to provide immediate access to funds up to the that with the amount of liquidity made available by £35,000 limit if a bank were to fail. the European Central Bank and the Federal Reserve Ms Knight: Yes, I think it is possible to design a yet when asked a specific question by us, the system, Chairman, whereby payouts can be quicker. Governor on 29 November said that: “The The existing Financial Services Compensation European Central Bank has not increased the Scheme has been designed primarily for investment amount of liquidity at all since the beginning of products and not for deposit protection in terms of August.” He said: “The Federal Reserve has not a quick payout scenario. If we look at the various raised the total amount of liquidity very much,” and options that are currently in operation in other then he went on to contrast that with the Bank of countries, I think that there is there some England: “The amount of liquidity that we are information and some models which we could extending to the banking system is almost 30% probably usefully consider here. We made brief higher. Can you explain that apparent conundrum? mention of some of those within our submission to Ms Knight: I will try but I think you will have to the Treasury on reform of the Deposit Protection redirect most of those questions back to the Scheme, a copy of which we sent to yourself. Governor of the Bank of England. In eVect, what we had in the UK was a money market framework Q1550 Chairman: Adrian, if you could just take that which was more constrained than that of the and add to the point that if depositors were to receive European Central Bank or that operated by the Fed. immediately their deposits from the FSCS, what Thus for a UK bank accessing liquidity there were implications would this have on depositors’ status as collateral rules which were much tighter and there creditors? Could creditor status be transferred to was the so-called penal rate, which was not levied the FSCS? elsewhere. Whereas technically liquidity might have Mr Coles: Clearly it is possible to design a scheme been available, it was unattractive to take it because where depositors get their money back immediately. of the costs involved and because of the lack of That is exactly what happens in America with the ability to oVer up the broader range of collateral. It Federal Deposit Insurance Corporation Scheme. is interesting to note that now—in fact today—the They normally aim to get deposits in the hands of the market operation that is going to be undertaken by depositors of a failing bank within 24 or 48 hours. the Bank of England actually does adopt the The answer to your first question is absolutely yes, collateral arrangements that we proposed and although it is fair to observe that in the American reduces the penal rate; it is now as we asked. I think system most of the banks that have been saved over the last ten or so years have been very tiny 36 Ev 294–303 Processed: 30-01-2008 11:11:00 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG8
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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 a significant amount of discussion on this and have discussions with our fellow trade associations both said to the FSA that we want to engage on this point in Europe and also in the US because of the of explanation. What I also would say though is that diVerences that were operating in respective money the attention has been paid on prevention and I markets and we too were aware that somehow the think in this instance we should be looking at statistics at the bottom seemed to imply a diVerent prevention. The question is often asked “did story than we were experiencing. We asked the individuals understand that there was some deposit question: what did it look like and how did it feel like protection or not?” Certainly they got the hang of for you? The answer that we got from all of them is that relatively quickly with the Northern Rock, as that it looked like their central banks were standing we are all well aware. behind the industry ready to provide liquidity as and when it was needed in a broader way that the UK Q1555 Mr Todd: I think awareness will be wider which was more in line with that which the industry now! was requesting. Ms Knight: There is greater awareness now and in one respect that is a good thing because it means that Q1552 Mr Todd: The FSCS compensation scheme is we can play into that awareness with providing designed primarily not to deal with the failure of a knowledge. As I say, we have said to the FSA quite very large firm. How do we define the limits of what clearly that the banks want to engage on this. We do it is supposed to deal with and the apparent liabilities not just think it is for one part of the industry. We that the state presumably bears for firms that are so think that there is a broad question that needs to be large that it cannot cope? asked and answered and that is: how do we describe Mr Coles: The current arrangements are quite clear. to the individuals how they are protected? 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 Q1556 Mr Todd: You listed four elements of a out to the depositors of a failing bank after the protection scheme that you felt were required. Do reforms that have been agreed earlier this year are you think the scheme does actually meet those four implemented on 1 April 2008. So anything above £4 elements of requirement? billion the Financial Services Compensation Scheme Ms Knight: I think the key to all this is actually speed cannot help with. In fact, the current figure would be of payout and I think it is the speed of payout that about £2.5 billion. How do we define how big an we need to address. That might require a mixture of institution we want to save beyond that is very much scheme rule changes but also might require some Y legislative changes to allow earlier intervention with more di cult. If you are looking at Northern Rock Y that is an institution that has clearly been defined as a deposit taker that has got into di culty. ‘too big to fail’. If you are looking at some of the Mr Coles: I think the speed of payout issue is related smaller banks or smaller building societies, the to the size of the institution. As I said, if you look at actual dividing line becomes very diYcult. 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 Q1553 Mr Todd: Do you think there is an argument depositors of credit unions, typically those payments for transparency about where that line lies? are being made in seven to ten days, so for small Mr Coles: Think there are two issues regarding institutions we are almost meeting the standards in transparency. First of all, should there be an America. For much larger institutions it is much indication to depositors about the size of the more diYcult. 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 Q1557 Mr Todd: Lastly, do you think co-insurance support in the event of a bank failure in relation to has no great value because it simply muddies the the size of the bank. I think that would also be water and confuses the customer as to what extent of important information for a depositor to know. 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 Q1554 Mr Todd: The protection scheme was clearly of debate. Interestingly, I think it is the Netherlands largely unknown to depositors themselves. Do you which has just gone through that discussion (because think that banks have a clear obligation to display co-insurance is quite common there) and in so doing on their products exactly where the guarantee lies they lifted their deposit protection scheme to the and to what extent it is? equivalent of about £25,000 in full and then over Ms Knight: I think you can actually express that that it was co-insurance up to about the level we are question rather more widely: is there a well-known at the moment in the UK. So there is a role but it is explanation of the various protections given by the the point at which it starts. Financial Services Compensation Scheme to the broad range of individuals who engage in a variety of ways with the financial services industry? The Q1558 Mr Todd: That means that transparency is all answer is that, whilst it is no secret, I do not think the more critical so that people clearly understand that there is necessarily the sort of pulsating clarity what they are buying into. which we needed look at now. Certainly so far as the Ms Knight: I think this is all part of your earlier banks are concerned, we have, not surprisingly, had question, if I may say, about how we explain. Processed: 30-01-2008 11:11:00 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG8
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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 which we submitted to the Treasury Select diYcult thing. When we had a limit, apparently, of Committee is this: we need to be looking with £31,700, that was extremely diYcult to explain to the considerable attention at prevention, and that is depositor. where we believe the whole issue lies; on the preventative side. We think that the Deposit Q1559 Mr Fallon: Ms Knight, the banks have been Protection Scheme as it is currently formulated— extremely profitable in the last few years, yet you 100% to £35,000 with a requirement by the industry have been hiding behind a scheme that nobody really to pay quickly—is a workable model. The question understands and that is not really properly funded. that arises is how does it get from the FSCS to the The Chancellor’s guarantee for Northern Rock individual deposit takers, and that is an area where, depositors would not have been necessary if we had as I say, rules and legislation may be required. had a properly funded upfront scheme with notices in every branch in every bank telling people exactly Q1562 Mr Fallon: But what the Governor said was how quickly they can get their money out. required was a scheme that did not mean that people Ms Knight: Interestingly of course, there has just had to wait more than a year to get their money out. been a full discussion about the whole of the Ms Knight: We would entirely agree. Financial Services Compensation Scheme and the Deposit Protection Scheme, undertaken by the FSA Q1563 Mr Fallon: Are you not dragging your feet with the assistance of consultants, and they came up on this? with the current limits and current arrangements Ms Knight: No, we have put forward some that we have. I think the reality is that it is certainly proposals, as you know. We entirely agree that a possible to be able to use a deposit protection route scheme that requires a year to pay out is not good for certain sizes of institutions that take deposits, but enough. As Adrian Coles has just said, where the over a certain amount—and if we look again scheme has been used has been with failed credit elsewhere around the world—you are into bigger unions, there the payout is quick, and indeed has issues than a protection scheme can properly cater been getting quicker. If one is looking at large for. On the question of whether it is properly funded, numbers of individuals, there are systemic issues and one of the things that we have here in the UK is there is panic hanging around there as well. I do not embedded within the legislation is a requirement, an think that one should just say that it is the obligation if you like, on the FSCS to make demands responsibility of an independent or quasi for payments into it when it knows the extent of its independent scheme to address that situation. 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. Q1564 Chairman: Last week, Mr Fallon and I were There is a requirement and that is a requirement that talking to your equivalent, the American Bankers has to be fulfilled for the FSCS to make demands Association, in Washington and they were very clear from the relevant part of the industry if it requires that an upfront funded scheme was essential for the funds. 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 Q1560 Mr Fallon: But it is not true to say that the economically so you have a fund there that is American scheme simply operates for the very, very available. That was their unequivocal view to us. small banks. Continental Illinois which failed was Mr Coles: Could I add a point there. I think the £40 billion, about half the size of Northern Rock, crucial diVerence between the British scheme and the and that was 17 years ago, so it is not true to say that American scheme is not the upfront funding; the it is small banks. Your evidence to us says that you crucial diVerence is that the FDIC is backed by the want to stick with this post funding model? full faith and credit of the US Government, and I Ms Knight: Correct. think that is what gives the confidence to depositors in the United States. 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 Q1565 Chairman: No, no, no, but they were very days? clear on this upfront funding. Mr Coles: I know that is a diVerence but this is Ms Knight: Putting money upfront is not the only V way of making sure that you can get your money another important di erence. back in a few days. If there is a requirement on the Chairman: You are missing the point. They were industry to pay there is a requirement on the very, very clear on that and they were saying why not industry to pay. It seems rather diYcult to see why get the money in the fat years so that when the lean one should have some large sum of money just years come there is no problem getting money out of hanging around waiting when actually the issue is people? That was the issue. I just put that as public not one of is there money to pay out in a diYcult evidence. Nick? circumstance; it is how quickly can a deposition access their money and what rules changes and what Q1566 Nick Ainger: The Financial Services legislation changes are required in order for that to Authority in their Financial Risk Outlook in come about. If I may say, one of the main concerns January and the Bank of England in their Financial which I think comes out from the memorandum Stability Report in April both gave clear warnings of Processed: 30-01-2008 11:11:00 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG8
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18 December 2007 Ms Angela Knight CBE and Mr Adrian Coles problems of weakened credit risk assessment and 1986 and, typically, building societies fund impaired market liquidity. Why did the banks not themselves 70% retail and 30% wholesale. Had listen to those warnings? Northern Rock stayed a building society, it may or Ms Knight: The banks did. may not have been a successful institution but it would not have come to the sticky end that it appears Q1567 Nick Ainger: What action did they take? to have come to in the way that it has. Ms Knight: As far as the banks themselves individually are concerned, they did, as I am Q1570 Nick Ainger: Ms Knight, do you think informed, take full notice of the points that were perhaps there is a lesson here to be learnt for the made to them and the issues that were raised. Clearly banks in that if they adopted the same requirements we have one bank that may have taken a diVerent that the building societies have, that would actually view and I know that you have had a discussion with give greater protection and security and stability? them. I think also, though, the one thing that neither Ms Knight: The Northern Rock had a particular authority nor indeed the industry, wherever it was in business model, as you know. If you are looking at the world, expected was the way in which the the banking industry generally of course, it is much housing problems of the US unfolded as rapidly as broader based in what it does in terms of its they did and as widespread as they did. Nevertheless, operation, how it funds itself and its various I think one of the comforts that we can take in the activities. If you have any institution of any sort UK is not only do we have a strong banking industry which has a very narrow focus, in terms of both its but they do heed the documents, the consultations, business model in what it does and indeed how it and the other communication that are issued from funds itself, then clearly it is far more hostage to our various authorities. fortune than would otherwise be the case. I think one of the issues as well in all this, though, comes back Q1568 Nick Ainger: So everything in the garden is to your earlier point about the FSA’s rosy, there is no problem? Surely our experience communications on risk, and that is that the from August onwards is that there have been serious challenge process that the regulators undertake with problems and warnings were not heeded? various institutions in respect of risk and exposure. Ms Knight: I do not know why you say that. Quite This is something that certainly we believe warrants clearly there are some very diYcult market looking at further. Clearly the FSA did have an situations taking place, but you cannot necessarily engagement earlier this year with the Northern Rock cure a market situation that has arisen nor can you in terms of stress-testing and risk and so forth, and do anything other than handle something well as it this highlights an area that is something, as far as the arises. We have well-capitalised banks, they are industry is concerned, requires clarification. We handling the situation that has arisen, but what you want to see proper stability in the market and proper cannot expect them to do is suddenly manage to stability within the industry. rectify a problem that has arisen in America. What can be expected them is to look at their credit Q1571 Nick Ainger: Have you got any idea when assessment and look at how they are handling their these warnings are issued by the Bank and by the V own a airs, and I think that is something that we FSA if they are taken note of? You have just told the have seen. Committee that they were and yet we ended up with V Mr Coles: Can I o er an observation from the the mess that the banking industry got itself into in building society point of view there. On the day the August. What measures or what further action do Financial Risk Outlook was published by the FSA, you think particularly the FSA could be taking to we sent out a circular to our members strongly ensure that when they do issue warnings that action advising them to read the FRO. We gave them full is taken by the banks? details of the relevant pages for building societies, Ms Knight: If I may say, you are talking about one the relevant developments in the mortgage and bank, not banks in general. There may well be an savings market that would be most important for institution in any walk of life that does not building societies to read, and our evidence is that necessarily take the appropriate action at the building societies read that carefully and were fully appropriate time, but in terms of the industry and expecting a slowdown in the housing market this banks in general, do they act on warnings, the year. They were not expecting the closedown of answer is yes. Are they considered? We see that markets in August but they were expecting a consideration around the various committees that slowdown and we encouraged them to read the we operate within the BBA, so we are well aware of relevant documents. the sorts of actions and the sorts of issues that are addressed and how the industry in general addresses Q1569 Nick Ainger: Can I follow on from that and them. I think also, though, the question is this: what ask you if Northern Rock had still been a building is the nature of the follow-up by the various society, would it have experienced what it authorities themselves? Because I agree with you it is experienced this summer? one thing to issue some sort of communication and Mr Coles: If Northern Rock had still been a building quite another to say that they have also put in place society it would not have been able, by law, to fund the right tools and the right monitoring process to itself 75% from the wholesale markets. A building see whether those actions have taken place. We do society can fund itself to a maximum of 50% in the wonder whether that is another area which warrants wholesale markets under the Building Societies Act further review. Processed: 30-01-2008 11:11:00 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG8
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18 December 2007 Ms Angela Knight CBE and Mr Adrian Coles
Q1572 Mr Love: In the press release that you put out responsible for communicating with depositors, and on behalf of the BBA on 5 December you are quoted I think that was one of the key weaknesses on 13/14 as saying: “The operation of the Tripartite was September. Firstly, it was not clear who was actually found wanting when the Northern Rock problem in charge of making that communication and, arose.” What changes would you like to see to make secondly, as Hector Sants has said in his evidence to it work better in the future? you, some of the terminology that was used was Ms Knight: First of all, we do support the Tripartite; inappropriate for the ordinary man in the street. we think that the problem is more in execution than Who is in charge of communication when you have in structure. The piece of work that we want to see got a crisis problem and where there is a crisis of done and, as far as I am aware, has not been done, confidence, which is essentially a communication and it certainly is not yet in the public domain even issue, is a very important improvement that needs to if somebody has looked at it, is this: if the various be made to the MOU. authorities had taken action earlier, both regulatory Ms Knight: That is right. and in respect of the Bank of England, with the Northern Rock, would we have had a more orderly Q1575 Mr Dunne: Can I turn to the issue of oV outcome? Certainly the perception is that whilst balance sheet structures and transparency and issues were raised at certain points in the timetable, disclosure. Hector Sants, when he was here last actions by the authorities were far more ‘wait and week, said that we needed to consider the use of oV see’. For example, no changes took place within the balance sheet financing. Could you comment on money market structure, there was no alternative or whether you think there are mechanisms to bring Plan B despite many approaches, it appears, put it in particular types of structures onto banks’ balance place in respect of Northern Rock. Before we know sheet? Would that be welcomed by the industry or exactly what sort of changes need to be made to the would that be a problem for the industry? Tripartite, we need to have that piece of work Ms Knight: Of course, some are already being undertaken by our authorities; what would have brought back onto balance sheet, as you know. happened if they had taken action rather than wait and see. Clearly there is a question of leadership Q1576 Mr Dunne: But by default. within the Tripartite. There is also a question of Ms Knight: I think the wider question is we are where getting the right information reported at the right we are, but should one be looking at other changes time. There is also something about the individuals in the future? Some of the points that we believe involved as to whether it is at the right sort of warrant further investigation surround seniority. Lastly, I think that there is a lot of work transparency and they surround some of the way in being undertaken on financial stability within the which ratings agencies should operate. I do not want FSA but there are not all that many people on that to cast them as the devil in all this, but there are some side within the Bank of England, and as far as issues there. Also some of the accounting standards financial services and the Treasury is concerned, we help as well. There are some accounting standard would like to see that side strengthened as well. changes which take place in eVect from this year and, Mr Coles: Could I add one point to that? which again give greater clarity in that area. What we want to do is to see how these operate not park Q1573 Mr Love: Just before you do that, Mr Coles, the issue, but see how those accounting standards let me press Ms Knight a second. Is there an implied operate and take forward with some degree of criticism in what you have just said about the rapidity the whole question of transparency and Governor’s decision in relation to the provision of whether and what that provides in terms of liquidity at the very early stages of this problem? furnishing the right sort of information to the Ms Knight: Certainly as far as the industry were market. There is, dare I say though, a proper role for concerned, they were looking for changes to the confidentiality in everything; it is getting that money market in July in some degree of urgency and balance right. the question about wider collateral and the penal rate had been on-going with the industry for around Q1577 Mr Dunne: Do you think Basle I is the culprit 12 months. This is not an implied criticism—I am here in large part by allowing banks to provide just stating the facts—and I do not want to have that liquidity facilities to oV balance sheet vehicles terminology used. But there were certainly V without having to provide any capital adequacy? di erences of view of how the money market should Ms Knight: I think it is certainly arguable now that operate and particularly when there were what were Basle I is not the right tool for the job, but we are up referred to as ‘stress conditions’. and running with Basle II. The market does move on and standards do have to be reviewed frequently to Q1574 Mr Love: Mr Coles, what was your ensure that they keep up with the market. The whole Association’s attitude? question of looking at liquidity is part of Basle II and Mr Coles: For me, looking at the Memorandum of that is the part that is underway at the moment. One Understanding, one of the key issues that is missing of the issues though is that you cannot look at these from that is “which of the Tripartite authorities is things from just one jurisdiction. It is not possible to responsible for communication once a crisis has say, “The UK is going to do this,” because we begun?” If you look at the final paragraphs of the operate in a global market. Therefore I think that MOU, which is talking about crisis management, this area has come rapidly up the agenda of Basle II neither the Bank, the Treasury or the FSA is and the discussions which have been stuck for some Processed: 30-01-2008 11:11:00 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG8
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18 December 2007 Ms Angela Knight CBE and Mr Adrian Coles time are now likely to be unstuck. I say again that they properly understand the nature of the liquidity has got to be looked at internationally and business without being subject possibly to not just in one jurisdiction. regulatory capture. Mr Coles: I think Basle II is going to be particularly important because pillar three of Basle II is all about Q1580 Chairman: In a word, Angela, is it a case of market transparency. It is about institutions giving first-tier banks getting first-tier regulators and much more information to the market about the second-tier banks getting second-tier regulators? nature and structure of the balance sheet and the Ms Knight: I think I could argue that you want first- liabilities that they have under particular tier regulators with second-tier institutions— circumstances, and that should aid the transparency issue that you are talking about. Q1581 Ms Keeble: I wanted to ask a bit more about Ms Knight: Yes. transparency and disclosure following on from what Philip Dunne asked. Adrian Coles, you mentioned in particular the third pillar of Basle II. Do you Q1578 Mr Dunne: Do you think the FSA is equipped really think that that would be adequate, given the to regulate banks properly? problems which have been already encountered with Ms Knight: Yes I do. I do think they are equipped to an organisation which I think you said was already do that. I certainly think that they need to review operating to Basle II standards? how they do it. It seems to us in the industry that Mr Coles: I think there are two issues about there has been very considerable attention paid to transparency. The first is what is the nature of the capital and very considerable attention paid to, the bits of paper that are being issued by issuing conduct of business rules, but the gap in between has institutions and are the people buying those bits of not had the focus that it should have had. I paper well enough informed to understand what appreciate that it almost seems year-by-year they are buying. I do not think there should be additional requirements are placed upon the FSA to intervention in that area. I think it is up to the people regulate more or regulate diVerently, and I think we who are buying the paper to employ the experts to all understand the diYculty of addressing that properly understand the nature of the financial scenario. There is the very real problem now as to arrangement that they are buying into. I think the how the FSA should be regulating banks and more important question is when people invest in whether they do necessarily have the right tools and banks, should they know whether or not those banks the right people in place. That is where they need to have invested in risky bits of paper on the other side look. We think there is some strengthening that is of their balance sheet? Pillar three is certainly going required and we would rather strengthen the existing to give us much more information on that, although system than put a new system in place. 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. Q1579 Mr Dunne: Could I just press you on the people aspect. Do you think the people within the Q1582 Ms Keeble: Can I just come back on that FSA have enough knowledge of the financial point because you said the banks should employ the instruments currently being used by banks and is people who are able to look into the investments and there a retention problem at the FSA of people with to work out— those skills? Mr Coles: —when they buy them. Ms Knight: The answer to the first question is clearly no, because if you are a practitioner in the market, Q1583 Ms Keeble: That is right and, in a sense, the you see how quickly it is developing; if you are not a people who then invest in the banks are dependent practitioner in the market, you do not. Healthy on the banks doing that first bit properly. One of the regulation is about interchange of people from the things which has emerged through our discussions is market into the regulator and from the regulator that the due diligence is not adequate in terms of back into the market. I know the FSA is aware of people looking into what lies behind the commercial this and they have been assuring the industry and the paper. Do you think there is a real need for the wider public that they are paying attention to the banking sector to improve its due diligence so that quality and calibre of people that they have. I think when it discloses what it has invested in, it does not the industry does want that to take place as well but I just say we have invested in these triple-A star rated suppose we are sometimes guilty of buying out good securities but it says what is actually bundled up in regulators at the same time. A flow between those securities? regulator and industry and industry and regulator is Mr Coles: I think personally that would be helpful. important in this, as it is in other areas as well. Mr Coles: I think there is an issue about consistency Q1584 Ms Keeble: Could you say a bit more than of regulation. I know of one large building society, just “it would be helpful” because otherwise we do for example, that has had its relationship with the not know enough about what your thinking is about FSA headed by five diVerent people in four years. what the banks should be doing. That does not give the relevant people very much Mr Coles: Building societies typically do not invest time to understand the nature of the institution in these pieces of paper anyway, so I think I will defer which they are supervising. I would like to see to Angela on that one about the nature of the someone doing a minimum of two or three years so investigation that should take place in due diligence. Processed: 30-01-2008 11:11:00 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG8
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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 Ms Knight: I think you will find that that is entirely disclosures generally are concerned, IFRS 7 is one of correct. Some will have said that they want an the standards that is coming into force. I think that exposure where there is a higher return and thus a will certainly help on general disclosures—there are higher risk, and that is also a perfectly reasonable some others, as I have said earlier. Theses are all lending decision for them to have taken. What is coming into place over a relatively short period of important here though is not should banks have a time. I think it is important to see exactly what mixture of diVerent types of lending, diVerent types clarity they bring. However, the answer to the point of analysis and diVerent types of criteria—of course that you made about whether there has been too they should; it is an assessment of risk. If there was great a reliance on something being called triple A or not that assessment of risk much of the financing of triple B rather than a proper investigation behind, is anything from British industry to industry around that is probably the case. Certainly Basle II has the world would not take place. What we have here, brought the reliance on external ratings agencies though, is probably a pretty unique—I sincerely more into the fold than I think was intended, so hope it is unique—occurrence whereby what is, in more needs to be done in respect of these agencies. eVect, a serious housing problem in one country has, We have put a list, which I hope we sent to you, of through the spread of risk, found its way around the some of the specific issues that we think it is world. Not just in the UK but to other financial important to look at in terms of this whole area of centres as well. transparency. One is clearer signposting between mortgage-backed securities based on prime assets Q1590 Mr Breed: I think that is overly simplistic. and securitisation based on sub-prime for example. Can I ask two quick questions. Was Northern Rock Another relates to the sort of actions that a member of the BBA? programme managers ought to be taking in terms of Ms Knight: Yes. regular updating, disclosure of information, and so on. Are there more things that can be done? The Q1591 Mr Breed: And did it discharge all its answer is yes. Some of them do get into rather responsibilities to the BBA properly? arcane-sounding language but the question is is it Ms Knight: As far as we were concerned, yes, it going to be more understanding, does it need to be participated in committees and it took part in more understandable, and those are the sorts of discussions around the committee. The recommendations that the banks are making responsibilities— because better transparency is where they want to get to. Q1592 Mr Breed: There are a lot more obligations than that to the BAA. Q1585 Ms Keeble: What are your criticisms of the Ms Knight: The membership relationship with a credit ratings agencies? trade body is, as you rightly say, something of a two- Ms Knight: I think they need to monitor their ratings way street in that we are primarily there to assist our more; I think they need to articulate why they have members, often on regulatory and tax issues, and got to the ratings they have; and I think there is lobby on their behalf. There is a two-way flow of something about the separation of the provision of information, but what we would not expect is for one ratings from the financing of the agencies that is of our members to talk to us about their business and important as well. commercial decisions; that is for them. We are there for the generic issues, the market issues and those Q1586 Mr Breed: Is it not abundantly clear now that things which are common to everybody. The banks collectively have been totally irresponsible in Northern Rock was, after all, regulated by the FSA. lending vast amounts of money against worthless bits of paper? Q1593 Mr Breed: So the announcement in August Ms Knight: No. 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 Q1587 Mr Breed: How can you stack that up? August— Ms Knight: There is certainly a problem which has arisen, but it is by no means distributed evenly right Q1594 Mr Breed: No, the problem with Northern across the banking industry. Rock, your member? Ms Knight: That was in September. Q1588 Mr Breed: So they all knew exactly what they were lending against and the value of the pieces of Q1595 Mr Breed: When did you become aware of paper that they were lending against? the problems with Northern Rock, at the same time Ms Knight: As you will know, the exposure is as all of us? V di erent and no doubt the knowledge has been Ms Knight: Yes, the Thursday evening when the leak V di erent as well, because some of these structured occurred about the lender of last resort products are far more complicated than others. arrangements was the first time that we were aware of the situation. Q1589 Mr Breed: Some banks have been able to lend perfectly satisfactorily against asset-backed Q1596 Mr Breed: That one of your members was in securities of which they knew the total value? failure essentially? Processed: 30-01-2008 11:11:00 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG8
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18 December 2007 Ms Angela Knight CBE and Mr Adrian Coles
Ms Knight: Correct. We were certainly aware of the are, like I think the rest of us, hopeful that this period concerns in the market and we had read the analysts’ of uncertainty will come through and then they will report. We had seen the share price fall and we had be able to use their repriced risk and their review of read the statement that the Northern Rock had their business model to recover in the activities in made about its own finding issues, which was in which they want to get involved. 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 Q1602 Mr Mudie: So that is the first one—make everybody else did. these instruments a bit more transparent and carry on as before? Ms Knight: I do not think that just carrying on as Q1597 Mr Mudie: If I could get some common before is exactly the description of what I have just ground between you and my colleague Colin Breed. said. I think, if I may say, that the assessment of the Your defence of the banking industry is business model and the business that you want to be understandable by your position, but would it not be in and what you think is going to happen to that correct to say that some banks acted unwisely and business is something that is taking place right now maybe even irresponsibly in terms of these past within the industry itself. They are assessing where months? they have made losses and they are assessing what is Ms Knight: In which respect? I beg your pardon. the situation with some of these complex products. To decide what the outcome and what changes they Q1598 Mr Mudie: Are you sticking to the position are going to make, I do not think that a) I can tell that they are all as pure as the driven snow and that you and b) I doubt that they have all come to that this was something that could not be avoided or are conclusion yet, because at the moment some of the you agreeing that some of them perhaps now wish problems of the sub-prime are still in the process of they had not got into certain business? unfolding, so there has to be an element of wait and Ms Knight: I am sure they do. I do not pretend the see, an element of review, as well as an element of industry is perfect. I do think it does a good job but change. 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 Q1603 Jim Cousins: How damaging has all of this in some of the stuV that they have invested in, yes. been to London’s markets? Ms Knight: I think it has been quite damaging Q1599 Mr Mudie: I have certainly got the actually. I went out to Brussels in about the middle impression from some of the folk that have come of September for the first time after the Northern before us that their lack of exposure was more down Rock, and I keep going out there, and also because to timing; they got in late rather than in at the start we are an association where 60% of our members are and so their exposure was less, but it was not a from overseas, we get the impressions of the industry question they were not in it because it was too and of authorities around the world, London does profitable not to be in it. rather look like its authorities dropped the ball, that Ms Knight: It also depends on the type of business when push came to shove and a problem arose other that you are running. Whether you are focusing countries managed to deal with it and the UK predominantly at investment banking or are focused somehow did not. It is partly because so much got predominantly at the retail market, so that would played out in the public domain and queues outside also depend upon banks’ exposures to sub-prime. banks are immensely visual things. I think that we have to recognise that it has done us damage and Q1600 Mr Breed: Angela, in the October Financial that we have quite a lot of work to do to restore Stability Report, the Bank of England said that the that damage. banks should reflect on their business models and they gave three scenarios. If I could put the scenarios Q1604 Jim Cousins: Who should lead the as (i) they should redesign the credit structures and international action that is required to bring about carry on, (ii) carry on as before because it is better standards across jurisdictions? profitable and they might regard this as a temporary Ms Knight: There is a number, as you know, of big setback—which I find amusing—or (iii) that they international entities, IOSCO being an obvious one should scale down and move back towards a more and the World Bank another. There are therefore a traditional model of banking; which one do you number of organisations and institutions already think you would prefer and which direction do you there. I think that the best way to make those sorts think the banks will move in? of global institutions work properly is for countries Ms Knight: I certainly cannot dictate to any bank which have big financial centres such as ourselves to what it is that they should do. fully engage with global standards. You can never be sure that everybody is going to abide by global Q1601 Mr Mudie: Yes, but your advice is closely standards because in the end it has got to be locally watched. administered, but the big centres are the ones that Ms Knight: One can certainly see from their actions have the people, they have the products, they have what it is that they are doing and that is they are the broad range of services and have of course the reassessing the credit situation. They are looking at self-interest of getting the global standards right. their activities and their business models and they That is the sort of engagement which I sincerely hope Processed: 30-01-2008 11:11:00 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG8
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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 of a second-tier financial institution not getting into and the FSA have both been making proposals over trouble and all the focus being on the big recent times and no doubt earlier as well. institutions? Ms Knight: I think there is a number of reasons. Clearly the big institutions are always there in terms Q1605 Jim Cousins: Have we not got on the of the systemic risk that they would create if they get international level the same slightly chaotic into diYculties and the sheer numbers of individuals separation of accounting standards, reserve and consumers in the retail business that they do. requirements and actual regulation that to some Thus there is an inevitability that they will always be degree you are saying are reflected in our own crawled over by regulators of the highest calibre, and national arrangements? I think that is right. It does seem to us though, Ms Knight: And of course this is reflected in Europe Chairman, as far as the Northern Rock is concerned as well even before we get out of our region. First of that the regulators maybe only looked at two parts all, there is an inevitability in the sense that of the business, they did not look at the business as V standards have built up from di erent bases. a whole, and that the process whereby the regulators Accounting standards have come up from the looked at the risk assessments and scenarios that accounting profession, prudential supervision has Northern Rock had been undertaking were not tended to come up from central banks, financial strong enough. I do not have any particular regulation from various financial regulators and so additional information, but this is how we see it forth. To co-ordinate them together is, as you rightly externally. Also that maybe steps could have been say, absolutely essential. I think that we see a greater taken when there was a realisation of the impact of co-ordination taking place right now. We note the Northern Rock’s total exposure to the wholesale particularly, for example, the work of Basle and the market that. Instead action was not taken; rather the work of the accounting industry and that needs to be situation was left as one of wait and see. Wait and see built upon, coupled with proper consultation with can bring problems and that is why we believe that, the industry, as the industry knows whether as part of either your inquiry or a further inquiry, it something is going to do the right thing or not do the is essential to do an exercise to show what would right thing. There will always be diVerences of view have been the results if action had been taken earlier but it is how it works practically that is important. by the regulators. If perhaps they had followed Bringing a recognition of co-ordination together through on the general warnings that they gave to into the minds of countries and various authorities the market, and if changes had therefore been made is work which is on-going. I suspect that if the in advance of the problems of late August and Northern Rock has done us any good it has actually September. brought that recognition very strongly into play in more than one area—that co-ordination between Q1607 Chairman: Adrian, do you want to add authorities is essential, and it is essential locally, it is anything before we finish? essential regionally, and it is essential internationally Mr Coles: The only thing I would add to what as well. 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 Q1606 Chairman: Just a last question to Angela. banking model. I think one of the conclusions that Mention has been made, as George said earlier, building societies have reached over the last three about the warnings that were sent out from the FSA months is an absolute vindication of their decision to and the Bank of England, regarding Northern retain the traditional model that has worked very Rock’s business model, there were comments in the well for them over the last 100 years or so and will market about that type of model and about the continue to work well for them into the future. growth and the fluctuations in the share price. Why Chairman: Thank you very much for your evidence, were these things not picked up? Was it the mentality 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 distribution of losses means that interbank lending Committee. I believe that you have an opening rates have risen further relative to expected oYcial statement. Could you first introduce yourselves for interest rates. The behaviour of those spreads has the shorthand writer, please. been very similar in the sterling, dollar and euro Mr King: Thank you, Chairman. On my left is John markets, exacerbating concerns about a ‘credit Gieve, Deputy Governor for Financial Stability. If I crunch’ in the major industrialised countries. That may Chairman, I would like to read a short opening remains the concern not only of the Bank of England statement. As you and the Committee will be aware, but of all the major central banks, and I will return in the problems in the financial sector remain with us. a minute to our market operations. But we are also A painful adjustment faces the global banking sector thinking about the changes needed to prevent the over the next few months as losses are revealed and crisis that befell Northern Rock from happening in new capital is raised to repair bank balance sheets. the future. There are, as I said in my speech in Belfast Uncertainty about the possible scale and in October, three main lessons from the recent Processed: 30-01-2008 11:11:00 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG8
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18 December 2007 Mr Mervyn King and Sir John Gieve turmoil for the UK’s framework for managing the banks around the world announced a co-ordinated financial system. First, the UK authorities are alone set of actions in response to increased pressures in in G7 in being unable to deal with a distressed bank short-term interbank lending markets. The Bank has under a special resolution regime. We rely instead on raised the amount on oVer, and widened the range normal corporate insolvency laws. But if a bank of high-quality collateral eligible, in its regular three- enters administration depositors may have to wait a month lending operations that had already been considerable time to gain access to their funds. scheduled for both today and for 15 January. Our Knowing that, they have a strong incentive to join a lending in other operations will be correspondingly bank run. So at present we cannot allow a bank to reduced. The actions announced last week fail unless it is clearly insolvent. In turn the demonstrate that central banks are working together expectation that the authorities will try to avoid to try to forestall any prospective sharp tightening of insolvency puts a floor under the bank’s share price credit conditions that might lead to a downturn in and that prevents the authorities from intervening to the world economy. A key lesson that central banks implement a reorganisation of the bank. So a special around the world have taken from the recent turmoil resolution regime is the most important reform now is that, in stressed conditions, any bank that is seen and it will require legislation. Second, experience in to come to the central bank to borrow—whether in other G7 countries suggests that a new regime regular standing facilities against high-quality should be supported by credible deposit insurance collateral or against wider collateral in a discount arrangements. A model for deposit insurance that window or support operation—can become draws on international experience would have ‘stigmatised’ in the market. It important that, in permanent 100% coverage up to a limit with future, banks have a means of accessing the central transparent and widely understood prompt payout bank when necessary. So over the next year, and in commitments. Third, the experience of Northern consultation with the banks, the other tripartite Rock demonstrates the importance of regulating the authorities and other central banks, we will be liquidity position of banks. Northern Rock believed reviewing this element of our money market that its adoption of Basle II meant that it would have operations. In due course we shall publish a revised surplus regulatory capital, and in July it proposed to ‘Red Book’ that describes our operations in the increase its interim dividend for 2007 by 30%. But its sterling money markets. Chairman, I am grateful for liquidity position remained extremely vulnerable to the type of shock that occurred on 9 August. It is the opportunity to make that statement this morning clear that regulation of capital alone is insuYcient. and John and I stand ready to answer your Tomorrow the FSA will publish a discussion paper questions. on liquidity regulation, and the Bank fully supports this initiative. Much has been said about the Q1609 Chairman: Fine, thank you very much, operations undertaken by central banks in the Governor. Regarding last week’s actions by the money markets during the recent turmoil. All central central banks, the markets appear to have taken the banks have the same primary objective in this area: recent joint action, not as a sign of strength, but as a to implement monetary policy by keeping interest sign of things being worse than people thought. How rates on overnight borrowing in the money market would you respond to that suggestion? in line with the interest rate set by the MPC. After a Mr King: I do not think I would fully share that short period of volatility in August, we have view. There was always a risk that any intervention achieved that objective. The gap between overnight by a central bank could be interpreted as a sign that interest rates and Bank Rate in the United Kingdom the central bank has seen something that others have has, on average, been the same as in the euro area not, but I think the fact that this was an international and smaller than in the United States. I will pass over co-ordinated action which we at the bank were a description of our money market operations but 37 extremely keen on making international did achieve leave it in the text for the record. Last week, central two objectives. One was to demonstrate that the central banks were working together—perhaps that 37 The text read as follows: “I would add two important points about our money market operations that have not been had not been as evident as it might have been since widely understood. First, a unique feature of our system is August, and, secondly, it was a clear recognition that that the total amount we lend to the banking system each all the central banks were saying to the market, month is determined, at the beginning of each month, by the “Yes, we do understand the deterioration in banks themselves. We are now supplying £6bn more than sentiment in credit markets”, which had been very on 1 August—an increase of 37%. Neither the ECB nor the Federal Reserve has increased their supply of reserves in evident over the previous four weeks, “and we are this way. Second, central banks can only keep overnight conscious of the concerns that you have and we are interest rates in the market close to Bank Rate by lending determined to take whatever set of policy action is to banks just the amount the system requires. If we were to necessary to ensure that we do not see a serious provide more money than banks are required, or in our case want, to hold, there would be excess money in the system downturn in the world economy.” 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 Q1610 Chairman: There is a view held by some that injection of money to the system. Similarly, the Bank of this is not just a crisis of liquidity but of solvency England has extended funds to the banking system through and, as a result, the concerted actions of the central its lending to Northern Rock—as Northern Rock pays banks may not help. away the money to its creditors, it adds to the reserves of other banks. So we too have adjusted our other lending so Mr King: It is certainly true that the reason for the that the net injection of liquidity since August is in line with rise in spreads in inter-bank markets in the past the extra £6bn requested by banks.” month is not due to a shortage of cash. That was the Processed: 30-01-2008 11:11:00 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG8
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18 December 2007 Mr Mervyn King and Sir John Gieve case in August and September when the banks were in the co-ordinated action is to lend against a trying to accumulate as many liquid assets as narrower range of collateral only marketable possible and the rise in the inter-bank spreads in that instruments. The money will be auctioned oV and, in period did represent an attempt to accumulate that process I fully expect that the rate which people liquidity, but the large banks are now awash with who get the money will have pay for it will turn out to cash. The issue is not whether they have enough constitute a significant premium over bank rate. So, cash; the issue is whether they are willing to lend, and in that sense, there is a penalty rate built in through in recent weeks (and this was the reason for the co- the auction process itself. ordinated action and the concern shared by all central banks) what has become evident is that Q1612Chairman:Whydoyouthinkyouhavebeenso banks are concerned about the capital position of widely understood then? other banks. They do not know where the losses Mr King: Misunderstood, I think. resulting from the array of derivative financial instruments will finally come to rest, and, I think, in Q1613 Chairman: Misunderstood. the last four weeks we have also seen a more Mr King: I wish I had been widely understood. disturbing development, which is that the banks themselves are worried that the impact of their reluctance to lend collectively will lead to a sharper Q1614 Chairman: I think we all would! downturn in the United States and perhaps Mr King: There are two reasons for that. One is that elsewhere, thus generating further losses outside the I failed to speak out in August to explain how money housing and financial sector which will feed back market operations worked, and I wish I had done, onto bank balance sheets and reinforce their and by the time it became possible to do so in reluctance to lend because of the need to generate September, we were right in the throws of the problems with Northern Rock and it was an more capital. That concern is a serious one, because Y it does hold out the prospect that, if banks behave in extremely di cult environment against which to that way, there will be a self-reinforcing downturn in explain the arcane details of money market credit and activity. That is not necessary by any operations.Thesecondreasonisthatveryfewpeople, means, and, provided we can help to dispel that in fact, do understand money market operations. Evennow Ifind itvery hardtoexplain, andI makebig sense of fear (and that was one of the reasons for the V actions last week—a demonstration that the central e orts to see people to explain it to them. Very few banks are clearly aware of these concerns and people seem to understand the basic point that, in problems and we will take the appropriate actions to order to implement monetary policy—to keep respond to it) then, in fact, we will be back again in interest rates in the market, overnight interest rates, the position where, I think, after the end year banks inline withthepolicy ratessetbytheMonetaryPolicy will gradually realise that, once all the losses have Committee in our case, the Governing Council in the been revealed and once they have taken steps to case of the ECB—once the month has started, the rebuild the capital of their balance sheets, which amount of liquidity which can be injected into the several big banks have already done, then conditions system is completely fixed. If you try to inject any will return to a more sustainable position. moreinthanthebanksare toldtoholdastheirreserve targets or,in ourcase, choose tohold asreserves, then the banks will have surplus reserves, will try and lend Q1611 Chairman: It has been suggested that your it out and that will push the overnight rate down. If own position, Governor, is characterised by a U- you do not inject enough, then people will be turn. In the summer you were saying that if you were scrabblingaroundto getliquidityandthatwillbidthe lending to banks at a penalty rate and there were interestrateup.So,whateverliquidityisinjected(and certain conditions in the collateral you were often it attracts great headlines), what central banks accepting, now there is not a penalty rate and you then do is to oVset that. What they give in one hand have widened the collateral which you will accept. they take away with another within the same You also mentioned on Radio 4 and other places that maintenance period, not the same day or even you were not here to bail out banks, that “the role of necessarily the same week, but within the same the Bank of England is not to do with what the banks maintenance period you have to do it. That is why I ask us to do”. People would suggest now that what have been trying to explain to people since the you have done is the opposite of what you said you beginning of August that the European Central Bank were not going to do in August and, as a result, you has, in netterms, injected hardly anyextra liquidity at have done a perfect U-turn. all, the Federal Reserve four or 5%, I think, and the Mr King: It is not my view of what I have done. What Bank of England37% more. Why is that? It is because we did in September when oVering a term tender was we allow our own banks to set their own reserve to say we are willing, given the concern about the targets,and,iftheychoosetoholdmorereserves,they British banking system, to oVer money at a very wide can do so and we supply the increased amount spectrum of collateral, including raw mortgages, and correspondingly. if we were going to lend against that kind of collateral—theEuropeanCentralBank,forexample, Q1615 Chairman: You mentioned that you failed to would not lend against that kind of collateral—then speak out. In our inquiry we are looking at the issue we felt it appropriate to put in place a penalty rate of communication strategy of the tripartite which was fixed ex ante so that any money would be arrangement. Would you consider that is an lent at the clear penalty rate. What we are doing now important area for us to focus on? Processed: 30-01-2008 11:11:00 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG8
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18 December 2007 Mr Mervyn King and Sir John Gieve
Mr King: Yes, it is, and particularly in the case where person in the queue, because if other people had not there is a problem of a failed bank. I would say, gone and started the run, then it might have been though, that one of the problems that the tripartite perfectly acceptable for it not to have happened. I do arrangements faced in September was that, although not think there was any inevitability in that. the processes for making recommendations on a lender of last resort operation—the decision of the Q1619 Chairman: The reason I am asking that, Chancellor—worked extremely smoothly in my Governor, is that you consider the deposit view, we were still hoping, even on the Thursday, the V protection scheme inadequate. You know that it is day before the facility was o ered, that it would be not 100% guaranteed, so you know that when people made on Monday—that was the plan—and it was find this out (and it was not evident to everyone) they only during the course of the Thursday, when say, “Goodness, I am only going to get 90% of the rumours started to spread in the market, that it was money I put in.” felt necessary to accelerate that to the Friday Mr King: Absolutely. morning, and that put a lot of pressure on the communication strategy, but, clearly, we need to think further about that. Q1620 Chairman: Surely somebody must have thought about that during that period. Q1616 Chairman: On the deposit protection scheme, Mr King: Indeed, but that does not mean to say that you have mentioned in your public statements that it was inevitable that a bank run would occur. Let me it is inadequate. How long have you held that view ask John to talk about the deputies’ discussions. and did you communicate that view to the Treasury Sir John Gieve: When we were planning the lender of in the past? last resort support we knew that it might not work Mr King: I think all the Tripartite Authorities have and, if it did not, there would then be a choice been aware of this and thinking about it. One of the between either, in a sense, guaranteeing all the things which Callum McCarthy and I initiated when deposits of the bank or, alternatively, allowing we both started at around the same time was to Northern Rock to go into administration. But we took the view that it was worth trying a classic pursue regular crisis management exercises, and out V of those exercises in 2005–06 came the very clear lending operation first, because that o ered the chance that Northern Rock would be able to get understanding that we had no adequate tools for Y dealing with a failing bank. The Treasury completely through the liquidity di culties in the short-run and agreed with that and, indeed, work was going on in then resume normal operations after that. the Treasury to think about how best to handle that Mr King: Could I just add that one of the ways we right the way through 2007. So these issues, I think, hoped to deal with this was by having a covert were understood and, as I say, the Treasury was operation. That might or might not have worked, working on it, but when we had the exercise in 2006, but that was the reason we were arguing for a covert I did not say to the Chancellor afterwards, “I have a operation, and that was ruled out only on the great crystal ball here. I can see that in 18 months’ Tuesday, two days before the Thursday of the time Northern Rock is going to get into trouble. decision. Therefore, we’d better rush this legislation through in the next few months.” This was not something, I Q1621 Chairman: John, you say you were aware it think, that we felt had to be done overnight, this was might not work. We have got these missing four something that needed careful thought and days, or these four days of inaction. Surely there had attention. to be a bit of forward thinking in that. Sir John Gieve: Which four days are those? Q1617 Chairman: Did you advise or provide information to the Treasury, say when the Q1622 Chairman: From the Thursday to the emergency money facility was announced to Monday, the emergency, when the Chancellor Northern Rock, that there would be a risk of a run guaranteed everything. You are sitting down given your views of the deposit protection scheme? thinking this thing might not work because people Mr King: I will ask Sir John, because most of the are only getting 90% guaranteed. Why was that not discussions of that took place at the deputies level. done straightaway? What I will say is that I do not think that on the Sir John Gieve: We did realise that oVering a limited Thursday, when we suddenly had to advance the collateralised facility was not guaranteed to save date of the operation, that we thought that a run was Northern Rock. We hoped that it would restore inevitable. The nature of a bank run is that it is a confidence. I think that was a reasonable judgment knife edge: it might happen, it might not. That is at the time, and other people commenting on it at the Y exactly why a bank run is so di cult to handle. time thought so too. But I think we did not do enough to reassure the retail depositors, and that Q1618 Chairman: But you have described the became clear on the Friday. I think the deposit reaction of customers as being rational. Do you protection scheme was one element in that, but one think it is rational? feature of Northern Rock was that it had a large Mr King: Once the run had started, once other number of very big depositors who had deposits well people had started to run, then it was, indeed, above the 35,000, and those are always more rational, given the system we had, to join the bank slippery, if you like—they tend to move on the basis run, but it was not necessarily rational to be the first of relatively small changes in interest rates—and so Processed: 30-01-2008 11:11:00 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG8
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18 December 2007 Mr Mervyn King and Sir John Gieve even taking the measures we have subsequently Mr King: Indeed. taken on deposit insurance to make it 100% up to 35,000 would not have helped them. Q1628 Chairman: And you could pass the necessary legislation in the House of Commons to eVect that Q1623 Chairman: Governor, you mentioned the change quickly? deficiencies in the system and the concerns you had Mr King: You could indeed. for a number of years. Had you written to the Chancellor with your prescription for the way Q1629 Chairman: Would that be a system which is forward? worthy of consideration, do you think? Mr King: We had after the crisis management Mr King: It is not a permanent system I would exercises involving the pricipals, the note, the record recommend. I think it is much better to have an of that, and the standing committee deputies that equivalent of the FDIC with that ability to intervene followed it made it clear that all three Tripartite early. This is now very late in the day. The right Authorities felt that an urgent work programme on system tohave hadwould havebeen onewhich would how to resolve the problems of a failing bank was have intervened in the case of Northern Rock well necessary, and that work was carried out. before 9 August.
Q1624 Chairman: But did you as Governor write to Q1630 Chairman: But given our own Committee is the Chancellor? looking at this issue, this is an issue which should be Mr King: I did not write to the Chancellor because on the agenda, you think, in the future? there was no need. It was in the minute agreed by all Mr King: As I said, I do think that legislation to give three Tripartite Authorities. the authorities thepower to intervene earlyin the case of a failing bank is very important. Banks are not like other companies. Q1625 Chairman: If you felt it was such a pressing need with four pieces of legislation required and the Q1631 Chairman: So it should be on the agenda. The system never really worked, as I say, would it not Government has said that it will wait for our report have been wise to have written to the Chancellor and before finalising any legislative proposals for put your prescription for the way forward on record? handling banks in distress. We hope to produce that Mr King: We did not want to force a prescription at by the mid to the end of January. Do you think the a point when all three authorities agreed that Government is correct to wait for that? measures needed to be taken to find a mechanism for Mr King: Yes; absolutely. Indeed, even that is rather resolving a failing bank and to improve deposit a quick timetable. What matters is that we get the insurance. That was something which, it was agreed, proposals right and we get the details sorted out, and, the Treasury would work on. There was no dispute as I said to you when I came in September, I very about that. much hope that the Treasury Committee will take the lead in all this because, in my view, this is something Q1626 Chairman: Okay, we will follow that up. which deserves cross-party support. This not a party Governor, the issue of nationalisation has been politicalissue,thisisanissueinwhich,asIsaid,we are mentioned, whether we are talking about the only G7 country that does not have the power to nationalisation or public administration, or deal with a failing bank in this way. whatever. I had the opportunity to the speak to the Chairman: Okay. We hope to get that out by mid FDIC last week in Washington and, as a result of January. Michael. that, I would ask you: what would your preferred process of nationalisation be if it took place? Would Q1632 Mr Fallon: Governor, just to be absolutely it be a long-term public sector commitment or clear, it was as a result of the stress tests in 2005 that it something similar to what the FDIC has with the wasminutedthatthe improvedlegislativeframework bridge bank authority where, if it took place under needed was now urgent? FDIC, Northern Rock would be immediately Mr King: 2005 was the deputies meeting and crisis passed to private sector managers to run it, not by management exercises. The principals, that is Sir FDIC but private sector managers, so that it is Callum McCarthy, the Minister and myself, first got prepared for sale? Can you envisage a system like involved in the crisis management exercise in 2006, this in the United Kingdom? and at the end of that exercise Callum McCarthy, Mr King: I certainly can, but I think it would require myself, Ed Balls as Government Minister and legislation to achieve it. That is the first point that I Treasury oYcials, all agreed that a key part of the made. If we were to get to nationalisation (and I future work programme was to work on these issues, stress “if”), then I think it would be better if it could and that programme was indeed put in place. be used as a means of breaking the log-jam and going into an arrangement which would pass very quickly Q1633 Mr Fallon: What was the date of that? to a new management team and, ultimately, to a new Mr King: That was late in 2006. ownership team. I do not see anyone is attracted by the idea of having on an indefinite— Q1634 Mr Fallon: So that was a year ago? Mr King: From now, yes, and work on this was Q1627 Chairman: No, but you could have assisted indeed going on in the Treasury at the point when them by identifying a management team. Northern Rock got into trouble and it seemed to be Processed: 30-01-2008 11:11:00 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG8
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18 December 2007 Mr Mervyn King and Sir John Gieve perfectly reasonable. I did not say to anyone, “You Q1640 Mr Fallon: Is it the case, do you think, that have to do this by the end of July otherwise we will the Government can now move quickly enough? not be able to deal with Northern Rock.” No-one Mr King: Yes, but it is important to get it right. I anticipated that, but the work was going on. 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 Q1635 Mr Fallon: No, but it was identified as from the Financial Services Authority, then it will urgently needed a year ago? probably be sensible to have a period in which Mr King: It was important, yes. people can discuss and debate the proposals and then you in Parliament will have the responsibility of Q1636 Mr Fallon: You said “urgent” in answering taking through this legislation. That is not a quick the Chairman. process either. Mr King: Yes, but that requires designing and thinking about legislation, and that is not a simple, Q1641 Mr Fallon: I understand that, but if this was straightforward matter. 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. Q1637 Mr Fallon: So the Treasury has not been Mr King: That is why I think it is important now to dragging its feet on that? move quickly but not so quickly that we get the Mr King: I do not believe it has been dragging its detail wrong. At the end of 2006 I certainly did not feet, no. I could perfectly well have written in June anticipate that it was likely that we would be faced and said, “Look, what is going on with this?”, and with this problem during 2007, and I quite readily we asked about it, but I think this is a matter where accept responsibility for that. I did not say you have it was important to persuade people, including you, to do it by the middle of 2007; I said it is important to look at the experience of other countries and that we work on this, not let it just stand on the recognise that maybe this is one case where we can shelves gathering dust but work on it, and we made learn something from the rest of the world. But; to that point and that was agreed by all the participants win opinion over and to get new legislation through in the tripartite meeting in 2006. 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 Q1642 Mr Fallon: But the minutes said it was opposed to 2008. urgent? Mr King: Yes, but “urgent” does not mean rushing it in such a way that you get it wrong. Q1638 Mr Fallon: But it promotes the position now, without this legislation, that for any one of the ten Q1643 Mr Brady: Can I return to something Sir big retail banks which ran into similar trouble to John said a little earlier. I think in relation to the Northern Rock, the Treasury would have to do lender of last resort facility you said, “We knew it exactly the same, guarantee all the deposits all over might not work and, if it did not work, we had a again and, if necessary, underwrite a lender of last choice between guaranteeing all the deposits or resort facility. allowing Northern Rock to go into insolvency.” Mr King: I very much hope we will not get into that Who made that choice? position, but the reason and the need for new Sir John Gieve: Ultimately the Chancellor made the legislation and the reason I am stressing it now is choice to oVer the guarantee to depositors. that we do not have a means of dealing with this absent the new legislation. Q1644 Mr Brady: But I think your comments referred to the time before the facility had been Q1639 Mr Fallon: The Sunday Times reported a granted. You were saying, “We knew in advance senior bank oYcial as saying that the Prime Minister that if it did not work we would have this choice to and Chancellor were “unable to focus because make”? morale throughout the Government is so low”. Sir John Gieve: Yes. All three parties agreed that the Were you that senior bank oYcial? next move was for the Bank to oVer a facility to Mr King: I can assure you, they are not my words Northern Rock to see if it could tide it through these and I do not share those views at all. I have meetings liquidity diYculties. There was no dispute on that. from time to time with senior economic commentators. One of those was, indeed, with Mr Q1645 Mr Brady: But this question of whether to Stelzer, but the discussion was about economics. I give a 100% guarantee to depositors had been explained to him how our money market operations considered before the lender of last resort facility worked. I am always trying to find people who do was granted and a decision had been taken not to do not understand how it works and point out to them it at the same time as the facility was granted. how it does, and I explained to him the three points Sir John Gieve: The form of the guarantee, I do not in my October speech, which, again, I mentioned this think, had been discussed. We were oVering a morning, but the conversation was about secured lending facility and, if that did not work, economics, not about politics. None of the then the question was: would we continue to oVer comments in the article I recognise at all, and they however much money it needed or not? We knew are certainly neither my views or my words. that that would require a government guarantee— Processed: 30-01-2008 11:11:00 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG8
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18 December 2007 Mr Mervyn King and Sir John Gieve that was not something the Bank could do oV its believed that the sign of reassurance of having a own balance sheet—so, in that sense, there was a facility from the Bank of England would help them further choice beyond the secured facility on and, in fact, that is what would prevent a retail run whether to just provide whatever funds were needed in their view. Obviously, sadly, it did not turn out to or to let the bank go into administration, but we be the case, but the legal advice was clear, though I thought it was worth, as a first step, having a go at gather now that, at least on the Market Abuses helping Northern Rock through its problems. Directive, there is still a diVerence of view between the interpretations of some in the UK and some in Q1646 Mr Brady: To be very clear, specifically on Brussels. There are also some diVerences in the guarantee to retail depositors, that was interpretation between the original advice we had something, therefore, that had been considered and the current advice that is being received. before the facility was granted and a decision was Somehow this still needs to be resolved, but, frankly, taken not to extend that guarantee at that time? it is not the most important issue, because I think the Sir John Gieve: We decided not to make an explicit Chancellor was absolutely right in saying that the guarantee that all depositors would get their money facility of the size required would almost certainly come what may, and at the time I still think that was become public knowledge, so it was not really an a reasonable judgment. In retrospect, of course, we issue worth pursuing. Nevertheless, that is an issue did not reassure the depositors because we did not to be resolved still on the table. I think, from my oVer that guarantee on the Friday, so we had to oVer conversations with central bankers from around the it on the Monday. world, they are very conscious of this case and they recognise that, irrespective of what the law says, in Y Q1647 Mr Brady: Who made that decision at the practice now it may be extremely di cult for lender time? of last resort operations to be conducted in the Sir John Gieve: On Thursday? 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 Q1648 Mr Brady: At the time previously. At the time think about how they intervene, which all of us will that you decided not to extend the 100% guarantee want to think carefully about. 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 Q1651 Mr Brady: The legal advice on the Market Chancellor. Abuses Directive, I think you said, came from the FSA? Q1649 Mr Brady: I am asking about the decision. Mr King: Yes, it was the FSA’s advice but it was Sir John Gieve: The decision not to go further than taken by the lawyers involved in the tripartite that was a tripartite decision in which, I think, all arrangements. There were lawyers from all three three parties were at one. bodies.
Q1650 Mr Brady: Can I move on and ask you, Q1652 Mr Brady: Would you be willing to share that Governor: when you gave evidence to us in advice with the Committee? September you told us very clearly that, “As a result Mr King: I would have to take advice as to whether of the Market Abuses Directive in 2005, we were the lawyers will allow us to do that. Often this advice unable to carry out a covert lender of last resort is given as a matter of legal privilege. I think I need operation in the way that we would have done in to consult on that. I personally do not feel strongly about it, but I think I do need to take advice on 1990s.” It has been reported since that the European 38 Commission does not agree with that view. Is that that. because the text of the directive is diVerent from the Chairman: I think that is a wise answer, Governor. UK legislation that enacts it, or is it matter of diVering opinions on the same text? Q1653 Mr Love: Is it inevitable that Northern Rock Mr King: There are certainly diVering opinions in will be nationalised? the legal world on that and, I can tell you, the final Mr King: I do not know. I do not think anything is resolution of whether there could or could not be a inevitable. I think it is still possible that it may be. covert operation was reached on the Tuesday before Until January we do not know what the state of the the facility was given. It was a decision by the FSA, financial market conditions will be. I do not think supported by the tripartite legal advice, on two you can rule out the possibility that a management grounds, one under the listing requirement and team will be able to obtain the degree of financing Northern Rock’s obligations as a listed company, that will enable it to become the preferred bidder and which the FSA is responsible for, and secondly, for that to lead to a successful bid. I would not want under the Market Abuses Directive. We were to speculate on what would happen. It is very advised by the FSA that under both it would require diYcult to do so. Northern Rock, not the Bank, to make a public statement to the fact that it had the facility. I should Q1654 Mr Love: We are told that it would need to say that Northern Rock were very keen to make a raise around £15 billion, mainly to pay back part of public statement that they had the facility. Their that that has been loaned by the Bank of England. view was that they did not want the covert operation; they wanted it to be overt because they 38 Ev 217 Processed: 30-01-2008 11:11:00 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG8
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Is there any possibility that they can do that in the Q1657 Mr Love: I was intrigued by your statement. timescale, especially since quite a lot of the You include knowledge of a discussion paper on shareholders, hedge funds in particular, seem to be liquidity regulation being produced by the FSA. I briefing against them? wonder whether you would care to comment—I am Mr King: I see two aspects to that. The first one is assuming that you have been consulted in relation to that, of course, part of the original bids did include this as well—as to whether it addresses issues of co- a proposal from the bidders to raise money and pay ordination between the tripartite partners? back at least the initial Bank of England lender of Mr King: Yes, it does, because it makes very clear last resort facility. That has become more diYcult in that, whatever regulation FSA adopts in an the last couple of weeks because of the deterioration improved sense to regulate liquidity, it will want to in sentiment in the financial markets, but if those co-operate and work with the Bank of England, were to improve in the New Year, that may come because the way we conduct our money market back onto the table again. The second thing I would operations will clearly have implications for the way say is that the diYculty of reaching a reorganisation they choose to measure liquidity and decide how to of Northern Rock, which is absolutely, desperately regulate it. But there is a very important point that needed, is made much more diYcult by the fact that was made by Professor Charles Goodhart in an article he wrote on liquidity a month or so ago, the shareholders can block what seems to be a where he said that there is no single number in sensible discussion of reorganisation by the people measuring liquidity that will tell you the true story. who are financing the vast bulk of the balance sheet, It is no good just looking at the amount of liquidity and it is precisely that problem to which the idea of you have got for the next two weeks, or the next four early, prompt, corrective action and having an weeks, you need to look at a range of numbers and agency that can intervene in a failing bank before it apply a qualitative judgment as to whether or not the reaches the stage of insolvency which is, in my view, institution has adequate liquidity. I do think it is so important. It is why all the other G7 countries important that this be taken much more seriously have introduced a mechanism like that, and the because, as I said, the Northern Rock is an FDIC is perhaps the best. 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 Q1655 Mr Love: Turning to the tripartite capital ratios of any bank in the UK, proposed to arrangement, do you think there is a need for drastic return that to shareholders and yet it was in a very surgery to the tripartite agreement? vulnerable liquidity position. That shows, if Mr King: No, I do not think there is a need for anything does, that capital is not all. That is not a drastic surgery. I think the bits of it that were criticism of Basle II, Basle II is designed only to look described explicitly in the Memorandum of at capital, but it does mean that, in parallel with it, Understanding, which set out the responsibilities of you do need a proper regime of regulation of the three partners, worked pretty well, but what did liquidity and the discussion paper the FSA will not work so well was that there were issues that came publish tomorrow is the first step on the process of up that were not described in the Memorandum of making sure we get one. Understanding, and the most important ones to me Y are the absence of su cient instruments available to Q1658 Mr Love: There have been suggestions and, the authorities to deal with a failing bank. That is indeed, comments made that perhaps the way to why I put so much weight on the importance of the address the tripartite arrangement is to create a new three points I made to you at the beginning this body that would come into play exactly in the morning. I think if we had the power to intervene circumstances that happened in relation Northern earlier, if somebody had the power to intervene Rock. Would you have any sympathy for that type earlier, and there had been a diVerent deposit of reordering of the way in which the arrangements insurance system, then I do not think the problems operate? with Northern Rock would have led to the outcome Mr King: What I think is most important is that we that resulted. 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 Q1656 Mr Love: Would you accept the criticisms views on, and that is something that can be about lack of co-ordination between the tripartite discussed. What is most important is that someone partners and, if so, what changes do you think are has got it and can exercise it. necessary to improve co-operation? Mr King: I think the co-operation worked well. It is Q1659 Mr Love: You are not minded to suggest that clear that the shock of seeing Northern Rock get into that should be with the Bank of England? such diYculty and the television pictures of Mr King: No, because the one principle that I have depositors on the street really made a big impact on pursued absolutely to the limit while I have been people, but I do not think that in and of itself means Governor is that we have never fought any turf that the co-ordination of the tripartite authorities battles. I would much rather give up any pretence did not work. As I said, when it occurred we simply that we should be involved in this than for the UK did not have the instruments to deal eVectively not to have these powers available to some with it. authority. It is not my objective to try to acquire or Processed: 30-01-2008 11:11:00 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG8
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18 December 2007 Mr Mervyn King and Sir John Gieve accumulate powers in the Bank, it is my only rate for two years, and I said, well, the Bank of objective to make sure that the UK has a system of England does not normally lend £30 billion to a resolving failing banks that works, and we do not going concern. In any event, our balance sheet is not have one at present. big enough for us to make that kind of decision, and it was absolutely clear, whatever way you looked at Q1660 Mr Love: So you are going to leave it to the it, it was clearly state aid. It was for a takeover bid Treasury Select Committee to make up their mind. to pay a positive share price to another company; so Mr King: I think the Treasury Select Committee are it was clearly state aid. So I said to the Chancellor an admirable group of people to recommend where that this was not something which the Bank of that power should reside. England would do. My advice, clearly, was that this Chairman: You are going too far, Governor! was not an operation which either central banks or governments normally did. If it were to go ahead it Q1661 Mr Mudie: Does that include me? would require an indemnity for the Bank of England Mr King: Absolutely. 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 Q1662 Mr Mudie: Governor, I would like to follow V up on a question Mr Fallon put to you in terms of make an o er of a loan of that kind to one bank to this leak that was very embarrassing for the buy Northern Rock without making it quite clear to Chancellor, Prime Minister and yourself. I accept other potential bidders that they too would have that you are nothing to do with it, but The Sunday access to it, and I think, as the Chancellor said when Times did say it was a senior Bank of England he came to you before, the idea that if he stood up oYcial. I would be interested to know what you have and said, “I am willing to lend £30 billion to any done since The Sunday Times came out. Have you bank that will take over Northern Rock”—that is had your senior people in? Have you checked not the kind of statement that would have helped diaries? Have you asked which ones put you in this Northern Rock one jot or tiddle. It would have been embarrassing position a few days before this a disaster for Northern Rock to have said that. So, hearing? I do not think it was ever a practical proposition, Mr King: I do not believe that anybody in the Bank but, in any event, no formal bid was tabled as far as would make comments of that kind. I know my we were concerned. colleagues well and I would not dream of saying, “Who had lunch with whom and when?” That is not Q1666 Mr Mudie: Mr Brady pressed you on this and the kind of comment that anyone in the Bank makes. I would like to come back to it. Did the Chancellor get specific Bank of England advice to give the retail Q1663 Mr Mudie: Do you think it is a type of depositors a guarantee at the same time as the reporting that The Sunday Times gets up to, using a announcement of lender of last resort? source in the Bank, a senior source in the Bank of Mr King: No. I have said that before. No, he did not. England? Mr King: I do not believe for a minute that those Q1667 Mr Mudie: Absolutely not? words in quotes corresponded to anything that a Y Mr King: Absolutely not. There was no discussion, Bank of England o cial actually said. in fact, among the principals until the Sunday. On the Saturday I spoke with the Permanent Secretary Q1664 Mr Mudie: So The Sunday Times were just of the Treasury and I met the Chancellor in person bolstering their story by the lazy use of a Bank of on the Sunday morning, and that is when I made my England senior source? clear advice, as he pointed out to you when he gave Mr King: You might think that, I could not possibly evidence to you earlier this year. comment. I have learnt over the years not to believe a lot of what is in the newspapers. Q1668 Mr Mudie: Let us be clear: which day did the lender of last resort leak out and become public? Q1665 Mr Mudie: The press are after the Mr King: It leaked out late on the Thursday. Chancellor, and yesterday’s Financial Times made Rumours in the market started on the Thursday three assertions about Northern Rock, and I would afternoon which led to a meeting at four o’clock of like to go through them with you. One of them I the standing committee of deputies, and at that raised with you last time, but I will be specific. Was meeting it was decided that, because of the concern there a rescue bid from Lloyd’s TSB on the table the about leaks in the market, not the television leak weekend before the run? That is the first part of that later on but rumours in the market, that the facility question. Was it specifically put to the Chancellor as should be announced at seven o’clock the next either advisable or acceptable, and did he reject that morning. That is when the decision was taken, on the advice, if given? Thursday afternoon. There were television reports Mr King: There was no firm bid on the table at all. later that evening. 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 Q1669 Mr Mudie: Against that timetable you did bidder but they wanted to know first, before putting not give advice to the Chancellor that when he made a bid on the table, whether it would be possible for that announcement he should also announce the them to borrow about £30 billion without a penalty guarantee for the retail depositors? Processed: 30-01-2008 11:11:00 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG8
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Mr King: No, we did not. superstructure of derivative instruments has been built on top of securitised assets, the whole complex Q1670 Mr Mudie: The third thing was that the structure of CDOs and CDOs of CDOs, and so on,.. Chancellor was advised to use the full leverage of the I suspect there may be less demand for it. I think they Bank facility to push the shareholders and will still exist for those people who genuinely believe management to accept an immediate private sale. they really understand the instruments, and there are Did the Bank give advice to the Chancellor to use those in specialised financial institutions who do that leverage at that sensitive time or, to your that, but I rather think that pension funds and others knowledge, did the FSA give the advice? may come to recognise that securitisation is fine but Mr King: Can you repeat the proposition. I do not just follow the basic maxim: only invest in what you recall anything like this. This is a proposal for— understand. John. Sir John Gieve: I think the key thing that the FSR Q1671 Mr Mudie: On the back of being so helpful to has shown up is that some unintended incentives Northern Rock. You have said yourself, Governor, were set up in the originate and distribute model as one of the things that is going to be a problem, if the it applied to credit products. So you find the negotiations went well and you were prepared to originators of mortgages had a strong incentive to think there was an oVer acceptable, the shareholders go for volume rather than quality and an awful lot are going to have a say. of bad loans were made; I think the rating agencies Mr King: Indeed. had an incentive to take on as many ratings for as many products as they could; I think the investors V Q1672 Mr Mudie: And I think the proposition is that had an incentive, because of the di erent yields, not to look at the fine print of what those ratings actually at the time you were putting the money in and there V was disarray and panic, et cetera, you had leverage o ered and, instead, just to go on the label; and, finally, I think the banks had an incentive to use oV- to say to the shareholders, “We want an immediate private sale.” Those are the exact words. balance-sheet vehicles for a lot of their operations. The market will correct some of these and the role of Mr King: Well, there was no proposition like that on Y the table, and my understanding and our legal advice the authorities will be to step in where o cial action was that it would not have been possible, because is also necessary to correct them. whatever accelerated deal one tries to bring about, the shareholders must be given proper time to Q1675 Peter Viggers: Yes. Banks do not trust other consider a bid and others must be given a chance to financial institutions, and you, Governor, said that make their counter bids. So, there was no advice at part of your role is to “dispel that sense of fear”, but all to do that. It was not possible. is not the problem that that fear is justified? Mr King: Certainly at present it is justified to be Q1673 Mr Mudie: Can I ask your deputy, because he cautious about where the losses on many of these has been getting a rough press and this is an complex and opaque instruments will ultimately opportunity. Do you think you have operated well come to reside. That is why I think we need a little the link between the FSA and yourself in the area bit of patience to get through the period, perhaps the you are in? Has it worked well or have there been end of February, March, when financial institutions deficiencies, and have you contributed to the will have had to reveal most of those losses marked deficiencies? to market and take whatever resulting steps are Sir John Gieve: I think the links between the Bank necessary to rebuild their balance sheets, and at that and the FSA have worked well in terms of exchange point I would hope that we will have made a big step of information and communication. They do not forward. But, as I said in August and when I came to just depend on me. I am on the Board of the FSA, see you in September, the most important step that is Callum McCarthy is on our Board, but we have put required here is that the private sector (and it can in place daily calls about market developments, the only be the private sector) needs gradually to FSA are represented on my Financial Stability restructure and re-price many of those complex Board and I think those did ensure that we shared instruments which people are now very reluctant to the information we had and we discussed the issues. lend against or buy, and that will take time, but the It does not mean we always agreed, of course. process is slowly beginning. There are risks to the Chairman: Thank you very much. world economy in the meanwhile if it results in a banking system that is reluctant to lend to industry, Q1674 Peter Viggers: A central ingredient of our and it is our job to try and take steps to minimise present diYculties is securitisation, the banks have that, but the resolution of the problems in the it, of originating and distributing loans and other financial sector will hinge on the restructuring and assets, and in your October Financial Stability re-pricing of instruments and the revelation of losses Report you stated that this model has been shown to and the rebuilding of balance sheets. At that point, have significant flaws. Would you calibrate those and at that point only, will you see inter-bank for us? spreads, these LIBOR spreads, return to normal Mr King: Let me make a brief comment and then ask levels, and it is very instructive that, whatever view John, because he is in charge of the Financial you take on how central banks have conducted their Stability Report. The securitisation model, I think, money market operations, there may be room for will return, but not in the way in which it has been disagreement, but whatever central banks did, these operating in the last few years in which an enormous three-month LIBOR spreads are absolutely Processed: 30-01-2008 11:11:00 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG8
Treasury Committee: Evidence Ev 187
18 December 2007 Mr Mervyn King and Sir John Gieve identical now in the euro area, sterling and dollar, mortgage market where people, without a great deal and that tells you that it does not have a lot to do of sophistication, were encouraged to take on loans with the provision of liquidity and money market that perhaps they could just about aVord to buy a operations, it has a great deal to do with the factors home that they never thought they would ever be that you mentioned. able to aVord and they were encouraged to think that they could aVord it, but only when the policy Q1676 Peter Viggers: The weapon available to you, rate set by the Fed was 1%, and once interest rates of course, is credit, and it is rather like pushing on a got back to a more normal level of 5%, they clearly V piece of string, whereas what we need is someone to could not a ord it. sort out the rotten apples? Mr King: Yes, and that will gradually happen, and I Q1679 Mr Breed: That might have been the genesis think the regulators and, indeed, the banks of the problem; that does not absolve our banks themselves have a very strong incentive to see this from lending vast amounts of money against asset- happen, but it does require auditors to go through a backed securities the underlying value of which they careful process of working out and validating the had no idea or ability to calculate. valuations which banks themselves put on their Mr King: I think a wide range of purchasers of those assets, and this will gradually happen over the next assets should ask themselves questions about few months. whether they really did understand what they were Sir John Gieve: I think the fear consists of two things. buying, but they are accountable to their One is that we do not know yet what the price is of shareholders, their trustees, whoever, and I think what has already happened, the subprime crisis, and, those people will have a lot to say about the decisions if you like, where the losses lie and whether it will that were made to take on board these assets. require recapitalisation. But there is also a fear about the future of the economy, particularly in the Q1680 Mr Breed: Prior to 1997, when the Bank of US, and the possibility that if that goes into England was involved with banking supervision, did recession there will be a further round of losses. I it monitor bank liquidity as part of that think that part of the central banks’ job is to provide supervisory role? some confidence that the economy will be managed Mr King: I think over a long period it has declined, in a responsive way going forward. We may not be the attention paid to liquidity. It is quite remarkable able to do much about the subprime losses, which that in the 1950s and 1960s as much as 30% of the are in a sense still being worked out, in the past. assets of a bank had to be held in liquid assets. That was part of the regulatory regime. Of course, banks Q1677 Peter Viggers: No doubt the situation will were not wildly profitable at that time because if you shake down, but should there be a role for leadership have to hold so much of a balance sheet in liquid here and who should take it? assets, your chance— Mr King: Central banks have discussed this a great deal amongst themselves, and I think the conclusion Q1681 Mr Breed: Much of it was held with you. we have all reached is that actually the resolution of Mr King: Much of it was, indeed, held with the the re-pricing of instruments is something which has Bank. Over time that ratio has declined until it is not to be conducted in the private sector, and the much more than about 1% now. 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 Q1682 Mr Breed: But you did monitor liquidity? losses and take steps to rebuild their balance sheets, Mr King: The Bank monitored it. One of the and you can see that beginning to happen, and I interesting aspects of this is that at the time when the think we just need a little bit of patience to see that Basle capital regime was being negotiated the Bank of England did start an initiative to begin a parallel process through. Meanwhile, as John says, the V challenge facing central banks, and one of the Basel liquidity adequacy regime, and it never got o reasons for our co-ordinated action last week, was to the ground; other central banks were not so try to ensure that the sense of confidence in how the enthusiastic. It is a shame, but maybe we need to get future policy will be conducted is suYcient not to back that. add this further fear that there will be a layer of extra losses coming down the road. Q1683 Mr Breed: Sir John, you are the Deputy Governor with responsibility for financial stability Q1678 Mr Breed: Teasing out a little bit more what and you are a member of FSA Board. Why are you you said about these asset-backed securities, is it not still in the job? now clear that far too many banks were Sir John Gieve: Because there is still an important irresponsible in lending vast sums of money against job to do and I have been appointed for five years. so-called asset-backed securities where they had no idea whatsoever of the underlying value of that Q1684 Mr Breed: Do you think you have discharged asset? that particular responsibility satisfactorily, bearing Mr King: I do not want to make generalisations in mind the state we are currently in? about what banks did or did not do. I think what is Sir John Gieve: Obviously there are lots of lessons to very clear is that in the United States there was some learn from the last six months, but I do think I have pretty extraordinary lending in the subprime done a reasonable job, yes. Processed: 30-01-2008 11:11:00 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG8
Ev 188 Treasury Committee: Evidence
18 December 2007 Mr Mervyn King and Sir John Gieve
Q1685 Chairman: Going back to the point Colin fundamentally wrong with the model or is it, as you made, we had one chief executive of an investment describe in your October report, that there are bank in here who could not even make a stab at what significant flaws in it, which you indicated earlier a CDO was. The issue here is the complexity of these could be addressed by the rating agencies, in whom products, is it not? around this table nobody has got any confidence, in Sir John Gieve: Yes. getting their act together, or the auditors, and, again, around this table I do not think we have got a great Q1686 Chairman: A tiny number of people knew deal confidence in them? If it is so diYcult to get to them, but maybe they did not even know, at the end the bottom of the risk involved in these complex of the day, what it was and how explosive a cocktail financial instruments, these CDOs, why do not we this was. This is the issue here. It is an understanding actually try and indicate that they should not be used of the ownership aspect where the risk was at all and we will not end up in the position that we diversified. These are the real core issues, are they are in now? not? Mr King: I want to try and distinguish between the Mr King: They are, but there is an element of (as I financial turmoil that we have now on the one hand call it) search for yield. Alan Greenspan would call and the fate of Northern Rock on the other, because it human nature; others might call it greed. Imagine they are separate. I think the turmoil created the two neighbours on a Saturday afternoon talking conditions in which Northern Rock met its fate, but over the fence, and one says, “I have got a terrific it was not inevitable, had we had a well designed investment adviser. He has told me to buy these system for dealing with failing banks, that it would things called CDOs. I have got no idea what they are, have resulted in what actually happened. So we can but you should see how much money they make.” deal with that, even if there is future financial And the other one says, “I will have some of that.” turmoil. We can put in place, as the Chairman said Once you see instruments that produce profit, earlier, a system for dealing with failing banks. In people will invest in it until the point when they terms of the originate and distribute model, I think, realise it has turned into losses. It is sad, it is that has been helpful in may respects and the plain unfortunate, but this is an aspect of investment that vanilla sale of securitised mortgages has been a very appears to have occurred for as long as investment healthy development and has, in fact, enabled a has been recorded in human history. number of smaller financial institutions to obtain funding from others by borrowing against the Q1687 Chairman: Surely there have to be some up- securitised form of mortgages, and that has been lines in the future. We have got to change this helpful. Where it has become much more system. problematic is certainly the excitement, possibly the Mr King: What we have to do is two things. One is hubris, of parts of the financial system in thinking to put in place a system that as far as possible is that they could devise and invent instruments of designed to help us deal with a failing bank, because ever-growing complexity and, at the same time, banks are diVerent from ordinary companies, and, assume that the market in those instruments would secondly, we have to work harder to try to draw always be deep and liquid. It is almost a people’s attention to the complexity of some of these contradiction in terms that if you invent an assets and to make them think twice. When I spoke instrument that only a handful of people at the Mansion House in June I could not have been understand—understanding it demonstrates the clearer. I said: are we really cleverer than the kind of abilities that win you a Nobel Prize—you financiers of the past? The answer to that is pretty cannot expect the market to be deep and liquid, and obvious now, but trying to get people to think about what we have to try to do is to make sure that people that is not easy. One of the tasks that John and I have responsible for investment decisions, whether it is in the next few months is to try to work out a way pension fund managers or others, just say to in which we can ensure that when we write Financial themselves, “I am not going to be seduced into Stability Reports and give warnings, that we do not investing into something I do not understand, even just put it out into the ether, we try to find a if I get criticised by people for not earning a high mechanism by which people have to respond and enough rate of return as the next man last year.” One they visibly have to respond. I do not have any of the diYculties here is this immense pressure from simple answers to that, but I do think it is a challenge short-termism to demonstrate, even as a fund for us. It is one of the lessons and we have to do manager, that you have to have each quarter an something about it. above average return. This is a collective madness, Chairman: We have given that some attention. Nick. the idea that everyone can have above average returns, and that is the sort of psychology that needs Q1688 Nick Ainger: Governor, following on from to be changed, not that we need to ban certain Peter Viggers’ and Colin Breed’s questions, what instruments. I do not think that will help. It is the started, as you and Sir John have described, as mis- underlying motivation behind it: what led people to selling of mortgages in Chicago or Washington DC buy things that they did not understand? That is the ends with global financial turmoil, a run on a British problem we have to address. bank for the first time ever in 140 years and nearly 6,000 people in the north-east of England facing redundancy. The conduit for that virus has been the Q1689 Nick Ainger: Yes, it is a problem we have to originate and distribute model. Is there something address. How are we going to address it? Processed: 30-01-2008 11:11:00 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG8
Treasury Committee: Evidence Ev 189
18 December 2007 Mr Mervyn King and Sir John Gieve
Mr King: I have no simple answer. On our part, we Q1694 Nick Ainger: But that way of dealing with it have the responsibility for trying to think much just deals with the symptom rather than the real more deeply about how we can get our message cause. about the risks in the financial system across to a Mr King: I think the real cause does lie, in essence, wider range of people and to make sure that the in human nature and the wish to try and get higher financial institutions respond and acknowledge in returns. My own belief in this, and I think experience public that they have seen our warnings and bears it out, is that if you try to pass some detailed understand them so they cannot use alibis later on, regulation saying a particular kind of security but in the end it does come down to human cannot be sold to certain people, then there are very motivation that, if they think that something they do clever people out there who will just devise a new not really understand may nevertheless give them a kind of instrument that has not yet been prevented higher profit, they will go for it. from being sold to others and people will get round it that way. What we do need is clearly a sense of Q1690 Nick Ainger: If that is a problem, then it is responsibility. There is cultural change, I think, in going to continue, is it not, unless there is clear getting away from this extraordinary short-term regulation to prevent it happening, to actually focus on returns in the financial world, but also change human behaviour or banking behaviour? people who buy these instruments, whether they are Mr King: I do not think you can regulate— pension fund managers or people who hold positions in banks, need to recognise that they Q1691 Nick Ainger: The problem is we already had a should be held accountable for making decisions situation, because of the business model of Northern about what assets they choose to hold and it does not Rock, that was far riskier than other models, but make sense to go out and buy a whole lot of clever nothing was done about it. things that you do not understand just because Mr King: That is where liquidity regulation would somebody whom you have hired as a fund manager help: because if we had a system of proper liquidity tells you that is what you should do; it is the latest regulation, although Northern Rock would have thing. shown up as doing very well on the capital side, it would have looked very flawed on the liquidity side, Q1695 Nick Ainger: But that is exactly what they and that would have been picked up. The FSA did. recognise that, and that is why they are proposing Mr King: That is what some of them did. their discussion paper, so they can improve the Sir John Gieve: Can I just add a couple of points. system of liquidity regulation. That is the lesson Firstly, the investors in these cases were professional from Northern Rock. investors and included actually the banks themselves, many of whose losses came from Q1692 Nick Ainger: In terms of lessons that can be retaining chunks, tranches, of securities that they learnt about the originate and distribute model and themselves had helped promote. The second point is the CDOs, would you propose regulation to prevent that addressing this has to be done on an what you have described as human or banking international basis, because these are international nature, if you like the requirement within certain instruments; and so we are working through Basle, financial institutions to take unnecessary risks to where the director of financial stability in the Bank achieve high returns? is leading the work on liquidity, and in the FSF, Mr King: I would not be in favour of regulation to where I and Callum McCarthy are involved, to try prevent people devising and selling instruments if and get an international policy consensus on how to they wanted to do so. What I believe is that, after this address these issues. episode, the demand for such instruments, the very complex and opaque ones, will fall radically. What is much more important is that 15 years from now we Q1696 Chairman: Another method, to add to Nick’s publish in our financial stability report a reminder point, is training for people and banks so they have that 15 years ago this is what happened, because proper training, Governor. To take the example of there are cycles in this. You see crises, people learn Northern Rock, neither the Chief Executive nor the the lessons and then gradually they forget them. Chairman had a financial qualification. Mr King: I do not want to comment on that. What Q1693 Nick Ainger: Exactly. Surely the problem I would say about Northern Rock (and this is the would be in 15 years’ time if you actually publish in tragedy of Northern Rock) is that most of the staV your financial stability report, “We told you so, and that worked in Northern Rock on the lending side, so it has happened again.” Is not that the risk by not all the evidence shows, did an excellent job in taking regulation to try and address the problem? appraising the loans that they were making, and that Mr King: I think clearly we need an adequate system they monitored very carefully and they did not lend of regulation of banks, but I think the combination money to people who should not be borrowing from of the existing capital regulation and a new regime them. The lending side was handled extremely well. for liquidity regulation would be suYcient, provided It was the borrowing side; it was the business that we also had in place an ability to have a special strategy that was fatally flawed in this episode where, resolution regime for banks so that when they did get once those markets had closed in mortgage backed in trouble it did not have adverse consequences for securities, they were absolutely unable to finance the depositors. their wholly illiquid assets. Processed: 30-01-2008 11:11:00 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG8
Ev 190 Treasury Committee: Evidence
18 December 2007 Mr Mervyn King and Sir John Gieve
Chairman: That as is an eloquent answer for us. making some of the investors more dependent on Sally. credit ratings agencies because they will look to them for a wider range of assessments? Mr King: Rating agencies is a very important issue Q1697 Ms Keeble: I wanted to ask about the credit for everyone to confront. It is being discussed rating agencies, but first, very quickly, what you internationally in the Financial Stability Forum, basically said this morning is that there is and John is the representative of the Bank in the uncertainty still about the possible scale and Financial Stability Forum, so I think John should distribution of losses, that there is some work taking take this. place to bottom these out, although it is not clear Sir John Gieve: On the five suggestions, the final one, whether people know where the risks are, and they should they give some view on market risk, I think are just not saying, and we will not really know until when Hector Sants came here he said it depends on next March April, once the banks start to rebuild whether they can do it sensibly and in an their balance sheets, exactly where all the risks have understandable form, and I agree: if it is going to been and what the losses will be. That will be seven confuse people further, then they should not do it. I or eight months after the start of the crisis. Do you think it is quite important for the functioning of really think it is adequate to watch this unfold with capital markets that the rating agencies do re- the possible risk of another Northern Rock disaster? establish their credibility, because it is a collective Mr King: I think the problems we are facing are good, if you like, to the players in the capital markets international in nature, as John has said. The that they are able to rely on an independent body to problem of Northern Rock is a UK problem because give some assessment of credit quality. we do not have an adequate framework for dealing with failing banks, but to solve the international problems will require a process. We said at the very Q1699 Ms Keeble: But (a) they are not actually beginning that it will be lengthy process by which all independent, which is one of the basic problems, and these complex instruments will have to be (b) there is a little sort of caveat at the end, and I restructured and re-priced in order for the auditors think it is from your report, saying that it is still and accountants to be able to calculate what the true critical how they carry out their own due diligence, position of each financial institution is. We have which is like a health warning, which is an certainly encouraged them, and the IMF have astonishing throw-away line. How do you propose encouraged them, to move as quickly as possible in to get people to improve the due diligence? this process. It is not easy, because when markets are Sir John Gieve: First of all, we do not have to make open, and deep and liquid, then marking to market, them do it. In a sense investors all round the world as is the current convention for establishing losses, are currently thinking they put too much weight on makes a great deal of sense and can be done without the rating agencies and are trying to either restrict an enormous degree of exceptional eVort, but once their investment range to the products they those markets have closed, it then becomes understand well or to increase their own work on extraordinarily diYcult to know at what prices you where to put their money. So, I think that that is a should value some of those instruments, and that is market development. exactly the diYculty that some of the banks have had. It it is quite possible that if the auditors are insisting on using, say, a fire-sale price used by Q1700 Ms Keeble: How about the independence another bank to value the assets, many of the losses factor? that are currently going to be revealed will be Sir John Gieve: I think the independence—. I think marked up again to profits next year as some of the fact that the rating agencies are paid by the issuer those prices recover a bit. This is a tricky and diYcult is a problem and did encourage the rating agencies process. It does need to be gone through, but it has to expand their business into structured credit as far been a very salutary lesson, because this crisis has as they could, and perhaps beyond where their become international in nature. It is not a crisis of models could really support the rating. I would emerging market economies or failed macro- welcome it if investors themselves could sponsor a economic policies in the rest of the world, this crisis rating agency which was dependent on investors; in goes right to the heart of the financial centres of the other words they were being paid by the people they three big developed parts of the world, and that has were supplying the service to; but that has not been, I think, a salutary lesson. I think many of those proved possible as a business model. I would not be lessons will be learnt, but what we have to do now is surprised if some of the investment bodies consider to encourage the banks to go through this process of that again. revealing the losses and then recapitalising the balance sheets. Q1701 Ms Keeble: How are you going to carry these proposals forward? I would just come back to you, Q1698 Ms Keeble: Can we turn to the credit ratings Governor. You said this was an international agencies, because in the financial stability report problem and needed international solutions, but we there are a number of recommendations made for are supposed to be world leaders in financial reform, including widening the scoring systems to services. Surely it is not adequate to say it is an include diVerent factors. Do you think that this international problem and we are just little UK here might have the unintended consequence of actually doing our own thing. Surely we should be having a Processed: 30-01-2008 11:11:00 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG8
Treasury Committee: Evidence Ev 191
18 December 2007 Mr Mervyn King and Sir John Gieve major influence in the international arena, in Mr King: Yes. John has been working on this, so I particular in dealing with the problem of the will let him answer. ratings agencies. Sir John Gieve: Essentially, this does widen the scope Mr King: That is absolutely right, and we are, and of the guarantee to pretty much the whole balance there is no doubt that a lot of material that goes to sheet, excluding the capital instruments and the the Financial Stability Forum comes from the work Granite securitised instruments. Of course, all that of the Federal Reserve and ourselves. We are the two guarantee is secured against the assets of the main financial centres that people look to in wanting company. So, if there is a net asset value in the advice in these areas and we are making a big input company, then there is security for all the assets that into it, but, as John says, trying to find a purely have been guaranteed. domestic solution will not work. These are international ratings of internationally traded instruments; so we have to take our partners with us; Q1705 Mr Dunne: So you can confirm this is a but there will need to be, I think, reappraisal of this. Treasury facility, not a Bank of England facility, Not least is the fact that the Basle system of capital although it is operated through the Bank of regulation that is about to be introduced more England; but the risk falls on the Treasury rather widely across the world does itself rely on ratings than the Bank? provided by ratings agencies, and that is an issue that Sir John Gieve: It does, yes. The guarantee is a I am sure people will want to look at again. Treasury guarantee, and it goes wider than the 25 Sir John Gieve: Just on what could be done, the main billion advance that we have actually made. It covers rating agencies are approved by regulators, by the also all the retail deposits and now nearly all the FSA and the SEC, so that their ratings can be used wholesale deposits as well. in regulation. One possibility which I know we are examining is whether we build on that certain new requirements. There is a code at present, but you Q1706 Mr Dunne: Indeed. Does it also cover the could build on that, for example, in the areas that we investments which Northern Rock has in other have suggested. So that would be a way in which market traded securities: so instruments issued by public authorities could influence what happens. other issuers where the trader will on trade it? Sir John Gieve: It does not cover the asset value of their assets, it covers their liabilities under some Q1702 Mr Dunne: Before coming on to looking to swap and other transactions. the future, I would like to ask a couple of questions about what has happened today. Can you confirm what the Bank of England exposure is to Northern Q1707 Mr Dunne: I am looking at the balance sheet Rock today? of 31 December 2006, and obviously there are more Mr King: I am not going to give a number today, recent balance sheets available to you, I assume. because I do not think the central bank in its role as There is some six billion of debt securities in issue lender of last resort should be giving a sort of public covered bonds. Those are bonds which have been commentary, minute by minute, on the scale of any issued by others which have been acquired by facilities. What we have said is that if it would help Northern Rock. Is that right? the company itself to reveal the scale of the Sir John Gieve: I am sorry, I have not got that in borrowing, then it is free to do so, and ten days ago front of me. Northern Rock itself has issued covered it did reveal that the facility was from that point bonds, and part of the announcement today was to £25 billion. cover the liability that may arise if the obligations exceed the proceeds of the realised collateral on those covered bonds. Northern Rock also has a Q1703 Mr Dunne: From the Bank of England. Mr King: Yes, but in two facilities. It is very treasury which holds some securities, interest important to distinguish between two facilities. The bearing securities, and it made a statement, I think first facility was the original Bank of England lender last week, about the nature of those securities. of last resort facility. That is securitised against Mr King: Of the total balance sheet, approximately collateral that is in is our possession; we have that in 40% is in Granite, about a third is now covered by our accounts. The second facility, introduced in the extended guarantee, about a quarter is the October, is the facility from the Government contribution of the Treasury and the Bank through through the Bank of England to Northern Rock their loans to Northern Rock, leaving a very small with an indemnity from the Government, and that is residual for the basic capital of the bank itself. entirely at the risk of the Government and, therefore, they determine what happens to it. Q1708 Mr Dunne: What you are telling us is that roughly half of the balance sheet at the moment is Q1704 Mr Dunne: Thank you for making that clear. guaranteed by the Government in one form or The Government today has announced that they another, roughly £50 billion? have increased their guarantee arrangements to Mr King: As John said, if you take out the basic cover, it appears, all liabilities of Northern Rock. capital of the bank—subordinated debt, equity and Could you comment on that, in particular the scale so on—and take out Granite, put those two things to of that underwriting and the security package, if one side, then most of the rest of it is eVectively there is one, underlying it? covered by the guarantee. Processed: 30-01-2008 11:11:00 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG8
Ev 192 Treasury Committee: Evidence
18 December 2007 Mr Mervyn King and Sir John Gieve
Q1709 Mr Dunne: That would also cover Northern Q1715 Mr Dunne: Could I take you back, Governor, Rock’s sellers’ share, as it is known, within Granite; to your answer to the first of Mr Mudie’s questions so approximately seven billion pounds of, in relation to the history of Northern Rock, the way eVectively, Northern Rock’s equity in Granite is it unfolded. You were very clear in saying that there now also subject to the guarantee. was no firm proposal on the table when you were Mr King: That is an asset, not a liability. This only asked whether the Bank would guarantee a bidder’s covers liabilities. funding arrangement. Would you as the Bank of England have seen the detail of negotiations that Q1710 Mr Dunne: Indeed, but in relation to the were taking place between Northern Rock and any collateral package that the bank has, if that of the bidding vehicles? collateral were to fail, the guarantee would be called Mr King: This is between Northern Rock and the in relation to those assets? bidders in the recent— Mr King: There are two kinds of collateral here. On the original Bank of England facility there is name- Q1716 Mr Dunne: In September before the lender of specific collateral, which is already in our possession last resort. I am specifically referring to the Lloyd’s in our accounts in Euroclear and so on—that is TSB approach. already legally in our possession—there is a margin Mr King: No, at that stage any discussions between over the extent of the loan, so that we are a clear Northern Rock and any other potential bidder margin above the value of the loan, and then the would come under the heading of private sector second facility is basically covered by a floating solutions and were the responsibility of FSA. charge of all the assets of Northern Rock, the whole lot, right down to the paper clips. Q1717 Mr Dunne: Indeed; so you would not necessarily have known whether there was a firm Q1711 Mr Dunne: Indeed. So the Bank of England proposal available. You were being asked has quite properly got the best security and the specifically whether you would provide a facility and Government has got the least. you would not necessarily have been privy to all of Mr King: I do like to think that we are seen together the detailed negotiations that were going on between in the public sector as a consolidated balance sheet, the private bidder and Northern Rock? but it does mean that it is appropriate for the Mr King: No, but I would have thought that, if there Treasury to take the decisions about what is had been a firm bid on the table, we would have been happening to Northern Rock, because they are the informed of it, and we were not. ones bearing the risk. Q1718 Mr Dunne: You were informed, were you Q1712 Mr Dunne: Indeed; and that risk would not? You told us, I think today, you were invited to appear to have increased significantly with this provide a facility in the context of a bid. additional undertaking given today. Mr King: In the context of a possibility of a bid, but Mr King: I think this was a natural extension to help it was not suggested that there was a firm bid on the company. What is important now is to try to the table. make sure we can stabilise the company and, as soon as possible, find a new management team and Q1719 Mr Dunne: No, but the bid could only have organisation to take it forward. I think that is the been firm had you provided a facility, and, therefore, next step. for you to say that that there was no firm bid on the proposal is circular? Q1713 Mr Dunne: Indeed, but if the bank is only Mr King: No, I do not think that is right. We were solvent as a result of the guaranteed facilities which quite explicitly told that it was not the case that there you have put in place, and if any of the underlying was a clear bid which was there in every detail but asset values are not realisable at the level at which could proceed only if the money was made available. they are in the bank’s balance sheet, then the tax That was clearly not the situation. The situation was payer will lose, will they not? other way around, that the bidder did not want to Sir John Gieve: There is a margin of capital, as come up with a firm bid or get into excessive detail Mervyn was saying. Yes, no lending is without risk, until it knew that such a facility would be available. and if the assets prove to be worth less than they are That was what we were told. currently valued at, yes, that is the risk. Q1720 Mr Dunne: Was it the case that that precise Q1714 Mr Dunne: Indeed, and in a falling housing confirmation from the Bank of England was in market and in a market where it is diYcult to limbo, if you like, over the week leading up to the determine the underlying value of some of these date on which you decided that would not be securities which are sitting on the banks balance provided? sheet, that would look increasingly likely. Mr King: No. Sir John Gieve: To be clear, Northern Rock’s assets are nearly all prime mortgages in the UK. Of course, Q1721 Mr Dunne: And, therefore, that the bidders you can have defaults on prime mortgages, but were being encouraged to continue their discussions Northern Rock was not itself in the business of in the hope and expectation that you might come creating sophisticated products. through with that confirmation? Processed: 30-01-2008 11:11:00 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG8
Treasury Committee: Evidence Ev 193
18 December 2007 Mr Mervyn King and Sir John Gieve
Mr King: It certainly was not my understanding. Q1726 Mr Mudie: Governor, in your October When I spoke to the Chancellor, when there was financial stability report you were commenting on communication between my oYce and his, he also the business model of banks, and you projected three shared my view, and it was my advice, that it would scenarios. Which scenario would you prefer the be most peculiar for either the Bank or the banks to adopt? Government to make a £30 billion loan to a going Mr King: Sorry, the scenarios in the— company to buy another one when that would have to be made public long before you could actually be Q1727 Mr Mudie: One of them is redesign the sure the bid was going to go ahead, and I think the securities so they are transparent and keeping that bid was then withdrawn. It was not withdrawn; it business; the second one, which I cannot believe you never materialised. would accept, is regard the present situation as a Mr Dunne: I need to move on because I am short temporary set-back and carry on as before once the of time. market has settled; and the last one is to settle back Chairman: I think we will have a last question, and go towards a more traditional model of Philip. banking. Mr King: I certainly do not accept the second one, because I think it is very unlikely that we will come Q1722 Mr Dunne: Okay, Chairman. Do you believe back to that. I do think that the originate and that it is important for the confidence of the financial distribute model has real value, and I would not system in this country that central bankers serve want to see it disappear. Indeed, in some ways what their full term? happened was that it was not a proper originate and Mr King: I have no idea. In general, I think central distribute model because many of the assets did not bankers should be appointed and serve whatever actually fully disappear oV banks’ balance sheets, part of that term they wish to see through. they were still kept on through the links, through conduits which had to be supplied with liquidity facilities and special investment vehicles. So, I would Q1723 Mr Dunne: If you were oVered a second term, like to see perhaps a mixture of a return to a more would you expect to serve it in full if your health traditional banking operation. There is a real place allowed? for securitisation, but I do think that what is most Mr King: What a depressing thought. That is important is that we need to recognise that banks something we will return to after Christmas. can be rather dangerous institutions at times. They have extraordinarily highly levered balance sheets, and a mixture of appropriate regulation and careful Q1724 Chairman: Have a good Christmas. management of their liquidity position by banks is a Mr King: Thank you very much. sine qua non of any healthy financial system, but in Chairman: Okay, Phillip. reserve we must put in place those three changes that I mentioned in my opening statement because I think they are fundamental to having a banking Q1725 Mr Dunne: I do have some other questions. system where we can have confidence that, if Can I have a very quick question in relation to your problems arise, we have a method of dealing with statement today and the operation of monetary them. policy? Is it your expectation that the concerted action by the Bank of England and the other central Q1728 Mr Mudie: If problems arise. That takes us to banks, which was announced last week and is being Mr Ainger’s questions. As Governor, if you have a V implemented today, e ectively marks a new desired model, do you see yourself as having a direction for monetary policy and recognises the proactive part in ensuring that financial institutions Y V di culty of e ecting spreads, which we talked about adopt that model or is it that you are just there to when we last met, thorough reductions in short-term clear up the mess? interest rates? Mr King: I think the Governor does have a role in Mr King: It is hard to say whether it would turn out speaking out, as I did in the Mansion House in June, to be an important step. I do think what was but I have to give some serious thought now to how valuable was the demonstration that the central far we can ensure that our general views and banks were all facing the same problem and comments are really taken on board. I do believe recognised that there was no easy way through. that the experience of the last few months has been Indeed, the diYculty we face is that even the a chastening one for not just London but for all the operations we have put in place cannot be major financial centres in the industrialised world, guaranteed and, indeed, are unlikely to bring about and they will learn lessons. Our task, I think, as an a significant reduction in spreads, except in so far as institution that will be here long after any of us are the operation can improve the confidence of the around, is to make sure that institutionally we keep banking sector in believing that the central banks coming back to remind people that these risks and acting together will try to ensure that there is not a problems can occur. serious downturn in the world economy and, hence, that they should be less concerned about the capital Q1729 Mr Mudie: Do you think your only weapon position of other banks than they might have been in is making a speech? I do not mean to decry making a recent weeks. speech but can you not be more proactive than that? Processed: 30-01-2008 11:11:00 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG8
Ev 194 Treasury Committee: Evidence
18 December 2007 Mr Mervyn King and Sir John Gieve
Mr King: We have no other policy instrument. weeks there has been a palpable sense of—I use the word—fear in financial markets about the capital Q1730 Mr Mudie: Using your influence. position of banks, and that was a point where I think Mr King: In the end influence comes down, I think, all of us in central banks decided that, collectively, to making an argument which convinces people. Our we needed to take action. That had not been done task is not to tell people what to do; FSA are the before; no central bank had acted in concert with regulator. If by giving speeches which are suYciently others in August or September—there appeared no compelling and through the financial stability report need to—but now there was a collective feeling that and the work from John’s team we can convince we ought to do that together, and we have. people that what they were doing was to take risks that they did not fully understand, then maybe we Q1733 Jim Cousins: Do you think more action by will bring about some improvement, but I do feel central banks or other international financial that in the last few years we are seeing a certain agencies will be required. This is not the end. degree of hubris, and it is never easy to persuade Mr King: It is not end, and I do not know. I do not people suVering from that to think deeply about think the provision of liquidity in this form is the be risk. Alan Greenspan was not very successful in all and end all. It is not a simple answer. I very much getting across the idea of irrational exuberance. We doubt that of itself it will lead to a significant have to keep plugging away and trying, but I think reduction in these spreads in the inter-bank market, trying to win the argument is our main weapon. but I think the demonstration that central banks are working together is important. Q1731 Mr Mudie: I think he got out in time though! Sir John Gieve: Can I just mention three ways in Q1734 Jim Cousins: Governor, I must put this to which I think we can have influence. First the FSR, you. Do you not think that your colleagues in central for which I am responsible, is a good analysis, widely banks will start to have worries about our central recognised as such, but we can probably do more in bank because of its communication failures and the market. For example, talking to analysts, and so because of the leaks with which it has become on, who themselves comment on banks to try and associated? ensure that they are aware of our view of the Mr King: I do not think it has become associated vulnerabilities. We can do, and are doing, a lot in the with leaks, and I do not think there are international policy arena, so through Basle and the communication failures. I said to you that I wish I FSF, which I have spoken about, to change had spoken out in August. I felt that there were international policy. And thirdly we can consider enough people speaking in August; it did not need whether we can take this analysis down a level; we more; but I wish I had spoken out in August. What have been deliberately careful under the MOU not we have been trying to do is to clarify how these to get involved in assessing individual institutions money market operations work, and they do not because that has been the FSA’s job, but there is a work by injecting extra liquidity into the system, question about whether it would be helpful for us to they work by substituting one maturity for another go a little bit further in drawing out the lessons for or, in some cases, using diVerent ranges of collateral, particular institutions where that would help the but it is not a case of injecting additional liquidity. FSA in their task of identifying vulnerabilities. We are the only central bank that injected a Chairman: Thank you. Jim and then Mark to finish. significant extra amount of liquidity.
Q1732 Jim Cousins: Governor, you told us this Q1735 Jim Cousins: You told Radio 4, “It became morning you think this is a crisis at the heart of our evident that many of the funders of British banks main financial centres, and we have seen in the last around the worlds were no longer willing to fund week or two co-ordinated action by a group of British banks.” Do you not acknowledge that your central banks to put cash support into the banking own performance and your own judgments are now system. Why did it take other central bankers to a market factor which is aVecting us all? force you to give up the principle of the penalty rate? Mr King: No, I do not accept that. I certainly accept Mr King: It did not, and we have not given it up, in that the fear of Northern Rock has led to diYculties the sense that the auction this morning that was for the British banking system. As I have explained, conducted did produce an eVective penalty rate. I think the real cause of that was the fact that it Those Banks who obtained money against wider entered August 9 with a very weak liquidity position collateral paid an interest rate of around 60 basis and that after August 9 the authorities together had points above Bank Rate; so the mechanism for doing no eVective tools with which deal with a bank in that it did, in fact, produce exactly that; but the nature of position. That is why the changes, I think, are so the problem in the last four to five week has changed necessary in the long-term. Those were the causes. quite markedly, and when that changes we too will change. When I sent my document to you in Q1736 Jim Cousins: Sir John, you have heard all the September before coming on 20 September,39 I made discussion about the nationalisation of Northern very clear in it that the judgments we were making Rock and you have a considerable knowledge about the nature of operations are ones that we yourself of Northern Rock. How easy would looked at almost daily, and in the last four or five Northern Rock be to denationalise? Sir John Gieve: As you know, plan A is to complete 39 Ev 214 the Virgin or Olivant approaches. Processed: 30-01-2008 11:11:00 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG8
Treasury Committee: Evidence Ev 195
18 December 2007 Mr Mervyn King and Sir John Gieve
Q1737 Jim Cousins: I know about plan A. Rock would be available to other banks if they were Sir John Gieve: Plan B: if we are forced down the to find themselves in a similar situation. That is why road of nationalisation, it would clearly be, as I think it is critically important to move to a Mervyn said, as a temporary measure to then permanent regime with a special resolution regime relaunch it in some form. I do not know whether it for banks and a reform of deposit insurance, because would be easy or not. We are concentrating on the that is the exit route from where we are now to go bids we have got rather than the bids we might get in into that new regime. those circumstances. Sir John Gieve: If you were setting up something more like the FDIC in the UK, I think it would make Q1738 Jim Cousins: Do you think there could be a sense for that also to do the deposit insurance, and problem with denationalisation? especially if you were having payments in advance Sir John Gieve: I am pretty sure that if the bank into a deposit insurance fund. So, I think the future either went through an administration process or of the FSCS depends on whether we are doing that. was nationalised, it would be possible to pass many of its activities to other institutions in the private sector. Q1743 Mr Todd: What I am asking about, and you are conceding this, is the linkage between deposit Q1739 Jim Cousins: How many of its employees? insurance, which is a way of reassuring the Sir John Gieve: I really could not say. consumer, depositor, and the public policy issue of how you ensure that a financial institution continues Q1740 Mr Todd: The FSA have defined the role of in being if one takes the view that all but those which the Financial Services Compensation Scheme as are insolvent should remain in being, and then the being not able to deal with all potential failures in diYcult issue of moral hazard, in which, if you have financial terms nor to be a crisis management tool. made that public policy commitment that these Should it be more comprehensive in its coverage of institutions should continue in being, how you potential crises in financial services providers? control their behaviour, since they are, by Mr King: I think that will depend on where the implication, passing on risk direct to the taxpayer? special resolution regime authority were to reside. Mr King: That is why it is so important not to rely We look to you for guidance on that, as I said earlier, just on deposit insurance. If you have deposit but what is most important is to recognise that insurance, there is no point having 90%, because that deposit insurance for banks is, in my view, rather V will not stop the bank run, as we saw, it has to be di erent from insurance of other types of savings 100% but only up to some limit. In order to prevent products and investments. It is not obvious they banks taking excessive risks on the back of that need to be in the same institution. deposit insurance—the moral hazard risk—it is much more important to have in place the special Q1741 Mr Todd: At the moment there is some lack resolution regime whereby the authorities can get of clarity as to what such a scheme would cover. If it control of a bank that has been taking too many is purely designed for some very small institution of risks, particularly on the liquidity front. That is why, some kind and has no ambition to cover anything as John says, the FDIC mechanism does naturally very much larger, then that begs the question of go hand in hand with the deposit insurance for where the liability for resolving the future of larger banks, but only for banks. institutions should lie and, if one wants to control the risk of that lying in public hands, how we seek to minimise the risk of that occurring. Mr King: I think any such reform to bank deposit Q1744 Mr Todd: If you like, that is the trapeze safety insurance ought to cover all banks. That would be net, but there should be some mechanism to ensure the sensible thing. It is a practical matter. It is much that people are not actually playing the high harder to resolve problems with big banks than with trapeze act. smaller ones, but that is a question of eVort and Mr King: That is regulation. scale, not a question of principle.
Q1742 Mr Todd: The British Bankers Association in Q1745 Mr Todd: Because we have got to find a one of their submissions to us has said it is self- means of controlling the risk to the public sector. I evident, and in this current environment it is diYcult think most of my constituents would be alarmed to to envisage the UK authorities allowing the failure think of the scale of commitment, which some of the of implicitly any retail deposit-taker. Are we in a earlier questioning amplified, that their tax had been position where no deposit-taker could ever be guaranteed towards already in this particular crisis allowed to fail? or that w could end up actually owning a bank as an Mr King: I think if we had a repetition, for example, outcome. That would be a considerable surprise to of a BCCI case, where it became clear that the bank most of my constituents. was totally and wholly insolvent and there was no Mr King: Indeed, but that is why I think the only possibility of salvaging it, then I think there would way out of this is to move to a carefully designed be little point in saving it, but in terms of banks that special resolution regime for banks and associated seem to have a prospective future, as the Chancellor deposit insurance. Only once you have got that in said, the guarantee that was extended to Northern place and you get away with tax— Processed: 30-01-2008 11:11:00 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG8
Ev 196 Treasury Committee: Evidence
18 December 2007 Mr Mervyn King and Sir John Gieve
Q1746 Mr Todd: And a regulatory regime. Sir John Gieve: We believe there is a net asset value Mr King: Yes, and a regulatory regime. in Northern Rock, and the default record so far on its loans is pretty good by industry standards. Q1747 Mr Todd: To reduce the risk to the public However, you can never be certain of these things. purse to a point that people would regard that as a very unlikely eventuality to arise anyway. V Mr King: Yes. The price for having e ective implicit Q1749 Chairman: Governor and Sir John, can I support from the public sector is the acceptance of Y thank you for your evidence this morning. We have su cient regulation and, crucially, the ability to had an invite for Christmas drinks at the Bank of intervene in a failing bank before the point of England tonight, but you will have to take my insolvency. Chairman: Graham with the final question. apologies. I have got a more important agenda going to a concert in my local constituency, but I am sure Q1748 Mr Brady: One last question on Northern you will all keep yourselves fit, ready and proper to Rock. Sir John, you used an interesting phrase read our report when it comes out in January! earlier. You said if there is net asset value in Mr King: We look forward to reading it. We hope Northern Rock. What is the Bank’s assessment of you will be writing eagerly over Christmas! that? Chairman: Thank you. Processed: 30-01-2008 11:12:39 Page Layout: COENEW [SO] PPSysB Job: 386890 Unit: PAG9
Treasury Committee: Evidence Ev 197
Thursday 10 January 2008
Members present
John McFall, in the Chair
Nick Ainger Mr Andrew Love Mr Graham Brady Mr George Mudie Mr Colin Breed Mr Sioˆn Simon Jim Cousins John Thurso Mr Philip Dunne Mr Mark Todd Mr Michael Fallon Peter Viggers Ms Sally Keeble
Witnesses: Rt Hon Alistair Darling MP, Chancellor of the Exchequer, Mr John Kingman, Second Permanent Secretary, and Mr Clive Maxwell, Director, Financial Services, HM Treasury, gave evidence.
Q1750 Chairman: Chancellor, good morning to you anticipated even two or three months ago and we and your colleagues in this last evidence session on need to get them absolutely right. The Cabinet OYce the Financial Stability and Transparency Inquiry guidelines are that you have a three-month before we produce our Report. Can you introduce consultation and I think it is pretty important that your colleagues please. we do. That means, bluntly, that I need to publish Mr Darling: Yes, of course. Today I am something by the end of this month. Now, when we accompanied by John Kingman, whom you will met in October, I think there was some thought that know, who is the Second Permanent Secretary at the you would publish your report in the middle of Treasury and has been playing the lead role amongst January and I understand it may be slightly later Treasury oYcials in relation to Northern Rock, and than that. I do not think that is a problem in the also Clive Maxwell, who is the Director of Financial sense that, if we do get your report before we Services at the Treasury and who has been doing a publish, it may be that there are some things which lot of work on our proposals for reform of the we may not have considered ourselves which we may banking system. be able to adapt, but, even if we did not, we will have during the consultation period the benefit of Q1751 Chairman: Now, last week you told the considering whatever your recommendations are Financial Times that you intended to give new and we are not going to agree on everything, I powers relating to failing banks to the FSA. Does suppose, who knows, but we will certainly be able to that mean that you have concluded that the FSA was take on board, I hope, a great deal of what you say, not responsible for regulatory failings and, maybe so the work that you are doing is extremely more importantly from this Committee’s point of important because there is nobody else carrying out view, does that mean that we pack up and go or will this sort of investigation at the moment and it is the Treasury Select Committee Report precisely what a select committee ought to be doing recommendations, which we hope to produce before and it is very, very important. Now, before I go on the end of January, be an important, integral part of to the first part, do you want to pursue the process? your consultation exercise? Mr Darling: If I can answer the second question first, if I may, there may be many occasions when Q1752 Chairman: Well, Chancellor, you and I have ministers might wish that select committees pack up had a discussion this week and, as a committee, we and go, but this is not one of them, I can assure you. are very keen to get our report out before the end of As I said to you when I came to you in October, you January to inform, and to be part of, your are conducting a fairly extensive inquiry into the consultation exercise and we certainly hope to do circumstances surrounding Northern Rock’s that. We may not be publishing all of the evidence at diYculties and, equally importantly, you are looking one time because of the immense amount of evidence at what improvements might be made to the that there has been, but the real meat of it will supervisory regime and also the arrangements were hopefully be published in time for you to consider it, we to face a similar situation at some time in the and we will keep in contact on that. future. I said to you in October that I wanted to Mr Darling: Sure, and I think that would be very publish our proposals after I had the benefit of useful. If we can get a consensus in the House of seeing the Select Committee report. The only thing Commons and the House of Lords too, that would that has changed since then is that I want to get make things so much better, but I really would like primary legislation on to the statute book, if at all to get legislation, if at all possible, on the statute possible, in this parliamentary session. Now, if you book by the end of this parliamentary session. Now, work back, that means we really have to have a Bill obviously we do not know how precisely that is getting its second reading pretty soon after we come going to end, but I think what we want to avoid is a back after Easter. The proposals that I publish will situation where we simply cannot do it because we have to be consulted upon because they are going to did not leave ourselves enough consultation to get be far more wide-ranging than I think was a— Processed: 30-01-2008 11:12:39 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG9
Ev 198 Treasury Committee: Evidence
10 January 2008 Rt Hon Alistair Darling MP, Mr John Kingman and Mr Clive Maxwell
Q1753 Chairman: Well, that is reassuring and we will Q1754 Chairman: In his evidence to us, Sir Callum keep in contact on that, Chancellor, so if you would McCarthy suggested that it would be better to like to go on to the first point. pursue options for private ownership for Northern Mr Darling: On to your point about the FSA, when Rock, and I think that is widely agreed, before I appeared before you last October and on many discussing any nationalisation proposals. Does the occasions since in the House, I made it clear that I Government have any plans in place for taking over think the essential architecture of the system that we Northern Rock if it deems it necessary? have in this country is sound and that you have the Mr Darling: Well, I have made it clear right since my Financial Services Authority which is responsible statement in November when I set out the principles for the prudential supervision of financial that would underpin our approach to the future of institutions, including banks, in this country. It is a Northern Rock that all options, including single regulator, it has been fully operational now nationalisation, are on the table, and I have always for seven or eight years, it is a model which most of been clear about that because, if we cannot find a the world is seeking to follow and I do not subscribe private sector solution, then we have got to keep all to the view that we should go back to where we were those options on the table. Now, I think all of us before that when, frankly, we had seven or eight believe that a private sector solution would be highly diVerent regulators; I do not think that makes any desirable and indeed even many people who sense. So we have got the FSA responsible for advocate nationalisation always point to it as being prudential supervision on the one side and we have a stepping stone between where we are now and an got the Bank of England which has two core ultimate private sector solution, but I think it is responsibilities. One is monetary policy, and we are important that people understand that all options proposing nothing that will interfere with the Bank are on the table and they have been on the table. of England’s independence in monetary policy, and I think that is absolutely fundamental, but its second Q1755 Chairman: During our visit to America as a responsibility which is of equal importance is to committee, we looked at the Federal Deposit maintain the financial system itself, and that is very Insurance Corporation, that being the rescue body important and I think the Bank should have that. for banks. In America, quite a number of banks go What I was talking about last Friday is that I believe under, the relatively smaller banks than exist here, that there are a number of changes that are necessary but one of the issues there was that they take the and, when we set out our proposals at the end of this bank over for a very short period of time and have month, people will see them in full and the details, private management managing it where the FDIC but I do think that one of the gaps in the supervisory are not involved as managers or investors in it, but regime at the moment is that it is not clear that the then pass it on. Does that hold any attractions for FSA has all the powers that I think it needs in order you here in the sense that you have given to get information from institutions and, crucially, consideration as to who would manage a publicly when it looks like an institution is getting into administered Northern Rock and would you see it Y di culty, I think it needs more powers along the being temporary in nature if it did happen? lines of the systems in America and Canada which Mr Darling: I think there are a lot of attractions intervene earlier to help a bank that might be in from the experience in the United States and also trouble and perhaps at a later stage even help with Canada, it is a similar there. Obviously the situation Y restructuring if a bank is getting into real di culties there is diVerent, as you correctly say. There are or a reorganisation, even a merger or acquisition. about 8,500 banks in America and they do tend to go Now you ask, does that mean that I have concluded down more often than in this country. I would not that nobody was to blame at the FSA and, as I said, say it is routine, but it is not unusual and a lot of I think, in October and as I have said in the House, these banks are very small and based in states, in big Callum McCarthy, the Chairman, has made it clear cities and so on. Therefore, the United States has this that, in retrospect, looking back, the FSA should standing body, the Federal Deposit Insurance have taken more action when it saw the extent to Corporation, which you referred to, and it stands which Northern Rock was exposed because of its ready and is used from time to time. As I said in my particular business model, but I do not think it interview with the FT last week, I have my doubts as follows from that, therefore, that you dismantle the to whether or not we would want to maintain here a FSA or you do not give it the tools to do the job. The standing body that might never be used, and I think FSA has got to learn from any mistakes that it made actually in America it is 14 years since this was last just as the rest of us have to do, but I think it makes used, but I do think that the philosophy behind it sense to give the FSA additional powers. I should whereby at an early stage the FSA could put in the say that the changes that I envisage will aVect the equivalent of a company doctor to help a bank that Financial Services and Markets Act and they will may be getting into diYculty to turn it around and almost certainly need amendment to the Banking make the necessary changes and then perhaps see it Acts as well. They will be pretty wide-ranging through or, if it goes beyond that, to be able to insist because I think what is clear from this whole episode on restructuring or, if the bank gets into very severe is that we do need to make improvements to diYculties, actually take over the running of it prior strengthen the various tools at our disposal so that, to passing it on, but the object must be, if at all in the event of this sort of thing happening again, we possible, to pass it on. I do not think any of us are can take action and we can take it in a way that is in the business of the state acquiring banks; I do not eVective. think that would be a very good idea. Processed: 30-01-2008 11:12:39 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG9
Treasury Committee: Evidence Ev 199
10 January 2008 Rt Hon Alistair Darling MP, Mr John Kingman and Mr Clive Maxwell
Q1756 Chairman: There has been comment in the Abuse Directive because there there is some press by some players in the market that perhaps any flexibility, provided you can keep it confidential, and legislation that you have would not be compatible in today’s world that is a big ask maybe, and the with the European Convention on Human Rights. second thing is that you have got to be sure that you Do you have any comment to make on that? are not misleading people. Well, you have to ask Mr Darling: Well, as you know, legislation has to be yourself the question: when do you get to the stage compatible with human rights and indeed the where you might be doing the misleading? I think Minister introducing the Bill has to sign a certificate some clarification from the Market Abuse Directive to that eVect and, if not, they have to say it explicitly. would be helpful anyway, but, in relation to this Shareholders’ rights are important, but at the end of Directive, it was not a thing that drove us to make an the day, if you are talking about the position that we announcement on the Friday morning as opposed to are in at the moment, say, with Northern Rock, the trying to keep it quiet. Government, the taxpayer have a huge interest in this and I made it very clear in November that our Q1758 Mr Brady: But there was no contact with the principles are clear, that we want to look after the Commission during that period. Had there been any depositors and that is very, very important, and we contact with the Commission on this subject want to make sure that we get the money back that following the crisis management exercises that were the Bank of England has lent. Shareholders, I think, undertaken in 2005/06 by the Tripartite authorities? always accept that, if you buy shares, they can go up Mr Darling: I will ask Clive to comment on that in or down and it is especially the case that some of the a minute, but, when these things were tested in the people who have been buying shares since Northern second half of 2006, I think whole consideration was Rock got into this diYculty must have been aware given to a whole range of matters, the compensation, that there were certain problems with this bank and the tools available in relation to getting control of a lot of the people we see commenting are not the deposits and so on, but can you deal with the sort of people who do these things with their eyes point, Clive? shut, their eyes were very open indeed, but the Mr Maxwell: I am not aware of specific contact with Government will at all times behave properly, but the Commission on that particular subject on the the Government has to look after the taxpayer Market Abuse Directive. interest, it has to look after the depositors’ interests Mr Darling: From my direct experience, never mind and I think shareholders have always understood what happened before, this was not seen as that, when you buy shareholdings, they can go up, something that was so material that it was almost, if but they can also go down. you like, a showstopper. The Market Abuse Directive is there for very good reasons, to stop Q1757 Mr Brady: The Governor told us that the people being unaware of the true circumstances of a wording of the Market Abuse Directive was company, but I think, of all the things we needed to ambiguous. Did the Treasury or any of the fix, as looked at in 2006 and 2007, I would not put Tripartite Authorities contact the European this top of the list. It is a consideration, but no more Commission for a clarification of the Directive than that. before ruling out covert intervention? Mr Darling: No, because the situation did not arise. Q1759 Mr Brady: But it was not really a material Again, there are two aspects to this question. I will factor in ruling out covert intervention? come on to the Market Abuse Directive, if you Mr Darling: On the Northern Rock case? No, it would like, because there is some clarification that was not. might be helpful for future occasions, but in relation to the Northern Rock situation, you may recall that, Q1760 Mr Brady: Moving on to the question of the when I spoke to you in October, I made two points, guarantee for depositors, Sir John Gieve said to us firstly, that Northern Rock felt they would have to at our last meeting before Christmas that it became make some form of statement, if not at least a profit clear on Friday 14 September that the lender of last warning, because the situation had changed resort facility had not reassured retail depositors. dramatically since they had last spoken to the Why did it then take you until shortly before 6.00pm market, and also it was thought to be quite a on the following Monday to announce the guarantee material consideration that they were going to be that was the only way to halt the run? getting lender of last resort facilities. The other Mr Darling: Well, for reasons that again, I think, I consideration to my mind, and here I was proved set out last October, I do not think on the Friday the absolutely right on everything bar the timing, is that extent of the guarantee that was then available to I was pretty sure this was going to leak, therefore, the Northern Rock depositors was a primary thing in chances of it being maintained as a covert operation people’s minds. Remember, what had happened was were likely to be slim. I may say, going back to Mr that there were rumours in the market on the McFall’s first point about the role of this afternoon of the Thursday, the day before the 13th, Committee, I would very much welcome your and it then appeared on the BBC News in the collective views on the ability to mount covert evening and it was fairly dramatic news that a fairly operations because I think the present situation well-known bank had gone to the Bank of England where there has to be almost immediate disclosure for help. Then the queues started to form on for lender of last resort facilities does make things Thursday evening and dramatically so on the rather diYcult, which brings me on to the Market Friday. I think it was probably at some point late on Processed: 30-01-2008 11:12:39 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG9
Ev 200 Treasury Committee: Evidence
10 January 2008 Rt Hon Alistair Darling MP, Mr John Kingman and Mr Clive Maxwell
Saturday that it was becoming clear that something the same session that you are referring to, Sunday would have to be done. As the Governor made clear was the first time that the Tripartite Committee in his evidence in the same session you are referring discussed this. to, we discussed this on Sunday and agreed that it was likely we would have to do something and I Q1764 Mr Brady: If this had been brought to you on became convinced that it was. Guarantees are quite the Friday though, presumably then you would have complicated and, as you know, we have changed the been in the position to announce the guarantee terms since it was originally announced and then it before the markets opened on the Monday? was thought best to announce it at the end of Mr Darling: If I had believed, on advice, that a Monday because we were not in a position to do it guarantee was necessary and that it would have at the start of business on Monday, and that is when resolved the situation, then of course I would have we announced it and suddenly the queues went and taken action at the earliest opportunity, but I it certainly slowed down the rate of withdrawals. actually do not think, given what was going on at that time and hindsight is a wonderful thing, that the guarantee was the issue on the Friday. I think that Q1761 Mr Brady: So you would have announced it people were so surprised that this had happened and before the markets opened on Monday, if it had been they were seeing people queueing up, and it remains possible to do so? the case that the money was there and people could Mr Darling: We were not in a position to have done have got it out if they wanted and that has never been it then and I was pretty clear that, given the gravity a problem as far as Northern Rock is concerned, of the position that we faced, when I announced the but, as I say, as Mervyn King has said, as Callum guarantee, I wanted to be pretty clear what exactly I McCarthy said, as I have said, this was discussed on was announcing because people would want to the Sunday for the first time and we took action on know beyond doubt what the position was. the Monday.
Q1762 Mr Brady: And it was announced as soon as Q1765 John Thurso: Chancellor, I would like to go it was possible to announce it? back to the Market Abuse Directive and particularly Mr Darling: Yes, and basically you have a choice the question of the legal advice, but, before I do so, over these things. I think you either have to do this can I just clarify what I think I heard you say which at the start of business or at the end of business and was that the authorities’ judgment during that I think announcements during the course of business critical week was that it “was not a showstopper”, I can be problematic. As for the timing of the think is what you said. guarantee, that was my judgment and that was my Mr Darling: No, I said that, all things being decision for which I am solely responsible. considered, the Market Abuse Directive did not really figure in it because the two things that were in my mind were, firstly, the company itself believed it Q1763 Mr Brady: When we saw you in October, you would have to say something, it would have to told us that you did not think a guarantee or the reassure— extent of cover under the depositors’ scheme was an issue on the Friday, whereas Sir John Gieve implied Q1766 John Thurso: Presumably it would have had that it was the main issue on the Friday. It seems to that advice from Freshfields? us that this was clearly a key topic of conversation at Mr Darling: It is from their own legal advisers. The the deputy level on the Friday. Should that have second thing is that my belief was that there was been brought to you at the principal level sooner every chance that this was going to leak and I was than it was? dead right. Mr Darling: I am not aware that it was, but I listened to what John Gieve said on 18 December and I also Q1767 John Thurso: There is a great diVerence listened to what the Governor said who, I suppose, between advice ex ante and leaking ex post. is John Gieve’s boss, and he was very clear that we Mr Darling: Well, there may be, but my belief, given sat down to discuss this on the Sunday and we had that I thought it would leak and in any event not discussed that before. As I said to you last Northern Rock felt that they were under pressure to October and I remain of the view, things were such say something, was that it was better to make a on the Friday that I suspect that, no matter what I statement on our terms rather than be in a position stood up and said in relation to a guarantee, you where it gets out and you then have to make a would still have had the queueing problem because statement perhaps at a time which might have made what you had was a dramatic announcement, and the situation even worse and I just think that would this is something that has changed in the last 20 years have been wrong. with 24-hour news, and the queues started to form and the situation just got worse and worse and Q1768 John Thurso: Mervyn King, when he came worse, and I think it was not actually until the before us, gave evidence when he said in the most Saturday that people started talking about unequivocal terms that his first preference was for a guarantees. We discussed the thing on the Sunday covert operation and I think the exact quote was, “as and I announced it on the Monday, but certainly, as we used to do in the 1990s”. Is it the case then that I know from my own record of what happened and the other members of the Tripartite arrangement did also in relation to what Mervyn King said to you at not share that view? Processed: 30-01-2008 11:12:39 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG9
Treasury Committee: Evidence Ev 201
10 January 2008 Rt Hon Alistair Darling MP, Mr John Kingman and Mr Clive Maxwell
Mr Darling: Yes, Mervyn King was of the view that pretty clear that they had to make something public his preference would be to do it covertly. I am bound and I was pretty clear that this was going to come out to say that, if I had thought that you could do this in any event. Now, we discussed these things, but the particular exercise covertly, I would have been quite Market Abuse Directive was not actually central to happy to do that, but my fear was that it was going our minds. Of course we are aware of its existence. to come out and, if it was going to come out in a disorderly manner, then I think that would have Q1773 John Thurso: I am sorry to press you, but I been even more damaging. think it is terribly important, particularly given our discussions in Brussels. There was actually no legal Q1769 John Thurso: So, even if it had been, in your advice given to any member of the Tripartite view, legal, you would have still not supported a arrangement on this particular subject? covert— Mr Darling: There was no advice coming from Mr Darling: There were two considerations, and the Brussels that said, “You’ve got to make this public”. first one actually was the fact that Northern Rock believed they had to say something and they had Q1774 John Thurso: Was there any advice given by their own legal advisers as far as that is concerned. legal authorities, whether government oYcers or They certainly had to issue a profits warning because outside firms, to any of those three bodies in this it was the first time they had to draw to the markets’ country at that time on whether or not it was a covert attention that things were not all well. You may operation that was possible or not? remember at that time that another large bank had, Mr Darling: I cannot speak for the Bank of England for wholly technical reasons, borrowed money from and the FSA, but we did not seek legal advice on the Bank of England overnight simply because the whether or not this should be a covert operation. settlement system had not cleared everything, and This was a judgment that we had to reach based on there was no end of speculation. Remember, there the fact that Northern Rock, who, I think, did seek was a lot of feverish speculation at that time and legal advice, I think I am right on that— people were phoning up banks on a daily basis, Mr Maxwell: Yes. saying, “Have you been to the Bank of England?”, Mr Darling:—and their directors were under so we are not talking about the comparative pressure to make a statement and on my judgment, calmness we have got now, but we were talking and it was right, that this was going to leak and about a very feverish time. somebody went to tell the BBC and maybe others that this was the case. Q1770 John Thurso: The reason I want to try and nail this, and the Chairman has given us a relatively Q1775 John Thurso: The Governor said to us, “I had brief time to do it, is because a great deal has been still hoped, and indeed I pressed strongly, for the made, and much evidence has been given, that the ability to conduct a covert operation, but in the end preferred option was a covert option and the reason the strong legal advice among the Tripartite why it could not be done was entirely legal advice. Authorities was that it could not be done”, so the Did each member of the Tripartite arrangement get only way to square your statement with his separate legal advice or was there one set of legal statement is to say that you were, within the advice given to the Tripartite arrangement? authorities, discussing the legal advice, but nobody Mr Darling: I do not think we all went oV to our actually went and got legal advice. lawyers and discussed all these things. The Market Mr Darling: I cannot tell you oVhand whether the Abuse Directive is there, we are aware of it, but, as Bank of England or the FSA went to the lawyers in I said to Mr Brady, it was not the primary the week in question. All I can do is tell you what consideration. Now, I think if it were possible for us considerations were in front of the Tripartite to be able, beyond peradventure as far as the law is Committee, which I chair, during the course of the concerned, to conduct covert operations for week that we took that decision. certainly a decent period, that would be hugely beneficial. On one view, there is suYcient flexibility Q1776 John Thurso: When we were in Brussels, the in the Market Abuse Directive to do that, provided, Commission oYcials we met conveyed to us the I think I am right in saying, that you can be assured strong view that the Market Abuse Directive was Y it is kept confidential, but again that is di cult, and never intended to prevent a covert operation— also that you are not actually misleading people. Mr Darling: I know that.
Q1771 John Thurso: Was that specific legal advice to Q1777 John Thurso:—and also that, in their view, it any of the Tripartite members on the subject of did not prevent a covert operation. We have got whether or not it was covert and possible? strong evidence from the Governor that that was his Mr Darling: No. preferred option. It seems clear that it was not pursued because of the risk that you assessed, or Q1772 John Thurso: So there was no legal advice whoever assessed it, of a leak. Is that actually where specifically given? we are? Mr Darling: As I said to Mr Brady and I think I said Mr Darling: I have never argued that the Market it last October, we were not sitting there, saying, Abuse Directive was the thing that governed the “What does the law say in relation to this?” We were decision that this operation was going to be made driven by the fact that Northern Rock itself were public. In October and on every occasion I have been Processed: 30-01-2008 11:12:39 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG9
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10 January 2008 Rt Hon Alistair Darling MP, Mr John Kingman and Mr Clive Maxwell asked about it, I have said that the decision was a solution and I hope we will be able to do that, but driven by two things, Northern Rock’s position, and I think it was the right thing to do and I do not agree the FSA is the listing authority for these things who with Professor Buiter’s analysis which of course will undoubtedly have looked at the position, but the starts from the proposition that we should have let Market Abuse Directive was not actually the the bank go under. stumbling block, but it was actually— Q1783 Peter Viggers: The interest premium Q1778 John Thurso: With regards to the legal reflecting government support for the Bank of advice, what we have got down to is the sum total of V England lending facility to be paid ultimately to the the legal advice in the whole a air was the partner Treasury has been rolled up and subordinated as tier responsible at Freshfields and that was it. two debt. Why did you accept this lower status for Mr Darling: Sorry, what partner? amounts and what are the implications of doing so? Mr Kingman: Well, we took that decision in the Q1779 John Thurso: Well, whoever gave the advice context of our wider aim which is to create a period to the Northern Rock Board. in which there is stability for the bank. The position Mr Darling: I do not know that the advice was given you describe is correct, that is to say, the premium to Northern Rock. What I do know is that the over and above base rate is rolled up. The amount Authorities’ decision to make a public statement on involved is not gigantic in the context of the sums the Friday morning was taken as a result of the involved in Northern Rock, it is well under £100 considerations that I have set out. I do not believe million in the period that we have given that that the Market Abuse Directive was the stumbling agreement. block. I am well aware of the advice that you have been given in Brussels in relation to that, but I do not think it was the issue. Of all the things we had to Q1784 Peter Viggers: You made your advances and consider, this was not the issue. guarantees to a company which was controlled by a board whose model had completely failed. What Q1780 Peter Viggers: In October, Chancellor, you steps did you take to ensure that the company acted told this Committee that you fully expected to get in accordance with your wishes? What guarantees back the money lent to Northern Rock. Do you and controls did you take over the company? remain as confident now, although state guarantees Mr Darling: Firstly, the money that has been extend to about half the total liabilities of advanced has been advanced against the security of Northern Rock? the company’s collateral, but you raise a point which Mr Darling: Yes, one of my objectives is to make brings me back to the first point I made in response sure we do get our money back. When we reach a to Mr McFall’s point about why I think the FSA conclusion, whatever that conclusion is, one of the need greater powers and that is this: that the priorities, in addition to protecting depositors, is to company is owned by its shareholders and the make sure that we get our money back. shareholders appoint the directors, the Government does not appoint the directors, but, when you get to V Q1781 Peter Viggers: Well, you are aiming to, but a situation like this where you o er support for the are you confident you will? good of the financial system on behalf of the public, Mr Darling: Yes, I very much hope we do, as I said I think there does need to be the availability of in October. powers to the Government to take greater control, and that is what I am proposing with the reforms which I shall publish later this month. At the Q1782 Peter Viggers: Professor Willem Buiter moment, the problem we have got is that the characterised state support for Northern Rock as company is owned by its shareholders and the “open-ended breastfeeding”. To what extent were directors are answerable in law to the shareholders, you in control of the way in which public financial so the security that we have got is either in terms of exposure has extended since September and to what security over the company’s assets or that we lend extent were you carried along by events? money in terms of premiums and other guarantees. Mr Darling: I am aware of Professor Buiter’s view Mr Kingman: I would just add that we have, as you and I think, put shortly, he takes the view that we would expect, lent rather a large sum of money to should have let Northern Rock go under. That is this bank and taken very significant loan what I think he said fairly consistently at the time. I protections, as you would expect in this sort of disagree with that. Again, as I said to you last situation, which means that a whole variety of October and since, the reason that we decided to V commercial decisions they have to take require the o er lender of last resort facilities was because we authorities’ agreement. That is obviously not a believed that there was a wider systemic risk to the fantastically sustainable way to run the business and financial system. Now, that is the only consideration any solution will have to protect our interests in an and that has always been the case as far as lender of ongoing way, but allow genuine commercial last resort facilities are concerned, and I believed decision-making. there was a serious risk of contagion and, therefore, we oVered that support. Having oVered that support, we need to see that through. Over the last Q1785 Peter Viggers: Did you use your leverage of few weeks, we have been working intensively by the advance of money as fully as you could have giving the company breathing space to try and reach done? The Board was left, for instance, with the Processed: 30-01-2008 11:12:39 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG9
Treasury Committee: Evidence Ev 203
10 January 2008 Rt Hon Alistair Darling MP, Mr John Kingman and Mr Clive Maxwell opportunity to declare a dividend or indeed to available had this happened two or three years ago declare bonuses, so why did you not use your is not immediately available just now. You cannot leverage as lenders? look at what is happening to Northern Rock in Mr Darling: Well, I think, if I remember rightly, they isolation from what is going on in the general thought again about the question of issuing a markets at the moment and, as you know better than dividend, but the position is, as I have said, we have many, the conditions in the markets at the moment lent money and we have explained the security of the are very diYcult right across the world. Bank of England and, therefore, ultimately the Government has, but you are right, we do not run Q1787 Mr Fallon: Chancellor, in underwriting the this company. I think that one of the things that is rest, almost all now, of Northern Rock’s balance unsatisfactory at the moment is that, when you get sheet just before Christmas, you have given the into a situation like this, we do not have all the levers taxpayer almost all the liabilities, but no control at at our control that we would like, hence my all over the assets. That is the position, is it not, that proposals for a restructuring facility with the FSA so you have got no control over the bank’s expenditure that, were we to get into the situation again, we could and its current activity? at a far earlier stage say, “Look, support is coming” Mr Darling: We have issued it a guarantee because or provide support where, without having to pass it is the logic of what we were doing in the first place special legislation or use the insolvency laws which and, as I say, we are working towards a solution and are quite complex and were actually not designed for part of that solution will include the return of the a situation like this, we can actually take the powers money that was lent by the Bank of England. that we need. At the moment, the Board is there, it is answerable to its shareholders and it is not the Q1788 Mr Fallon: Is it true that securitisation Government’s Board, if you like. designed by your advisers, Goldman Sachs, to securitise the taxpayers’ lending would then have to Q1786 Peter Viggers: To some, it has seemed that be guaranteed itself, triple A, by the Government? the Treasury has been flat-footed and carried along Mr Darling: Well, Goldman Sachs, as you know, by events in the last six months. Could that be have been hired by the Treasury to advise us last connected in any way with the fact that you had a autumn and just before Christmas we said that we completely new ministerial team in the summer and had asked them to look at funding options. Those that scarcely anyone in the Treasury has more than discussions are continuing and we have not come to ten years’ experience going back beyond 1997 of a concluded view. I did not hear it myself, but I think Treasury activity? there was a speculative piece on the BBC this Mr Darling: The only point I would agree with you morning, but all I can tell the Committee is that we is that unfortunately neither the Treasury nor are looking at all of the options available, I very anybody else has that much experience of banks much want to find a private sector solution, if I can, getting into these sorts of diYculties. You are right, and, when I have got something to report, I will that in the early 1990s there were some diYculties. report to the House in the way that I have done. We have had BCCI, we have had Johnson Matthey and we have had Barings, but that was a long time Q1789 Mr Fallon: Under which of these options ago and we have been fortunate that, until last year, would the level of taxpayer support start to fall we had not had the sort of experience we have had significantly before Easter? with Northern Rock. In relation to Northern Rock, Mr Darling: We have not reached a preferred option and we need to keep sight of this, the diYculty that yet. We are still having discussions and we have had Northern Rock got into was primarily the intensive discussions over the last few weeks with responsibility of that company which had a business Goldman Sachs as well as with the company and model that was completely exposed when the money with the prospective bidders and, as I say, when we markets dried up. I think it was three-quarters of have a proposal, then we will come to the House and their lending depended on them being able to get set it out. access to the wholesale markets, and that is what the problem was. In relation to the action that we took Q1790 Mr Fallon: Chancellor, this has been going on subsequently when Northern Rock got into for four months now. It is four months since you diYculty, as soon as it was clear that it was not going bailed out this bank. You have committed over £25 to be able to achieve funding, we took action billion of taxpayers’ money with no guarantee that immediately to put in place lender of last resort we will get all of it back, no timetable for repayment facilities and, since that time, what we have been and no clear outcome in sight for the Northern Rock doing is trying to find a solution. As I said to Mr Board or the people who work for it. Is it not the McFall, I would like to find a private sector solution, position here that you have got neither a policy nor if that is at all possible, but that may not be possible a clue? at the end of the day because, whilst the conditions Mr Darling: The position is that we are operating in in the money markets are now much better than they extremely diYcult circumstances, the markets are were before Christmas, it is still a challenging time, subject to huge uncertainty and, as you will know, but I hope we can find that solution and I will do my on a couple of occasions this autumn it has been level best to do that. However, given the current quite clear that many institutions have found it economic conditions which are unusual, it is not diYcult to borrow and to lend, so these are not surprising that a solution that might have been normal conditions. It is not surprising, therefore, Processed: 30-01-2008 11:12:39 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG9
Ev 204 Treasury Committee: Evidence
10 January 2008 Rt Hon Alistair Darling MP, Mr John Kingman and Mr Clive Maxwell that, whereas a couple of years ago Northern Rock Mr Darling: I will ask Clive to comment on this in a might have got into diYculties and then fairly bit more detail, but I think what we need to do is to quickly somebody would have come along and said, have better visibility of what institutions are doing re “Okay, we’ll take it”, that has not happened because arrangements for looking after the depositors, the these are not normal conditions. What I have systems they may have if they need to pay money out endeavoured to do over the last few months is to and also to get information and, having got make sure that, having intervened, we see that information, to be able to talk to the Bank of through and we try and reach a solution. Now, I England about it because, as you know, there can be agree with you that we will reach a stage, and I said diYculties if I get information from you for a last October that I was going to give the company perfectly good reason and I cannot then pass it on to until the middle of February to come back with somebody else, another supervisor in this case proposals and we are reaching a stage where we are because you are talking about the Bank of England, going to have to reach a conclusion one way or so it is to clarify the law in some cases where the FSA another, but I will defend to the hilt what we have say there are gaps there, but also to make sure that done over the last few months because I think it was we have got the information we need when the the right thing to do and indeed at the time it was appropriate circumstances arise so that we can take widely supported, although I quite accept that some prompt action. of those who supported it at the time are now Mr Maxwell: To give an example of an area where I running away from the support they once gave us. think the FSA feels that the information it has been getting from banks has not covered everything that it would like would be around liquidity risk. In Q1791 Mr Fallon: If the bank has to be nationalised in the end, are we guaranteed to get all of our publishing its discussion paper in December, it set money back? that out as one of the issues it wants to tackle and it Mr Darling: As I said earlier on, one of our can do some of that through its rule changes and we objectives is to get our money back. will also look at legislative changes, if they are necessary, to facilitate it doing that.
Q1792 Mr Fallon: All of our money? Mr Darling: Yes, to get all of our money back. That Q1796 Mr Breed: So for ten years or so they have not has always been my position, and I also said in the felt the necessity to have information concerning the House of Commons last October that we would do liquidity of banks? that at an appropriate time, but our intention is to Mr Maxwell: They have had information about V make sure that we get the money back. That must be liquidity, but it has been around a di erent sort of the basis on which we proceed. liquidity regime, around the sterling stock regime which was a diVerent sort of regime. I think there is a widespread recognition across most countries in the Q1793 Mr Fallon: You have changed your wording. world that liquidity regulation needs to change and Mr Darling: No, I have not. that has been looked at internationally by the Basle Committee and in Europe, and the FSA will need to Q1794 Mr Fallon: You have said it is a hope, an make sure it gets more updated information, more objective and now you have said it is an intention. Is rapid information about liquidity as part of it a guarantee that we will get it back? implementing a regime like that. Mr Darling: What I have said on many occasions is that I intend to ensure that we get our money back, Q1797 Mr Breed: Well, either they did not and that is what I have said. I may have used a V understand it or they did not consider it important di erent formulation, but it adds up to the same enough. thing, no matter how much you want to play with Mr Darling: I think it is true to say, as Clive has just words, Mr Fallon. been saying, that it is relatively recently that Mr Kingman: It is worth remembering, and I think regulators are beginning to focus on the fact that it is a point John Gieve mentioned in his evidence to liquidity is just as important as capital adequacy. you, that this bank has positive net assets, in fact Again, I said this when I spoke to you last October, significant positive net assets. It is assessed by the one part of the work that we are doing at the FSA not only as being solvent in a balance sheet international level for financial stability and the sense, but also meeting the FSA’s capital IMF is to make sure that regulators focus on the requirements. So there is, on the assessment of the liquidity problems because this is unusual, the FSA, significant positive value in this bank. present diYculty across the world. Previous people have been driven because people did not have Q1795 Mr Breed: Right at the beginning of the enough capital, but the problem we have got just session, Chancellor, you indicated that part of the now, ironically in many cases, is that there is plenty new legislation you are thinking about would of capital now, but it is just frozen, it is a liquidity include powers for the FSA to seek or obtain problem, so I think the answer to your question is information from banks as part of their supervisory that 10 years ago, if you had said, “What’s the big regulation. What information can they not currently problem?”, people were really focused on capital get under their existing powers that you are going to adequacy rather than on the whole question of give them new powers to get? liquidity. Processed: 30-01-2008 11:12:39 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG9
Treasury Committee: Evidence Ev 205
10 January 2008 Rt Hon Alistair Darling MP, Mr John Kingman and Mr Clive Maxwell
Q1798 Mr Breed: The Governor of the Bank of got is when people say, “Ah, but it didn’t happen”. England told us, “At present, we cannot allow a Well, I know that it did not happen because we took bank to fail unless it is clearly insolvent”, and the the action that was necessary, and I would not BBA commented that, “it is diYcult to envisage the actually like to be the one that said, “Well, let’s see UK authorities allowing the failure of a retail what happens”, because, no matter how diYcult deposit-taker”, but does that not fly in the face of the things are with Northern Rock, it would be rather usual sort of thinking in the financial markets that more diYcult to prove if I was sitting here with banks actually must be allowed to fail? rather more casualties on my hands. Mr Darling: The test that we apply, and this has always been the case as far as the Bank of England Q1803 Mr Breed: What role, if any, is the Treasury was concerned under the present Governor and playing in next week’s EGM with Northern Rock? previous governors, is that, if it failed, would it have Mr Darling: Well, we are not. an adverse eVect on the viability of the financial system. It is the systemic risk that you look at rather Q1804 Mr Breed: You have provided no than any other factor. If you look back at the banks information to the Board concerning the current that went down in the 1990s, Barings, the lending? consideration there was that it was not a retail bank. Mr Darling: No, the EGM has been called by certain It had some retail deposits, but it mostly was not, shareholders and the Board is answerable to its V therefore, it was not going to a ect the system shareholders. We are in constant touch with the generally. BCCI went down for reasons that were Board, as you might imagine, given these present nothing to do with the financial system in general, circumstances, and the EGM is a matter for the but the way in which that bank was operated, as we shareholders. well know. Looking further back, there were banks Mr Kingman: Absolutely, and the Board is in that failed before that in the 1970s and Johnson absolutely no doubt about where matters stand and Matthey in the 1980s, so the test is whether it will we talk to them all the time. aVect the wider financial system, and that is what we need to look at. Q1805 Mr Breed: So, when the shareholders turn up at the EGM, they will have nothing from the Q1799 Mr Breed: But, with the depositors secured or Treasury or the Bank of England? looked after, why was there the necessity then to Mr Darling: We are not going to the EGM, if that is protect the shareholders and others in respect of any what you are asking. potential failure of Northern Rock? Mr Darling: We are not protecting shareholders Q1806 Mr Dunne: The Governor, when giving and, as I said earlier on, shareholders know that, evidence to us in September, said that our system, when they buy shares in general, they can go up and meaning the British system, for dealing with they can go down. insolvency and public insurance is markedly inferior to that of other countries. This was identified in 2005 Q1800 Mr Breed: But £26 billion has been put in. when the stress tests were undertaken. The depositors are being protected, so who were you Mr Darling: No, 2006. protecting then by putting £26 billion into Northern Rock? Q1807 Mr Dunne: In 2005, and then in 2006 when Mr Darling: We are protecting the depositors. the crisis management exercise was undertaken, so there have been two years’ worth of advanced Q1801 Mr Breed: I accept that, that is the one side, warning that the system was not operating properly. but everybody else— What work was the Treasury doing, admittedly Mr Darling: Because of the current legislation, the prior to your appointment as Chancellor, but during government guarantee is the only way to do that and that period to put in place the sort of legislative again we will have proposals in the future, which I arrangements that you are now contemplating? think the Governor talked about, which will allow us Mr Darling: Well, in 2006, as you know, the stress to separate out depositors’ cash and then get it paid tests were conducted, in the second half of 2006, and out as quickly as we can, should this thing happen in they concluded at about the turn of the year 2006/07 the future, but the point of lender of last resort when it was agreed that action needed to be taken facilities is to enable the company to continue, and and work was put in place there. I may say that, even it is getting the breathing space it now needs to try if the work was concluded in short order, we still and find a solution. would not have had legislation until this parliamentary session because it would have never Q1802 Mr Breed: In other words, not to let it fail. been on the statute book by the end of July, in other Mr Darling: Of course. The alternative would have words, before Northern Rock happened, but work been to let it fail back in September and my was being carried out. As the Governor said in his judgment, the judgment of the Governor of the Bank evidence and he was pressed on this point on 18 of England and the Chairman of the Financial December, he said that at the time that they were Services Authority was that, had we done that, there discussing these things, people did not think there would have been a risk of contagion into the rest of was a need or an urgency, a very pressing urgent the banking system and that was a risk that we were need to do this. In fact, he took some time to spell not prepared to take. The problem we have always out that he thought it was more important to get it Processed: 30-01-2008 11:12:39 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG9
Ev 206 Treasury Committee: Evidence
10 January 2008 Rt Hon Alistair Darling MP, Mr John Kingman and Mr Clive Maxwell right, to consult, to get what would be complex Q1811 Mr Dunne: Identified when? legislation, and it will be complex legislation, on the Mr Maxwell: Since late 2006 when the principals statute book, including amendments to the discussed these sorts of issues. insolvency law. I think anyone who has dabbled even in insolvency law will know that it is an Q1812 Mr Dunne: As we learned yesterday when we absolute minefield once you start opening it up. were discussing the Capability Review of the Department, there is a perceived weakness in the experience levels within the Treasury and an Q1808 Mr Dunne: I believe it was minuted that it was acknowledged weakness within your ministerial urgent as far back as 2005, but we will let that by. team and a lack of experience— When were you firstly made aware of the need for Mr Darling: It does not say that at all in the review. legislative change following your appointment to your current role? Mr Darling: I would need to check because, as you Q1813 Mr Dunne: It was acknowledged yesterday— would expect, when you take over a new Mr Darling: I would not want you to department, the department briefs you on 101 inadvertently— diVerent things, but it was clear to me in September/ October as I started to look at some of the things Q1814 Mr Dunne:—that none of your ministerial that I could see were not right that we would need to colleagues had any experience of financial matters. make changes and we would probably need to make Of course they came in with a new team which you legislative changes. came in just prior to this crisis which was not your responsibility because of your recent appointment and I accept that. Q1809 Mr Dunne: It was clearly apparent following Mr Darling: Thank you very much! the Northern Rock crisis, but the point of my question is to establish whether there was a team of Q1815 Mr Dunne: Could I just pick up some people working within the Treasury who were able comments raised in earlier questions. In extending to brief you in advance of Northern Rock that there the guarantee in December, and I believe it was the was a significant problem with our insolvency single largest underwriting by the Government of protection. any activity in the private or public sector, you did Mr Darling: There was certainly a team of people so on a day when the House of Commons was still working on this, but what I could not be sure about, sitting and you chose not to make a statement to the and I would need to check because I do not want to House that day. Could you explain why? give you the wrong information, but I am not aware Mr Darling: I made a written statement. I do not of, and certainly there were no, proposals being put always do oral statements. You are right, it was a to me prior to the middle of August. significant extension, but it was a logical extension of the policy that I have been pursuing since this Q1810 Mr Dunne: But, Chancellor, what it raises in happened back in October to ensure that the my mind is the degree of experience and competence company was able to carry on and that it had the breathing space while we try and find a solution in within the Treasury over significant financial Y matters of this order of magnitude. what are very di cult circumstances. As I said in Mr Darling: No, I disagree with you. The people reply to earlier questions, these are not normal times working in the Treasury are extremely skilled and in the markets. At other times, it might have been there is a lot of experience there. As the Governor relatively easy to say, “Look, the Board has failed in this”, and the company can be sold to somebody said, in 2006 it was identified that there were Y weaknesses, there were things that needed to be who can make a go of it, but these are di cult times. done, and work streams were put in place because It is patently obvious that people are not buying and this is complex. When you see our proposals when selling in a way that they would do at other times. they are published at the end of this month, there will be a lot of people who will say, “Look, this is very Q1816 Mr Dunne: You have said today that it complicated. You need to have a lot of thought remains your intention that taxpayers will not lose about this. You won’t have got it right first time”, so money out of the extension of guarantees to that work was being carried out, but, as the Northern Rock. At what level of loss would you Governor himself said in December when he consider it appropriate to resign? appeared before you, at that time, simply because Mr Darling: I said to you that I want to ensure that the present situation was not an immediate we do get our money back, and that remains our contemplation, he said that he did not attach that policy. Beyond that I am not proposing to get into, degree of urgency which, with the benefit of frankly. hindsight, others are now demanding. Clive, who is responsible for this department, may want to add a Q1817 Mr Dunne: So your position is on the line if bit. we do not get any money? Mr Maxwell: We had a team of people working on Mr Darling: My position is clearly set out, as I have this and that has been a joint team involving the said on several occasions to the Committee. Treasury, the Bank of England and the FSA. It has also involved legal expertise tackling these issues Q1818 Chairman: Presumably your position is on since they have been identified. the line every day, Chancellor, is it not? Processed: 30-01-2008 11:12:39 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG9
Treasury Committee: Evidence Ev 207
10 January 2008 Rt Hon Alistair Darling MP, Mr John Kingman and Mr Clive Maxwell
Mr Darling: Being Chancellor has got many, many Mr Darling: It was two provisos, I think. advantages, but also, you know— Chairman: Okay. Q1825 Mr Mudie: There were no provisos on Monday. In fact the senior oYcial who saw us said Q1819 Mr Mudie: One of the things I have certainly they deliberately left “wriggle room”—and those are found, and I believe it is more widely shared, is the his words—in the Directive for just such a reason why the Bank of England did not intervene in happening. a more pragmatic, dynamic way throughout August. Mr Darling: There are though, but my I was pretty rough on the Governor here on this understanding is that there is flexibility provided you area. His excuse, his explanation, was there were can be sure that what you have done remains four things that stopped him acting to carry out a confidential and the second point is that you do not covert action and get a market solution. I have got end up misleading people. The first one is actually the verbatim record in front of me. One of those pretty problematical. In this case he was hardly was MAD? confidential when he appeared on the BBC. Mr Darling: The Market Abuse Directive? Q1826 Mr Mudie: We are talking mid-August rather than when it came out in September, but the Abuse Q1820 Mr Mudie: Yes. You have dismissed this as Directive is you will not keep anything secret—the being something of little interest, of little use, of little odds against that are long—but it is when it emerges importance. He said it was fundamental. It was one that you have acted this way have you abused the of the four fundamental reasons he gave the market and the legislation allows you to take covert Committee for not intervening. action and, when it comes out, you are covered in the Mr Darling: Yes, he raised four issues. One was the legislation. That is the basis. You are bringing depositor protection, which I think we all accept. forward legislation as a result of lessons learned and The present situation needs to be changed so that we the Governor of the Bank of England says there are can protect people. That is actually a pretty big one. four fundamental things that must happen. In the He raised the weekend takeovers problems, legislation, the consultative paper you are going to although I think in terms of both EU legislation and bring forward, are these four matters going to be also the takeover power you cannot do a weekend covered? takeover. I think in this day and age it would be Mr Darling: Yes. diYcult anyway to get shareholders’ consent to do that. He also raised the Market Abuse Directive and Q1827 Mr Mudie: Including MAD? he raised that in the context of his desire. In a perfect Mr Darling: Yes. world, if we all had our way, it would be highly advantageous to be able to do these things in a covert sort of way, because that is the whole point of Q1828 Mr Mudie: The last question on MAD. The it. However, what I said to you in reply to John suggestion has been raised that, if Europe say it did Thurso’s point, the Market Abuse Directive was not not stop you, it was a British decision, when we put in the front of our minds when we sat down and that Directive in we gold-plated it. discussed what we would do and how we would do Mr Darling: I do not think we did. it, but I think the Governor raised a number of issues. Q1829 Mr Mudie: Can I ask you to be specific when you say you do not think we did. Can your oYcials confirm: the Directive that came, was it gold-plated Q1821 Mr Mudie: He raised four fundamental here? Yes or no. reasons and MAD was one of them. Mr Darling: I do not believe it is. Mr Darling: That is right, but I do not think he Mr Maxwell: My understanding of that part of that maintained, but for that particular one, we would Directive is that it is not gold-plated. I will check that have been able to do something covertly. absolutely and we will cover it in our consultation paper. It is also worth saying that the European Q1822 Mr Mudie: It was fundamental. regime is very heavily based on what UK practice is, Mr Darling: I do not think— because we were seen as having a leading regime in Europe. Mr Darling: The other thing, Mr Mudie, is that the Q1823 Mr Mudie: Yes, he said, “These four things decision was made in Britain but it was made by the are fundamental.” Tripartite Committee, it was not made in Brussels or Mr Darling: I think he was looking at them together, Europe at all, which is why I repeated this morning was he not? Certainly in relation to the ability--- One and last October that it was not the Market Abuse of the big issues that you will need to address, we Directive that was in the front of our minds when we need to address, is (a) is it desirable to do these things discussed this. covertly and, if it is, (b) what else do we need to do to ensure that we can? Q1830 Mr Todd: We have had contradictory views on the purpose of the Financial Services Q1824 Mr Mudie: I understand that, but we go to Compensation Scheme. What do you think its Europe this week and Europe say the legislation purpose should be? What institutions should it seek allows you to do it. You are covered. to cover? Processed: 30-01-2008 11:12:39 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG9
Ev 208 Treasury Committee: Evidence
10 January 2008 Rt Hon Alistair Darling MP, Mr John Kingman and Mr Clive Maxwell
Mr Darling: What institutions? collect the contributions made. Would it not be better to reverse the model and make this an Q1831 Mr Todd: Yes. insurance scheme into which banks and other Mr Darling: It should be primarily institutions that institutions paid at points in the market place when take deposits, which are banks and building they are better able to cope? societies. Mr Darling: Of course that would mean that you would be taking money out of the system at the Q1832 Mr Todd: The evidence we have had is that moment, it would not be free to be lent, and its purpose is really more narrowly defined as being a therefore there would be a cost to both savers and way of bailing out small credit unions and not larger borrowers because the banks would have less money financial institutions such as Northern Rock or even available and they would charge more to lend it; so V some smaller than that. Is that your understanding? I think there is a trade o . You either take the money Mr Darling: No, it is certainly not the case now, out, if you like, up front and, therefore, savers pay because even before the changes were made there has by getting less interest rates or those who borrow pay been protection for people who have got deposits in more, or you operate the present system, but that is quite large institutions. Were you to take away the something which will be part of this consultation protection for people who have got their money in that we will look at. You will no doubt have views banks and building societies, I think that would be yourselves. quite damaging, but the structure of the funding and the extent of the compensation scheme is one of the Q1837 Mr Todd: You do not have a view yourself. things that will be covered in the goodwill that will Mr Darling: I think that the present system has be made. worked. I would be quite wary about taking more money out of the system, particularly at the present Q1833 Mr Todd: Let me read you a bit of what the time, because I think you might exacerbate quite a BBA have said: “We need to be clear about what diYcult situation, but these are things that we need compensation can and cannot do. The Financial to look at and I have got an open mind on it but I Services Compensation Scheme cannot create a zero can see the diYculties. failure regime and will not be able to cope with the failure of a systemically significant bank.” The Q1838 Mr Todd: The guarantee points where impression given from that evidence is that this deposits are fully guaranteed, you floated raising would be a fund set aside to deal with smaller that level somewhat from its existing level, but the institutions but in larger institutions the state would BBA, perhaps understandably in the context of what always be obliged to bail out the institution and you have said, have suggested that the current level guarantee the deposits. Is that your feel of what is adequate for 96% of deposits. Where do you draw would be an appropriate outcome? the line? Mr Darling: I know the BBA represents many that Mr Darling: Again, that is something that we have pay into the scheme and, therefore, might be listened to what people are saying, we are consulting tempted to try and make it more restrictive rather on that and we will reach a view, but I am not in a than less so, but if we are going to encourage people position today to express the Government’s to save and give people confidence to save, then I concluded view on that. think they deserve a reasonable degree of protection. There are always going to be arguments about how Q1839 Mr Todd: One thing that I would have much, whether it is 100%, and other issues too, but thought is consensual is that the consumer needs to I am not attracted to a scheme that basically was be utterly clear as to where that guarantee lies and restricted to credit unions, for example. what actions are available to them to manage their aVairs to keep within it, because it was obvious in Q1834 Mr Todd: So, in principle, you want a scheme this crisis that very few depositors actually knew which envelopes all deposit-taking institutions? what scheme existed, where the cut-oV points lay Mr Darling: I think we need to build on where we are and what they could do. at the moment, I think that is the right way to do Mr Darling: Absolutely. I agree with you. this, but as the BBA also said, there does need to be proper consultation about the funding, the extent, Q1840 Chairman: In our visit to the United States, the nature of compensation. Chancellor, we did pick up quite a lot of good information on that area taken from the American Q1835 Mr Todd: Let me turn to the funding. At the Bankers Association, who are very keen on the moment the funding is after the event. upfront system from the point of view that in the Mr Darling: Yes. good times you can give it but in the lean times not so much so. In principle they were very, very keen on Q1836 Mr Todd: So a catastrophe happens, you then that and they did say in passing that British banks collect the money together to compensate the which have branches in the United States are very depositors who may receive it some time later. happy with that system. I just put that to you. Bearing in mind that the circumstances of a collapse Mr Darling: I think that is true. British banks are are likely to be ones in which institutions have less always happy to operate within the rules and money available than they otherwise would do, this regulations locally. I think the BBA does not quite will not be the most favourable circumstances to share the views of its American counterpart. Processed: 30-01-2008 11:12:39 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG9
Treasury Committee: Evidence Ev 209
10 January 2008 Rt Hon Alistair Darling MP, Mr John Kingman and Mr Clive Maxwell
Q1841 Chairman: I just mention that. Mr Darling: Because the FSA is the—. There are two Mr Darling: I think opinion is divided here, reasons. The FSA is the supervisor of individual depending on whether you are paying it or not. banks. It already is responsible for looking at things Chairman: Exactly. like capital adequacy, looking at standards, a whole host of things, and it would seem to me to be very Q1842 Mr Simon: The FT report you in your odd to have another institution responsible for just interview last week as having told them “that other one aspect of supervision, that of liquidity. The measures would give greater power to the FSA to second thing is that the Bank of England has a more gain access to the information it needed in assessing general responsibility about ensuring, if you like, the a bank’s liquidity situation”, which is a slightly stability of the financial system as a whole. I do think, especially if an institution gets into diYculties, elliptical formulation. Do you envisage a supervisory role of individual banks in the provision that we need to do more to ensure the Bank has of liquidity for the FSA? access to information about individual institutions Mr Darling: The FSA does supervise individual because that actually might have a bearing on their banks. This is the point that was raised just a few overall stance, but what I do not want to do is to go back to the old days up until 1998 where you had a moments ago which Clive gave an example as to V where the FSA does not think it has enough powers profusion of regulators looking at di erent aspects at the moment. I just want to make sure that the FSA of financial institutions, because I think that is likely has got the powers it needs to find out the health of to cause us more problems rather than less. the institution that it is regulating so that it can take appropriate action. Q1846 Mr Simon: Is not what they were assuming that the Bank has a greater history and more competency in what you might call more active Q1843 Mr Simon: A lot turns on what we mean by supervision than the FSA, which is a more passive “supervise”, I think. The language that you used to regulator? the FT or that they report you as having used is Mr Darling: The Bank of England was responsible purely about access to information. It seems to me for the prudential supervision of the banking system there is a slight diVerence between merely accessing at a time when there were less significant institutions, information about what is happening and a more and they were mostly based in the UK and pretty proactive concept of supervision which actually much what they did in the UK, and in those days it ensures liquidity. Is the FSA going to intervene in was the case that the Governor could simply raise his order to— eyebrows at the Chairman of the bank and they all Mr Darling: In a proportionate way, yes. What we knew each other and they got on fine and that was want to do is to make sure that the FSA has got wonderful. The world has moved on since then. suYcient powers to be able to say to an institution, London is the pre-eminent financial centre of the for example: what steps have you got in the event world at the moment. All of our banks actually trade that you cannot get access to your funding? What is across the world. If you speak to the chief executives your fall-back position? What is the extent of your of a big bank here, they are as much bothered about exposure and then, of course, to act upon it. their shareholders here as in America, Hong Kong and across the world. I think the world has moved Q1844 Mr Simon: The FSA to act upon it? on. I cannot speak for Professor Buiter, but I do not Mr Darling: Yes. The primary responsibility for think there is any significant body of opinion that these matters rests with the Board of the institution believes that the Bank of England should go back to concerned, but the supervisor has to react according being the prudential supervisor of banks, not least to the information that they get. It is not just a for the reason that the neat line between banks and question of collecting information, putting it in the insurance companies is no longer there; a lot of these cupboard and saying, “Well, that is very financial institutions cover a whole host of activities. interesting”, it is a question of collecting As I said at the start, I think the basic architecture is information and then, if it is appropriate, taking right, but we do have gaps in the law at the present action. What I should say, as the FSA and others time which we need to fix and that is what I want have said, nobody can guarantee nothing will go to do. wrong in the future. You cannot guarantee that a bank or institution will not fail. What I think you Q1847 Mr Simon: The FT also says that you want to can expect is that the supervisor is able to get the move to a Cobra type arrangement where the other information they need to adequately discharge their Tripartite partners advise you more and you duties, and that is what I want to ensure. ultimately make the decision more. Is that right? Mr Darling: I will be publishing proposals in Q1845 Mr Simon: Professors Wood and Buiter in relation to the Tripartite system. I think essentially, evidence to us identified what they called a provision as I said to you, the primary duties on the FSA and of liquidity as the key weakness of the working of the the Bank of England are right; they must retain Tripartite arrangements, and they recommended responsibility for that. Where I think the that the single, best way to address that would be (to Government clearly has an interest is, as in Northern quote them) for the Bank of England to take over the Rock, that once you start providing support the supervision, for liquidity purposes, of individual taxpayer has a real interest, but I think what we do banks. Why the FSA rather the Bank? need to do is to have a situation where, if you have Processed: 30-01-2008 11:12:39 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG9
Ev 210 Treasury Committee: Evidence
10 January 2008 Rt Hon Alistair Darling MP, Mr John Kingman and Mr Clive Maxwell got three people in a room, it must be within the Mr Darling: Yes. people’s contemplation at some point, especially when you are dealing with an acute situation, that somebody has to at the end of the day say, “Okay, Q1851 Jim Cousins: You have made your position we have listened to all the arguments; this is what we clear on that, but if, as a result of the EGM, you took are doing”, which is essentially how the Cobra the view that your own options were limited or system operates. cramped in some way by its decisions, would you form that view quickly and report to it Parliament? Mr Darling: As I have always made clear at each Q1848 Jim Cousins: Chancellor, you have just stage in relation to our policy in relation to Northern described London as being the pre-eminent financial Rock, I have made a point of coming to the House centre. Do not you think that either the of Commons and I attach a great deal of importance nationalisation of a bank or the arrangement which to keeping the House informed. you yourself have put in front of the Committee this morning whereby banks’ deposits are seized and put under separate control would be disastrous to that Q1852 Ms Keeble: You told us in October, reputation? Chancellor, that there needs to be better regulation Mr Darling: No, I think in relation to the deposits, to stop banks hiding things oV balance sheet. What in America at some time, in Canada, in fact in many type of regulation are you thinking of and how do countries, there are provisions whereby, if a bank you see it operating without stifling innovation? gets into diYculty, you can get the depositors’ Mr Darling: I am all in favour of innovation, but money out. It is not exactly seized, it is returned to what we need to be wary is of innovation that means the people whose money it is so they do not have to that people do not actually know the true picture in worry about it. I am not in favour of a scheme that relation to a bank. I think there are two aspects of simply, apropos of nothing in particular, you can this. One is our own domestic legislation, and that is just turn up and grab assets, but we are not talking something that the FSA is looking at, but crucially about that at all, we are talking about a situation also, I think this is something where the where, in order to ensure that you can maintain the international work is very, very important because financial system if an institution gets into trouble, this is an international problem. The Forum for there are tools at your disposal. They have this, as I Financial Stability is looking at this, it is also being say, in many developed countries but, as I said, and looked at at the European Union level, I will be I think I said this in the FT as well, whatever we do discussing it with my French, German and Italian has got to be proportionate. I do not want to get counterparts next week and, when the Financial ourselves into a situation that the Americans got Stability Forum reports at the G7 in Japan in themselves into after the Enron aVair where they February, I hope we will have proposals in front of introduced legislation which was well-intentioned at us not just in relation to the oV-shore SIVs but also the time but which has actually resulted in business in relation to credit rating, in relation to early coming across the Atlantic. That is fine for us, but I warning systems, a whole range of matters which think we have to make sure that we do not reverse need to be looked at and which, frankly, we can deal that, and we do need to do things that are with to some extent here in the United Kingdom but proportionate but at the same time we have also got we actually need international co-operation. to protect depositors’ interests in this particular case as well as taxpayers’ interest. Q1853 Ms Keeble: Are you concerned that your own (and I think it probably chimes with the wider public Q1849 Jim Cousins: Chancellor, I take your point mood as well) interest in having more eVective and about the need for patience in these matters. Do you tougher regulation does not rest perhaps quite so yourself accept that patience may be required to get well with the FSA’s move towards more principle- the Government’s money back out of Northern based regulation, which is actually quite a diYcult Rock, certainly if Northern Rock is to survive as a move in quite a turbulent time? sustainable business, but even if it were to be broken Mr Darling: No, I am very much in favour of the up it might take years for the money to come back principle-based regulation. I have never believed out. that you can ever have a rule and regulation for Mr Darling: I think I remember I was asked this in every eventuality, and nor would you want to the Commons in the autumn. Our prior is to get our because you would end up putting people in such money back and I think you would want to avoid a straight-jackets you would pay very dearly for it; so situation where at its extreme, if you attempted to realise all the assets on day one at the present time, I am very much in favour of principle-based and I then I suspect the price you would get is rather am in favour of principle-based proportionate diVerent to the one that you might get at a more regulation, but I am also in favour of making sure opportune time in the market, but that is a judgment that if we have got a gap in the law, if the regulators we will have to reach as and when we reach a do not have the tools to do the job, that they should conclusion. have the tools to do the job.
Q1850 Jim Cousins: A member of the Committee Q1854 Ms Keeble: If we look specifically at the has raised with you the issue of the EGM of liquidity rules, and I think your colleague is just Northern Rock next week. getting it. Processed: 30-01-2008 11:12:39 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PAG9
Treasury Committee: Evidence Ev 211
10 January 2008 Rt Hon Alistair Darling MP, Mr John Kingman and Mr Clive Maxwell
Mr Darling: He cannot wait. Mr Darling: I think that because so many countries are aVected by these problems, diVerent aspects on a Q1855 Ms Keeble: It is on page five. There are very diVerent basis, there is a political momentum which general principles there about liquidity: a firm must I think is very helpful. The very fact that I can meet maintain adequate financial resources and so on, my three counterparts next week, all of whom have and a firm must conduct its business with due skill, got concerns, and the fact that I am in regular touch care and diligence. Do you think that a move with Hank Paulson, the Treasury Secretary, because towards giving priority to those quite general the Americans have got concerns there too, means principles is going to provide the kind of robustness that I hope we will push this forward. We have also people expect in dealing with what was the root of got to make sure we get it right. I mentioned to Mr this problem? Cousins the example of how you can get it very Mr Darling: I think so. Clive may want to say a word wrong with the Sarbanes-Oxley legislation in in a moment, but what we want to do is to make sure America. We have got to get it right, but I think there are clear principles which firms understand, people, not just people in general but I think particularly in relation to liquidity. As I said earlier, institutions themselves, realise that as a result of this is just an important as making sure you have got what has been going on over the last three or four adequate capital. In particular, if you take the years it does no-one any good to have a situation Northern Rock example, if Plan A fails, what is your where people do not fully understand the risks to Plan B, and if you do not have a Plan B, what are you which they are exposed, and that is fundamentally is going to do about it? why we are in the position we are today. Mr Maxwell: I think what is set out here by the FSA actually explains how it looks at these things in the Q1859 Ms Keeble: Is it this year? context of its principles, but it then goes on to say Mr Darling: I hope so, yes. I hope we can make very that it believes that in some areas quantitative substantial progress this year, because, frankly, we arrangements and requirements are also necessary do not have ten years to get this right. You are and that they fit into those principles. So just as it is probably thinking of Basel, which is an example of impossible always to rely on quantitative elements in where it did take ten years to implement it. I do not taking these sorts of decisions, you need some sort of think this is something you can pursue at a leisurely qualitative assessment as well. It is also important place, but it is important also to get it right. the other way round to make sure you have got some V measurements and then di erent sorts of standards Q1860 Chairman: Chancellor, you mentioned that being used here. you do not want to stifle financial innovation, and I think that is a working aim, but we are in this Q1856 Ms Keeble: You have also talked about the situation because of reckless financial innovation in changes that you would like to see in bank that the bottom line is that no-one any longer trusts behaviour, which I assume is to deal with the the rating agencies’ judgment or the originate distribute model, and you referred also to creditworthiness of complex structured instruments, the Credit Ratings Agency, which is around risk and that in itself some are suggesting is putting a hole assessment and measurement in-house. How do you Basel Pillar I. Is it not the case that forcing the rating see as a government that you are going to be able to agencies to clean up their act is a necessary condition influence that very complex and diYcult area? for Basel II to get on track again? Mr Darling: In terms of supervision, that is a matter Mr Darling: There are two things would say about for the Financial Services Authority in this country credit rating agencies. Firstly, they should always be and its corresponding organisations elsewhere, and regarded as a source of advice rather than the final the Government does not get into that detail of word as to what you do. I think there may have been regulation. some cases where people have taken the word of a credit rating agency and that is it, but the second Q1857 Ms Keeble: No, but it is influencing thing is, of course, questions have been raised in behaviour, is it not? relation to how eVective, how diligent they have Mr Darling: What we do not want to do is to stifle been, but if you take the root cause of the present innovation. Nor do we want to get ourselves into a crisis in America, for example, in the housing the situation where we prescribe the way in which market in particular, the root cause is institutions, mortgages have to be funded, for example. What I on advice (and we do not know, obviously, how think we can expect the regulators to do is to ensure much they relied on credit rating agencies, that people understand how these things are funded substantially or not), lending money to people who, and understand the risks to which they are exposed frankly, were never going to be able to pay it back and, therefore, can price those risks accordingly, but when the interest rates went up, and it must have that is something for the FSA to do. been within their contemplation that interest rates at 1% were going to go up at some stage. Q1858 Ms Keeble: You mentioned the need for the international agreements, which can sometimes take Q1861 Chairman: But at the core of that is complex an inordinately long time, but you also said you structured products? hoped to see progress in February. What is your Mr Darling: That is right. One of the issues that timeline for getting some agreements through the needs to be looked at, for example, is that credit international machinery and getting it into eVect? rating agencies do advise companies in relation to Processed: 30-01-2008 11:12:39 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PAG9
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10 January 2008 Rt Hon Alistair Darling MP, Mr John Kingman and Mr Clive Maxwell the very instruments they are then going to raise, and speech in which he said, “I think there is trouble these are issues that need to be sorted out, ahead”, are we then saying risk committees of banks particularly at an international level. all around the world would have to look at the speech and then say, “Do we do something?” or are Q1862 Chairman: It would be reassuring if you were we saying that there would be an expectation, a to give us an undertaking in terms of Basel II that supervisory requirement, only if it is something this issue is going to be looked at. slightly more formal than that? Mr Darling: It is. It is being looked at at the IMF level, it is being looked at the Forum for Financial Stability as well. Q1865 Nick Ainger: I am not suggesting that. On these two occasions, in January it was in the FSA’s financial risk outlook. It was not a speech; it was Q1863 Nick Ainger: Chancellor, you were talking actually there: a carefully worded report. The same just now in response to the Chairman about the root was true of the Financial Stability Report of the cause of this problem being the miss-selling of Bank of England in April, again, clearly identifying mortgages in the United States which then spread this problem, and yet nobody reacted, it would throughout the whole financial community, through appear, other than one or two institutions. CDOs and SIVs and so on, but in fact it should not have been a surprise, what happened in the summer, Mr Darling: One of the things we need to reflect on because both the Bank of England and the FSA gave is how do supervisors, having expressed a general specific warnings that there was a threat to a concern or even a particular concern, then make sure liquidity problem. In January the FSA quite clearly that it is acted upon? I suspect that is an issue here, said that “market liquidity remains abundant at the it is an issue around the world, but for the past few moment, but it is still important for market years, as you know, we were talking about these participants to consider how they would operate in things, as you say, you refer to specific warnings. The an environment where liquidity is restricted”. The question you ask yourself, if you were to go back to Bank referred specifically in its Financial Stability American where the immediate problems stem from, Report in April to impaired market liquidity, all as why was it there that someone did not start asking a result of the subprime mortgage problem. It would questions about their exposure to these houses appear, possibly other than Goldman Sachs, that where it was quite obvious that the house was not virtually no bank appears to have taken any worth what people thought it was and there was no cognisance of those two quite clear warnings in the income to go with it? UK and it would appear from our meetings in Brussels and in Frankfurt that, in fact, European banks did not really take note of similar warnings Q1866 Mr Love: Chancellor, you indicated earlier that they were given. What can you do in the work on that all opportunities are open in regard to that you are planning ahead now to address these Northern Rock, including the possible problems? nationalisation. Right at the beginning the Mr Darling: One of the things that I think we can do Chairman asked you about the Human Rights Act. is to strengthen the role of the IMF in relation What influence will the Human Rights Act have on especially to these international global problems, the way you respond to shareholders’ interests in that there is a more formalised way of bringing to Northern Rock if you have to nationalise it? people’s attentions that there are problems Mr Darling: The Government is legally obliged to mounting and that people ought to start making obey the law. There is no surprise there. When we plans against the situation deteriorating. You are introduced the Human Rights Act, I think at the end right that the Bank of England has issued general of the last decade, we were very aware of that and so warnings; the FSA itself has. The questions that we have to take that into account, but, as I said to the arise from that are twofold: at an international level, Chairman earlier, equally I am quite sure that people how do you make sure that a report or a speech by who have been buying Northern Rock shares since a central bank governor that actually is beginning to September were fully aware of its present sound warning bells is acted on? The second thing is, circumstances. of course, enforcing regulation. You need to ensure the FSA, having flagged this up in general, then starts to look, in particular, at institutions that they Q1867 Mr Love: I want to ask you specifically about were concerned about. the consideration that shareholders will receive, but let me put it to you in this way. Can you reassure the Q1864 Nick Ainger: Presumably the risk committees Committee, if nationalisation becomes the only that banks have could formally look at the report option, that when you consider buying the shares that either the central bank or the regulatory from shareholders you would take into account authority has provided, flagging up a particular either the market position of their shares or, indeed, warning and then they would have to formally what shareholders would have received should one respond to that warning. Is that a way that it could or two of the private sector options have been a be done? possibility? In other words, will you relate what the Mr Darling: I think that is something that you would shareholders receive to the market, rather than to have to think fairly carefully about. For example, perhaps what some people think would be a suppose that the Governor of a central bank made a generous solution really to the Human Rights Act? 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10 January 2008 Rt Hon Alistair Darling MP, Mr John Kingman and Mr Clive Maxwell
Mr Darling: We have to give regard to the Human to Northern Rock or supervision, inevitably there Rights Act, but I will take into account all those has to be a degree of judgment, especially in relation things that I am legally obliged to take into account to supervision. For example if you take Northern whatever solution we may reach. Rock as it was, there has to be a degree of judgment as to at what point do you intervene. The FSA Q1868 Mr Love: Can I ask you about the issue of the accepts that perhaps looking at it now they should intervention of the FSA in the future when a have said to Northern Rock , “You cannot carry on financial institution is in diYculty. I wondered in a situation where you have got no plan B.” whether you have given any consideration as to whether or not that should be based on the judgment Q1870 Mr Love: My final question Chairman. You of the regulator or whether there should be specific have indicated that although things have improved, criteria or rules that they would have to follow in the credit crunch is still having an impact. Is it yet order to justify any intervention? having an impact on the real economy rather than Mr Darling: I think there would have to be clear the financial sector? Mr Darling: I think it is very diYcult to be sure as to rules because the law can only operate on the basis V of certain things happening. As I said earlier on, I am what the ultimate e ect will be. I can just say this: not in favour of legislation which would give the that last October at the Pre-Budget Report I down- rated our forecast for growth for this year because I state the arbitrary power to intervene in a bank when V there is no possible justification for doing so. was sure that it would have some e ect, but my cause Inevitably, you have to have some degree of for optimism that we will get through this is that our discretion because you cannot legislate for every economy is fundamentally strong. This last year it conceivable possibility. You can think of 101 was the fastest-growing economy of any developed reasons why a bank might get into diYculties and country. We have very low levels of unemployment. pose a systemic risk. I think it is important that we 1975 is the last time it was as low as this. We have got provide as much certainty as possible, precisely over 29 million people in work. Crucially we have because of the point that I think Mr Cousins was got low interest rates and inflation is at or near our target of 2%. There are a lot of reasons to be more making; we want people to be able to invest in this V country with certainty, where they know what the optimistic. It was a completely di erent position to the one that we were in 15 years ago where interest rules are, just as if they invest in America or Canada rates were high and three million people were or wherever they know what the rules are there, and unemployed. We are in a very much stronger they understand that and they are quite happy with position. Having said that, we are going through that. We do need a degree of certainty. We cannot some diYcult times. Right across the world there are just give people blanket sweeping powers but, on the problems. I mentioned the housing market in the other hand, you do not want to get into a situation United States for example and whilst, if you look at where you find the one thing that you had not got the money markets, the conditions are better now— down in the Act happens and you are back to square and I think a great deal of that was due to the action one again. taken by central banks just before Christmas—I think this year is going to be diYcult. However, Q1869 Mr Love: I accept what you say that you need provided we stick to the course we have set I remain a balance, but in the reality of the situation these are optimistic. always very fast-moving circumstances. You do not have a lot of time to sit back and make judgments, Q1871 Chairman: Chancellor, we have almost kept and therefore following the situation may well be the to time. We hope with our report to keep strictly to best judge at that particular time rather than time and that it works in with your consultation depending on rules. exercise. We thank you for your evidence this Mr Darling: What you need is a legal framework. If morning and we look forward to that consultation you take everything that we have been discussing exercise. this morning, whether it is in relation to the lending Mr Darling: Thank you very much. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [SE] PPSysB Job: 386890 Unit: PG10
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Letter from the Governor of the Bank of England to the Chairman Together with other members of the Monetary Policy Committee, I will be appearing before the Treasury Committee on 20 September. In advance of our regular appearances before the Committee I normally circulate to you the text of a short opening statement which I make before questioning starts. Since we last met in June the turmoil in financial markets, which continues, has clouded the outlook. Given the importance and complexity of developments in financial markets, a more extensive explanation of the Bank’s analysis and judgments would perhaps be helpful to the Committee. Inevitably, such an explanation will be longer than my usual opening statement, and for that reason I believe it would be helpful if that statement were provided in advance of our appearance before the Committee. I am conscious that in sending you this statement I am taking a snapshot of a fast moving situation with a long exposure camera. I am grateful to you for allowing me to make public today the attached statement. I look forward to our meeting with the Committee on 20 September. 12 September 2007
Memorandum from the Bank of England
TURMOIL IN FINANCIAL MARKETS: WHAT CAN CENTRAL BANKS DO? The recent turmoil in financial markets has increased uncertainty in the world economy. Problems that surfaced first in the US sub-prime mortgage market are now visible more widely. All those involved, whether banks, other financial institutions, regulators or central banks, need to analyse carefully the causes of the recent turmoil and think through the long-term consequences of any actions if they are to respond appropriately. So in this note I shall try to answer two questions. First, what are the immediate causes of the recent turmoil and what are its implications? Second, what can and should central banks do to alleviate the problems? In due course we shall all have time for a more detailed examination of this episode and the lessons to be learned from it.
1. What are the immediate causes of the recent turmoil and what are its implications? Since the beginning of August, there have been sharp movements in financial markets: prices of loans, and assets backed by loans, have fallen; prices of government securities have risen; and interest rates on inter-bank lending have risen. Rising default rates on sub-prime mortgages in the United States were the trigger for the recent financial market turmoil. It is important, though, to put recent events in perspective. The world economy has been strong for the past five years. Our own economy has been growing at a steady rate for a considerable period. There are major problems in the US housing market to which the authorities there are responding with both macro and micro measures. But the losses from defaults so far remain small relative to the capital of the banking system. None of this is meant to say we should be complacent. But the source of the problems lies not in the state of the world economy, but in a mis-pricing of risk in the financial system. And it is on that set of issues that we need to focus to determine the remedies, both short-term to address the current problems and long-term to prevent a recurrence. Why have developments in one part of the US mortgage market proved so important for a wide range of financial markets? Sub-prime mortgages are one type of loan that banks have parcelled together into securities backed by the cash flows from those loans—a process known as securitisation. Those securities have been sold by banks to investors. They have also been sold to investment vehicles, many of which have been established by the banks themselves. Many of these vehicles have financed their purchases by issuing short-term commercial paper. Securitisation of loans has separated the information held by loan originators from those exposed to the risk of default—investors in asset-backed securities or commercial paper. The unexpected losses sustained on assets backed by US sub-prime mortgages have highlighted the potential costs to investors of uncertainty about the types of loans underlying the assets they purchase. So for the time being the markets in these instruments have either closed or become very illiquid. Vehicles financed by short-term commercial paper are holding assets which can no longer be traded in liquid markets. They now find that they have borrowed short to lend long—normally thought of as a function of banks. As a result of this maturity mismatch, vehicles set up by banks and others are now finding it extremely diYcult to obtain funding through asset-backed commercial paper. The markets are now withdrawing short-term funding from such vehicles, a process not unlike a bank run. Many investment vehicles have been Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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forced to shorten the maturity of their commercial paper, making their borrowing even more short-term and their maturity mismatch even greater. Other vehicles have been unable to issue at all. For example, since the beginning of August the value of asset backed commercial paper outstanding in the US has fallen by almost 20%. Some investment vehicles will need to be wound up. In many cases, however, the sponsoring bank will have written a backup line to the vehicle, guaranteeing its funding. Many of the securitised loans may now be re-priced, restructured or taken back by the banks. A process is starting that will expand the balance sheet of the banking system. But how far that process will go is hard to tell. The vehicles can be taken back onto banks’ balance sheets. Banks as a whole are well capitalised and should be able to do this. Moreover, the funds that were directed to asset-backed securities and commercial paper will now be available elsewhere. In the end, that funding will come back to the banking system, although between banks the distribution will diVer. So the adjustment period may be awkward and, during it, banks are placing a premium on holding assets which can quickly be turned into cash. The increase in demand for liquid assets during the adjustment period is one reason why, in all the major economies, yields on liquid assets like government securities have fallen. It also helps to explain why the compensation needed for banks to lend to other banks over periods longer than overnight has risen and why the volume of inter-bank lending has been increasingly concentrated at shorter maturities. Since the beginning of August, the spread between interest rates for three-month inter-bank lending and central bank interest rates expected over that period has risen in all the major economies. At present, the average spread is 110 basis points in sterling and 90 basis points in dollars. This is the natural economic result of a change in the preferences of banks over the composition of the assets they wish to hold on their balance sheets. In addition, banks have raised their demand for reserves at central banks. Banks settle payments with each other using central bank money and they hold reserves at the Bank of England to manage their daily payment needs. Conditions in financial markets have made their payment needs less predictable. As a result, banks have wanted to hold more reserves. They have tried to fund those reserves by borrowing overnight from other banks. Over the past month, interest rates on secured overnight borrowing have averaged 5.9 1%—16 basis points above Bank Rate. That spread was wider than usual—since the introduction of the current money market regime, it has averaged three basis points. These changes in the distribution of assets across the financial sector, and ba s’ preferences over diVerent assets during the adjustment period, are likely to have consequences for the wider economy through the interest rates for borrowing and lending faced by households and companies. It is too soon, however, to quantify the impact on the economy as a whole. In the short term, some corporate loan rates will rise in line with inter-bank rates. Banks that are unable to sell pools of loans that they had securitised, or who need to support oV-balance sheet vehicles, may cut back on new lending. But banks whose potential funding liabilities to vehicles or conduits are small as a proportion of their balance sheet may be able to exploit profitable lending opportunities, which may not be as open to those banks which are now hoarding liquidity. So there may be a redirection of borrowing from within the banking system. This is part of a normal market adjustment. Funds that had been invested in asset-backed commercial paper issued by vehicles and conduits will find their way back to the financial system, perhaps directly through bank deposits or indirectly via the corporate sector by purchases of corporate debt. It is notable that yields on investment-grade corporate bonds are unchanged since the beginning of August. And companies, including some financial institutions, have been able to issue long-term debt. Nevertheless, there has since mid-July been a widespread reassessment of the compensation investors seek for bearing risk. Equity prices have fallen in all major economies. Most of that adjustment took place in July—before the turmoil in credit markets. The FTSE All-Share today is 6% below its level at the beginning of July. As this re-pricing of risk passes through to borrowers, the supply of credit faced by households and companies may lighten somewhat. In summary, the turmoil in financial markets since to beginning of August stems from a reluctance by investors to purchase financial instruments backed by loans. Liquidity in asset-backed markets has dried up and a process of re-intermediation has begun, in which banks move some way back towards their traditional role taking deposits and lending them. That process is likely to be temporary but it may not be smooth. During that process, demand for liquidity by the banking system has increased, leading to a substantial rise in inter-bat rates.
2. What can and should central banks do to alleviate these problem? Three distinct policy instruments can be deployed by central banks: interest rates, money market operations, and other general liquidity support operations. First what role should monetary policy play in the present situation? The answer is to protect the public from the consequences of the recent turmoil by continuing to maintain economic stability. That is done by setting interest rates in order to meet the 2% target for inflation. Interest rates are a flexible tool and can be adjusted quickly when necessary. If, in the wake of a shock to the financial system, the terms on which the Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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financial system extends credit to the private sector become less favourable, then borrowing and overall demand would weaken. Other things being equal, that would lower the inflation outlook Of course, other things are not equal. When the Monetary Policy Committee meets each month it reviews all the evidence on the outlook on inflation before reaching a judgment. The August Inflation Report implied that some slowdown from recent strong rates of economic growth was needed to meet the inflation target The new element introduced by the recent turmoil is that eVective borrowing rates facing households and companies will rise somewhat So, as we said in the August Report, the Committee is monitoring credit conditions intensively. It is too soon to tell how persistent and how large any change in credit conditions for household and corporate borrowers will prove to be. A new Bank of England Credit Conditions Survey will be available to the MPC at its next meeting. Second, the central bank is responsible for the smooth functioning of the payment system among banks— the short-term money markets and what is known as the high value payment system. Central banks discharge that responsibility by providing reserves that enable banks to settle among themselves. In the reform of our money market operations a year ago, we made very clear, and this is a unique feature of the British system, that the banking system as a whole will get the reserves that it itself requests. Each month, at the beginning of what is known as the maintenance period, running from one MPG meeting to the next, banks set their own reserve targets. They are not imposed. We then supply the reserves that the banking system as a whole requests. The objective is to allow banks to deal with their own day-to-day liquidity needs and, by supplying in aggregate the banks’ demand for reserves, to keep the overnight interest rate close to Bank Rate set by the Monetary Policy Committee. If any individual bank has misjudged its reserves target and finds that on any day, due to unusually large payment flows, it needs additional liquidity, then that is supplied against eligible collateral at a penalty rate. There is automatic and guaranteed access to the standing facility in return for eligible collateral and a penalty rate of 1% above Bank Rate. It should be clear that because standing facilities are available at the borrower’s discretion and against eligible collateral, they are quite distinct from what is known in other financial centres as “emergency liquidity assistance”, and under the UK tripartite framework as lender of last resort arrangements, where the central bank decides that there is a policy objective in lending to one or more institutions. Reflecting these diVerent aims, the collateral required is diVerent. The interest rate for secured overnight borrowing was, in August, unusually high relative to Bank Rate, indicating that banks’ aggregate demand for central bank reserves had risen since they set their reserves targets. For the current maintenance period, which began on 6 September, the reserves banks raised their target levels of reserves by 6%. That larger quantity of reserves was supplied by the Bank of England in its open market operation on 6 September. As expected, some pressure on interest rates for overnight borrowing was relieved. Last week, we announced that, during the current maintenance period, we will make available to banks additional reserves, up to 25% of the reserves target, if the secured overnight rate remains higher than usual relative to Bank Rate. The reason for this is that there are grounds for suspecting that banks may, at the start of the current maintenance period, have underestimated their demand for reserves, and the additional reserves will help to bring the overnight rate into line with Bank Rate. We will announce the terms of this week’s operation on Thursday. Provision of central bank reserves, in exchange for high-quality collateral, cannot be expected to narrow the spreads between anticipated policy rates and the rates at which commercial banks can borrow from each other at longer maturities, and has not done so elsewhere. So, third, is there a case for the provision of additional central bank liquidity against a wider range of collateral and over longer periods in order to reduce market interest rates at longer maturities? This is the most diYcult issue facing central banks at present and requires a balancing act between two diVerent considerations. On the one hand, the provision of greater short-term liquidity against illiquid collateral might ease the process of taking the assets of vehicles back onto bank balance sheets and so reduce term market interest rates. But, on the other hand, the provision of such liquidity support undermines the eYcient pricing of risk by providing ex post insurance for risky behaviour. That encourages excessive risk-taking, and sows the seeds of a future financial crisis. So central banks cannot sensibly entertain such operations merely to restore the status quo ante. Rather, there must be 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. In this event, such operations would seek to ensure that the financial system continues to function eVectively. As we move along a diYcult adjustment path there are three reasons for being careful about where to tread. First, the hoarding of liquidity is a finite process. When any transfers of the assets of vehicles back onto banks’ balance sheets are complete, the demand for additional liquidity, and the associated rise in LIBOR spreads, will fall back. The fragility of sentiment at present means that the system is vulnerable to her shocks and it is important to monitor financial conditions extremely closely. But the banking system as a whole is strong enough to withstand the impact of taking onto the balance sheet the assets of conduits and other vehicles. Second, the private sector will gradually re-establish valuations of most asset backed securities, thus allowing liquidity in those markets to build up. Indeed, there are market incentives to speed up the process both of taking assets back onto balance sheets and to re-open markets in securities that have closed. Already there are tentative steps in this direction which will allow the price discovery process to restart. 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institutions have incentives to reveal their positions to obtain better access to funding. Some are tapping long-term paper. And there are opportunities to make money for those who can assess and value instruments and eventually repackage and reissue them. DiYcult and time-consuming though that process may be, it will also slowly reduce that pa of the rise in market rates which reflects counterparty risk. Third, the moral hazard inherent in the provision of ex post insurance to institutions that have engaged in risky or reckless lending is no abstract concept. The risks of the potential maturity transformation undertaken by oV-balance sheet vehicles were not fully priced. The increase in maturity transformation implied by a change in the eVective liquidity in the markets for asset-backed securities was identified as a risk by a wide range of oYcial publications, including the Bank of England’s Financial Stability Report, over several years. If central banks underwrite any maturity transformation that threatens to damage the economy as a whole, it encourages the view that as long as a bank takes the same sort of risks that other banks are taking then it is more likely that their liquidity problems will be insured ex post by the central bank. The provision of large liquidity facilities penalises those financial institutions that sat out the dance, encourages herd behaviour and increases the intensity of future crises. In addition, central banks, in their traditional lender of last resort (LOLR) role, can lend “against good collateral at a penalty rate” to an individual bank facing temporary liquidity problems, but that is otherwise regarded as solvent. The rationale would be that the failure of such a bank would lead to serious economic damage, including to the customers of the bank. The moral hazard of an increase in risk-taking resulting from the provision of LOLR lending is reduced by making liquidity available only at a penalty rate. Such operations in this country are covered by the tripartite arrangements set out in the MOU between the Treasury, Financial Services Authority and the Bank of England. Because they are made to individual institutions, they are flexible with respect to type of collateral and term of the facility. LOLR operations remain in the armoury of all central banks.
Conclusions The path ahead is uncertain. There are strong private incentives to market players to recognise early and transparently their exposures to oV-balance sheet entities and to accelerate the re-pricing of asset-backed securities. Policy actions must be supportive of this process. Injections of liquidity in normal money market operations against high quality collateral are unlikely by themselves to bring down the LIBOR spreads that reflect a need for banks collectively to finance the expansion of their balance sheets. To do that, general injections of liquidity against a wider range of collateral would be necessary. But unless they were made available at an appropriate penalty rate, they would encourage in future the very risk-taking that has led us to where we are. All central banks are aware that there are circumstances in which action might be necessary to prevent a major shock to the system as a whole. Balancing these considerations will pose considerable challenges, and in present circumstances judging that balance is something we do almost daily. The key objectives remain, first, the continuous pursuit of the inflation target to maintain economic stability and, second, ensuring that the financial system continues to function eVectively, including the proper pricing of risk. If risk continues to be under-priced, the next period of turmoil will be on an even bigger scale. The current turmoil, which has at its heart the earlier under-pricing of risk, has disturbed the unusual serenity of recent years, but, managed properly, it should not threaten our long-run economic stability.
Letter from the Governor of the Bank of England to the Chairman
MARKET ABUSE DIRECTIVE DISCLOSURE REGIME AND EMERGENCY LIQUIDITY SUPPORT In evidence given to the Treasury Committee on 18 December 2007, I answered a question from Mr Brady about the legal advice we received on the Market Abuse Directive [Q 1652]. I said that I would be wiling to share that advice with the Committee but that I would need to explore whether I could do so or whether the advice continued to be subject to legal professional privilege. I have now checked and the advice does remain subject to legal privilege. I attach instead a note on behalf of the Tripartite Authorities on the Market Abuse Directive Disclosure Regime and Emergency Liquidity Support, that I hope the committee will find useful. Mervyn King, Governor of the Bank of England
Memorandum from the Tripartite Authorities 1. This note sets out the views of the Tripartite Authorities on the Market Abuse Directive (MAD) regime and disclosure requirements concerning the provision of emergency liquidity support to financial institutions by way of explanation of the conclusions reached in Northern Rock. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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The MAD Disclosure Framework 2. The general requirement laid down by the Directive is that publicly-traded companies must make public disclosures of inside information—ie information of a precise nature likely to have a significant eVect on the price of their securities—as soon as possible. MAD operates on the basis that full, timely and proper transparency is a pre-requisite for trading in financial markets. 3. The relevant exclusion from this general disclosure requirement in the MAD framework is the provision which allows companies at their own risk to delay the disclosure of inside information so as not to prejudice their legitimate interests. An example of this are cases involving matters in the course of negotiation where the outcome would be likely to be adversely aVected by the disclosure of the information. An implementing Directive specifically mentions cases where the financial viability of the company is in grave and imminent danger and where disclosure would seriously jeopardise the interests of shareholders by undermining the conclusions of negotiations to ensure the company’s long-term recovery. 4. However, the ability to delay a disclosure is subject to two overriding conditions: a. The company must be able to ensure the confidentiality of the inside information. Hence if a leak occurs, the information must be disclosed as soon as possible—there can be no further delay. b. The failure to make a disclosure of the information should not be likely to mislead the public. Non- disclosure would be misleading, for example, where the market would reasonably expect the company to make a disclosure in order to correct an impression resulting from its recent market statements which was now contradicted by the inside information which had arisen. As the Directive is currently drafted, neither of these conditions can be waived or disapplied.
Application to Emergency Liquidity Support 5. News that a financial institution’s financial position is such that it requires emergency liquidity support from the Bank of England is capable of constituting inside information as it is information which could have a significant impact on the institution’s share price. Unless the conditions for delaying a disclosure are met, the information would in that case need to be announced to the market as soon as possible. 6. Accordingly where a publicly traded company has applied for and obtained from the Bank of England emergency liquidity support and where that constitutes price sensitive inside information it can delay disclosing that information for so long as the both of the conditions in MAD for doing so remain satisfied: a. that the information has not otherwise become public; and b. non-disclosure would not be misleading because, for example, silence amounted to endorsement of a specific misapprehension by the market resulting from recent statements by the company. 7. It is in the first instance for a listed company to consider its disclosure obligations, in conjunction with its advisers. Within the framework of the Tripartite arrangements and the Financial Services and Markets Act 2000 it is the responsibility of the FSA as the UK Listing Authority to supervise listed companies in this respect.
Northern Rock 8. In the period leading up to the announcement on 14 September of emergency liquidity support for Northern Rock, each of the Tripartite authorities took legal and other advice on a number of issues as they arose, including on issues of disclosure. However, the question of whether Northern Rock, as a listed company, was subject to specific obligations to disclose was an issue for the company itself, and for the FSA as the UK Listing Authority. It was the view of the FSA that, once the company had obtained emergency liquidity support, an announcement would have to be made if the market was not likely to be misled, given previous statements made by the company. Hence there was no reason to dissent from the view taken by the directors of the company, on the basis of their own legal advice, that an announcement should be made. In the event, given the reports about the company on 13 September the confidentiality condition was also not met and the company made an announcement before the market opened the following morning. 9. The Tripartite Principals took the view that, given there was going to be an announcement by the company, there should be a formal announcement of the support by the Tripartite in the interest of maintaining orderly markets. Mervyn King Governor of the Bank of England January 2008 Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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Memorandum from the Financial Services Consumer Panel
Northern Rock This has clearly been an event of major significance and we will be following up with the FSA the substantial issues that arise from it. These include liquidity, compensation limits, consumer communications and credit issues.
Liquidity In particular we will be asking the FSA about its assessment of institutional and market liquidity and business model stress testing. We wish to satisfy ourselves that the FSA is looking critically at the events of the summer and responding swiftly to evidence of weaknesses or gaps in its current policies and procedures—or simply identifying now areas where it could work better.
Compensation Scheme Limits Although the FSA issued clear statements that it judged Northern Rock to be solvent and that it exceeded its regulatory capital requirements, those statements did not assuage consumers’ concerns following rumours and eventual confirmation of the Bank of England’s decision to provide the bank with emergency liquidity support. Naturally these events have reignited the debate about limits imposed on compensation payable by the Financial Services Compensation Scheme. We welcome the commitment from both Government and the FSA to undertake a fundamental review of compensation structure and limits. Recent events have shown that crucially, if compensation paid to savers in the event of a banking failure is to be anything less than the full amount of all losses, this should be made clear in literature such as bank statements and marketing material. Consumers need regular reminders not to put all their eggs in one basket. Our own position is unchanged since the limits were last reviewed in 2006, when we advised the FSA that inflation had significantly eroded the real value of compensation and that in addition the deposit limit should be raised still further. Increasing numbers of consumers have been moving out of equity based products into what are perceived as “safer” deposit accounts. Consumers who sell their homes and wait before buying another, are likely to have large sums of money on deposit with banks and building societies. Even with yesterday’s welcome increase in deposit cover to 100% of the first £35,000, the limit is far too low to accommodate these changes in consumer behaviour. Nor do we see the rationale for the 10% reduction in cover which is applied to all claims over a certain amount, except those relating to compulsory insurance and from 1 October, to cash deposits.
Consumer Communications Consumer confidence in the financial services industry and in the regulator has taken a significant blow following the events in the market and at Northern Rock in particular. The reaction of Northern Rock customers was a clear demonstration of this. We are aware that there could be legal and practical diYculties in the FSA commenting on individual firms, but in the face of intensive media speculation over the summer we believe that there was and still is scope for the FSA to issue clear messages to consumers to assist them to identify what is important for them and so reduce the potential for panic and confusion. Borrowers will similarly be looking for clear and impartial guidance. We have asked the FSA to remind those who are experiencing financial diYculty of the importance of talking to their lenders at an early stage to identify a constructive way forward. While most attention has since focused on the position of savers, we continue to be mindful of the position of other retail consumers, such as investors, whose principal concern will be the financial viability and profitability of lenders and other financial institutions with whom they have invested, either directly or through pensions and other investment vehicles. Remedying a loss of consumer confidence in the regulator is a problematic issue, but the FSA could make a start by improving the amount, focus and clarity of its communications with consumers. On 12 September we wrote to the FSA setting out our concerns and have since met the Managing Director with responsibility for Retail Markets to pursue this further.
Credit Issues With one sub-prime mortgage lender already in administration and credit issues being high on the agenda, in our letter of 12 September we also encouraged the FSA to consider a timely reminder to firms about dealing fairly with borrowers in arrears and the provisions of Chapter 13 of the FSA’s Mortgage Conduct of Business requirements. The general principle of Treating Customers Fairly also applies, of course, but the significance of Chapter 13 is that there is an evidential provision in the rules that firms should adopt a Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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reasonable approach to the time over which the shortfall should be repaid. More could be done to communicate this to district judges who are hearing repossession cases. Then in the event that a firm taking possession proceedings was found to have failed to follow the rules, district judges could use this as an argument for refusing to grant a possession order. October 2007
Memorandum from the Financial Services Authority
RECENT TURBULENCE IN GLOBAL FINANCIAL MARKETS AND NORTHERN ROCK’S LIQUIDITY CRISIS 1. This memorandum is submitted in advance of the FSA’s appearance before the Committee on 9 October.
Recent Turbulence in Global Financial Markets 2. The turbulence which has characterised credit markets over recent months originated in the US sub- prime mortgage market but then spread much more widely in the financial system, with the contagion being fuelled by a fear of where the sub-prime risk now ultimately resides and a general loss of confidence in asset- backed securities and how they are rated. The chain of events leading from diYculties in the US to a tightening of credit markets globally and to serious problems in inter-bank lending in the UK is set out clearly in the note which the Governor of the Bank of England sent the Committee on 12 September. We would highlight one particular aspect of market developments in August and September: the disruption to credit markets in the UK and globally was partly due to a loss of confidence by buyers in high-quality commercial paper, leading to an almost complete and unprecedented disappearance of liquidity in the wholesale markets other than in the very short-term money markets. 3. In this Memorandum we summarise our regulatory actions over recent months, generally and in relation to Northern Rock. We explain how we worked with the Treasury and the Bank of England, within the Tripartite Framework, to respond to market developments and deal with problems in individual firms. Finally, we outline our plans to learn lessons from recent events. 4. To ensure that major banks at the core of the financial system remain sound and liquid, over recent months we have enhanced our monitoring of major market players by increasing the frequency of our monitoring of their liquidity and encouraging banks to take remedial action as appropriate. We have also assessed and dealt with threats to overall liquidity. This has included analysis of the funding and liquidity profile of the firms we regulate, including the obligations and implications of their involvement with Structured Investment Vehicles (SIVs) and Conduits. This also involved an assessment of the maturity and pricing profile of various instruments such as asset-backed commercial paper and other structured products, and their liquidity implications. 5. We have also collaborated closely with supervisors in other major financial centres to exchange information on developments in each centre, and to identify issues of common interest. From 9 August a daily, sometimes more frequent, discussion of developments has taken place between the Bank of England, the Treasury and the FSA.
Northern Rock’s Liquidity Crisis:The FSA’s Response, and Lessons to be Learned 6. As the Committee will be aware from previous FSA evidence, our general approach is to regulate in a way which supports competition and innovation in financial markets. We believe that, overall, this approach has served UK financial markets well. We adopt a risk-based approach to our work; that is, we consider the impact on our statutory objectives (including consumer protection and market confidence) if particular problems were to arise in firms, sectors, markets or among consumers. We also consider the probability of such problems actually materialising. Taking these two factors together enables us to make a judgement on what priority to give to particular risks, and to allocate appropriate FSA resource to dealing with them. In competitive markets there will be failures; as we have said in the past, it would be impossible— and, in any event, undesirable—to seek to eliminate all risk from financial markets and to operate a zero- failure regime. 7. We had been concerned for some time that the impact of a severe tightening in global credit markets would be very significant. For example, in our “Financial Risk Outlook” published in January 2007 we alerted firms to the need to consider how they would operate in an environment where liquidity was restricted, and we reminded firms of the need to incorporate stress testing and scenario analysis into their business models. On 19 July this year Hector Sants, on assuming his role as FSA Chief Executive, highlighted in a press conference following the FSA’s Annual Public Meeting concerns about possible deterioration in credit markets. However, whilst we felt that a market correction was likely, we attached a very low probability to a tightening of the speed, duration and scale which we have just experienced. Our Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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assessment was widely shared at the time by market commentators and analysts and by other banking regulators globally. However, it should be noted that we increased the intensity of our monitoring of credit markets in July. 8. Turning to the Northern Rock case, we supervise the firm in line with our overall risk-assessment framework. We carried out our most recent full risk assessment of the firm in the period December 2005 to February 2006. Since this last full assessment, our supervision has included monitoring the firm’s compliance with liquidity and other prudential requirements. We have also paid a number of visits to the firm to review particular aspects of its operations, including its arrangements for managing credit and liquidity risk and for stress-testing. In response to the firm’s Pre-Close Period Statement on 27 June we increased our supervisory focus. Our reviews included giving feedback to the firm asking it to carry out more work on liquidity risk and the cash-flow implications of stresses on its securitisation programme. However, as noted above, we did not envisage, and the firm did not carry out, stress tests on a liquidity event as sudden and then sustained as the actual stress experienced this summer. 9. From early August conditions in credit markets deteriorated and Northern Rock experienced increasing diYculty in securing wholesale market funding other than on an overnight basis. We further intensified our monitoring of credit markets and considered the possible impact on individual firms. Therefore from 9 August onwards FSA senior management held daily meetings to review market conditions and the latest position of firms that were vulnerable to these market conditions. This increased supervisory activity covered all major market players and, since the market turmoil had originated in the US sub-prime mortgage market, from an early stage one area of focus was Northern Rock. We also took part in daily telephone calls with the other Tripartite authorities to discuss the latest market conditions. In the period between 9 August and the end of September we held a variety of meetings with individual institutions, as well as three larger meetings (also attended by the Bank of England) with the CEOs of the major UK banks and UK institutional investors. 10. In order to mitigate the risk in Northern Rock’s position we carried out work under three main headings: — First, on 16 August we set up a Northern Rock project team working on: continuing supervision; liquidity support; a possible sale of the firm; and consideration of what would happen if the firm failed. — Second, we actively discharged our mandate to seek private sector solutions. Clearly this is primarily the responsibility of the board of a listed company and its advisors. However, we contacted a number of potential purchasers during this period. The FSA had a number of discussions with one potential purchaser, but no acceptable structure was identified in the circumstances. — Third, the company was continuing to investigate a variety of alternative funding strategies, notably the possibility of an underwritten securitised transaction. By 11 September it became clear that private sector solutions, including securitisation, were not an option. During this period the Tripartite Authorities were also looking at public sector funding options. 11. As the relevant markets remained eVectively closed, and the implications for Northern Rock became increasingly serious, we raised the position of the firm in the Tripartite Standing Committee. Following discussion in the Committee on 14 August, we formally directly notified the Treasury on 15 August of the position of Northern Rock. On 22 August the Tripartite Committee’s Joint Crisis Coordination Team set up a working group, which included workstreams on the practical aspects of enabling the firm to borrow against a wider range of collateral, and triggers for the recommendation of such support. On 29 August the FSA Chairman wrote formally to the Chancellor, copying his letter to the Governor of the Bank of England. Our judgement was that the firm was systemically significant in the market conditions prevalent at the time. We discussed with our Tripartite partners, in particular the Bank, operational aspects and the potential provision of a lender of last resort facility at some future date. During this period we also monitored closely other institutions to identify any funding problems arising from the tightening in credit markets. 12. When it became apparent that a private sector solution was not available and alternative funding options were not materialising, discussions intensified within the Tripartite on the timing and terms of a facility. At the same time it became increasingly apparent that the company would need to consider updating its trading statement in the light of its deteriorating financial condition. The Chancellor, on the advice of the Governor and the FSA Chairman, authorised the Bank to provide a liquidity support facility and the company’s proposed trading statement made reference to the provision of the facility. However, before any formal announcement from the company there was during the evening of 13 September media coverage of the prospect of such a facility being provided. On 14 September as part of a combined Tripartite announcement we confirmed our judgement that Northern Rock remained solvent, continued to meet its capital requirements, and had a good quality loan book. On 17 September the Chancellor announced that the Government, with the Bank, would put in place arrangements that would guarantee deposits held with Northern Rock. The Treasury subsequently issued statements on the terms of that guarantee. 13. In the period from 14 September onwards we supported Northern Rock’s communications with its customers by providing information, through our website and our Consumer Contact Centre, on the latest position and on steps which consumers could take. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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14. It should be recognised that the key dependency for Northern Rock was not its use of wholesale funding per se. In terms of its net short-term wholesale funding to balance sheet asset ratio it was not a significant outlier in relation to other UK banks. Rather, its key dependency was its use of securitisation; its securitisation product was a simple one, based on high-quality assets. The market disruption did not aVect Northern Rock’s existing securitisations, but the market for new securitisations had largely closed. Neither did the market disruption lead to a cessation of Northern Rock’s wholesale funding, but rather to a shortening of its duration and an increase in its price. The combination of these factors led the Northern Rock Board to seek assurance that contingency funding from the Bank of England would be available. The large retail outflows in mid-September led to a significant and sudden deterioration in Northern Rock’s liquidity and required it to draw on the Bank of England facility. So it is clear that a combination of circumstances led to the position which Northern Rock is now in, rather than any single event. 15. Responsibility for Northern Rock’s business lies primarily with its Board and management. But we recognise the great inconvenience and anxiety which Northern Rock’s problems have caused for its customers, and the wide public concern and loss of consumer confidence occasioned by the unprecedented events of recent months. Despite the Government’s safeguards for depositors, we are clear that what has occurred has been damaging. This is despite the fact that all depositors who have reclaimed deposits have been paid in full. As the regulator with a statutory duty to maintain market confidence and provide appropriate protection to consumers, the FSA needs to identify what lessons to learn, and what improvements to make. 16. As we note above, it is generally agreed that the disruption to credit markets we have experienced in recent months has been unprecedented. Yet it is already clear from our review of our supervision of Northern Rock before August 2007 that, whilst we understood the firm’s business model and the attendant risks, our assessment of the probability of market conditions deteriorating as they did has proved incorrect. 17. We will conduct a review of the lessons which the FSA should draw from the Northern Rock events, and what changes these suggest for the FSA’s risk-assessment and risk mitigation practices in general. We will publish the conclusions. We will wish to do this in a comprehensive manner, but it is already clear that the areas we will wish to examine (some of which were being worked on before the events of Northern Rock) include: — the extent to which the FSA’s framework for assessing risk within firms should place further importance on liquidity issues; — whether changes should be made to the FSA’s liquidity regime, and the interrelationship between the UK’s and other countries’ liquidity regimes; — the strengthening of stress-testing within firms, and the challenge to this from FSA supervisors; and — the continuing strengthening of the FSA’s supervisory resources. 18. Recent events have also raised questions about the adequacy of current deposit protection arrangements and their interplay with the lender of last resort function. The current system for deposit protection is operated within the framework established in 2001 under the Financial Services and Markets Act 2000. The Financial Services Compensation Scheme (FSCS) covers customers of all authorised financial services firms, including banks and building societies. The FSA is responsible for setting the rules within which the FSCS operates, including on eligibility of claims and compensation limits. Since 2001 it has dealt with a wide variety of firm failures and has paid out more than £950m in compensation to consumers. The FSCS is funded through levies on the industry and is free to consumers at the point of use. 19. The FSCS’s main function is consumer protection: it provides consumers with a measure of compensation in the event of failure of an institution in the financial sector. The existence of a compensation scheme helps to reduce the systemic risk that a single failure of a financial firm may trigger a wider loss of confidence. But while it contributes to encouraging consumer confidence in the markets, the FSCS was not designed, on its own, to be able to deal with all potential failures of financial firms, nor to be a crisis management tool in the event of a large-scale failure. 20. However, in the light of recent events we decided it was necessary to act to reassure depositors and so, as a first step, we announced on 1 October, with immediate eVect, that we have increased the FSCS limit for deposits to cover 100% of each depositor’s claim up to a limit of £35,000. The previous maximum payout was £31,700—100% of the first £2,000 and 90% of the next £33,000 of depositors’ eligible claims. The EU Deposit Guarantee Schemes Directive provides a minimum compensation for depositors in member states of ƒ20,000 (around £14,000). Member states can limit compensation to a percentage of deposits but can not limit it to less than 90% until ƒ20,000 has been paid. 21. Meanwhile, we have been considering the underlying funding arrangements for the FSCS. In 2006 we decided to hold a review in order to rectify a number of problems that had been identified. One clear deficiency was the overall capacity of the scheme; in our judgement it was necessary to increase the range of events where we could ensure that consumers would be paid when valid compensation claims were made. Currently the amount available to the deposit taking sub-scheme is a perpetual limit of 0.3% of protected deposits—a total of around £2.6 billion. Our proposals, on which we consulted earlier this year, will Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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substantially increase the funding available to around £4 billion per year across all sectors.1 While limited, this would significantly increase the funding available to the FSCS. We said in our Consultation Paper that we were not intending to establish a funding model capable of providing total cover in all instances, and we still believe this to be the correct approach. As we noted in our Consultation Paper, we would expect a large- scale failure to trigger the crisis management arrangements set out in the Tripartite Memorandum of Understanding.
22. Nearly all the industry strongly opposed our proposals, arguing that there was no need to change the current arrangements, which they believed were fit for purpose, and that introducing greater cross-subsidy between diVerent classes of firms was inappropriate. We are currently finalising our formal policy on the future funding model. The new funding model, with its increased capacity, would be introduced from 1 April 2008. 23. Working with the Treasury, the Bank of England and the FSCS, we will build on work that we began in 2006, in order to consider the broader framework within which the FSCS operates. We will focus on how best to deliver an appropriate level of assurance to consumers, including looking at both the monetary limits and improving the speed with which compensation payments can be made to consumers in the event of a large default. In this context it will be important to find a solution for deposit protection which takes account of appropriate changes to compensation arrangements more broadly, including in other financial sectors, and to avoid unintended consequences and possible knock-on eVects. As the Chancellor announced on 1 October, the Government intends to legislate to implement a more fundamental reform of the framework for depositor protection. We will consult jointly with Treasury as appropriate on further changes to the regime. 5 October 2007
Memorandum from the Financial Services Authority
This memorandum responds to the Committee’s requests at the evidence session on 9 October 2007.
1. Granite (Qq 231–240)
Decisions on the structure for any securitisation will rest with the originating bank. As part of our overall supervision work, we monitor the range of securitisation programmes used by UK banks, including the Granite securitisation used by Northern Rock. We have extensive discussions with the firms involved and access to all relevant documentation which they hold. The structure of the Granite securitisation meets industry norms and there is nothing to suggest that the Granite structure is not functioning as intended. The Committee should note that there is also an extensive body of public literature that explain the details of all types of securitisation activity. Securitisation is a well-established management tool and has been used in the UK for 15–20 years. It has been an eYcient and low-cost form of funding for the UK and global mortgage markets as the buyers of a mortgage securitisation are able to look for repayment purely from cash generated by the mortgage assets that have been securitised, as opposed to the bank itself For many transactions these buyers will include other banks, insurance companies and pension funds.
An integral part of securitisation is that the assets must be removed from a potential insolvency of the bank that has made the loans. In the UK, an eVective way for this separation to take place is via a trust structure. Each securitisation will include many “special purpose vehicles” (SPVs) that each has a role to play; for example one vehicle will hold the assets while another will issue bonds. The arrangements are overseen by independent trustees who ensure proceedings are undertaken in line with strict documentation during the transaction; overseas, many civil law jurisdictions have set up specific securitisation legislation in order to replicate the features of securitisation that can be achieved via trusts in common law jurisdictions such as the UK. It is not unusual for some of the SPVs to be based in oV-shore jurisdictions, such as the Channel Islands, where the laws are well-suited to the purpose. Tax considerations may also be a factor in decisions on where to domicile such entities.
1 The existing scheme’s funding is restricted to each contribution group: deposit-taking £2.6 billion (0.3% of protected deposits in total over the lifetime of claims received); general insurance providers £267 million annually (0.8% of relevant net premium income); general insurance intermediaries £82 million annually (0.8% of annual eligible income); life and pensions providers £544 million annually (0.8% of relevant net premium income); investment firms £400 million annually; and mortgage intermediaries £14 million annually (0.8% of annual eligible income). The amounts available would not be available to other groups as the current scheme does not allow for any cross-subsidy. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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The SPVs are typically legally owned by a holding company. To reinforce the separation from the bank, the shares in this holding company are held by a third party. In many cases, including Granite, they are held under the terms of a trust for the benefit of charitable institutions. The company used to facilitate this process in Granite is the Law Debenture Corporation. It should be noted that any payments to charity in this sort of structure are unlikely as the trustees ensure that payments are allocated in line with the strict payment schedule. In our response to your question we were not clear if it concerned the Northern Rock foundation or the Granite SPV. I would like to make it quite clear that the Granite SPV is entirely separate from the charitable body, Northern Rock Foundation, which was established by Northern Rock and which receives contributions by way of profit share.
2. The FSA’s communications with Northern Rock’s auditors (Q 241) We met Northern Rock’s external auditors as part of the last full ARROW assessment in December 2005. There were no material audit or control issues arising. Aside from formal communication with the external auditors, we checked the firm’s external audit status with senior management on an continuing basis, as part of our close and continuous relationship. No material issues have arisen during this period and this has been confirmed by the firm’s external auditors. As a result of the bank’s current diYculties we received a letter from Northern Rock’s auditors on 11 September and had a meeting with them on 20 September 2007. In this letter the auditors expressed concern that the firm might cease to be a going concern if a liquidity facility could not be arranged.
3. The regulatory relationship between the FSA and Northern Rock prior to August 2007 and how that relationship compared with other businesses in the same markets Our framework for assessing the risks to our objectives posed by individual firms is called “ARROW”. Full ARROW risk assessments are an integral part of this supervisory process; they are intensive stocktakes of individual firms and are supplemented by a number of other monitoring techniques. We have designated Northern Rock and more than a hundred comparable businesses as high- impact firms. In addition to these full ARROW risk assessments, we subject firms which we designate as high-impact to “close and continuous” supervision. This is characterised by very regular dialogue with the firm on the full range of supervisory issues, through ad hoc meetings and regular telephone conversations and email traYc. Our workstreams in supervising Northern Rock over the last two years have included: reviewing strategic and business developments through discussions with the firm; attendance at results presentations; monitoring the market; assessing the ongoing validity of our risk assessment; monitoring financial data, supervisory returns and management information; reacting to specific requests from the firm—such as the Capital Requirements Directive (CRD) waiver request which was a major workstream during this period; and undertaking the formal review process which sets the capital requirements of the firm on the basis of the risks identified by the firm and the FSA. We also carry out thematic reviews—projects to review practices in a range of firms in a specific area of their business. Northern Rock was subject to thematic reviews in the same way as other similar firms. In implementing our ARROW framework, we form ajudgement on how frequently we should carry out a full risk-assessment of each high-impact firm. In making that decision we take into account a range of factors including impact, probability, complexity, and the potential for the risk profile of the firm to change. Currently the mean period between full risk assessments for high impact firms is 26.4 months; this is longer than usual because of the work we are carrying out reviewing capital requirements under the CRD. Our first ARROW assessment of Northern Rock was completed in Q4 2002. Following this, we set the next regulatory period to run from December 2002 to December 2003. Following the assessment in December 2003, taking account of our close and continuous relationship with the firm, we set the next regulatory period to run for 24 months, from December 2003 to December 2005. After completing the most recent ARROW assessment in Q4 2005, we set the third (and current) regulatory period, to run from January 2006 to January 2009.
4. The discussions that took place between the FSA and Northern Rock in August and September 2007 and who conducted them Throughout August and September FSA management (Chairman, CEO, relevant Directors and Heads of Department) had frequent discussions with the Northern Rock senior management team. In addition, there were many conversations with the Chairman and Non-Executives of Northern Rock. and Hector Sants and I met the Chairman and Company Secretary on 30 August. Discussions with external parties on private sector solutions were primarily conducted by Hector Sants. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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In addition, a strengthened supervision team had almost daily conversations with Northern Rock from Monday 13 August, which increased after 21 August to twice daily conversations. In addition, they have visited Northern Rock three times since the beginning of August. During this period we also analysed the whole range of management and financial information submitted by Northern Rock.
5. Briefing of journalists You also asked us to provide further information relating to “the suggestion that the FSA briefed against the Bank of England in the media in September”. We understand that in making this suggestion the Committee had in mind two particular newspaper articles. We have reviewed these in detail. The FT story headlined “U-turn raises heat on King” (p1: 20 September) purports to be, inter alia,an account of a meeting between the major commercial banks, the FSA and the Bank of England on 19 September. It accurately reports that Hector Sants urged the banks (not the Bank of England) to lend to each other in the interbank market. This approach had been preagreed with the Tripartite Authorities, I do not believe that this supports an inference that that article represents the FSA briefing against the Bank of England. I would also observe that this meeting was attended by numerous parties, any of whom could have provided details to the press. For the record, on that day, the FSA confirmed that the meeting had taken place but declined to provide any information about the content. Indeed at the beginning of the meeting Hector Sants asked all parties to maintain confidentiality about the discussions. It should be clear that from the point of adverse market impact the FSA considered that the contents of this meeting should remain confidential and we were subsequently concerned when reports of it appeared in the press. The Daily Telegraph article from 20 September headlined “Government forces King U-turn” contains comments from various parties, about the Bank of England’s announcement of its new money market auctions. Its principal argument appears to be that HMT applied pressure on the Bank to change its policy and it quotes unnamed “political sources” to that eVect. None of that supports the allegation of FSA briefing. Towards the end of that article there is the following paragraph: “The Financial Services Authority was more open to the idea of relaxing rules, though informed sources deny reports the FSA took a strong stand. Relations between the FSA and the Bank have now become poisonous”. As I made clear in my oral evidence, I entirely reject this characterisation of relations between the two Authorities. Insofar as the article is concerned, it could hardly be said to represent the FSA in a good light in contradistinction to the Bank. It is not evidence of what has been claimed to be FSA briefing. I would suggest therefore that neither of the two articles you have brought to our attention supports the contention that FSA staV briefed against the Bank. Nonetheless, as you requested, I have made inquiries and am happy to assure your Committee that no FSA employees who are authorised to brief journalists on these matters carried out any briefing of the kind suggested.
6. The FSA’s Risk Committee The Risk Committee is a committee of the Board, made up of a number of non-executive directors. It is responsible for the following, on which it reports to the Board: — review and oversight of the risks to the FSA’s statutory objectives; — the executive’s appetite for such risks; and — the risk management and mitigation strategies and systems used to control such risks. The Committee met on the following dates in 2006–07: 23 February 2006, 25 May 2006, 26 July 2006, 25 October 2006 and 13 February 2007, 17 April 2007 and 17 July 2007. Sir John Gieve sent his apologies for the meetings on 25 May 2006 and 13 February 2007.
7. Information from regulated firms on liquidity In our supervision we rely to a significant extent on analysing information which firms report to us, on prescribed topics and with prescribed frequency. In this context, retail firms report on their liquidity position regularly; for example, building societies report monthly, mortgage lenders report quarterly, and banks report at least quarterly, with large retail banks reporting monthly. In the light of the market turbulence, from 9 August we intensified our monitoring of financial markets generally and engaged more closely with those firms likely to be most aVected by market developments. From 10 August this involved individual discussions with the large retail banks, which in some cases included daily contact, asking for updates on their funding and liquidity positions. We contacted smaller banks and building societies on 13 August asking for detailed information on their current liquidity. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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From 9 August we also asked for more detail in the data collected, and sought information on a prescribed stress scenario from some banks and building societies. The frequency with which we asked the larger firms to provide data using this framework varied from daily to weekly reporting, depending on their exposure to current market conditions. As part of this enhanced monitoring programme, on 18 September we sent a questionnaire to some smaller wholesale funded mortgage lenders and a further questionnaire to building societies. This questionnaire was referred to in the Financial Times on 27 September. This article suggested that this questionnaire had been sent to the largest banks. This was not the case—as noted above, work commenced with those firms on 10 August. As we have said to the Committee in our written and oral evidence, we believe that there are lessons to be learned from our supervision of Northern Rock in the period to August 2007, and we have begun a review, We will publish our conclusions. I hope that this information will be helpful to the Committee, including in the context of your hearing with Northern Rock on 16 October. October 2007
Supplementary memorandum from the Financial Services Authority This memorandum responds to the Committee’s requests at the evidence session on 11 December 2007.
Karin Forseke and her membership of the FSA Board [Q 1545] 1. Karin Forseke was appointed as a non-executive director of the FSA on 1 December 2004, at which time she held the position of CEO at Carnegie Investment Bank AB, Stockholm. She left Carnegie in February 2006. 2. In May 2007, Ms Forseke reported to me that the Swedish Financial Supervisory Authority (FI) was conducting an investigation into certain matters at Carnegie. She indicated that the events under investigation overlapped, to a limited extent, with her tenure. 3. On 27 September 2007, FI issued a report in respect of its investigation. I read and considered carefully the full report, as did the then Deputy Chairman, Deirdre Hutton, and the present Deputy Chairman, James Crosby. I discussed its findings with the Swedish Regulation, who confirmed that there was no allegation that Ms Forseke had committee any irregularity, and confirmed that the major problems at Carnegie had developed after Ms Forseke had resigned as CEO. I held further discussions with Deirdre Hutton, James Crosby and HMT, as well as clarifying Ms Forseke’s account of her time at Carnegie. 4. Ms Forseke brings significant international and markets experience to the FSA Board and her contribution is highly regarded by her Board colleagues, and the executive. 5. As a result, both I an those I consulted were unanimous in our view that it was appropriate form Ms Forseke to continue as a member of the Board of the FSA.
Rosemary RadcliVe and Northern Rock’s Audit Committee 6. In their evidence to the Committee on 4 December, PricewaterhouseCoopers referred (in answer to Q 1353) to having “obtained explicit clearance with the regulators that [Rosermary RacliVe’s] independence was not impaired”. The regulator in question was not the FSA by the Securities and Exchange Commission (SEC). The SEC had raised the issue of the suitability of Rosemary RadcliVe’s membership of the Northern Rock’s Audit Committee. 7. The background is that Miss RadcliVe had been a partner of PwC and was still in receipt of a PwC pension. The SEC had confirmed that PwC were required to be independent of Northern Rock in compliance with SEC rules, on the basis that there report to be issued by PwC under Regulation AB would be on the controls and operations within the company and would be included in a public filing in the USA. The matter was subsequently resolved in discussions between PwC and the SEC, and Rosemary RadcliVe was reappointed to northern Rock’s Audit Committee on 15 February 2007. In this context we would refer the Committee to the following extract from Northern Rock’s 2006 Annual Report and Accounts, “AUDIT COMMITTEE The Audit Committee comprises six independent No-Excutive directors and met five times during 2006. During 2006, membership of the committee increased to six, following the appointment of Rosemary RadcliVe to the Committee. Miss RadcliVe attended one meeting of the committee before resigning from it in light of concerns raised by PricewaterhouseCoopers LLP about the eVect that her membership of the Committee may have on their independence as Reporting Accountants under SEC rules in the USA. Miss RadcliVe is a former PricewaterhouseCoopers partner. Following further detailed considerations of this matter Miss RadcliVe has been reappointed to the Committee on 15 February 2007.” Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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The implications of nationalisation on Northern Rock’s Granite structure [Q1521] 8. The exact impact of any nationalization on the granite and the covered bond programmes depends on the nature and form of any proposed legislation which is primarily the responsibility of HMT. The Tripartite authorities have identified a number of detailed points regarding the programmes that would need to be addressed as part of any proposed nationalisation and it is intended that HMT would ensure that all of these points are adequately covered. October 2007
Letter from Chairman of the Financial Services Authority to the Chairman
Financial Services Compensation Scheme Funding Review 1. I am writing to inform you of the decision of the FSA Board in respect of the new funding arrangements for the Financial Services Compensation Scheme (FSCS) resulting from our ongoing work under the Funding Review which started in 2005. At our Board meeting on 31 October 2007 we approved the final rules for the new funding model for the Financial Services Compensation Scheme. 2. The new funding model will include five broad classes: life and pensions; deposits; investment; general insurance and home finance. With the exception of the deposits class, each broad class will be divided into two sub-classes based on provider/intermediation activities. For the first item, we have introduced explicit cross-subsidy arrangements, so that sub-classes can pick up liabilities from other sectors if they need to. The new funding model is a step forward for the arrangements for the FSCS: making it more robust and resilient and substantially increasing the funding available to it to over £4 billion per annum. 3. Moving forward, we have set up a new project: Banking and Compensation Reform. This project will look at the work flowing from the Tripartite Discussion Paper “Banking Reform—protecting depositors”, published in light of recent market events, including delivering the desired outcomes in a number of areas related to bank failure and insolvency. We will be reviewing the tools available to us in the event of a banking failure to provide appropriate consumer proctction and market confidence through financial stability and competitiveness. 4. In addition, we are pulling together a number of existing FSA workstreams in relation to the FSCS. This will include the work on tariV measures still outstanding from the Funding Review, as well as the FSCS Reform project (which has looked at speed of compensation payment and preliminary payments in the vent of failure of a deposit-taker), and existing work on tools for eVective bank resolution and dealing with insolvency. The project will also look at the scope of the FSCS, as well as the limits payable for claims for each sector, which is a piece of work we feel should be brought forward from 2009. 5. We see this as a key strategic project for the FSA with challenging objectives, and we will of course, keep you informed of progress in this area. We will be submitting evidence to the Treasury Committee on 11 December 2007, when we will be happy to elaborate on this further. 13 November 2007
Memorandum from the Financial Services Authority (FSA) and the Financial Services Compensation Scheme (FSCS) 1. This is a joint Memorandum by the FSA and the FSCS ahead of our appearance before the Committee on 11 December. The Memorandum covers: (a) the FSA’s role in the coming months in supervising Northern Rock, working with the Bank of England and the Treasury; (b) changes that have already been made to deposit protection; (c) the exercises now under way, involving the FSA, the FSCS, the Bank of England and the Treasury, to learn lessons from recent events and to improve the regulatory and compensation arrangements for the future; and (d) further information about the FSCS (included in Annex 1).
A. The FSA’s Role in the Coming Months in Relation to Northern Rock 2. Following the announcement in October of revised Bank of England facilities and the extension of the Treasury guarantee to new retail deposits, the firm is operating in the stabilisation period that extends to February 2008, and is considering its strategic options. The Tripartite Authorities’ objectives for any sale or restructure of Northern Rock are set out in their “Statement of Principles for Assessing Proposals”, published by the Chancellor on 19 November. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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3. The Tripartite Authorities are holding regular meetings with the Northern Rock senior management team. The FSA continues to supervise the firm at a much increased level of intensity. (Given current market conditions, we are monitoring all wholesale and retail banks and deposit-taking institutions closely). In parallel, other strands of work are being taken forward by the Bank of England and the Treasury as appropriate.
B. Changes Already Made to Deposit Protection by the FSA and the FSCS 4. The current system for deposit protection operates within the framework established in 2001 under the Financial Services and Markets Act 2000 (FSMA). The FSCS covers customers of all authorised financial services firms, including banks and building societies, for certain regulated activities. The FSA is responsible for setting the rules within which the FSCS operates, including on eligibility of claims and compensation limits. The FSCS is funded through levies on the industry and has the power to issue levies during the financial year if a particular failure or failures make that necessary. The FSCS service is free to consumers at the point of use. 5. In 2005 the FSA started to review the funding model for the compensation scheme, and on 14 November 2007 announced the changes it had decided to make. The new model, which will come into eVect in April 2008, will increase the financial capacity of the scheme for compensation arising from deposit-takers from £2.7 billion in perpetuity to £4.03 billion annually and will provide consumers with added certainty that valid claims will be paid, according to the limits placed on the amount of compensation payable by the FSCS. It will be a more robust, resilient, eYcient and cost-eVective scheme. 6. In addition to this work which had been in train for some time, in light of recent events, on 1 October this year the FSA increased the FSCS limit for deposits to 100% of the first £35,000 of each depositor’s savings, up from the previous limit of £31,700. The previous limit, last confirmed in 2005, was made up of 100% of the first £2000 and 90% of the next £33,000 of depositors’ eligible claims.
C. Learning Lessons from Recent Events 7. We recognise the widespread public concern caused by recent events and we are determined to learn lessons for the future. Some of the work under this heading is for the FSA; many workstreams involve the FSA and the FSCS working with others, including the Bank of England and the Treasury. 8. In the FSA’s view, recent events confirm the validity of its overall philosophy of principles—and outcome—focused regulation, which seeks to foster innovation and competition. In particular, the FSA believes that recent events reinforce the need to focus supervision work on the outcomes and consequences of management actions, rather than just on a firm’s compliance with individual rules. We recognise that a successful financial market place requires innovation and competition; overall, this approach has served the UK economy and its financial markets well. In turn, that means there can and will be failures. However, in the FSA’s view a principles-based regime provides the best chance of achieving the necessary balance between the benefits and risks of innovation. The work now under way, described below, is designed to reduce the impact on market confidence of any future failure.
The FSA’s Internal Supervisory Review 9. The FSA’s Director of Internal Audit has now begun a review to ensure that the FSA learns the lessons from the Northern Rock events, including for its risk-assessment and risk-mitigation practices as a whole. The review is examining the supervisory approach adopted for the period 1 January 2005 to 9 August 2007, looking both at Northern Rock and a small sample of other high-impact firms, in order to provide a basis for comparison. Where aspects of relevant regulatory practice or policy are currently already being reviewed or revised, the review team will take account of that work in reaching its own conclusions. The FSA will publish the conclusions of the review in March, following discussion by the February Board. The Terms of Reference for the Review is attached as Annex 2.
The FSA’s Liquidity Supervisory Review (national and international) 10. The Northern Rock case has also raised questions about the authorities’ approach to monitoring banks’ liquidity. The FSA and the Bank of England recognise the need to accelerate the work already in progress on modernising the liquidity regime, both domestically and internationally. The FSA will therefore publish a Discussion Paper on liquidity in December. The Paper will assess the eVectiveness of the existing FSA liquidity regimes in the light of recent events and will consider the need for change. The Paper will build on UK work begun in early 2007 in discussion with other regulators, under the aegis of the Basel Committee. The FSA will consult publicly for three months and plans to publish a consultation paper with firm proposals in mid-2008. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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Tripartite and FSCS work on Banking and Compensation Reform 11. Recent events have also raised questions about the adequacy and eVectiveness of current arrangements for dealing with banks in distress. In October the Tripartite Authorities set out the main issues in a joint Discussion Paper “Banking reform—protecting depositors”. We have now drawn together a number of existing and planned projects to ensure that the framework for dealing with banks in distress, including the framework for compensation work well to protect the interests of depositors and help promote the stability of the financial system. 12. The diagram below shows the work that is now under way, summarising the objectives of each workstream:
Banking & Compensation Reform
Banking Reform Compensation Reform Tripartite work Ongoing FSA/FSCS work
Objectives Objectives • Promote and maintain financial stability • A compensation environment that offers sufficient protection to retail customers • Protect consumers • Stakeholder confidence in the retail market is maintained • Protect taxpayers' interests and ensure an appropriate sharing of costs between all parties • Levies raised should be sufficient to meet payments and can be paid in a timely manner
• The scope of the compensation scheme reflects the risks attached to those activities and is in line with EU requirements EU requirements Provision for Powers for Changes to continuity of resolution of compensation
banking failed/failing environment Scope, Long-term services bank to safeguard limits and tariff depositors operation changes
Banking Reform 13. The banking reform project, led by the Tripartite authorities, and working with the FSCS and others, is reviewing the tools available when a bank is in distress, consistent with the aims of providing appropriate consumer protection, whilst maintaining financial stability and ensuring there is an appropriate sharing of costs, with the taxpayer interest protected. 14. Work is being taken forward in several areas, each led by the most relevant Tripartite Authority: (a) identifying the areas where we would want to ensure that continuity of banking services is provided; (b) the way the authorities might approach the resolution of a failing or a failed bank, and the powers which the authorities would need to achieve this; and (c) changes that are needed to the compensation framework to ensure that the FSCS can safeguard depositors of failed banks.
Compensation Reform 15. In addition, the FSA is pulling together, and in some cases bringing forward, a number of existing or planned FSA workstreams in relation to compensation provision for all UK consumers of financial services. The objectives for this work include: a compensation environment that oVers suYcient protection to retail customers; stakeholder confidence in the retail market is maintained; levies raised should be suYcient to meet payments and can be paid in a timely manner; and the scope of the compensation scheme reflects the risks attached to those activities and is in line with EU requirements. 16. There are two main workstreams under the heading: (a) Scope, Limits and Operation will look at the scope of the FSCS and at the limits payable for claims from each sector. We have decided to bring this work forward from 2009. (b) Long-term TariV Reform will review tariV measures still outstanding from the recent FSCS Funding Review, with the aim of designing tariV levels that better reflect the size and amount of business each firm undertakes. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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D. The Operation of the FSCS Scheme 17. Since 2001 when it was established, the FSCS has paid about £1 billion in compensation to consumers, including more than £560 million in payments to customers of failed insurance companies. It has handled the failure of firms as diverse as independent financial advisors and credit unions through to insurance providers such as Independent Insurance. Further information is provided in Annex 1. 4 December 2007
Annex 1
FURTHER INFORMATION ABOUT THE FINANCIAL SERVICES COMPENSATION SCHEME
Legislative Framework and Role of the FSCS 1. The FSCS, as a Scheme, is the compensation scheme of last resort for consumers of financial services. The Scheme’s role and scope—as to eligibility for protection and limits for compensation—are set out in the Financial Services and Markets Act (FSMA) and in FSA Rules. The FSCS, as the management company that operates the Scheme, is required by FSMA to be operationally independent. It is not part of the FSA, but accountable to it (and, ultimately, to the Treasury). 2. The FSCS became operational in December 2001, replacing eight previous compensation arrangements (including the Deposit Protection Board, Policyholders Protection Board and the Investors Compensation Scheme). The FSCS covers most financial services activities that are governed by FSMA and provided by firms authorised by the FSA. Deposits, insurance policies and investments are all protected. 3. Since 2001 the FSCS and the rules under which it operates have continued to evolve, taking account of a number of extensions to the FSA’s scope and in the light of experience. In particular: — July 2002: The FSCS protection extended to cover claims by members of credit unions. — October 2004: Further extension to cover mortgage advice and arranging. — January 2005: Further extension to cover general insurance intermediaries. — March 2006: FSA Discussion Paper on options for changing the FSCS funding structure. — June 2006: The FSA confirms existing FSCS compensation limits after review and public consultation. — March 2007: FSA Consultation paper on a new funding regime for the FSCS. — October 2007: The FSA raises FSCS deposit compensation limit to 100% of £35,000. — October 2007: Tripartite authorities publish a Discussion Paper entitled Banking reform— protecting depositors. — November 2007: The FSA publishes its final policy and rules on funding for the FSCS following consultation, with the regime coming into eVect on 1 April 2008.
Current Compensation Limits 4. Alongside the current compensation limit for deposits of 100% of the first £35,000 per person per authorised firm, the FSCS also provides cover for other types of financial products and services. The categories covered are: investments; mortgage advice and arranging; general insurance; general insurance advice and arranging; and long term insurance such as pensions and life assurance. There are diVerent compensation levels for the diVerent categories of claims.
Key Statistics December 2001 to 31 October 2007 5. Since December 2001 the FSCS has made a significant contribution to protecting consumers in the UK who would otherwise have had no avenue of redress. Key statistics for this period are: — Total compensation paid: £1.004 billion. — Of this, more than £580 million was for insurance claims—involving over 250,000 individual payments. — Total number of claims completed for investment and deposit-taking business: 87,000. — Total levies raised from the industry: £830 million. — Total recoveries by the FSCS, in its capacity as creditor of the failed institution: over £370 millio. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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Annex 2
NORTHERN ROCK: A REVIEW BY THE INTERNAL AUDIT DIVISION OF THE FINANCIAL SERVICES AUTHORITY
Terms of Reference 1. The Chief Executive of the FSA, Hector Sants, has requested a “lessons learned” review of the supervision of Northern Rock plc. A review team, led by the FSA’s Director of Internal Audit, Rosemary Hilary, has been commissioned to deliver a report to the Executive by 31 January 2008 and to the FSA’s Board at its meeting dated 28 February 2008. 2. The review will examine the lessons which the FSA should draw from the Northern Rock events and changes these suggest for the FSA’s risk-assessment and risk-mitigation practices in general. Where aspects of relevant regulatory practice or policy are currently already being reviewed or revised, the internal audit team will take account of that work in reaching its own conclusions. 3. Internal Audit will review the supervisory approach for Northern Rock plc during the period 1 January 2005 to 9 August 2007. In particular it will review whether the FSA’s prevailing framework for assessing risk was appropriately applied such that the supervisory strategy, including the Supervisory Period and level of resourcing, was in line with Northern Rock’s risk profile. A review of a small sample of other high-impact firms will be included over the same timeframe in order to provide a basis for comparison. 4. Internal Audit will then assess: (i) whether in future the FSA’s framework for assessing risk should place more importance on liquidity, stress-testing, competence of firms’ management and eVectiveness of governing arrangements. In assessing this element Internal Audit will take into account the emphasis in the More Principles-Based Regulatory approach on outcomes-based regulation; (ii) whether the processes or mechanisms for identifying, sharing and responding to internal and external intelligence/emerging risks (that may have firm-specific or sectoral impacts) can be improved; and (iii) whether improvements can be made in the adequacy of supervisory resource, both in terms of capacity and skills, devoted to high-impact deposit-takers. 5. The review team will exclude other areas of supervisory focus unless deemed appropriate by work emerging from the review. In framing recommendations for the FSA’s Board on 28 February 2008, this Internal Audit review will not accompany these with a formal cost-benefit analysis. 6. The conclusions of the review will be made public and any changes to the FSA’s approach will be communicated and/or be subject to consultation as appropriate. 7. In undertaking this review, the FSA is seeking to achieve the following outcomes: (i) to understand whether the application of the supervisory approach for high-impact deposit-taking firms was robust; (ii) in light of 7(i), to identify what lessons there are to be learned and to make recommendations that will enhance the supervisory approach going forward; (iii) in completing 7(i) and 7(ii), and in committing to publish its conclusions, to demonstrate to the FSA’s stakeholders (including regulated firms, consumers and staV) an ongoing commitment, as an organisation, to continuous improvement.
Memorandum from Northern Rock This memorandum responds to the Committee’s requests at the evidence session on 16 October 2007.
1. Liquidity [Q492] Graph 1.1 shows Northern Rock’s Total Liquidity Ratio from 1 January 2007 until 13 September 2007. Although liquidity was reduced, the total liquidity ratio was still 17% on 13 September 2007, but the cash element (the red coloured block) was being squeezed. Graph 1.2 shows the daily position on the combination of cashflow and Sterling Stock Assets from the start of 2007 until 28 September 2007. The extra liquidity taken in July 2007 of £2.3 billion shows clearly. Also the inflow of funds from Granite securitisation issues can be seen in January and in May. The May issue of £4.7 billion was overscribed by a factor of 2.2 times and was our third cheapest ever deal, reinforcing our belief that the high quality of assets and transparency of information would nevertheless give Northern rock access to liquidity in tightening credit markets. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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It can be seen that Northern Rock continued to fund during August—but the duration came down mainly to the very show overnight and one week categories instead of the more usual mix of three month and over. Because of the shorter duration, the Bank of England facility was sought. The retail run that started on 13 Septrember when the news of the facility leaked is clearly evidenced and is what seriously weakened the liquidity position.
2. Funding and Lending Profiles [Q522]
(i) Funding Graph 2.1 shows three snapshots (at 31 December 2006, 30 June 2007 and 30 September 2007) of the maturity profile of our non-retail borrowings—comprising wholesale, Covered Bonds and Securitised Notes—grouped by time duration. Graph 2.2 shows the same information, but with the time duration for each time snapshot shown collected together. Graph 2.3 shows—for the same three time snapshots—the actual amounts and percentages within each time duration. In Graph 2.3, you can see in the 30 September 2007 picture, that the naticeable shortening in duration in all the markets during August and September has pulled the 6–12 months bracket down to £888 million from £3,032 million in June 2007. The average maturity of wholesale funding at June 2007 was just over three years.
Profile of Funding Northern Rock is not a significant outlier in the size of wholesale funds as a percentage of Total Liabilities. Graph 2.4 shows a number of institutions with a higher reliance, as at 30 June 2007. Northern Rock was not an outlier in the rate of growth of its wholesale funds. Graph 2.5 shows growth in wholesale funds as a percentage change in total non-equity funding during H107. It was envisaged that maintenance of high asset quality and provision of transparency about credit would ensure Northern Rock benefited from a flight to quality in tightening markets. In addition, Northern Rock sought to widen its funding diversity—raising retail deposits in Guernsey, Ireland and Denmark as well as the UK. In securitisation, it raised funds in UK, USA, Europe and Asia. For traditional wholesale funds, in the last few years, we had added Medium Term Funding in USA, Europe and Australia and shorter term funding from Europe, Canada, USA and France to provide a diversified platform.
Funding Insurance Northern Rock had a standy loan facility of £750 million and a $775 million bilateral swingline facility in place to support its US Commercial Paper programme— making a total of $2.3 million. This was proportionately slightly greater cover than Countrywide in the US, given relative size of both leading programmes and balance sheets, including securitisation. In comparison, Countrywide in the US had a syndicated loan facility of $11.5 billion. This is 5 times larger than Northern Rock, but Countrywide’s mortage book at the end of 2006 was over 7 times larger than Northern Rock’s—£650 billion compared to £86 billion, including securitisations. (Countrywide’s new gross mortgage lending in 2006 was also over 7 times larger than Northern Rock’s—£228 billion compared to £29 billion. Countrywide’s new net lending was 6.7 times Northern rock’s—£99 billion compared to £15 billion). Importantly, Countrywide had the ability to use its mortgate backed notes as collateral to borrow from the US Federal Reserve on a general basis, under a general liquidity facility available to all US banks, while Northern Rock was not able to borrow in the UK on the same basis, nor indeed through the ECB as it understands other UK banks with sizeable European operations were able to do.
(ii) Lending Graph 2.6 shows our mortgage products—the top graph is by number of accounts, the bottom one by value of balance. The average remaining product life by number of accounts is just over 30 months, and by balance is 28 months. At the end of their existing product, a customer can choose whether to take out a new product with Northern Rock, or mover to a new lender. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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The quality of Northern Rock’s lending is high. Accounts in arrears of three months of more were 0.47% at 30 June 2007, in comparison with the CML industry average of accounts of three months in arrears of 1.06%. Arrears from 2006 and 2007’s lending by Northern Rock are showing the benefit of enhanced credit scoring techniques resulting from the requirements for the Basle II process and are performing better than 2004 and 2005’s lending judged at the same vintage points. 3. Since 14 September 2007 there has been no change to Northern Rock’s governance arrangements, which remain those set out in the Corporate Governance section of the annual report and accounts 2006 (pages 13–17). [Q500] However, both the original Sterling loan facility granted by the Bank of England on 14 September 207 and the revised facility, as amended and restated on 9 October 2007, and associated documentation contain provisions requiring the Company to obtain the Bank of England’s consent and requiring the Company to provide the Bank of England and other members of the Tripartite Authority information relating to the Company and its business. 4. The proportion of the stock of mortgages that were taken out by new customers in the last two years if 45% by number of accounts and 55% by value of balances. [Q685] 5. The number of shares owned outright by the members of the Board is 431,189—equivalent to 0.10% of the shares of the company (including options this is 2,125,470,0.50% of shares). Employees in the company own 3,570,012, equivalent to 0.85% of the shares of the company (including options this is 15,924,967,3.78% of shares). [Q708] If you rquire any further information on these points as stated in your letter dated 16 October, or on any other matters raised by the Committee, please let me know. 1 November 2007
Graph 1.1
Northern Rock PLC-Liquid Assets as a percentage of Non Securitised Assets 25.00%
20.00%
15.00% Investments Cashflow Sterling Stock 10.00% % of Non Securitised Assets
5.00%
0.00% Dec 06 Jan 07 Feb 07 Mar 07 Apr 07 May 07 Jun 07 Jul 07 Aug 07 Sep 07 Month End (September figures as at 130907) Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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Graph 1.2
Northern Rock PLC: Cashflow & Streling Stock Assets 29 December 2006 to 20 September 2007 12,000
11,000
10,000
9,000
8,000
£m 7,000
6,000
5,000 Cashflow & sterling stock Assets 4,000
3,000 29/12/06 12/01/07 26/010/7 09/020/7 23/02/07 09/03/07 26/03/07 06/04/07 20/04/07 04/05/07 18/05/07 01/06/07 15/06/07 29/06/07 13/07/07 27/07/07 10/08/07 24/08/07 07/09/07 21/09/07 Date
Graph 2.1
Northern Rock PLC: Maturity Profile of Wholesale Funding, Covered Bonds and Securitised Notes 70
60
50 31 Dec 06
40 30 Jun 07
30 Sep 07 30 Outstanding £bn 20
10
0 To 3 months 3-6 months 6-12 months 1-3 year Over 3 years Months to maturity Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
Treasury Committee: Evidence Ev 235 Graph 2.2 To 3 months To 3-6 months 6-12 months 1-3 year Over 3 years ep 07 Date 31 Dec 06 30 Jun 07 S Northern Rock PLC: Maturity of Wholesale Funding, Covered Bonds and Securitised Notes
0
70 60 50 40 30 20 10 Outstanding £bn Outstanding Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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Graph 2.3 Northern Rock PLC
Maturity Profile of Wholesale Funding, Covered Bonds and Securitised Notes 31 December 2006 To 3 months, £15,942m (22%)
3-6 months, 31,175m (2%)
6-12 months, £1,916m (3%)
Over 3 years, £49,699m (68%) 1-3 year, £4,485m (6%)
Total: £73,216m
Maturity Profile of Wholesale Funding, Covered Bonds and Securitised Notes 30 June 2007 To 3 months, £14,086m (17%)
3-6 months, £2,416m (3%)
6-12 months, £3,032m (4%)
Over 3 years, £58,260m 1-3 year, £5,256m (70%) (6%)
Total: £83,050m
Maturity Profile of Wholesale Funding, Covered Bonds and Securitised Notes 30 September 2007 To 3 months, £14,884m (18%)
3-6 months, £3,743m (5%)
6-12 months, £888m (1%)
Over 3 years, £56,450m (70%) 1-3 year, £5,066m (6%)
Total: £81,031m Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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Treasury Committee: Evidence Ev 239 Graph 2.6 67 170 173 177 180 4 167 170 173 177 180 Months 64 68 72 76 80 84 88 92 96 100 104 107 110 113 117 120 124 140 144 148 152 155 160 164 1 117 113 64 68 72 76 80 84 88 92 96 100 104 107 110 Remaing Term in Months Remaing Term 64 68 72 76 80 84 88 92 96 100 104 107 110 113 117 120 124 140 144 148 152 155 160 16 117 113 64 68 72 76 80 84 88 92 96 100 104 107 110 Number and Outstanding Balance Remaining Product Term by Number Remaining Product Term Remaining Term of Mortgage Product Remaining Term Remaining Product Term by Outstanding Balance Remaining Product Term Weighted Ramaining Product Term = 28.0 months Ramaining Product Term Weighted Average Remaining Product Term = 30.3 months Remaining Product Term Average 0 3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60 0 3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60 0
5 0 500
25 20 15 10
Number of Accounts (000’s) Accounts of Number 3,000 2,500 2,000 1,500 1,000 Amount (£m) Amount Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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Letter from the Chairman to the Chairman of Northern Rock The Treasury Select Committee has asked for further details on the recent changes to the board of Northern Rock announced on 16 October 2007. Given the ongoing support being provided by the taxpayer to Northern Rock, and our inquiry into the events surrounding the need for such support, it is important that we and the public remain informed about the current management of Northern Rock.
Non-executive Directors The changes announced on the 16 October 2007 see four non-executive directors retire, but two remain with the Board of Northern Rock. Under what criteria did non-executive board members resign or were allowed to stay with the Board of Northern Rock? Have any financial incentives or payouts been given to retiring members of the Board of Northern Rock?
Executive Directors Adam Applegarth has resigned from the position of chief executive, yet remains with the company until the end of “the second phase of the strategic review process”. By remaining with the company until this time, will Mr Applegarth receive any additional benefits or payouts that might not have accrued had he left early? Also, will Mr Applegarth receive a payout on leaving the company, and by staying until January 2008 will such a payout appear in the accounts of the company to be published in 2009, rather than those to be published in 2008? As well as this, Mr David Baker, Mr Keith Currie and Mr Andy Kuipers have been demoted from the Board of Northern Rock, yet remain oYcers of the company. What criteria were used to decide between demoting individuals and dismissing them? Has there been any decrease in pay or change in their terms of employment, in view of this demotion? I look forward to your comprehensive and prompt reply. 21 November 2007
Letter from the Chairman of Northern Rock to the Chairman Thank you for your letter of 21 November. I set out to create a Board fit for the immediate purpose of discovering the options available to Northern Rock and implementing the chosen solution in the best interests of the creditors, shareholders, employees and other stakeholders. I decided that a smaller committee Board prepared to meet frequently and work with intensity for some weeks/months was needed. Public spirited NEDs with an appropriate skills mix and a track records for delivery were sought. No easy task in the circumstances but I think with the addition of Messrs Devaney, LaYn and Adams we have done well. No financial payouts or incentives have been given to the four non-executive directors who retired from the Board on 16 November 2007. Executive Directors: in order to reduce the total Board numbers to eight with a majority of NEDs available for all meetings at short notice, I decided to reduce the Executive Directors to two, ie the postholders of the CEO and CFO positions. At the time of writing, no settlement has been agreed with Mr Applegarth and it would be therefore be too early to reply to your question other than to say that in the case of Messrs Currie, Baker and Kuipers, they currently remain in employment but have given up Board membership. I have not yet had time to agree terms for executive directors beyond those already in place. I will advice the committee once agreement has been reached. I can assure you that we have no intention of instituting large bonuses or payouts but contractual obligations will of course be honoured. 6 December 2007
Letter from the Chancellor to the Chairman I wrote to you on 20 September explaining the arrangements the Treasury and the Bank of England had put in place to guarantee deposits in Northern Rock plc during the current instability in the financial markets. I am now writing to explain both the extension of these guarantee arrangements, as notified to Parliament on Tuesday, and the terms of the Bank of England’s new facility. I recognise that it is standard practice when a department incurs a contingent liability in excess of £250,000 outside the normal course of business and for which there is no statutory authority, to inform Parliament of this and to explain the circumstances. Except in cases of special urgency such liabilities are only incurred 14 days after informing Parliament. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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In this instance it was impossible to observe the 14 day rule. The terms of the new guarantee and facility arrangements with Northern Rock were not concluded until early 9 October. I therefore wanted to be able to set out for your Committee our objectives in agreeing the main terms of these arrangements set in the context of our overarching approach to financial stability, which I am explaining to Parliament in my statement today. Details of these objectives, new arrangements and the consequent contingent liabilities are set out in an annex, which I am placing in the libraries of both Houses and releasing to the markets, as these details are market sensitive. The extended guarantee arrangements and the indemnity to the Bank of England set out in the attached note result in some extension of the contingent liability notified to you in my letter of 20th September. Should the Bank of England need support, provision for payment would of course be sought through the normal supply procedure. 11 October 2007
Annex To complement the Chancellor’s statement today to Parliament, this note sets out further details of the extension of the Government’s guarantee arrangements put in place for deposits in Northern Rock plc during current instability in the financial markets and the terms of the Bank of England’s additional facilities, announced on Tuesday 9 October 2007.
Guarantee Arrangements for Northern Rock
At the request of Northern Rock, new guarantee arrangements were put in place from Tuesday to extend 100% cover to all new retail accounts opened with the company from the data of the original guarantee arrangements, 19 September, for as long as the current period of financial market instability lasts. As under the original arrangements, these extended guarantee arrangements will supplement, and not replace, any compensation provided by the Financial Services Compensation Scheme, which the Financial Services Authority has recently extended to cover 100% of the first £35000 of deposits. In order for this guarantee arrangement not to provide the company with a commercial advantage, a fee (from which the Treasury will benefit) has been attached to it, set at a higher rate than the interest premium on the additional facilities outlined below.
Bank of England Facilities
Alongside the guarantee arrangements, the company has also requested that the Bank of England make additional facilities available to it. The company argued that additional facilities, on revised terms, would enable it to continue to pursue the full range of strategic options open to it. The company has confirmed that this process will be completed by February 2008, within the period of the additional facilities. The Authorities have made clear to the company that they will evaluate any proposal it puts forward against their objectives. In the case of the Treasury, and the Bank of England working with it, these objectives are to promote financial stability and the protection of consumers and taxpayers. The Financial Services Authority’s objectives are set out in Part I of the Financial Services and Markets Act 2000. It will also be necessary to continue to be compliant with EC state aid rules. In order to meet these objectives, the Treasury, Bank of England and Financial Services Authority have agreed on the provision of additional facilities through the Bank of England. These facilities are uncommitted and are, therefore, not subject to any specific borrowing limit. They are repayable on demand and will incur a premium rate of interest. The interest premium will roll up and rank alongside the company’s Tier II regulatory capital. The facilities are secured against all assets of the company but in view of the scale and nature of the new facilities, the Treasury has agreed to indemnify the Bank of England should the Bank of England face a deficit having previously made all reasonable endeavors to recover its claims on the company. The interest premium will therefore be passed to the Treasury. The Treasury has also indemnified the Bank of England against other liabilities that might arise from the Bank of England’s role in the extended guarantee arrangements and additional facilities. The company has in turn indemnified the Bank of England and the Treasury in respect of the guarantee arrangements and certain costs and expenses, including our advisor costs. The company has also agreed to the usual range of lender protections typical for facilities of this nature. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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Memorandum from HM Treasury This memorandum responds to the Committee’s requests at the evidence session on 25 October 2007.
Further details of the stress testing carried out under the auspices of the Tripartite Committee, during the course of 2007 (Q 799)
The Committee asked about scenario testing undertaken by the Treasury, Bank of England and FSA recently. Testing has included scenarios relating to financial events and to operational disruptions such as terrorism. The authorities engage in an exercise programme to provide assurance about the robustness of plans, tests responses to particular scenarios, and provides training opportunities. Objectives underpinning the exercise programme include: — testing and improving plans and decision-making processes against a range of scenarios; — training and familiarising staV with Tripartite crisis response arrangements in pressurised situations; — understanding how international counterparts will respond in a crisis; and — testing equipment and familiarise staV with back-up facilities. The programme of exercises has focused on the following main strands: — testing with private sector/exercising with wider Government; — testing tripartite plans and processes; — exercising with key international partners; and — connectivity tests. For reasons of market sensitivity, details of some exercises are not normally made public. The Treasury has been involved in the following tests or simulation exercises during 2006 and 2007: — HMT, Bank of England and FSA testing of back up and primary site communication links (February 2006); — HMT, Bank of England and FSA involvement in the EU-25 financial market simulation exercise under the aegis of the EU Economic and Finance Committee, with the participation of EU banking supervisors, central banks and finance ministries—76 participants at the premises of the ECB (April 2006); — HMT, Bank of England and FSA simulation of cyber attack on financial infrastructure (June 2006); — HMT and Bank of England half day simulation of physical and electronic attack (July 2006); — HMT, Bank of England and FSA six-week tabletop and live Market Wide Exercise on pandemic flu, including involvement from main private sector market participants and infrastructures (October to November 2006); — HMT, Bank of England and FSA financial crisis management tabletop exercise (November 2006); — HMT, Bank of England and FSA participation in a tabletop exercise with authorities from another major financial centre (February 2007); — HMT, Bank of England and FSA participation in a cross-government counter-terrorism exercise (March 2007); — HMT, Bank of England and FSA financial crisis management tabletop exercise (March 2007); Beside participating as appropriate in these exercises, the legal teams advising the tripartite authorities conducted joint training exercises in January and July 2007.
How many Treasury staV are working on financial stability issues (Q 807)
The Chancellor of the Exchequer is the principal member of the tripartite standing committee on financial stability, alongside the Governor of the Bank of England and the Chairman of the FSA. In most circumstances, the tripartite committee meets at the level of deputies. For the Treasury, the formal deputy member is the Managing Director, International and Finance (Stephen Pickford). He is supported by, and interchanges with, the Director, Financial Services (Clive Maxwell). They maintain regular contacts with their counterparts in the Bank of England and the FSA, both in normal and more stressed circumstances. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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Approximately 65 staV normally work on financial services in the Treasury. This includes approximately 16 in the Financial Stability and Risk (FSR) team, headed at team leader (Deputy Director) level. The FSR team has responsibility for the day-to-day operation of the tripartite arrangements, including financial stability and business continuity planning, and the Treasury’s interests in prudential regulation and in risk management in the financial sector. The team members are typically in daily contact with colleagues in the Bank of England and FSA in normal circumstances, and in even more intensive contact in more stressed times. The team has been supported by colleagues based in other parts of the Treasury during recent market developments. The Permanent Secretary (Nick Macpherson) is involved in discussions where appropriate, especially where there are potential financial consequences given his Accounting OYcer responsibilities. Arrangements are in place to ensure that senior members of staV—notably the Managing Director, Director or team leader—are available to deal with any unexpected financial disruptions. The financial services teams in the Treasury are supported by two teams of lawyers, amounting to approximately 50% of the department’s legal resource. The Department’s Legal Adviser has participated as appropriate in tripartite meetings and maintains regular contact with his counterparts at the FSA and Bank of England. More recently, additional resources have been moved to assist work on financial stability (in particular Northern Rock) and the Treasury has acted flexibly to bring in further expertise as the circumstances require: — an additional Director has been appointed on a temporary basis to the senior management team; — two additional team leaders (Deputy Directors) have been moved to this area, to head up work on reforms to bank depositor protection and to help manage the response to Northern Rock and associated legislative and policy analysis; — the Managing Director, Public Services and Growth (John Kingman) is responsible at the level of the Executive Management Group for the ongoing work with Northern Rock itself; and — these additional areas of work are also receiving further support from the Treasury internal legal advisors (who have had the help of lawyers loaned from other Whitehall legal teams), as well as from external legal and investment banking advisors. In total, approximately 15 additional staV are working on these issues, on a temporary basis, redeployed from other functions. October 2007
Letter from the Chancellor to the Chairman Last Monday I published a statement of principles underpinning the Government’s approach I proposals received by Northern Rock with regard to its future. These principles set out our commitment to protecting the interests of the taxpayer, protecting depositors and maintaining wider financial stability. They also explained how, as I have set out on number of occasions, any outcome must meet EC state aid rules. The Board of Northern Rock has announced to the markets this morning that it has concluded it wishes to take forward discussions on and accelerated basis with a consortium comprising Virgin Group, WL Ross & Co, Toscafund Asset Management LLP an First Eastern Investment Group. At this point I want to make two points clear. First, in reaching agreement with Northern Rock on its bidder status, the Virgin Consortium has at the same time confirmed to the Treasury and the Bank of England that it accepts that: — its equity and debt financing proposals will, at the point of announcement of a definitive transaction, be fully underwritten; — a included in the Virgin Consortium’s proposal, the private sector debt financing must be comparable in scale to any public sector debt financing required following closing; — the public sector debt financing required must be on comparable terms, including as to ranking in time of repayment and point of priority, as the private sector debt financing envisaged by the proposal; — there must be binding incentives for delivery of the Virgin Consortium’s plan for achieving appropriate credit ratings, bringing to an end any public sector guarantee arrangements, repaying the public sector financing and terminating any other public sector commitments; and — returns on equity investments made by member of the Virgin Consortium and other holders of ordinary shares must be restricted until the public sector loans have been paid back with interest and all other public sector commitments are at an end. It should be noted that in addition to these requirements, the regulatory requirements of the Financial Services Authority (including as to the business plan and control of Northern Rock) must be met and EC state aid requirements complied with. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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These confirmations given by the Virgin Consortium are in line with the principles I set out last week. Second, until a transaction is finalised, the Government continues to keep all options open in relation to the future of Northern Rock. I shall continue to keep the House informed and will be placing copy of this letter in the Library of both Houses. I am writing in similar terms to Edward Leigh MP. 26 November 2007
Memorandum from Julian D A Wiseman
Summary
1. The Bank of England is better at implementing monetary policy than it was, but not as good as it should be. Unnecessary complexity in the Bank’s operations worsened the eVect of the credit crunch on the UK. Better implementation of monetary policy would be simple and cheap.
History
2. The Bank of England has traditionally been abysmal at implementing monetary policy, whether measured by the variance of short-term interest rates around the policy rate,2 or by market participants’ opinion of the quality of implementation. Why does this matter? Under normal circumstances it leads to unnecessary volatility and a waste of resources, as well as allowing insiders to manipulate the market to their own advantage. And under crisis conditions holes in systems tend to widen as participants become less willing to trust each other’s solvency. 3. In 2003, the last full year of the previous regime, the success of the Bank of England at implementing monetary policy in £ was worse than the implementation of policy in dollars, euro, yen, Swiss francs, Canadian dollars, Australian dollars, New Zealand dollars, Danish krone, Swedish krona, Czech koruna, and Taiwanese dollars. To be fair, the Old Lady’s implementation was better than that in Norwegian krone, Icelandic krona, and several, but not all, emerging-market currencies. For a central bank that thought and thinks of itself as market-savvy, this was less than impressive. 4. So with this background in mind this critic of the Bank’s implementation of policy was delighted to hear, on 28 July 2004, the Executive Director Markets quoting Charles Goodhart’s description of an earlier version of Bank operations as “confused and silly”.3 Maybe this time the Bank would get it right!
Objective
5. In Reform of the Bank of England’s Operations in the Sterling Money Markets, 7 May 20044 the Bank describes its objectives, the first of which says: The first and primary objective is for sterling overnight interest rates to be in line with the MPC’s repo rate, leading to an essentially flat money market curve out to the next MPC decision date, with very limited day-to-day or intra-day volatility in market interest rates at maturities out to that horizon. Beyond the next MPC decision date, market interest rates will be free to reflect market expectations of future MPC interest rate decisions. 6. By “overnight interest rates”, the Bank means the cost of borrowing money against collateral (collateral being discussed later). So the “first and primary objective” is for the cost of secured overnight money to be very close to the policy rate. This is good; and this is measurable. 7. Also of note, because of the margin by which the Bank failed, is the third objective: A simple, straightforward and transparent operational framework.
2 Consider the diVerence between the policy rate and £ repo fixing, using maturities of 1 day, 1, 2 and 3 weeks, and 1 month. Score the standard deviation of this diVerence. Consider the same measure in the non-£ currency, for ƒ using the repo fixing (because it exists), and for the other currencies the Libor fixings or local equivalent. If £ is worse in each of the five maturities for which non-£ data exists, then £ is deemed worse. 3 www.bankofengland.co.uk/publications/speeches/2004/speech225.pdf 4 www.bankofengland.co.uk/markets/money/smmreform040507.pdf Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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Doing It the Simple Way5
8. In the UK, and in most countries, the banking sector needs to borrow money from the central bank. Banks withdraw physical cash from the central bank, and—mostly—need to pay for this cash with borrowed money. In sterling the banking system needs to borrow about £28 billion from the Bank of England—the £41 billion banknote issue less the government’s £13 billion overdraft in the Ways and Means account. These numbers vary along with the size of the note issue—larger at weekends and over public holidays—but nonetheless the banks are almost always in the position of borrowing from the Bank of England. 9. So why not do this the easy way? To implement a policy rate of 5% the Bank of England should be willing to lend money to good counterparties against good collateral, overnight and in good size, at the policy rate of 5%; and also be willing to accept overnight deposits from counterparties at a slightly lower rate, say, 4.9%. 10. That would be enough: against good collateral the cost of overnight borrowing could not rise above the assumed policy rate of 5%, and it could not fall below 4.9%. With banks being net borrowers from the Old Lady, the price would typically trade near the top of this narrow band. And every commercial bank would know that collateral is as good as money: if the collateral is put with the Bank of England, then money can be borrowed at the policy rate. 11. For reasons of prudence the central bank’s standing facilities should not be in?nite in size. If a counterparty were to become insolvent the collateral would have to be sold, and this might entail a loss. Since the banking sector needs to borrow a total of about £28 billion, a sensible upper limit for lending to any one large bank might be something of the order of £20 billion. As the banks are net borrowers, the limit on a counterparty’s remunerated deposit with the central bank could be smaller: perhaps half the maximum overdraft, so £10 billion per bank. Larger borrowings would be prohibited; larger deposits would be unremunerated. 12 This system would have satis?ed the Bank of England’s objective of “simple, straightforward and transparent”.
Doing ItaComplicated Way
13. Instead, the Bank has a system with a corridor that is usually ten times wider than above, and various bells and whistles to try to keep the price within this corridor. Each commercial bank has a reserve account, and can also deal on a separate account via open market operations (which are neither open nor at a market price). The Bank of England’s February 2007 Red Book6 provides the following explanation of its “reserves-averaging scheme”: UK banks and building societies that are members of the scheme undertake to hold target balances (reserves) at the Bank on average over maintenance periods running from one MPC decision date until the next. If a member’s average balance is within a range around their target, the balance is remunerated at the oYcial Bank Rate. 14. The Bank’s most recent Quarterly Bulletin says that aggregate reserves targets are about £17 billion. Since the banks are required to keep this £17 billion on deposit with the Bank, the central bank will have to lend this money to the same banks, as well as lending the £28 billion explained earlier. Again from the Red Book: Open Market Operations (OMOs) are used to provide to the banking system the amount of central bank money needed to enable reserves scheme members, in aggregate, to achieve their reserves targets. OMOs comprise short-term repos at the oYcial Bank Rate, long-term repos at market rates determined in variable-rate tenders, and outright purchases of high-quality bonds. 15. But, rightly, the Bank understands that the two features above, between them, would not be suYcient. For example, one private-sector bank might be able to borrow so much money from counterparties that, on the last day of the reserves period, it becomes a de facto monopoly supplier of funds, presumably at an extravagant rate. Accordingly, the Bank maintains a corridor of “standing facilities”: Standing deposit and (collateralised) lending facilities are available to eligible UK banks and building societies. They may be used on demand. In normal circumstances they carry a penalty, relative to the oYcial Bank Rate, of !/"25 basis points on the final day of the monthly reserves maintenance period, and of !/"100 basis points on all other days. 16. These standing facilities resemble the proposal above, albeit with some changes. First, these facilities need to be invoked actively, rather than being applied automatically to end-of-day balances. Second, because the Bank endeavours to supply the correct amount of central bank money via the three types of
5 This closely follows the text of The pretend market for money, originally appearing in the August 2007 edition of the journal of Central Banking, and also available via www.jdawiseman.com/papers/finmkts/implementing-monetary-policy.html. 6 www.bankofengland.co.uk/markets/money/publications/redbookfeb07.pdf Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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open market operations, these standing facilities are centred on the policy rate. Third, the band is very wide, on most days being &100 basis points around the policy rate. Even on the last day it is still a “penalty” of &25 basis points away from policy. 17. This complication is a mess, and a mess with consequences.
Doing ItaComplicated Way:Everyday Problems
18. The complication caused problems before the credit crisis, albeit problems less widely reported than those that came later. Too few funds were taken at the end-June OMO, causing inter-bank interest rates to trade abnormally high relative to the policy rate in the following week.7 19. This sudden increase in inter-bank interest rates could not have happened with a simpler arrangement, lending day-by-day against collateral, at the policy rate, as much as each counterparty wants, subject to some huge counterparty-by-counterparty limit. But the complexity of the Bank’s system caused a coordination problem: individual actions by counterparties failed to solve the collective problem.
Doing ItaComplicated Way:Signalling Problems
20. But the system’s complications caused worse problems not mentioned in the Quarterly Bulletin.In August the rarely used standing facilities were used by Barclays, reported by the Daily Mail on the 31st: The financial health of Barclays was being questioned after it was forced to ask for huge loans to bail it out. The lender has tapped an emergency credit facility with the Bank of England twice in 10 days. The loans for almost £2billion are fuelling fears that it has become too deeply involved in high- risk debt investments. 21. For the last decade the Bank of England has been very keen to signal to a wide range of economic agents that future in?ation will be close to its target. Given this care in monetary signalling, why does it allow this careless signal about financial instability? It is impossible to know whether this smoke helped give the impression of fire in the banking system, and hence the run on Northern Rock, but why has the Bank created a system that needlessly gives this false and dangerous signal? 22. The problem is that if a feature is little used, and is then used during any sort of market turbulence, some will believe that use of that feature contains signi?cant negative information. The solution is a simpler system that actually works, all parts of which are often used.
Collateral
23. Next we come to the separate issue of what collateral a central bank should accept against its monetary policy operations. (Financial stability operations are diVerent: a central bank might have to lend against poor collateral, or even against no collateral. But that shouldn’t be happening whilst the borrower’s previous management are still on the payroll.) Unlike the question of how to implement monetary policy given a definition of collateral, the optimal definition of collateral for monetary-policy operations is a genuinely diYcult problem. 24. If a central bank lends against a wide range of collateral, and allows counterparties to manufacture collateral, it risks exacerbating a mis-pricing of risk. Also the central bank would be taking far greater credit risk. For example, consider a commercial bank that has lent money to households in the form of mortgages. These mortgages are bundled into securities. If the central bank were to accept these securities as collateral, this would mean the following. 24a If the households should start defaulting in significant numbers, the counterparty would be insolvent just as the collateral provided by the counterparty is dropping in price—a credit loss for the central bank. 24b Because the central bank is holding the credit risk, in some sense it is doing the lending to the households. If the interest rate does not re?ect the creditworthiness of the households, how is the central bank to know? 25. Alternatively the central bank could lend only against the best collateral: bonds issued by the government of the jurisdiction of the central bank—for the Bank of England, gilts.
7 Described on page 356 of the 2007 Q3 Quarterly Bulletin under the heading “June–August maintenance periods”: www.bankofengland.co.uk/publications/quarterlybulletin/mo07aug.pdf. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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26. Before the recent loosening of the rules, the Bank had a mixed stance. 26a The Bank did not allow counterparties to manufacture collateral, as acceptable collateral are securities issued by European Economic Area central governments and central banks and major international institutions. 26b However, the Bank’s collateral policy implicitly entailed and entails substantial credit risk— without admitting that it does so. This needs explanation: the Bank accepts as collateral euro- denominated paper. Imagine that Deutsche Bank has borrowed some £20 billion from the Bank of England (an unremarkable thing, as Deutsche is a major player in £ markets), and has provided as collateral euro-denominated bonds issued by Germany. Then, for some reason, Deutsche goes bust. In theory the Bank of England would sell the German Bunds for euro cash, and then sell the ƒ for £ in the foreign exchange market. In theory. But in practice, central bank politesse would ensure that the Bank would not be willing to be seen to be selling the government bonds and the currency of a country whose largest bank had just defaulted. (Consider the reverse: Barclays goes under, and the following day the Bundesbank is seen selling gilts and selling £—how not to make friends.) So the Bank of England would have to wait for at least several weeks, and more likely several months, before converting the collateral into the currency of the loan. And, in the three months following Deutsche’s default, how far might the euro fall? It might lose 5% to 10%; and it might tumble more than 15%. Certainly very plausible is a "10% move in the euro, which would cost the Bank of England some £2 billion (more than the Bank’s £1.86 billion equity reported in the 2007 accounts). Hence the Bank of England, by allowing euro-denominated collateral, is taking substantial credit risk. 27. This is not necessarily a bad policy, but the Bank should not be pretending to itself or to others that its collateral policy protects it from credit risk. Indeed, the Treasury Committee might like to ask the Bank to explain the purpose of taking collateral, and judge this credit risk against that purpose. November 2007
Memorandum from the London Investment Banking Association 1. We are writing in response to the invitation of the Treasury Committee to submit written evidence in respect of the Committee’s inquiry into Financial Stability and Transparency. LIBA is the trade association for investment banks with operations in London. Its objective is to ensure that London continues to be an attractive location for the conduct of international investment banking business. A list of our members is attached (and is also available on our website: www.liba.org.uk). 2. Fresh information in relation to the events being examined by the Committee continues to emerge and we expect that this will remain the case for some time to come. Our thoughts are, therefore, necessarily only preliminary. We should add that we are seeking primarily to highlight points where further information or enquiry is needed before any conclusions can be drawn.
Executive Summary 3. In this submission, we comment on those issues identified in the invitation which are of particular relevance to our members, and on those with more general implications. These include: (a) The functioning of the Tripartite system and lessons for Lender of Last Resort operations; Criticism has been levelled at the very separation of responsibilities, with some arguing that it was itself a contributor to uncertainty. But consideration needs to be given to whether or not any alternative set of arrangements would have led to a diVerent outcome, before any potential changes to the arrangements can be properly assessed. (b) Possible modifications to the insolvency regime for deposit taking institutions, including shareholder notification requirements, transparency requirements, the Takeover Code and the Market Abuse Directive; On the question of whether bank depositors should be in a special position when compared to other creditors of an insolvent institution and the question whether “core banking functions” (however defined) should be preserved when an institution fails, we are considering the issues with our members and will respond in due course to HM Treasury’s discussion paper “Banking reform—protecting depositors” dated 11 October 2007. It has been suggested that the interplay of the various legal requirements which bear on transfers of shareholdings impose restrictions on the ability of the authorities to carry out a restructuring of a financial institution, without precipitating the very crisis which that restructuring is intended to avoid. It is clearly desirable that, if the measures concerned, in combination, have this eVect, appropriate modifications should be made, including at European level if that proves necessary. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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(c) Changes that may be required to the regulatory requirements regarding liquidity; Work at regulatory level and by the industry needs to be carried out carefully and thoughtfully. It would be easy to carry out a wrong analysis and draw a conclusion that could be damaging to firms’ ability to manage their own liquidity needs eVectively and securely. We think that liquidity risk management warrants further attention and we support the eVorts that are already in train. (d) Any other regulatory changes that may be required; At this stage, we would discourage hasty legislative intervention because: (i) The dimensions of the problem are not yet known; (ii) There are good grounds for believing that the wholesale market is beginning to correct itself; and (iii) Further work is under way in a variety of groups, considering a range of questions. In particular, we would single out international regulatory eVorts in relation to securitisation practices, disclosure and valuation. (e) The implications of any wide-ranging modifications to the operation of the Financial Services Compensation Scheme’s deposit sub-scheme; Minimum levels of compensation coverage are prescribed under the EU deposit guarantee and investor compensation directives. The home country basis on which these directives apply means that non-UK EU firms cannot be required to contribute to FSCS compensation payments made to UK customers. There is a question of competitiveness for the UK, therefore, which should not be lost sight of when changes to FSCS financing arrangements are discussed. We, with our Members, are examining the issues that the Tripartite authorities have raised in the consultative document, so we cannot comment definitively at this stage. To the extent that the FSCS is supposed to have some behavioural impact, it is clear that the level of confidence it provided proved inadequate during the events in September. It is not clear however what the position would have been with the more generous cover now available. It is also important to avoid arrangements that could lead to the kind of costs borne by taxpayers following the losses of US Savings and Loans depositors in 1986–95. In order to address moral hazard issues, in reviewing the UK scheme it will be necessary to consider arrangements that address the risk of depositors simply opting for accounts paying the highest rate of interest. (f) More general questions about the overall functioning of financial markets. Our view, briefly stated, is that shortcomings in the US relating to certain classes of asset backed securities led to uncertainty and loss of confidence in valuations more widely. That uncertainty, in turn, led investors to seek to unwind their positions in securities they perceived to be aVected; this rational response led, in turn, to illiquid market conditions in a number of markets. As we explain, the present position is correctly summarised, in our view, by the Financial Stability Forum. The ability of investment institutions to borrow money with which to acquire financial instruments of a stated credit quality is likely to be more relevant to a discussion of the operation of financial markets than the trend to more leveraged issuers—including the acquisition of quoted companies by private equity groups willing to take more risk with the corporate finance structure. We do not believe that this trend has had particular adverse eVects on the markets for financial instruments secured on other assets. 4. We are working with our colleagues in similar organisations around the world to co-ordinate the industry’s response to recent events and to contribute to international work by the industry and the regulators.
The Functioning of the Tripartite System and Lessons for Lender of Last Resort Operations
5. At this stage, we do not think it is appropriate to comment in detail on the operation of the Tripartite arrangements. 6. The Tripartite arrangements necessarily separate the responsibilities of the Treasury (overall responsibility for legislation and accessible to Parliament), the Bank (financial stability), and the Financial Services Authority (supervision), in relation to financial markets and institutions. The separation is intended to clarify the roles each body should play both in normal market circumstances, and in the event of a crisis. At this stage it is not clear whether the arrangements themselves worked as intended during the period leading up to the Government’s decision to stand behind Northern Rock, whether there were particular issues on the communications front or whether the arrangements were intrinsically defective in some way. Criticism has been levelled at the very separation of responsibilities, with some arguing that it was itself a contributor to uncertainty. But consideration needs to be given to whether or not any alternative set of arrangements would have led to a diVerent outcome, before any potential changes to the arrangements can be properly assessed. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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7. The justification for Lender of Last Resort (LOLR) operations, in the final analysis, rests in the special role that banks have in the financial system. Because there are clear externalities involved, banks can—in certain circumstances—look to the authorities for support in a way in which other commercial organisations cannot. LOLR action is traditionally justified in circumstances where the institution concerned is “systemically significant”. There are good reasons for the authorities to maintain some imprecision over how this term is applied in practice. What the Northern Rock case brings out is that, in assessing systemic significance, it is necessary not only to consider the institution itself but also knock-on eVects on other institutions, within the system. 8. It is worth noting that there is a conceptual distinction between the framework for the Bank’s operations in the sterling money markets—which, while they can be modified so as to provide additional central bank liquidity against a wider range of collateral, or over longer periods, in order to reduce market interest rates at longer maturity, are directed at the market as a whole—and the LOLR arrangements provided for in the MOU, which relate to individual institutions and can potentially involve a greater degree of flexibility. There is a balance to be struck between the requirements of these two regimes.
Possible Modifications to the Insolvency Regime for Deposit Taking Institutions, including Shareholder Notification Requirements,Transparency Requirements, the Takeover Code and the Market Abuse Directive 9. There are two areas where a policy review of the insolvency arrangements is already underway. These are the question of whether bank depositors should be in a special position when compared to other creditors of an insolvent institution and the question whether “core banking functions” (however defined) should be preserved when an institution fails. The tripartite discussion paper issued jointly by HM Treasury, the Bank of England and the FSA “Banking reform—protecting depositors” dated 11 October 2007 discusses both. As noted the section below, headed “Modifications to the operation of the Financial Services Compensation Scheme’s deposit sub-scheme”, we are considering the issues with our members and will respond to the Tripartite authorities’ paper in due course. 10. At European level, the Credit Institutions Winding Up Directive8 (“WUD”) has been designed to indicate which insolvency regime will apply to a bank with operations in more than one EU member state. Aspects of the operation of the WUD are currently under review. Any change to UK law will need to take account of the eVect of WUD and any changes to it as these emerge. 11. It has been suggested that the interplay of the various legal requirements which bear on transfers of shareholdings impose restrictions on the ability of the authorities to carry out a restructuring of a financial institution, without precipitating the very crisis which that restructuring is intended to avoid. It is clearly desirable that, if the measures concerned, in combination, have this eVect, appropriate modifications should be made, including at European level if that proves necessary.
Changes that may be Required to the Regulatory Requirements regarding Liquidity 12. Liquidity risk is one of the primary risks that financial institutions face. Liquidity risk for a firm is the risk that it will be unable to meet its obligations as they come due because of an inability to liquidate assets (or to obtain adequate funding—this is referred to as “funding liquidity risk”). There are two ways in which this risk is manifested: the illiquidity of the individual firm and the illiquidity of the markets. In this section we refer primarily to the liquidity of financial institutions and the need for this risk to be carefully managed. 13. A firm’s liquidity is measured by its cash reserves and its ability to realise its assets for cash. Market liquidity refers to the extent to which assets in a particular market can be readily traded without adversely aVecting the price. When liquidity dries up in a market, then firms’ ability to realise assets for cash is restricted and the firm’s own individual liquidity will be reduced and its ability to meet its commitments may be impaired. 14. The Basel capital adequacy framework is a framework for the solvency of a financial institution, seeking to ensure firms will have suYcient capital reserves to withstand a degree of loss due to impairment of value or defaults on their assets. Capital adequacy regulation does not address—nor is it intended to address—the liquidity of an institution. Unlike capital adequacy, liquidity is not regulated on a harmonised basis at the European level but national requirements exist. These requirements focus primarily on seeking to ensure that individual institutions maintain a stock of assets that are under normal circumstances highly liquid—or have access to such assets. Both solvency and liquidity regimes stress the need for firms to carry out scenario and contingency planning in relation to extreme conditions. 15. Regulators have been well aware for some time of the importance of liquidity regulation and there have been both regulatory and industry initiatives at international level as well as the national level in recent years. This work notably includes the issue by the Joint Forum (the Committee on which banking, securities and insurance regulators sit) of key principles for liquidity risk management. The current work of the Basel Committee builds on this contribution. On the industry side, the International Institute of Finance (IIF)
8 Directive 2001/24/EC dated 4 April 2001. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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issued, in March 2007, “Principles of Liquidity Risk Management”. Within the UK, industry associations (including LIBA, the British Bankers’ Association (BBA) and the International Swaps and Derivatives Association (ISDA)) are cooperating to analyse further how to develop such work. 16. Work at regulatory level and by the industry needs to be carried out carefully and thoughtfully. It would be easy to carry out a wrong analysis and draw a conclusion that could be damaging to firms’ ability to manage their own liquidity needs eVectively and securely. We think that liquidity risk management warrants further attention and we support the eVorts that are already in train. 17. We wish to draw particular attention to the following features of liquidity risk management that should be borne in mind in creating any new regulatory regime that applies either at international or at national level. 18. “One size does not fit all”. This point is true for many areas of regulation and especially so for liquidity, where the liquidity needs and risks of a firm can reflect the diVerent structures of business that may be in place. In the EU dimension, the same regulation frequently applies to banks and to investment firms; however the balance sheet structures (ie the funding and asset profiles) can diVer significantly between the two and expose these firms to diVerent types of risk. Quality of liquidity risk management and control must be high in both sectors, but the precise methods may legitimately diVer and in some cases it will be essential that they diVer. 19. When managing liquidity risk, international groups,—whether global or European and whether banking groups or securities groups—must also take account of the extent to which local regulations will impede or facilitate the group’s ability to direct funds to where they are needed among the members of the group. Therefore it is essential for regulators to weigh carefully how to take account of the cross border dimension and ensure that obstacles are not put in the way of a group’s ability to manage risk eVectively or to support subsidiaries or branches when this might be necessary. 20. We take comfort from the fact that regulators have been willing to pay close attention to the IIF work on liquidity management principles which we support and which associations in the UK (including LIBA, ISDA and the BBA) are seeking to assess and as necessary develop further in local conditions. We think this is a fruitful direction for work at the G10 and also the EU level, where the EU is presently monitoring the work of the G10. We support this approach. 21. However, we are also conscious that the Basel Committee focuses on banking regulation. If proposals for regulation are put forward that go beyond issues of risk management, then it is imperative that there is an assessment of the needs of investment firms. The FSA, in our view, is fully aware of this need but it will be important to ensure that this dimension is taken into full account if there is a possibility of new EU legislation applying to banks and investment firms. Both the FSA and HM Treasury will need to be proactive in any EU negotiation. 22. In conclusion, we support initiatives that focus on liquidity risk management principles. We endorse the call for more work to analyse how liquidity risk models have fared in the recent events, and to assess the cross border dimensions. We support the temperate approach that regulators have taken so far and stress the need to ensure that any new proposals are fit for purpose not only for banks but for investment firms.
Any Other Regulatory Changes that may be Required
23. It seems reasonable to expect that institutional investors will insist on improved contractual terms and much greater transparency of the underlying assets. At this stage, therefore, we would discourage hasty legislative intervention because: (a) the dimensions of the problem are not yet known; (b) there are good grounds for believing that the wholesale market is beginning to correct itself; and (c) Further work is under way in a variety of groups, considering a range of questions. In particular, we would single out international regulatory eVorts in relation to securitisation practices, disclosure and valuation. We refer to some of these in “International work” below. 24. We also caution against taking precipitate regulatory action. There is still much to be learned from the recent upheaval and work is currently underway on the part of both regulators and industry covering the causes and implications of recent events and the development where necessary of regulatory responses. It is important that the work is allowed to run its course and that market solutions are evaluated and impact assessment conducted before action is taken. 25. A number of themes are common in these reviews—including accounting policies, valuation, disclosure, transparency, risk management, credit rating agencies and supervisory activity—and we think that these issues are worthy of careful consideration given the global market inter-relationship highlighted by recent events. International agreement on any way forward is very important. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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Modifications to the Operation of the Financial Services Compensation Scheme’s Deposit Sub- scheme
26. Minimum levels of compensation coverage are prescribed under the EU deposit guarantee and investor compensation directives. These measures are silent, however, on how compensation payments should be financed but they note that the financing arrangements “must not . . . jeopardise the stability of the financial system” of a Member State. The directives follow the home country control principle. The level of cover is established by a firm’s home state, and a firm with customers in other Member States cannot be required to join the scheme in such customers’ country—if such a firm becomes insolvent, the customer will be compensated only by the firm’s home scheme (unless the firm has elected to benefit from additional “top- up” cover provided by a host scheme). The extent to which the home country control basis means that EU firms cannot be required to contribute to FSCS compensation payments made to UK customers should not be lost sight of when changes to FSCS financing arrangements are discussed. There are implications for the international competitiveness of the UK here. 27. The FSCS now provides cover in full for the first £35,000 of a person’s deposits in any bank or building society; for the clients of failed investment firms, 100% cover is provided for the first £30,000, with 90% cover provided for the next £20,000 (so the maximum cover is £48,000). 28. The Committee notes that in addition to reviewing deposit protection limits and payout times, there are questions about whether amendments should be made to insolvency law to allow the “continuity of function” to be maintained. These matters, together with the suggestion that there might be special arrangements for “critical banking functions”, are discussed in the Tripartite authorities’ “Banking reform—protecting depositors” discussion paper—which, within its compensation focus, covers the ground pretty comprehensively. At this stage we, with our Members, are examining the issues that the authorities have raised, so we cannot comment definitively at this stage. However, to the extent that the FSCS is supposed to have some behavioural impact, it is clear that the level of confidence provided in September was inadequate but it is not clear what the position would have been with the more generous cover now available. It is also important to avoid arrangements that could lead to the kind of costs borne by taxpayers following the losses of US Savings and Loans depositors in 1986–95. So, in order to address moral hazard issues, in reviewing the UK scheme it will be necessary to consider arrangements that address the risk of depositors simply opting for accounts paying the highest rate of interest. 29. Whatever the changes to be made in the FSCS turn out to be, and assuming that there are some limits on compensation, it will clearly be important to ensure that consumers have a reasonable understanding of the ground rules.
The More General Questions about the Overall Functioning of Financial Markets 30. The analysis of recent events has been covered in a number of papers. Our view, briefly stated, is that shortcomings in the US relating to certain classes of asset-backed securities led to uncertainty and loss of confidence in valuations more widely. That uncertainty, in turn, led investors to seek to unwind their positions in securities they perceived to be aVected; this rational response led, in turn, to illiquid market conditions in a number of markets. 31. The present position is correctly summarised, in our view, by the Financial Stability Forum9: “While the disruption to the functioning of credit and money markets and potential risks for the real economy have been significant, it is worth noting that other components of the financial system have continued to function well. This is the case for the financial market infrastructure, including for the payment and settlement systems. Also, to date, the hedge fund sector per se has not been as major a factor in the systemic problems as some might have expected. Furthermore, in comparison with previous episodes of increased global risk aversion, the capital cushions of major financial institutions thus far have held up well and emerging market economies have remained largely unaVected. These encouraging aspects are signs that eVorts by the private and public sector to strengthen risk management practices and resilience have been beneficial in reducing the severity of the market turmoil”. 32. We do not think that the trend to more leveraged issuers—including the acquisition of quoted companies by private equity groups willing to take more risk with the corporate finance structure—has had particular adverse eVects on the markets for financial instruments secured on other assets. The ability of investment institutions to borrow money with which to acquire financial instruments of a stated credit quality is likely to be more relevant. 33. Credit ratings and credit rating agencies played an important role in the growth of structured finance in recent years. Questions have been raised about the role of credit ratings and credit rating agencies in current markets, particularly in relation to the issues of (a) potential conflicts of interest in activities of rating agencies, (b) the role of credit rating agencies in the development of structured finance products and (c) the uses made by investors of ratings of these products. We note that the credit rating agencies are responding
9 Financial Stability Forum Working Group on Market and Institutional Resilience: Preliminary Report to the G7 Finance Ministers and Central Bank Governors dated 15 October 2007. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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actively to these issues and are currently involved in a review of their own methodologies. These studies should be allowed to run their course; we expect that the results over the next few months will provide a valuable contribution to the mature consideration of these questions. 34. As part of any review on risk management, questions about the use made by investors of ratings should be considered more broadly. 35. We also note that the role of the rating agency is to give its opinion of the probability of default and the expected loss given default under a certain set of assumptions. It is not part of the rating agency’s role, as we understand it, to give an opinion on the liquidity of the market for the security in question. 36. Following an extensive consultation process, on 23 December 2004 the International Organisation of Securities Commissions (IOSCO) published its Code of Conduct Fundamentals for Credit Rating Agencies (the Code), the purpose of which is to promote investor protection by safeguarding the integrity of the rating process. IOSCO said on publication that it expects all credit rating agencies to give full eVect to the Code by incorporating it into their existing codes of conduct. The application of the Code by the agencies is being reviewed by the agencies in conjunction with IOSCO members. In Europe, the Committee of European Securities Regulators published a questionnaire in June 2007 on the rating of structured finance instruments as part of its second annual programme to assess the implementation of the Code by the rating agencies. The purpose of this questionnaire was to enable CESR to gather information from interested parties on the functioning of this specific segment of the rating business. CESR extended its deadline for comment to the end of September in the light of market events. If there is to be any further work on credit rating agencies, it should build on this base.
International Work 37. In addition to the work being done by IOSCO and CESR referred to in paragraph 36 above we are aware of a number of initiatives: (a) We note that liquidity risk management is already a subject under discussion in both Basel and the EU.10 (b) Work is underway by market participants on improving the transparency of valuation methodologies and we recognise the interest of regulators in ensuring robust and reliable valuations in a prudential context while ensuring compatibility with international financial reporting standards. (c) There have been calls for increased disclosure by firms of, inter alia, their (direct or indirect) exposure to the US sub-prime market; their contingent exposures to oV balance sheet vehicles and to other structured products adversely aVected by recent events; and their exposure to counterparties with positions giving exposure to one or more of these things. It goes without saying that such disclosure should be managed on a consistent basis, seeking to ensure that the disclosures are broadly comparable. (d) We note the fact that the Financial Stability Forum has established a special Working Group and we look forward to the further results of its deliberations. (e) On 10 October 2007 the Hedge Fund Working Group published a consultation paper which puts improved disclosure to investors at the heart of best practice standards for the industry. The Report addresses issues about financial stability raised by the G8 and Financial Stability Forum as well as other concerns about the hedge fund industry. The new standards focus particularly on the areas of valuation, risk management, disclosure and fund governance. The Group has also recommended that hedge fund managers disclose more information about themselves on their websites and that more information about the industry is made available collectively to the wider public. Responses have been invited and the consultation period will run until 14 December 2007. We understand that the Group intends to issue its final report in January 2008. 38. The implementation in the EU of the revised Basel accord through the Capital Requirements Directive (2006/48/EC and 2006/49/EC) should also be of benefit by making capital requirements fit changing risk profiles and creating incentives to support the proper management of risk. 39. We are working with our colleagues in similar organisations around the world to co-ordinate the industry’s response to recent events.
Conclusion 40. We strongly support the eVorts underway by regulators and the industry to examine the causes of the current market turmoil and to formulate internationally agreed next steps in relation to the issues that are identified as requiring action. We continue to believe that a consistent outcome is highly desirable and that this can best be achieved through international co-operation.
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41. It is very important that the various investigations are allowed to run their course. Market participants have a strong incentive to understand the causes of the market turmoil and develop relevant solutions for themselves. The proper regulatory process controls, including evidence based policy-making, a proportionate approach and the development of regulatory impact assessments and cost-benefit analysis, remain important. 42. We think there is value in avoiding hasty conclusions on possible regulatory action and regulatory actions that “crowd out” appropriate market solutions. It is important that market participants fully absorb and appreciate all the lessons that should be learnt from these events. As ever, there is a delicate balance to be struck by the authorities in taking action to improve the way the market currently works without unduly stifling future innovation. 43. Further, we believe that both the industry and the regulators will benefit from working closely together in reviewing both the causes of the current market turmoil and developing measures reasonably designed to reduce the probability and the impact of future events of this type. 44. We stand ready to contribute further to the Committee’s deliberations. November 2007
Memorandum from Dr Paul Hamalainen, Lecturer in Accounting and Financial Management, Loughborough University
Executive Summary 1. This written evidence statement indicates that the Northern Rock crisis has brought to light a number of problems in the UK deposit taking institutions regulatory environment. The statement argues that it is primarily these weaknesses, rather than the actions of a specific person or persons, that have caused and perpetuated the Northern Rock turmoil. Therefore, the remedial focus of the committee in preventing a similar bank run in the future should be on tightening the UK deposit taking regulatory environment. The key weaknesses in the current regulatory system are: 1) a poorly structured and operated deposit insurance scheme; 2) a lack of a specific insolvency regime for deposit taking institutions; and 3) a poorly structured supervisory framework for dealing with deposit taking institutions that are experiencing diYculties. 2. This statement provides recommendations to strengthen the current regulatory environment. In summary, they are: 1) to introduce a deposit insurance scheme that transfers insured depositors’ money within a day either through a bridge bank approach or the insured deposit Transfers method depending on the deposit taking institutions characteristics; 2) to guarantee 100% of depositors funds at the current level of £35,000 or potentially up to say £50,000 per person per bank; 3) to consider moving from a “pay as you go” deposit insurance funding approach to a pre-pay approach; 4) to introduce risk-based deposit insurance levies on deposit taking institutions; 5) to introduce a clear uniform order for distributing the assets of failed deposit taking institutions; and 6) to introduce a Prompt Corrective Action (PCA) regulatory approach for dealing with deposit institutions that are experiencing diYculties. In contrast, to the PCA regime in the United States, the PCA approach should be based on tripwires that reflect both solvency and liquidity risks. 3. These recommendations reflect the fact that the UK deposit taking regulatory environment requires fundamental revisions at two levels (both pre-crisis and post-crisis) rather than simply to the deposit insurance scheme. This is due to the fact that there are tradeoVs between diVerent aspects of the regulatory environment. For example, introducing a PCA approach should limit the potential claims on a deposit insurance scheme and thus a “pay as you go” funding approach could arguably be retained. This written evidence statement discusses the recommendations for the regulatory environment in detail under the headings provided in the Treasury Committee’s press notice No 88 with regard to a focus on pre-crisis and post-crisis solutions.
Northern Rock
4. Pre-crisis events Northern Rock has suVered financial diYculties as a result of a liquidity squeeze in most credit markets during summer and autumn 2007. Its funding model placed significant reliance on access to wholesale credit markets. Although the scale of the shutdown in credit markets was unprecedented, deposit taking institutions have historically failed for liquidity reasons as much as solvency ones. Therefore, liquidity should be aVorded the same level of importance as solvency in the deposit taking regulatory regime. The failure of Northern Rock’s management to appreciate the bank’s liquidity risks and the weak regulatory regime concerning liquidity risk allowed Northern Rock to develop a potentially vulnerable position, which was exposed during the summer of 2007. The Northern Rock management can argue that it has a good quality loan book, but this loan book cannot be funded without extreme support from the regulatory authorities. Solvency should not be used as an excuse to support a deposit taking institution that suVers Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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severe liquidity problems, because it can encourage future moral hazard behaviour. Therefore such an institution should be allowed to fail. The benefit of the bank being solvent is that investors should be able to recoup the majority of their funds. 5. The Bank of England’s approach in providing liquidity to UK deposit taking institutions through the short-term money markets compared to the approaches adopted by the European Central Bank and the Federal Reserve may have exacerbated the problems at Northern Rock. However, the Bank is right in its attempt to restrict future moral hazard behaviour by allowing only top quality collateral to be used and for short maturities. The diYculty for the Bank of England is that certain UK deposit taking institutions were able to access the “softer” regimes available in continental Europe and the US, thus undermining the Bank’s stance.
6. Pre-crisis solutions The key point to take on board from the events leading up to the Northern Rock crisis is that a suitably structured pre-crisis regulatory regime could have prevented the problem from escalating. The key limitation with the current approach in the UK is not the Tripartite system and which party has responsibility for what part of the financial system; rather it is how to regulate the system. Focusing specifically on the case of potential failure of a deposit taking institution, the regulatory authorities are, and always will be, reluctant to decide if an institution should fail until it is too late. For example, who out of the Tripartite group would have been be willing to have closed Northern Rock, either prior to them taking out Lender of Last Resort facilities, or even now when an estimated £23 billion of taxpayers money has been expended propping up the institution, whilst at the same time wholesale financial institutions are not renewing their funding arrangements with Northern Rock. The fear of law suits from Northern Rock stakeholders such as the junior bondholders and shareholders would be too heavy a burden for any one person to bear in making this decision. This forbearance problem is common across most financial regulatory regimes in the world and should be addressed in future UK regulatory reforms to prevent a similar crisis occurring in the future. A solution to the forbearance problem is a PCA regulatory approach such as the one in operation in the United States. This is because a PCA approach formalises specific ratio tripwires which when breached serve as the basis for mandatory action by the supervisory authorities. In the United States, tripwires are based on an institution’s solvency and increasingly harsh restrictions apply as their solvency deteriorates. Such prompt corrective actions include increased monitoring, raising additional capital, requiring acceptance of an oVer to be acquired, and closure of the institution. 7. The UK should consider adopting a similar PCA approach, but go one stage further and include both solvency and liquidity ratios in the tripwire categories. Thus, the primary causes of bank failures would be captured. The UK regulatory regime does already have informal solvency and liquidity ratio targets, but in both cases they are one-dimensional and there does not appear to be any specific corrective actions proposed if targets are breached. The corrective actions should be formalised and for both solvency and liquidity risks tripwire categories should be constructed, so as to accelerate regulatory authority action. For example, in the case of large UK deposit taking institutions, 5 day, 10 day and 1 month Sterling Liquidity Ratios should be calculated and diVerent percentage tripwire categories created for each calculation. Such a framework means that the supervisory authorities would have a comprehensive structural/legal mechanism enabling them to act early in preventing a bank problem becoming a full-blown crisis and warding oV potential lawsuits if an institution has to be closed. Two additional benefits to the whole deposit taking supervisory regime as a result of introducing a PCA approach are firstly, that tripwires also place bank management under increased scrutiny to ensure adequate solvency and liquidity of their institution, and secondly, a likelihood that fewer claims will be made on the deposit insurance scheme as a result of bank failure. This last point is discussed in further detail in the section on depositor protection below. The linkage between pre-crisis mechanisms such as PCA and post-crisis mechanisms such as deposit insurance emphasises how a suite of pre-crisis and post-crisis deposit taking regulatory reforms should be considered in the UK following the Northern Rock crisis.
Depositor Protection
8. Post-crisis events and implications The government’s response to the run on Northern Rock to protect all of its depositors (and the implicit guarantee that this has been extended to depositors in all other banks) has set an extremely dangerous moral hazard precedent, especially for larger banks. However, a lack of clearly structured and adequate post-crisis regulatory structures left the government with little choice but to protect depositors, otherwise it may have led to potentially significant systemic financial consequences. The problem for the Tripartite Group now lay in providing a suYciently credible no bailout policy so as to extinguish investors’ safety perceptions in the event of a future deposit-taking institution failure. This can only be achieved through fundamentally revising the UK deposit taking regime to clearly place the risks of bank failure on large depositors, all junior bondholders and all shareholders. These are the stakeholders that should be taking on the risks and costs of bank diYculties and failures. However, an inability to have clear and adequate pre-crisis and post-crisis regulatory mechanisms in place has provided sophisticated investors with time to remove their investments Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
Treasury Committee: Evidence Ev 255
from Northern Rock, thus forcing Northern Rock to continue drawing down funds from the Bank of England. In eVect, any potential cost of bank failure is gradually being passed on the government. Recommended pre-crisis mechanisms that should reduce the likelihood of having to implement a post-crisis response were discussed in the previous section. The remainder of this section covers the post-crisis mechanisms that could alleviate a repeat of the farcical situation that has been witnessed as a result of the liquidity crisis at Northern Rock.
9. Post-crisis solutions The two key post-crisis solutions that have been found to be wanting as a result of the Northern Rock problems are a poorly structured and operated deposit insurance scheme and a non-existent specific insolvency regime for deposit taking institutions. I will deal with each in turn and stress that both mechanisms have to be improved so that they work in tandem with each other. In addition, clearly outlining ex ante how failing deposit taking institutions will be dealt with in the future provides the regulatory authorities with clear resolution structures and options, and highlights to investors their risk ranking.
10. Deposit Insurance Scheme failings and recommendations The whole ethos of the current UK Financial Services Compensation Scheme (FSCS) is reactive rather than proactive and herein lays the fundamental problems with the scheme. This is reflected both in the way that the scheme is funded and in the slow manner in which depositors are paid following bank failure. The FSCS does provide a good degree of payment protection compared to other European countries, but the scheme can learn a lot from the ethos of the Federal Deposit Insurance Corporation (FDIC) in the United States where they are required to select the resolution method for failing deposit taking institutions that results in the lowest cost to the deposit insurance fund (and hence taxpayer). 11. Looking first at how insured depositors are dealt with. They have to be assured that within one day of bank failure they will have access to their insured deposits. The time taken to repay insured depositors can be thought of as a liquidity risk for depositors. It is the fact that the current FSCS may take up to six months to repay investors (as well as the co-insurance element that use to exist in the FSCS pre-October 2007) that drove insured Northern Rock depositors to withdraw their money. In addition, to further reassure insured depositors and reduce the opportunities for a bank run, insured depositors should not only have access to their funds swiftly, but also to crucial banking facilities so that they can continue to undertake day-to-day activities. Deciding on an appropriate level of deposit insurance coverage is an extremely diYcult process. 100% of the current £35,000 appears reasonable to cover the so-called “widows and orphans” as would raising it to £50,000. Introducing a substantially higher limit than £50,000 does raise the prospect of moral hazard behaviour by deposit taking institutions, but at the same time increases bank’s potential costs of funding the depositor protection scheme. However, under the “pay as you go” FSCS funding approach no deposit institution is currently paying a levy to the FSCS for deposit protection. Therefore, the “pay as you go” approach is exacerbating the moral hazard problem. The problems with the current UK FSCS funding arrangements will be addressed more specifically later in this section. 12. There are a number of diVerent resolution methods available for failing deposit taking institutions, some of which should be considered in any future UK depositor protection scheme. These include Straight Deposit PayoV, Insured Deposit Transfers, and Bridge Banks. The Straight Deposit PayoV method will pay insured depositors with a cheque once a bank has failed. The current FSCS is based on this approach. Downsides with this method are that there will be a number of days of depositor liquidity risk whilst the cheque is clearing and it can lead to disruption in the local community (particularly relevant for building societies) where the institution is a key provider of local financial services. An alternative is the Insured Deposit Transfers method. This approach involves transferring insured deposits and secured liabilities of the failed deposit institution to a healthy institution that agrees to act as the agent for the deposit insurance scheme. The deposit insurer would make a cash payment matching the amount of the transferred liabilities to the agent bank. This method reduces the disruption caused by a Straight Deposit PayoV to insured depositors and the local community [FDIC, 1998]. Finally, the Bridge Bank approach is where a temporary bank is created to transfer the insured depositors, secured creditors and assets of the failing institution. In that way, key banking facilities can continue to operate without disruption. The remaining creditors remain with the deposit institution that is in receivership. The FDIC’s intention with a Bridge Bank is to sell it to a bidder within two years of its creation. The FDIC’s experience with the Bridge bank approach is that it can be particularly useful in dealing with deposit institutions that have failed as a result of liquidity problems. This is because, compared to a situation in which asset quality problems have built up over time, a bridge bank gives the FDIC and potential bidders an opportunity to review the bridge bank in a more stable environment and arrange a permanent transaction [FDIC, 1998]. The FDIC has also found the bridge bank approach especially useful if the failing deposit institution is large or complex. This is partly because they did not have to negotiate with a failed institution’s shareholders and bondholders. However, the United States experience of bridge banks did highlight the necessity for additional legislation after a couple of years in the form Cross Guarantee provisions. This legislation enabled the deposit insurer to recover some of the costs for handling troubled banks from other solvent deposit institutions in the same banking group, even if the FDIC actions will subsequently force the other deposit institutions to become insolvent. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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13. A revised UK depositor protection scheme should include clear guidance on the approaches that are available to resolve bank failures and necessary legislation introduced a priori to support these approaches. In addition, an overarching requirement that the least cost resolution method is undertaken will prevent excessive costs to the taxpayer. As a result, the regulatory authorities will be sending a clear message to bank shareholders, bondholders and large depositors that they are at risk in the event of deposit institution failures. These investors should in turn reflect this in the yields that they demand from deposit taking institutions for their investments. At the same time, insured depositors can be confident that swift resolution measures will be introduced to enable them to access their insured funds immediately. 14. Apart from discussing how to deal with insured depositors, the other key depositor protection scheme issue is how it should be funded. The current ‘pay as you go’ funding approach exacerbates a reactive ethos to deposit insurance in the UK. Deposit taking institutions are called upon to provide support to the depositor protection scheme when there is a deposit taking institution failure. In contrast to a “pay as you go” funding model, a “pre-funded” approach is where deposit taking institutions pay annually into a deposit insurance fund which hopefully builds up over time to cover claims during times of bank stress. There are a number of problems with the “pay as you go” approach, which conflict with other desired aspects in a revised depositor protection scheme. Firstly, if the regulatory authorities want to ensure that insured depositors obtain their funds without disruption then a “pay as you go” deposit protection scheme is unlikely to deliver the necessary funds quickly enough. It can be envisaged that the government would have to step in temporarily to cover the deposit insurance fund’s shortfall whilst the levies are being collected from supporting deposit institutions. The potential exception to this could be the Bridge Banks approach, although such an approach may be inappropriate for smaller bank failures. Secondly, a “pay as you go” scheme can lead to procyclical problems; namely that demands for levy contributions will be made at exactly the time when deposit taking institutions are experiencing a period of distress [Blinder and Wescott, 2001]. This could cause an exacerbated slow down in banking activity during business cycle downturns. In contrast, a “pre-funded” model can overcome the procyclical problem by deliberately being constructed to allow depositor protection funds to rise during more favourable economic conditions and decrease during less favourable ones. Finally, if the regulatory authorities feel that a “pay as you go” funding model is most appropriate for the UK then some form of PCA supervisory mechanism must be introduced. This is because PCA forces the supervisory authorities to intervene in impending bank diYculties at an early stage. Therefore the likelihood that there will be calls on the deposit insurance fund is significantly reduced and so the limitations of a “pay as you go” approach that are discussed above can be minimised. 15. Regardless of which depositor protection scheme funding model is used, there should be some consideration in introducing risk-based contributions. This could be based on amongst other things a deposit taking institutions probability of causing a loss to the deposit insurance fund due to the composition and concentration of the institution’s assets and liabilities and the amount of loss given failure. In that way, the institutions that are most likely to cause deposit insurance payouts provide the majority of the funding.
16. Insolvency regime failings and recommendations In line with other countries a specific insolvency regime should be introduced for failing deposit taking institutions. The special nature of banks can justify the immense regulatory and supervisory structures that exist to protect financial stability. The same justifications can be used to support the introduction of a specific insolvency regime. Such a regime should clearly state the order in which deposit taking liabilities will be refunded in the event of a deposit taking institution failing. At the moment in the UK, depositors rank alongside general unsecured creditors in order of repayment. This should be amended so that uninsured depositors are specifically placed in advance of general unsecured liabilities. As a result of this adjustment, the key deposit institution funding investors will be clear as to their risk ranking in the event of bank failure and should price this risk accordingly in their investments. 17. The insolvency regime would also have to accommodate PCA provisions if it was decided to introduce such a pre-crisis regulatory approach, because in some instances a deposit taking institution will be closed before it is technically insolvent. 18. In summary, there are a number of significant post-crisis mechanisms that can, and should, be introduced in the UK. These would clearly outline ex ante the regulatory authorities mechanisms for dealing with deposit taking institutions that are in diYculty and remove any doubt as to the position of bank investors in a resolution. In turn, this should enhance the important concept of market discipline by bank stakeholders, whilst at the same time providing insured depositors with ready access to their funds. Equally, a set of clear post-crisis structures would enable the regulatory authorities to invoke resolution procedures swiftly so that those investors that should be taking on the risks of bank failures do not have an opportunity to withdraw their investment. This is quite clearly not happening in the Northern Rock case. However, the Tripartite Group was severely restricted in the quality and types of mechanisms that it has had at its disposal. The size of the lender of last facility that was provided to Northern Rock suggests that there were significant concerns amongst the Tripartite Group as to the extent of potential funding diYculties at Northern Rock. However, the existing deposit insurance scheme structure and coverage and the poor insolvency regime meant that closing Northern Rock swiftly was out of the question without causing potential systemic Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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concerns. Instead the Tripartite Group had to rely on either a buy-out by another deposit taking institution or the lender of last resort facility. As no buyer was forthcoming the Tripartite Group was left with no choice, but to advance an emergency lending facility.
Overall Functioning of Financial Markets
19. Transparency issues The shutdown in credit markets during the summer of 2007 can be wholly ascribed to a lack of transparency. Investors and financial institutions were unsure where the losses from sub-prime investments lay and therefore it was better to hoard cash than lend it to each other. Providing greater transparency on complex financial instruments would help to alleviate this problem. However, this is not the only transparency problem. It must be remembered that UK deposit taking institutions report with a significant delay and only provide detailed financial information twice during the accounting year. The timing of this financial crisis has meant that investors have been relying on unaudited interim financial statements and have to wait for the year-end audited statements for the next full reporting schedule. Equally, unlike in the US, no large UK bank has posted a third quarter trading statement as yet. Therefore, investors have little contemporaneous information on UK banks and the credit crisis to disseminate at the moment. The UK regulatory authorities should look at enhancing the frequency and quality of UK accounting disclosures per se for deposit taking institutions as well the issue of reporting more complex financial instruments.
Conclusion 20. This written evidence statement clearly argues that the UK deposit taking regulatory regime was shown to be wanting both in the run up to, and subsequent diYculties experienced, as a result of the liquidity crisis at Northern Rock. The statement argues that it is primarily these weaknesses, rather than the actions of a specific person or persons, that have caused and perpetuated the Northern Rock turmoil. Therefore, the remedial focus of the committee in preventing a similar bank run in the future should be on tightening the UK deposit taking regulatory environment. This written evidence statement recommends fundamental revisions at two levels (both pre-crisis and post-crisis) rather than simply focusing on the deposit insurance scheme. This is due to the fact that there are tradeoVs between diVerent aspects of the regulatory environment, which the regulatory authorities can use to alleviate a bank run in the first place.
References Blinder, A and Wescott, R (2001), “Reform of deposit insurance: A report to the FDIC”, [Available at: http://www.fdic.gov/deposit/insurance/initiative/reform.html] last accessed 28 October 2007. Federal Deposit Insurance Corporation (1998), Managing the Crisis: The FDIC and RTC Experience 1980–1994, Washington, DC: Federal Deposit Insurance Corporation. November 2007
Memorandum from the Alternative Investment Management Association On behalf of the Alternative Investment Management Association please find attached written evidence in response to the recent request from the Treasury Committee. We have provided a submission only with respect to the last point under section 3 namely “Overall functioning of financial markets—the role of hedge funds in the recent financial disturbance” since the other topics do not relate to the industry that we represent. I am also attaching a description of the Association and its membership. 1. Hedge funds are merely one of a number of participants in financial markets and in terms of assets controlled are a significant minority compared with other groups such as mutual funds, pension funds, insurance reserves and sovereign wealth funds. Hedge fund managers operating in the UK control assets of $415 billion1 compared with estimated worldwide hedge fund assets of $2,500 billion1 (ie UK hedge fund managers are 17% of the global total). 2. Recent studies by influential groups (eg The Bank of England http://www.bankofengland.co.uk/publications/fsr/2007/fsrfull0710.pdf; The Financial Stability Forum http://www.fsforum.org/publications/publication—21–87.html; The President’s Working Group http://www.ustreas.gov/press/releases/reports/hedgfund.pdf; The US Treasury Uhttp://www.treas.gov/press/releases/hp486.htm) have found no conclusive evidence that hedge funds are a source of instability in financial markets; on the contrary, evidence has been found that hedge funds are contra-cyclical in nature and are providers of liquidity to markets at times of stress. There have been several well-publicised examples in the recent past 2 in the U.S. and in Europe where hedge funds which specialise in the purchase of distressed assets have turned out to be the only buyers of businesses undergoing restructuring or otherwise on the brink of bankruptcy. Hedge funds are a valuable source of capital in such circumstances. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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3. All hedge fund managers with investment operations in the UK (estimated to number nearly 400) are regulated by the Financial Services Authority. The low incidence, in absolute and relative terms, of high profile “blow-ups” and regulatory investigations amongst hedge funds in the UK attests to the strength of this approach. 4. Hedge funds cannot be viewed as one homogeneous bloc; they vary considerably in size, frequency of trading, area of specialisation, investment strategy and investor base. If they all did the same thing at the same time none of them would make much money for their investors. 5. During high profile market events, such as the recent sub-prime mortgage fall-out and the crisis at Northern Rock, it is not unusual to find hedge funds opposing each other publicly and vigorously on diVerent sides of transactions with winners and losers being created accordingly. 6. The run on Northern Rock was not caused by the action of hedge funds.
Source 1 Hedge Fund Intelligence survey June 2007. 2 The purchase of ResMae Mortgage Corporation by Citadel Investments in June 2007; the purchase of Refco by Man Group in November 2005. November 2007
Memorandum from Fitch Ratings
1. General 1.1 This Memorandum is submitted by Fitch Ratings in response to the Treasury Committee’s hearings into Financial Stability and Transparency. 1.2 Fitch Ratings is a leading global rating agency committed to providing the world’s credit markets with independent, timely and prospective credit opinions. Built on a foundation of organic growth and strategic acquisitions, Fitch Ratings has grown rapidly during the past decade gaining market presence throughout the world and across all fixed income markets. Fitch Ratings is dual-headquartered in New York and London, operating oYces and joint ventures in more than 49 locations and covering entities in more than 90 countries. Fitch Ratings is a majority-owned subsidiary of Fimalac, S.A., an international business support services group headquartered in Paris, France. 1.3 This Memorandum addresses certain of the topics suggested by the Treasury Committee in its invitation for written evidence on Financial Stability and Transparency, dated 16 October 2007. In particular: — We provide our perspective on the recent events surrounding Northern Rock, our observations with respect to liquidity requirements and our treatment of depositor protection schemes for rating purposes. — We believe that the recent unprecedented lack of liquidity has highlighted the need for greater transparency with respect to banks’ investments. Particular areas where increased transparency would be beneficial include: (i) more detailed information on exposure to structured credit products; (ii) where such exposures are held (iii) for sponsored ABCP conduits, more data on underlying asset quality and composition by sector; (iv) nature and quality of actual and contingent exposures to specific oV-balance sheet vehicles; (v) valuation methodologies for structured credit products; (vi) break-down of LBO exposures by sector, asset quality and product type; and (vii) information with respect to investments in first loss pieces in securitizations. — We believe that the major bank players in the LBO market are strong enough to retain on-balance sheet loans that would have previously been sold oV, although not without certain caveats. — It is our overall view that the use of credit derivatives has been a positive development for the global financial system because they enhance risk transfer and dispersion. However, despite fairly recent accounting standards, financial reporting in this area is still opaque and current disclosure potentially obscures an institution’s intrinsic risk profile. Without enhanced disclosure, it is extremely diYcult for the average investor or counterparty to assess the influence of credit derivatives on an institution’s risk profile. — We provide our views on the role and regulation of rating agencies, as well as our thoughts on the advantages and disadvantages of hedge funds from the perspective of market stability. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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2. Northern Rock
2.1 The reasons for the diYculties faced by Northern Rock, and the events that led up to the run on the bank 2.1.1 Northern Rock’s 2007 interim results, published on 25 July 2007, were the last main source of public information on the bank before the series of events which led to the run on the bank. These results did not indicate any material deterioration in the bank’s situation. Asset quality at end-June 2007 remained good. Prime residential mortgages made up 77% of total assets and unsecured lending made up 7%; the commercial mortgage book was reduced to 1% during the first half of 2007. The remainder of its total assets consisted of liquid assets (14%) and fixed assets (less than 1%). The quality of Northern Rock’s residential book was good and broadly in line with that of its large UK mortgage lender peers, and its accounts in arrears were lower than the industry average. The bank did not extend subprime mortgages on its own account. Residential mortgages did include a large amount of first-time buyer and self-certified specialist mortgages, but the bank benefited from a strong expertise in these segments, as demonstrated by sound arrears ratios. The proportion of high loan-to-value lending was relatively large at end-June 2007, reflecting the bank’s strong positioning in the first-time buyer market. However, the proportion of new lending with a loan-to- value ratio over 90% decreased to 19% in the first half of 2007, down from 30% in 2005. Write-oVs in the first half of 2007 were minimal at GBP8m out of a book of GBP87 billion. 2.1.2 In light of the stress in credit markets during the summer, on 1 August 2007, we sent a questionnaire to the bank to review its exposure to US subprime and structuredUfixed-income securities. Based on the information received in writing from the bank on 14 August, and the information made public in the bank’s stock exchange announcement of 14 September 2007, the bank’s exposure to the US subprime market and to US structured credit through its treasury investment portfolio, mostly to highly rated instruments, was considered manageable. In addition, the bank was not exposed to oV-balance sheet conduits. 2.1.3 We also viewed Northern Rock’s capital position at the time as sound. Management estimated the bank’s surplus capital—ie, the amount above the total minimum regulatory capital required under Basel II—at around GBP600 million (out of GBP2.1 billion) at end-June 2007, including the profits for the first half of 2007. We had a call with the bank on 2 August to discuss its expected capital plans under the new requirements of Basel II. The bank stated that it expected its available capital resources would be well in excess of the new regulatory requirements at end-2007. 2.1.4 Northern Rock’s funding mix has historically been very much skewed towards wholesale funding. This remained the case at end-June 2007, with senior wholesale funding accounting for 66% of the balance sheet. Given the bank’s reliance on wholesale funding, management continued to make eVorts to diversify its investor base and had at its disposal a range of wholesale funding platforms. Secured funding, including securitisation and covered bonds, made up the majority of the bank’s wholesale funding, representing 47% of the balance sheet. Senior unsecured debt (16% of the balance sheet) was issued through seven diVerent issuance programmes and targeted an increasingly diversified range of investors. Customer deposits, including retail and corporate deposits, funded slightly more than a quarter of the balance sheet. New deposit-taking operations had recently been launched in Ireland and Denmark to diversify this funding source. Asset growth in the first half of 2007 (of 12%) was funded by growth in secured funding sources (securitisation up 14% and covered bonds up 31%, including the bank’s first US covered bond deal) and customer deposits (up 12%). Senior unsecured instruments (short and medium term combined) were down 3%. 2.1.5 Management also viewed its liquidity policy as a buVer against short-term volatility in the markets. At end-June 2007, the bank was meeting its policy of holding liquid assets in the range of 20%–25% of total assets, excluding mortgage loans in securitization pools. The existence of stand-by and committed repo facilities provided additional liquidity support. 2.1.6 Performance in the first half of 2007 was good although Northern Rock’s net interest margin was aVected by the mismatch between the diVerent bases the bank relied on for the pricing of assets and liabilities. More than its peers, Northern Rock had relied on wholesale markets to fund its loan book, hence a larger proportion of funding priced oV Libor. In the first half of 2007, the eVects of interest rate rises and adverse movement in Libor and swap rates caused the spreads on new fixed-rate mortgage business to narrow, eroding the equivalent of 18bps-20bps of its net interest margin. While profitability was likely to come down from the high, above-peer, levels consistently achieved by the bank over the past few years, we still considered that the bank was then in a position to achieve sound operating performance consistent with our ratings at that time, which were aYrmed on 29th June 2007, following the pre close period statement of 27 June 2007. 2.1.7 When disruptions appeared in the capital markets, we initiated a series of calls with Northern Rock’s Treasury Director to discuss liquidity and funding, in particular on 15 August, 3 September and 11 September. The bank explained to us that access to funding was becoming tougher and that securitisation markets were and remained closed, but the bank was working on a covered bond issuance and managing to get mainly short-term funds, and hence the issue for the bank remained primarily related to earnings. At that time, it remained diYcult to gauge how long these disruptions would last. On 13 September 2007, the bank contacted us to suggest a conference call for the following morning. The topic was not disclosed. The conference call with members of Northern Rock’s management team took place on Friday 14 September at 8am. Northern Rock informed us of the arrangements put in place with the Bank of England, the Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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Treasury and the FSA, and gave more background on the decision and its rationale. We then held a rating committee at 10am the same day. As a result, we downgraded Northern Rock’s Long-term Issuer Default Rating to “A” from “A!” and Individual Rating to “B/C” from “A/B”, and placed them both on Rating Watch Negative. The Short-term Issuer Default Rating “F1” was also put on Rating Watch Negative. The Support Rating of “3” was aYrmed.11 The downgrade, which we published following the public announcement made by the bank and UK authorities, reflected Northern Rock’s vulnerabilities arising from its heavy reliance on wholesale funding given the prolonged turbulence in fixed-income capital markets. The stand-by repo facility and ability to borrow on a secured basis granted by the Bank of England, together with the bank’s large treasury portfolio, alleviated short-term liquidity concerns despite market conditions. However, we also stressed at that time that negative market sentiment could further hinder Northern Rock’s access to funding. The ratings reflected our view at that time of the expected strength of Northern Rock when normal markets returned. The Rating Watch Negative reflected market uncertainties. 2.1.8 During the rest of the day and over the weekend, given the queues which built up in front of Northern Rock’s branches and the strongly negative reaction to the news of the Bank of England facility, it became evident that the negative reaction of both markets and customers to the news of the arrangements would be even greater than expected. As a result, we held another rating committee on Monday 17 September to review the bank’s position. The outcome of the rating committee was as follows: downgrade of the Long-term Issuer Default Rating to “A"” (A minus) from “A”, removal of Rating Watch Negative, and assignment of a Stable Outlook; upgrade of the Support Rating to “1” from “3”; downgrade of the Individual Rating to “C/D” from “B/C”, but with this rating remaining on Rating Watch Negative; and aYrmation of the Short-term Issuer Default Rating at “F1”. The upgrade of Northern Rock’s Support Rating reflected the continued strong public statements of liquidity support for Northern Rock from the Treasury and the Bank of England. As a result, we did not expect the Long-term Issuer Default Rating to fall below “A"”, and hence the Rating Watch Negative was removed. The downgrades of the Long-term Issuer Default Rating and the Individual Rating were based on the increasingly negative sentiment from wholesale market participants and retail depositors, which severely strained the bank’s funding options. We believed that when markets normalised, the impact on Northern Rock’s franchise and business model from a funding perspective would likely be greater than we anticipated on the previous Friday, despite the bank’s sound capitalisation and asset quality. The Rating Watch Negative on the Individual Rating reflected the uncertainty, and also the challenges, of implementing a new business model. The aYrmation of the Short- term Issuer Default Rating of “F1” was supported by the stand-by repo facility and ability to borrow on a secured basis granted by the Bank of England, as well as Northern Rock’s large treasury portfolio, consisting, at end-June 2007, of loans and advances to banks of GBP6.8 billion and available-for-sale securities of GBP8.0 billion.
2.2 Changes that may be required to the regulatory requirements regarding liquidity
2.2.1 We have the following observations about the ability to establish eVective liquidity requirements. Liquidity is inherently diYcult to analyse as it is influenced by perception and confidence. In addition, many assets and liabilities lack a contractual maturity and/or are subject to significant prepayment risk. Asset liquidity is also challenging to assess because assets which are liquid one day may be less so the next as investor and buyer appetite shifts. Liquidity has been the subject of much discussion over recent years as markets have continued to evolve rapidly and increasingly complex on- and oV-balance sheet instruments have been introduced. The fact that there is no harmonisation of liquidity standards for banks either at EU or international level is testament to the complexity of the subject and the challenge in adopting a rules-based approach or some mechanism that oVers a truly predictive ability. Basel II, and the Capital Requirements Directive, were not designed to specifically address liquidity risk. For example, Pillar 2 (of Basel II) provides the option for regulators to require additional capital to be held as a “substitute” for perceived liquidity deficiencies. However, this approach presupposes that liquidity is available at a price, ie, the additional capital charge will provide a cushion against an asset haircut.
2.2.2 One of the key challenges in both managing and assessing liquidity for banks is the broad range of size, structure, franchise, etc that is seen in the bank community, together with the increasingly complex nature of banking. Clearly, a “one size fits all” approach is not appropriate, yet a clear framework within which to operate is necessary. That would argue for a bespoke approach, however, the task then becomes more complex and transparency becomes increasingly diYcult to achieve.
11 Our benchmark bank rating is the Issuer Default Rating, which reflects a relative likelihood of default. For the separate ratings of individual bonds, loss severity is used to notch obligations relative to the issuer’s IDR. A bond with average recovery given default expectations will be rated at the same level as the issuer’s rating. A bond with notably above-average recovery given default expectations will be notched up from the IDR, while a bond with notably below-average recovery given default expectations will be notched down from the IDR. Fitch Ratings also assigns Individual and Support Ratings to banks to provide further clarity on the two key factors that feed into a bank’s IDR. Support Ratings provide our opinion of a potential supporter’s propensity to support a bank, and of its ability to do so, while Individual Ratings provide a view of the stand-alone position of the bank excluding such support. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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2.2.3 Banks themselves need to balance the need to maintain appropriate liquidity with a need to make a return on assets. Holding a large portfolio of UK gilts, for example, will probably leave most banks with, at best, a zero or minimum return—that is, liquidity has a cost. The cost of maintaining liquidity that would guarantee coverage in a severe liquidity crisis would be challenging for a bank. This means that, realistically, banks tend to maintain what is considered appropriate to meet a reasonable stress, and rely on the provision of additional liquidity by external sources in the event of an extreme crisis.
3. Depositor Protection
3.1 The current position regarding Northern Rock’s depositor guarantees, and the Government’s balance sheet 3.1.1 As discussed above, our most recent rating actions with respect to Northern Rock reflected the strong public statements of liquidity support for the bank from the UK authorities throughout that day (17 September) and the preceding weekend. The actual announcement later that day that the UK authorities would guarantee all existing deposits at Northern Rock confirmed this view. On 9 October, the Treasury announced the extension of the guarantee, at Northern Rock’s request, to all new deposits made after 19 September. Despite the guarantee from the Treasury and the Bank of England, the rating was not raised to “AAA” as the guarantee is only in place during the current period of instability in the financial markets.
3.2 Possible modifications to the Financial Services Compensation Scheme, including, but not limited to, limits of deposit protection, funding of the scheme and payout times, in the light of the publication by the Tripartite Authorities on 11 October of a document entitled “Banking reform—protecting depositors: a discussion paper” 3.2.1 Depositor protection schemes (as opposed to a 100% guarantee) typically only guarantee, to an individual, the return of a specified amount of money on deposit with a bank or financial institution that is part of the deposit protection scheme. From a rating perspective, the existence of a depositor protection scheme is therefore not a major factor. Clearly two companies can be covered by the same scheme but possess very diVerent risk profiles. Where a depositor protection scheme can prove beneficial is in a stress situation. Specifically, for a bank or banking system experiencing a crisis of confidence, the existence of such a scheme can help alleviate or even prevent a run on a bank, since retail depositors may take comfort from the scheme. In other words, such a scheme can potentially help stabilise the financial position of the bank and its credit rating, albeit typically at a much lower level than before the crisis struck. That said, such a scheme might not be suYcient to restore confidence in a bank and therefore stabilize its financial position. Also, any benefit to a specific institution will clearly depend upon the composition of its funding. Indeed, even if a depositor protection scheme is in place and a bank is heavily retail funded, its unprotected wholesale deposits and capital market funding, which are highly confidence sensitive, may nevertheless disappear to such an extent that a liquidity crisis would be triggered. 3.2.2 In terms of reforming the existing Financial Services Compensation Scheme as detailed in the discussion paper referred to above, one potential option is to change the general ranking of depositors so that they have preferred creditor status in a liquidation. This is the case for depositors in the US, for example, and in a number of other countries. However, while such a change would clearly benefit depositors in terms of ultimate recovery it, in itself, would not help address the issue of timely access to the deposited money. In addition, the change in status for depositors would not be without cost. Specifically, other senior unsecured creditors that currently rank pari pasu with depositors would become subordinated to the depositors. The actual extent of the economic impact of any subordination, and resulting potential negative rating action, would depend upon the scope/amount of deposits granted preferred status, the type of preference granted and the exact make-up of the relevant bank’s liability structure.
4. Overall Functioning of Financial Markets
4.1 Lessons learnt from the eVect of US sub-prime mortgage lending defaults on financial institutions and financial stability 4.1.1 It remains our view that the current challenging market conditions faced by financial institutions, which were triggered by the diYculties in the US sub-prime mortgage market, have raised serious liquidity rather than solvency concerns. The majority of financial institutions are in a robust financial position with strong underlying earnings, good asset quality and robust capitalisation. Nevertheless, the impact of the sub-prime problems on liquidity has been significant, primarily via two channels: first, it is more challenging and more expensive to raise funding; and second, illiquid secondary markets have made it diYcult to value positions in structured credit products and the valuations that are available are very stressed (which has resulted in large mark-to-market losses) for some banks. In our view, this unprecedented lack of liquidity was created by an acute lack of confidence in the global capital markets. Market participants simply withdrew from the market as they were concerned they would ultimately end up exposed either directly or indirectly to the US sub-prime market. Capital markets are still highly volatile: investors remain concerned and issuers are not keen to access the market at current pricing levels. One of the key issues, therefore, is how to restore confidence to the market? In our view, one of the primary ways this can be achieved is through Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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increased disclosure and transparency. Since part of the paralysis that aVected market participants was due to a lack of knowledge about the exposure of counterparties to the US sub-prime market, any initiative that results in greater financial disclosure, either through accounting, regulatory or self-imposed mechanisms, should be welcomed. Particular areas where increased transparency would be beneficial include: (i) more detailed information on exposure to structured credit products (such as sectors involved and credit quality of the underlying assets); (ii) where such exposures are held (eg, on balance sheet, in either the banking or trading book, or oV-balance sheet); (iii) for sponsored ABCP conduits, more data on underlying asset quality and composition by sector; (iv) nature and quality of actual and contingent exposures to specific oV-balance sheet vehicles, including SIVs and third-party ABCP conduits; (v) valuation methodologies for structured credit products; (vi) break-down of LBO exposures by sector, asset quality and product type; and (vii) information with respect to investments in first loss pieces in securitizations, whether directly originated and retained, or purchased from third-parties. In addition, it would be helpful if such information were disclosed in a consistent format within each bank, and published on a regular basis.
4.2 The eVects of highly leveraged transactions, including those relating to private equity, on financial institutions and financial stability 4.2.1 In terms of the leveraged buyout (“LBO”) market, the current illiquid market has meant that many banks are forced to retain risk that they had previously been able to process and distribute, acting primarily in the roles of advisor, intermediary and temporary warehouse of risk. The rapid evaporation of liquidity in the LBO market over the summer has resulted in banks’ balance sheets becoming a longer-term home for LBO loans, which exposes their earnings to fluctuations in the price of the underlying assets. However, it is our view that, even under extreme scenarios, bank capital stands up very well to a highly illiquid LBO market; we believe that the major bank players in the LBO market have the flexibility to ride out a prolonged period of illiquidity. Furthermore, the banks’ large and diversified earnings profiles allow them to emerge relatively unscathed even if they were forced to sell deals, funded at par, at the currently anticipated level of distressed prices. However, this issue raises broader concerns in that the current LBO market is a drain on bank liquidity. This, combined with the banks’ potential exposure to ABCP conduits, SIVs and generally illiquid structured credit markets, means that liquidity is at a premium and could result in an increased probability of a credit crunch, which in turn could lead to asset quality problems.
4.3 The eVect of complex financial instruments on financial stability, and the need for greater transparency in regard to such instruments 4.3.1 We have advocated greater financial transparency with regard to complex financial instruments for some years now, through, for example, our publicly available annual credit derivative survey and contributions to regulatory bodies such as the Financial Stability Forum. Our particular concerns relate to the credit derivatives markets. These products make it much easier for banks to originate and distribute risk rather than originate and hold, which has been the traditional banking model. As a result, by being an investor in another bank’s structured products or a seller of credit protection in the credit default swap market, banks are able to increase their exposure to credit risk. However, it is important to note that these products allow greater flexibility in managing credit risk as they have eVectively added liquidity to the banking book—a traditionally illiquid asset. They can, therefore, also reduce an institution’s exposure to credit risk. Indeed, our overall view of the credit derivative market is that it has been a positive development for the global financial system, facilitating enhanced risk transfer and dispersion. Growth in the credit derivatives market has significantly increased liquidity in the secondary credit markets and allowed the eYcient transfer of risk to other sectors that lack direct origination capabilities. The issue, though, is that financial transparency has not kept up with the pace of market growth and innovation. Despite fairly recent accounting standards such as IFRS 7 “Financial Instruments: Disclosures”, financial reporting in this area is still opaque and current disclosure potentially obscures an institution’s intrinsic risk profile, net of the eVect of credit derivatives, and increasingly has the potential to render peer group comparisons of traditional financial ratios less relevant. Without enhanced disclosure, it is extremely diYcult for the average investor or counterparty to assess the influence of credit derivatives on an institution’s risk profile. In particular, with respect to banks’ traditional measures of loan growth, concentrations, asset quality and leverage have the potential to be heavily influenced by the use of credit derivatives as well as other forms of risk transfer. We remain fully supportive of any initiatives to improve disclosure and financial transparency in this area.
4.4 The role and regulation of ratings agencies 4.4.1 We provide independent, timely and prospective opinions on the creditworthiness of entities and transactions. These opinions, which are expressed as credit ratings, are intended to be used by investors as an indication of the likelihood of receiving their principal and interest back in accordance with the terms on which they invested. However, we expect our ratings to be only one of many factors that an investor will consider when making an investment, since the ratings address only one of many factors that would typically Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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be relevant to such a decision. For example, our ratings do not opine on relative market pricing. We would note that we make it very clear in the definitions of our ratings, available on our free public website, what our ratings mean. 4.4.2 The credit ratings themselves express risk in relative rank order, which is to say they are ordinal measures of credit risk. Thus, they should be regarded as broadly consistent indicators of relative vulnerability, rather than predictive indicators of actual, cardinal default rates. Obligations that are highly- rated have lower credit risk than lower-rated obligations, but the individual ratings themselves are not intended to be predictive of a cardinal frequency of default or a percentage expected loss. 4.4.3 Our ratings are assigned in a manner reflective of our core principles—objectivity, independence, integrity and transparency—and our Code of Conduct is consistent with the IOSCO Code of Conduct Fundamentals for Credit Rating Agencies (the “IOSCO Fundamentals”). We make all published methodologies and criteria freely available on our public website, so that interested parties can understand our approach. All rating actions with respect to public ratings are accompanied by a published rationale to explain the key factors behind the rating decision in each case. 4.4.4 Since 2002, rating agencies have been under review by a variety of national and supranational regulatory bodies. Because a credit rating is fundamentally an opinion (about creditworthiness), these bodies have generally concluded that they cannot meaningfully regulate the substance of these opinions, or the procedures and methodologies by which these opinions are determined. Regulatory bodies do not want to incur the potential moral hazard that such regulation could entail; additionally, they recognize that such regulation could lead to a standardization of methodologies, thereby removing the benefits of competition in the credit rating industry. 4.4.5 The focus, instead, is on ensuring that rating agencies have policies and procedures in place that address potential conflicts of interest and protect the confidentiality of nonpublic information. The approach of the IOSCO Fundamentals (referred to above), which has been widely accepted by regulators globally, is to set forward guidelines for rating agencies to follow when establishing their own codes of conduct. The following areas are specifically addressed: quality and integrity of the rating process, rating agency independence and avoidance of conflicts of interest, transparency and timeliness of ratings disclosure, treatment of confidential information, and disclosure of codes of conduct/communication with market participants. The IOSCO Fundamentals are not prescriptive; however, they do operate on the basis of the “comply or explain” principle. We would also note that the IOSCO task force that deals with rating agencies is currently reviewing whether the IOSCO Fundamentals need to be amended to address structured finance specifically. We are involved in this review process. 4.4.6 Nonetheless, we acknowledge the need among all financial market participants, including the rating agencies and regulators, to review fully the causes of the recent events in the financial markets. We accept that some investors have lost confidence in certain types of credit ratings. It is therefore imperative that we take action to restore that confidence. We are currently responding by looking at ways in which we can further enhance our products, criteria and methodologies. We welcome constructive feedback from all market participants and we are happy to engage in full and frank discussions with regulators regarding the most appropriate way forward for our industry.
4.5 The role of hedge funds in the recent financial disturbance 4.5.1 Since 2005, the hedge fund (“HF”) industry is estimated to have grown from around USD1 trillion of assets under management to more recent estimates of USD2 trillion on an unleveraged basis. Financial leverage, primarily from prime brokers and other banks, increases the funds that HFs are able to deploy by a factor of at least 2–3 times—implying closer to USD4-6 trillion of investable assets. This rapid growth has been particularly evident in certain sectors of the credit markets. For example, in the rapidly growing credit derivatives market, HFs are estimated to account for 60% of trading volumes in credit default swaps. Furthermore, the willingness of HFs to trade frequently, employ leverage and invest further down the credit spectrum has magnified their importance as a source of liquidity. However, as an investor class, HFs are inherently unstable largely due to their reliance on short-term, margin-based leverage. Their role is distinctly diVerent from that of the more traditional buy-and-hold institutional investors and relationship-oriented banks. Indeed, given the continued growth of HFs in the credit markets, the potential for a more synchronous forced unwind of credit assets is a possibility. For example, a sudden market shock that results in a price decline in certain assets would require HFs to sell assets to meet margin calls. In such a situation, HFs are likely to sell their most liquid assets first, thus potentially depressing the prices on these assets and increasing asset correlation in general. In addition, as HFs struggle to meet their margin calls, they are eVectively removed as a source of liquidity from the market, thus potentially exacerbating already illiquid markets. Although it is extremely diYcult to quantify this eVect in the context of the current financial market diYculties, given the lack of transparency in the HF industry, there is no doubt that their ability to provide liquidity to the market has been severely impaired by the decline in asset prices, particularly in the structured credit market. November 2007 Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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Supplementary memorandum by Fitch Ratings
This memorandum responds to the Committee’s requests at the evidence session on 13 November 2007.
Response to Request for Further Information
1. Requested Information with respect to Fees: (a) Please disclose all fees received by Fitch Ratings, and any sister company within the same group, from Northern Rock plc (“NR”) during the period 2003 to 2007. (b) Were these fees proportionate to fees paid by institutions comparable to NR for similar services? [Q977]
1.1 Fitch Ratings received £3,857,011 (excluding VAT) with respect to ratings and £46,627 for one of our subscription products. The ratings fees relate to the rating of NR and its debt issuances, as well as discrete RMBS and covered bond transactions. With respect to the subscription fees, there is no significant diVerence between the price paid by NR in each of the relevant years, and the average price paid by other UK banks and non bank financial institutions which subscribed for the same service in those years. With respect to the ratings work, the fees paid by NR in each of the relevant years were in line with the average fees paid by similar financial institutions,12 and often lower than the average. Please note that the amount of fees with respect to ratings work equates to 0.24% of the total revenues of Fitch, Inc. during this time period. 1.2 No sister company of Fitch Ratings received any fees from NR.
2. Requested Information with respect to Current Ratings: “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”. [Q1053]
2.1 Please see attached spreadsheet.
3. Requested Information with respect to Bank of England Suggestions: Provide your views on the following statements and proposals made by the Bank of England to improve the information content of ratings: (a) “Agencies could publish the expected loss distributions of structured products, to illustrate the tail risks around them. Agencies have made significant eVorts over the past few years to increase the transparency of their rating methodology for structured finance products, through publication of research reports describing their modeling methodology and their assumptions on correlations and recovery rates. But published distributions could provide a visual reminder of the fatter tails embedded in the loss distribution in structured products”. (b) “Agencies could provide a summary of the 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. Such a summary may satisfy investors that incentives are well aligned or encourage investors to perform more thorough risk assessments”. (c) “Agencies could produce explicit probability ranges for their scores on probability of default. Probability ranges would provide a measure of the uncertainty surrounding their ratings. Although such figures are already available retrospectively as transition matrices, an explicit probability range would allow investors to monitor agencies’ performance when rating diVerent asset classes”. (d) “Agencies could adopt the same scoring definitions. Currently, some use probability of default, some loss given default and others a combination. Converging on a single measure would reduce the risk of misinterpretation by investors”. (e) “Finally, rating agencies could score instruments on dimensions other than credit risk. Possible additional categories include market liquidity, rating stability over time or certainty with which a rating is made. Clear scores on these dimensions could encourage more sophisticated investment mandates and easier monitoring of non-credit risks in a portfolio. It would clearly take some time and money for agencies to develop the necessary expertise on these other risks, but some agencies have already proposed these additions”. 3.1 Fitch Ratings initiated a dialogue with the supervisory community, including central banks around Europe, in the Spring and Summer of 2007. At individual meetings with central bankers during this period, many of the topics covered in the suggestions set forth above were raised and discussed. Specifically:
12 The financial institutions used for purposes of this comparison were Bradford and Bingley, Abbey, HBOS, Alliance and Leicester and Nationwide. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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3.2 With respect to (a) above, we are currently considering whether we could publish expected loss distributions. As discussed with the Bank of England in July of this year, this approach may lend itself more easily to some asset classes than to others (for example, it would be manifestly easier for those asset classes where the analytical process already creates a stochastic distribution of losses). Additionally, there would be challenges in ensuring that such distributions could be readily communicated to users in a concise and unambiguous format.
3.3 With respect to (b) above, we support any initiative to enhance transparency and require more public disclosure from originators for the benefit of investors. We believe that the structured finance market is too opaque and that transparency can best be achieved by originators, servicers, issuers and arrangers making publicly available all information, both at issuance and throughout the life of a structured finance transaction, that they make available to rating agencies (in the context of their rating analysis). We further believe that the internet provides an excellent venue to host this information so that it is freely and publicly available to all interested parties. The public availability of this information would enable investors to make fully informed investment decisions without having to rely solely on credit ratings to determine credit risk and would allow investors to assess independently issues such as market and liquidity risk that credit ratings do not address. We do not think, however, that it should be the responsibility of the rating agencies to disclose the originator’s data. Our Code of Conduct prohibits us from disclosing confidential information, consistent with the IOSCO Code of Conduct Fundamentals for Credit Rating Agencies. Moreover, with respect to disclosing any interest retained by the originator or arranger, rating agencies will not necessarily know who holds what proportion of the issued bonds.
3.4 With respect to (c) above, we have been recognised, or are currently applying for recognition, as an External Credit Assessment Institution (“ECAI”) in all major markets where we operate. One part of this recognition process involves an explicit comparison between the historical default experience of an ECAI against a target band of cardinal default rates. This comparison is repeated on a regular basis going forward in assessing the performance of ECAIs over time. As we intend to maintain our ECAI status in future, we will be subject to a de facto review of our cardinal default process by every bank supervisory authority in whose jurisdiction we are recognised as an ECAI. Additionally, we are considering how we may better communicate publicly the analysis we carry out internally of the movements in historical default and transition rates, relative to long-term trends.
3.5 With respect to (d) above, we note that the topic of diverging definitions has been extensively reviewed as part of the wider debate surrounding comparability of rating scales over the past several years. In general, the distinctions in rating definitions among rating agencies are modest. The most independent review of this topic has been done in the context of the above-noted ECAI recognition process, which includes a “mapping” or correspondence table, established by each bank supervisory authority to plot rating agencies’ scales against default rates prescribed by the Basel II process. This process also results in a mapping table plotting the ratings of one agency against the ratings of other agencies. It is important to note that this process did not result in pressure from the user base to standardise rating definitions. The topic has also been raised more recently at hearings in October, convened by the Committee on the Global Financial System, at the Bank of England’s oYces, involving investors, arrangers and central bank representatives. The consensus was that the current modest variation in rating definitions reflected a healthy variety in methodological approaches and at the same time did not provide material obstacles to comprehension or application of the ratings by users. Movement towards a stricter homogeneity of output would likely not serve the market well and would reduce investor choice. In addition, there would be a variety of practical problems—for example, how (and by whom) would such a set of common definitions and related criteria be developed and maintained. We believe, however, that the market would benefit from a common definition of default for purposes of the production of transition and default studies by the rating agencies and any other interested parties. A common definition of default would provide investors and all interested parties the ability to more readily compare these studies against each other and thereby more accurately assess the relative performance of rating agencies.
3.6 With respect to (e) above, as discussed with the Bank of England at our July meeting, we are currently investigating whether we could provide opinions with respect to risk elements other than credit risk. For example, we have been working on ways to measure rating volatility, including stability scores. In fact, Fitch was the first agency to introduce such scores, after a lengthy development period, in early 2006. At the time we initiated Stability Scores, these were designed precisely to highlight the diVering performance characteristics of instruments which carried the same rating on the “AAA” scale. At the time, it is fair to say the market was less interested in rating stability, or indeed rating diVerentiation, given the generally much higher appetite for risk at that time. As a result, penetration of the Stability Score concept in the market was limited. In the meantime, we have worked on revising the Stability Scores to broaden the scope of products covered. Equally, it is fair to assume the market is now more sensitised to risk diVerentiation than it was in March 2006. As a result, we will be looking at proposing an enhanced version of the Stability Score process in due course. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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More generally, Fitch has done much work researching the best way in which to reflect additional risks aVecting issuers and transactions. Our discussions with institutional investors, central banks and other interested parties have indicated a marked preference for discrete scales for discrete dimensions of risk (ie, one scale covering default risk, one scale covering loss severity, etc) rather than combinations of risks on the same scale. Examples of successful multiple-scale sectors include our bank and insurance sectors, with a range of Support, Individual and Financial Strength ratings complementing the mainstream Issuer Default Ratings. In contrast, other areas where multiple scales have been introduced have seen more muted investor uptake. It is important to note that we cannot “force” usage of any of our scales, and equally—and reluctantly sometimes—we will withdraw scales for which we perceive low investor demand. December 2007
Memorandum from the Association of British Insurers The Association of British Insurers (ABI) represents the collective interests of the UK’s insurance industry. The Association speaks out on issues of common interest; helps to inform and participates in debates on public policy issues; and also acts as an advocate for high standards of customer service in the insurance industry. The Association has around 400 companies in membership. Between them, they provide 94% of domestic insurance services sold in the UK. ABI member companies account for almost 20% of investments in the London stock market.
Summary The situation at Northern Rock poses a crucial test for confidence in, and the credibility of, the Tripartite system. The way in which the authorities are perceived to have dealt with the situation will be vital to protect London’s position as the leading global centre for financial services. Any reform and next steps must be focused on achieving this. There now needs to be clearer demarcation of responsibilities and co-ordinated crisis management planning. To ensure future stability, both the Tripartite authorities and the market must be clear about where responsibilities lie. Additionally, it is important that the Financial Services Compensation Scheme (FSCS) provides compensation where necessary in a manner that is fair, aVordable and does not advantage one part of the financial sector at the expense of another.
1. Northern Rock
The functioning of the Tripartite system The ABI supports the current UK model of financial regulation, in particular the position of the FSA as a single integrated regulator. Increasingly, many financial firms carry out banking, insurance and investment business, so it makes sense to have a single regulator. Reform of the Tripartite system should concentrate on improving its operation, rather than changing its nature. In particular, we do not support the separation of banking supervision from the supervision of other financial services. However, there needs to be clearer delineation of responsibilities, particularly between the Bank of England and the FSA, in order to ensure better linkage between the oversight of systemic issues and the supervision of individual institutions, and co-ordinated crisis management planning. The underlying role of the Bank of England as lender of last resort requires it to have a good understanding of the markets and institutions at risk without duplicating the role of the FSA.
Regulatory requirements regarding liquidity The current supervisory regime concentrates on prudential solvency (ie ensuring that a firm has suYcient assets to meet its liabilities). However, the events at Northern Rock were caused largely by liquidity issues. There are a number of important distinctions between banks and insurers with respect to liquidity risk. Banks hold long-term, illiquid assets (such as mortgage loans) but short-term liabilities (deposits and inter- bank loans). This makes banks vulnerable to a sudden withdrawal of their sources of funds. Insurance companies, on the other hand, hold liquid assets (cash, bonds and equities), but longer-term liabilities. Therefore any mismatch between assets and liabilities (for instance, due to under-reserving for liabilities) would only emerge slowly over time. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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For insurers the current focus of prudential solvency is correct, and no additional requirements on insurers are needed to address liquidity issues. We would support measures to ensure that overall market liquidity could be maintained and enhanced, particularly in situations of market turbulence.
Other regulatory changes The Takeover Code and the regime within which the Panel operates is of fundamental importance to the integrity of the equity market and the confidence that investors place in it. It aVords flexibility and provides scope for important judgments by the Panel Executive in often challenging circumstances. We do not believe that either the Panel or the Code does, or should, represent an unnecessary impediment to achieving the right outcome for shareholders and their companies. The market needs information to ensure informed trading, but it is also important to avoid public disclosure that would be likely to be prejudicial to the interests of a company. That diYculty is recognised in the Market Abuse Directive (MAD), which allows information to be withheld in circumstances where it would be damaging to the interests of the company to make it available. Varying interpretations of this Directive have been oVered. In any event, we are struck by the FSA’s comment that, in today’s markets, it would be diYcult to keep the news of such support secret. It therefore seems sensible to concentrate on strengthening the operation of the Tripartite arrangements, and instilling greater public confidence in the system of depositor protection. On disclosure, a “false market” should not be allowed. If a bank is seeking emergency support, it should already have made a trading statement. It is then a matter of judgment whether subsequent undisclosed development warrants suspension of the shares. We recommend a reassessment of the appropriate level of transparency for banks dependent upon short- term liquidity. Also, our members are concerned by the limited formal disclosure of the amount of borrowing by Northern Rock and the terms on which this has been drawn down over the course of several weeks. It is possible that there is a false market at this time in the shares of Northern Rock.
2. Depositor Protection We strongly support a credible and eVective scheme to compensate the customers of failed financial institutions. The events at Northern Rock mean that compensation arrangements, particularly for deposits, need to be reviewed. The Government should be cautious in making changes; any reforms should be aVordable and should not distort the market for savings.
Compensation limits The Financial Services Authority (FSA) has to ensure that compensation limits are suYciently generous to protect ordinary investors, but do not give rise to issues of moral hazard, or distort competition between diVerent products. There must be a limit to the protection oVered, as otherwise financial institutions and consumers will become reckless, thereby, paradoxically, increasing the likelihood of a serious failure. Events have shown that the previous FSCS limits were not suYcient to prevent a bank run. However, the problem with these limits was not the overall level, butUthe fact that people only got 90% of their deposits back over a £2,000 limit and uncertainties over the timing of compensation. In most EU countries compensation is limited to the Directive minimum of ƒ20,000 (about £13,500). The new UK limit of £35,000 is suYcient to protect the overwhelming majority of depositors. Research carried out on behalf of the ABI last year suggests that a limit of £35,000 provides full coverage for 98% of cash- only savers. Indeed it would cover the total non-pension savings, across all types of instrument, of over 80% of the population.
Potential changes to the compensation scheme The discussion paper issued by the Tripartite Authorities rightly points out that the UK has, hitherto, rejected a pre-funding regime for compensation on the grounds that this would result in resources being tied up which could otherwise be used productively. The ABI also strongly opposes a pre-funding regime. In particular, we believe that the US pre-funding model is not an appropriate basis for a UK scheme. In the UK, insolvencies among banks and insurers are rare, so the compensation scheme is rarely called upon. Indeed, it has not been called upon in the case of Northern Rock. In the US, failures of small, local banks are relatively common. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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More generally, the US model would require fundamental changes to UK legislation—to insolvency law and the Financial Services and Markets Act, as well as to the existing compensation scheme. For example, in the US model the Federal Deposit Insurance Corporation has regulatory responsibilities to require struggling banks to take action to become recapitalised. If this fails, it has the power to declare the bank insolvent and assume the role of liquidator. In the UK such matters are the responsibility of the FSA, as the regulator (or a court appointed liquidator in the case of an insolvency), rather than the compensation scheme. We do not believe that such a radical change is needed to the current regulatory system, which, despite the events at Northern Rock, is generally seen as a model for other countries and has the support of the financial services industry.
The FSA’s review of FSCS funding The FSA has, for the past 18 months, been conducting a major review of FSCS funding, and has recently finalised proposals to introduce a cross-subsidy between diVerent sectors. The ABI has made clear its opposition to cross-subsidy throughout the FSA’s consultation process. We believe that cross-subsidy between deposit protection and other parts of the financial sector will increase the risk that diYculties in one sector could be passed onto others. Such contagion could lead to a loss of confidence in financial services as a whole. We do not believe that our customers would understand or support increases in their insurance premiums because an institution in another part of the industry goes out of business.
3. Overall Functioning of the Financial Markets Financial markets have recently made increased use of complex instruments such as credit derivatives. Valuations derived from models have been used to develop instruments of commercial merit. It appears that shareholders in banks were provided with limited information about the nature and extent of highly leveraged SIVs and Conduits. Often these structures were regarded as being oV balance sheet, but in practice full exposure remained with the managing bank. Banking regulations should ensure that full potential capital requirements are recognised in such circumstances.
The Role and Regulation of Rating Agencies The events over the summer have renewed interest in Credit Rating Agency (CRA) activity. CRAs have been reviewed in recent years by, amongst others, IOSCO (the International Organisation of Securities Commissions), the European Commission and CESR (Committee of European Securities Regulators). Institutional investors see rating as only one of several sources of information in the due diligence process. Many have their own in-house credit analysis teams. CRA opinions focus on the limited question of default risk, while investors’ interests will often extend to recovery levels. A credit rating awarded to a bank should not be seen as a broader guarantee of its business model. Institutional investors frequently receive mandates from clients limiting them to investments above a certain credit rating, but they do not believe that ratings should be the sole basis for investment decisions. Prescriptive regulation could therefore be counter-productive, as it would encourage market participants to rely even more heavily on ratings, which of their nature provide only limited reassurance. The ABI supports the IOSCO Code for CRAs, rather than regulation at European or national level. Regulation may also discourage entry to the market, and stifle innovation in modelling techniques. The ABI has indicated areas of concern, where change may be required as the markets evolve. For example, there are inherent conflicts in the standard “issuer pays” business model, combined with the user perception of ratings as a “public good”. The conflict of interest has been highlighted in the symbiotic relationship between the issuer and CRA in generating ratings in the structured products area. However, no practical alternative business model is available. The ABI favours competition between CRAs, both in terms of methodology and pricing. Any proposals on CRAs should be evidence-based and subject to cost benefit analysis. They should also be developed in a multilateral forum such as IOSCO.
Hedge Funds We do not consider that hedge funds caused the events over the summer. Some funds invested in the financial instruments that have caused diYculties, but it is unlikely that they have exacerbated the situation. Hedge funds are dependent on investment banks, both for the instruments in which they have invested, and for financing facilities. Some hedge funds may have encountered diYculties as banks reduced their general preparedness to lend, and also their assessment of the credit worthiness of these clients. This will have led some funds to reduce their exposure and to raise cash for prospective redemptions. However, we have no reason to suppose that hedge funds behaved improperly. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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The ability of the private equity sector to undertake buy-outs of increasingly large quoted companies has been facilitated by the appetite of the debt markets to finance such deals. High leverage and the use of complex capital structures have been characteristic of these transactions. This increasing demand for debt finance capability has no doubt increased the strain on the markets, but again we would not consider this to have contributed significantly to the summer’s events. November 2007
Memorandum from the Institutional Money Market Funds Association (IMMFA)
Executive Summary
1. The Institutional Money Market Funds Association (IMMFA) is the trade association representing the promoters of triple-A rated money market funds and covers nearly all major promoters of this type of fund outside the USA. Members’ funds under management exceed US$500 billion.
2. Confidence is a critical component of the financial system. The events of the summer saw confidence rapidly disappear, due partially to poor information flows and a lack of understanding of some of the complex instruments in circulation.
3. IMMFA recognises that there is no current European definition of a money market fund, unlike in the USA. Such a definition would have prevented sweeping generalisations being made by financial commentators, which ultimately further exacerbated the turbulence in global financial markets. IMMFA represents only Treasury-style money market funds, which have distinct product profiles and objectives, and should not be confused with any other fund in operation in financial markets.
4. Treasury-style money market funds are the only fund type permitted under to use amortised accounting for valuation purposes, in accordance with the Eligible Assets Directive (due for implementation in July 2008). This, and the underlying Committee of European Securities Regulators (CESR) guidance, should provide the definition which would diVerentiate between money market fund types. However, IMMFA recognises that the onus remains with IMMFA to educate market participants and commentators on the distinctions, definitions and risks inherent in the diVerent types of money market fund available and prevent further occurrences of misunderstanding in the market.
5. The nature of Treasury-style money market funds—which invest exclusively in short-term, high quality money market instruments, have a weighted average maturity of no more than 60 days, and hold assets to maturity, continues to enable these funds to provide same-day liquidity to investors. This has been true throughout the most turbulent and volatile market conditions experienced over the summer months.
6. Recognition of this liquidity has already been achieved through the amendments made to the UK liquidity mismatch regime. However, the events of the summer have heightened the need for liquidity by all financial institutions. Whilst the pan-European review of liquidity commissioned by the European Commission will address those instruments eligible as collateral, we urge consideration of amendments to the UK regime to include Treasury-style money market funds in advance of this timetable, in order to provide further liquidity facilities to all financial institutions in the UK.
Introduction
7. The Institutional Money Market Funds Association (IMMFA) are grateful for this opportunity to provide evidence to the Treasury Select Committee concerning financial stability and transparency.
8. IMMFA is the trade association representing the promoters of triple-A rated “treasury-style” money market funds (Treasury-Style MMFs) and covers nearly all of the major promoters of this type of fund outside of the USA. Treasury-Style MMFs are bought primarily by institutions to manage their liquidity positions and not for “total return” investment purposes. They are used as an alternative to wholesale money market deposits by a wide range of investor types as they oVer a practical means of consolidating and outsourcing short-term investment of cash.
9. Comments are provided on two important areas; (i) a need for standard recognised financial product definitions and (ii) the provision of robust liquidity facilities. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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Financial Stability
10. One of the key components of a stable financial system is the confidence of all those participating within that system. The events of the summer saw confidence quickly evaporate, both in wholesale markets, and more latterly—and visibly—in retail markets. 11. Confidence is inherently built once there is understanding of the fundamentals of the system. This understanding may only be achieved through the provision of suYcient information in a decipherable format that the end user can interrogate. Principal in this is the production and dissemination of widely accepted terminology which is recognised by users within that system. 12. The nature of today’s global financial markets has seen innovative developments of an increasingly complex nature, masked by an increasingly inaccessible language. However, the pro-longed benign market conditions prevalent prior to this summer’s turbulence bred complacency which limited the desire for information from end users. Put simply, the prolonged bull market was too good an opportunity to make money for product providers and investors alike without the bother of asking detailed questions on what was being purchased. 13. The absence of a recognised definition for money market funds within Europe has seen sweeping generalisations and assumptions made in relation to any fund which bears this name. As the trade association representing the providers of Treasury-Style MMFs, IMMFA has been working tirelessly for a number of years to educate wider market participants and commentators on the diVerent types of money market fund on oVer in Europe, in an attempt to provide clarity and latterly to help try to restore some semblance of confidence in aspects of the wholesale markets. 14. Money market funds first appeared in the USA in the early 1970s. Their success resulted in amendments to the Investment Company Act 1940, which instigated direct regulation of this fund type through Rule 2A-7 of the Securities and Exchange Commission (SEC). Following the implementation of this Rule in 1983, no fund within the USA is permitted to call itself a “money market fund” unless it complies with the requirements of SEC 2A-7. 15. In Europe, Treasury-Style MMFs—equivalent to their SEC 2A-7 USA counterparts have been a later development, but the similar objectives of these funds and subsequent appetite for them has quickly seen them established as a staple component of a corporate entity’s treasury management. Unfortunately, continental Europe has over the last 20 years developed a diVerent style of “money market fund” which has more the characteristics and investment aims of a total-return, short-dated bond fund (Investment-Style MMFs). This has undoubtedly added to the confusion for investors. 16. However, there is no regulation within Europe similar to that in the USA to define a money market fund and to restrict the use of the name. Consequently, a plethora of cash funds operate under the general money market fund banner. The absence of a recognised definition has seen contamination of the reputation of all money market funds following the action taken by AXA Investment Management to support its LIBOR-plus funds and BNP Paribas in relation to is asset-backed security funds, which were widely quoted as money market funds in the global press when in fact they lacked the stable pricing and strong liquidity characteristics inherent in a Treasury-Style MMF. 17. A Treasury-Style MMF is a collective investment scheme (CIS) that invests in quality money market instruments as defined by the Eligible Assets Directive (EAD) such as: fixed deposits; certificates of deposit, repurchase agreements, commercial paper (including asset backed); and floating rate notes, and is used mainly for corporate liquidity cash management purposes. All Treasury-Style MMFs must be awarded a triple-A rating from one of the three recognised independent credit rating agencies, and must also have the lowest susceptibility to market interest rate volatility. IMMFA only represents the interests of providers of Treasury-Style MMFs. 18. Treasury-Style MMFs should not be confused with their Investment-Style MMF counterparts which seek to achieve enhanced total-returns (ie combined capital and interest returns) by taking greater risks. These ‘enhanced’ or “dynamic” funds have more the characteristic of short-dated bond funds. The enhanced yield opportunity results from the usual risk-reward conundrum of higher credit and/or market risk combined with lower liquidity. Whilst markets were stable, the susceptibility to market volatility of these funds was not evident, and the greater risk was accepted by investors seeking more competitive returns. When markets became volatile and investors sought to redeem their investments, the liquidity risk inherent within many of these funds became immediately apparent, with significant reductions in fund values caused by the “forced-selling” of quality credit assets into illiquid markets, triggered by diYculties in valuing assets, resulting in many cases for capital support to be provided by willing sponsors or parents. 19. The important distinction between the two types of money market funds was not made on numerous occasions throughout the market turbulence; for example, Kate Burgess in the Financial Times described the distinction as being “blurred”.13 However, as explained the risk profile and objectives of each type are fundamentally diVerent and are intended to meet the requirements of diVerent types of investors.
13 Financial Times, 29 August 2007 “Casualties still emerging from credit crisis” by Kate Burgess. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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20. Whilst Treasury-Style MMFs have the characteristics to maintain capital security and increase liquidity in the most volatile and illiquid of market conditions, Investment-Style MMFs are simply not as robust and cannot provide an investor with the same level of comfort. 21. Treasury-Style MMFs are the only investment fund type permitted to value their assets portfolio on an amortised accounting basis—similar to most banks. This has been recently confirmed in the Eligible Assets Directive 2007/16/EC, and is recognition of the lower levels of risk presented by such funds. 22. IMMFA believes that the fact that Treasury-Style MMFs are the only mutual funds permitted to value assets using this methodology provides an opportunity to create a unique regulatory definition that would help resolve the historic definitional confusion that exists between liquidity and ‘total-return’ money market funds as recently evidenced during the market turmoil. However, at present the onus remains on IMMFA to educate market participants and commentators on the distinction, definitions and risks inherent in the diVerent types of money market funds available in the absence of a regulatory taxonomy. 23. IMMFA is also taking steps to enhance the information which is made available to investors in a Treasury-Style MMF. This need had been identified—in advance of the events of the summer—in recognition that the implementation of the Capital Requirements Directive would attract greater investment from financial institutions which in turn would necessitate greater provision of management information, especially for credit risk and large exposure calculation purposes. 24. However, IMMFA recognises that we also have lessons to learn from recent events, especially the need for meaningful data provision in market turmoil situations in order to retain investor confidence in Members’ funds. We are therefore planning to work closely with investors to determine their information requirements and if possible to produce this in a standardised format.
Treasury-Style MMFsasaLiquid Investment 25. Treasury-style MMFs have capital preservation and liquidity as their main two investment objectives with the achievement of competitive returns of secondary importance. As such, they provide an ideal opportunity to enhance European prudential liquidity provision. 26. There are two basic types of Treasury-Style MMFs available; constant net asset value (CNAV) and accumulating net asset value (ANAV). Both types use amortised accounting to value their underlying asset portfolios. Shares in CNAV funds are issued with an unchanging face value (eg £1 per share). Income in the fund is accrued daily and can either be paid out monthly to the investor or used to purchase more shares in the fund. ANAV funds operate under the same investment guidelines as CNAV funds and income is accrued daily. However, unlike CNAV funds, income is not distributed; instead income is reflected by an increase in the value of the shares. 27. The underlying assets of Treasury-Style MMFs must have a fixed maturity date, or maximum interest reset period, of no more than 397 days, and the weighted average maturity (WAM) which measures the market interest rate risk in a fund’s asset portfolio must not exceed 60 days. This is crucial in reducing market risk from significant interest rate volatility and to ensure that a fund can provide same-day liquidity to investors. In eVect, a Treasury-Style MMF operates as a “hold-to-maturity” fund in that it seeks to ensure that it has suYcient assets maturing each day to meet any potential investor redemptions. 28. Quality assurance is to a large extent provided by the fund’s rating. The rating criteria stipulate the fund’s asset range and restrictions (such as quality, type and currency), acceptable counterparty risk and acceptable choice of custodian. Treasury-style MMFs are all registered under the UCITS Directive 85/611/ EEC and are subject to the associated legislative requirements and regulations imposed within the fund’s domicile. In addition, IMMFA operates a Code of Practice, designed to maintain highest standards of market practice by members. 29. During the market turbulence of recent months, Treasury-Style MMFs have maintained strong credit quality and liquidity throughout. There have been no downgrades of a triple-A rated Treasury-Style MMF on either side of the Atlantic, and no assets held within an IMMFA members’ Treasury-Style MMF have been placed on market-watch by any credit rating agency. 30. The short-term nature of the funds is specifically designed to provide liquidity for investors as and when required. The constant maturity stream of underlying holdings ensured that same-day liquidity was available throughout the most illiquid conditions experienced in August and September. 31. The ability to value assets on an amortised basis enables Treasury-style money market funds to hold assets to maturity. There has been no “fire-selling” of assets, with redemption being made at par at maturity. This strategy ensures that susceptibility to market volatility is reduced to a minimum. 32. The market turbulence saw investors flee for security and quality. Members’ funds have grown significantly over the summer to record highs, with over US$504 billion in funds under management as at October 2007. This growth is a clear indication that the underlying principles of Treasury-Style MMFs— of capital security and liquidity—make them a valuable component of a treasurer’s liquidity cash management policy. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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UK Liquidity Regulations 33. The liquidity of credit institutions within the UK is subject to one of two regulatory regimes; (i) the liquidity mismatch regime; or (ii) the Sterling Stock liquidity regime. Amendments to the liquidity mismatch regime to permit holdings in a qualifying money market fund14 to be eligible for liquidity purposes were only formally introduced to the FSA Handbook on 6 October 2007. This was too late to provide additional liquidity facilities to UK banking institutions when they were needed most during the summer. 34. Whereas amendments have been made to the liquidity mismatch regime, no corresponding changes were made to the Sterling Stock liquidity regime. The outcome of the pan-European liquidity review, initiated by the European Commission before any of the events of the summer had begun to unfold, will include determination of the list of eligible collateral for liquidity purposes, which may influence the UK Sterling Stock liquidity regime. 35. However, we strongly advocate that Treasury-style money market funds are included as eligible collateral within all liquidity regimes in operation throughout Europe—including the Sterling Stock liquidity regime. The performance of these Treasury-style money market funds in stressed conditions is indicative of their robustness and low levels of volatility. The ability to have access to liquidity in all circumstances is a fundamental necessity for all financial institutions, the importance of which cannot be underestimated following the events of the summer. Further, whilst the pan-European review of liquidity will present an ideal opportunity to widen the list of eligible collateral (where appropriate), the events over the summer highlight a pressing need for liquidity provision in advance of the timescale of any European Commission review. We therefore recommend that appropriate amendments to the UK Sterling Stock liquidity regime be considered in advance, and independent of, the work of the European Commission. 36. Treasury-style MMFs are able to provide a solution to liquidity needs; however, IMMFA recognise that we have a responsibility to further enhance our liquidity provision for the benefit of Treasury-Style MMF investors. To that end, we are currently working on an initiative to improve our liquidity provision still further, through the introduction of the ability to repo Treasury-Style MMF shares. This would not only allow investors to monetise their holdings by entering into a repo with a counterparty who was willing to take the shares as collateral but also support lender of last resort activities during a general market turmoil situation as currently experienced. Such a facility would provide further liquidity to the investor, whilst the counterparty to the repo would receive collateral which would not redeem at anything below par. November 2007
Memorandum from Standard & Poor’s
1. Executive Summary 1.1 Standard & Poor’s Rating Services (“S&P”) submits this memorandum in response to the Treasury Committee’s request for written evidence on the role and regulation of credit rating agencies. We understand that the Treasury Committee has also asked S&P to give evidence on Northern Rock. Representatives of S&P will attend at the hearing on 13 November to provide oral evidence on these topics. In the meantime, we refer the Committee to the most relevant of the public statements we have made concerning Northern Rock from 2005 onwards, which are listed in the appendix to this memorandum. 1.2 In section 3 we provide a description of our credit ratings and explain what they are intended to represent. We explain in particular that such ratings address the likelihood of default of securities, not their marketability. 1.3 In section 4 we provide some background on our ratings of residential mortgage-backed securities (“RMBS”) and summarise the actions that we took from early 2006 onwards, in response to our concerns over the deteriorating quality of RMBS transactions. 1.4 S&P at section 5 underlines its commitment to learning lessons from recent events. We have enhanced our procedures and we are engaged in an active dialogue with numerous market participants so that we can determine what further steps we should take. 1.5 Section 6 deals with regulation. S&P has replaced its prior Code of Practices and Procedures with a new Code of Conduct which represents further alignment of its policies and procedures with the Code of Conduct Fundamentals for Credit Rating Agencies published by the International Organisation of Securities Commissions (“IOSCO”). We discuss our adherence to those standards annually with the Committee of European Securities Regulators (“CESR”) which reports on credit rating agencies’ code implementation and compliance to the European Commission.
14 As defined in Article 18 of the MiFID Implementing Directive 2006/73/EC. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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2. Standard &Poor’s 2.1 S&P is a business unit of Standard & Poor’s, itself a division of The McGraw-Hill Companies, Inc, (“McGraw-Hill”), a global business services provider in the fields of financial services, education and business information. Standard & Poor’s has roots going back to 1860. Standard & Poor’s was created in 1941, when Standard Statistics merged with Poor’s Publishing Company. Standard & Poor’s currently employs approximately 8,500 employees worldwide, of which approximately 1,000 employees are based in Europe. Standard & Poor’s has been a division of McGraw-Hill since 1966. 2.2 The business of Standard & Poor’s is to provide financial market intelligence. It is perhaps best known as one of the world’s leading providers of independent credit ratings. Standard & Poor’s also maintains a wide variety of tradeable and benchmark index products and services (such as the S&P Global 1200 index) and provides mutual fund analysis and independent equity research. 2.3 Standard & Poor’s has been engaged in issuing credit ratings since 1916. The total amount of outstanding debt rated by S&P globally is approximately US$34 trillion in 100 countries. S&P rates and monitors developments pertaining to these issuers from its operations in more than 21 cities in 16 countries around the world. 2.4 Standard & Poor’s has had an operation in London since 1984. Approximately 650 employees are based in London, which is Standard & Poor’s largest base in Europe.
3. S&P’s Credit Ratings 3.1 A credit rating is an opinion that we publish on the creditworthiness of particular issuers or financial obligations. In order to understand our role, it is important to recognise that our opinions relate solely to creditworthiness, by which we mean the likelihood that a particular obligor or financial obligation will pay, on time, the principal amount of the debt and interest owed. 3.2 Our ratings do not constitute recommendations as to whether investors should “buy”, “sell”or“hold” rated securities, nor do they consider the suitability of securities for particular investors or groups of investors. Similarly, our ratings do not address the likely market performance of an investment or whether its price can be said to reflect its credit risk and/or its expected returns. At their core, our ratings speak only to the likelihood of timely repayment. They are not designed to address other market factors, such as supply and demand, that may aVect the pricing of securities. 3.3 Our ratings are based on the facts available to us at the time opinions are formed. They are designed to be stable and, unlike market prices, they do not fluctuate on the basis of market sentiment. Nevertheless, it has always been the case that credit ratings, including high “investment grade” ratings, can and do change. After a rating has been issued, S&P reviews developments that might alter the initial rating, known as the “surveillance process”. A rating may be upgraded or downgraded as a result of adjustments to the risk profile of an obligor or security, or because of the emergence of new information. We do not downgrade securities in response to market sentiment; we make adjustments to our ratings when the facts demonstrate the need to make adjustments and not before. 3.4 Our ratings range from the highest category of AAA, through AA, A, BBB (which is the lowest of what are referred to as to the “investment grade” ratings) to D (indicating a situation where an obligation is in default). Ratings for AA to CCC may be modified by the addition of a plus (!) or minus (") to show relative standing within the major rating categories. Our highest rating of AAA denotes that, in our opinion, an issuer or security has an extremely strong capacity to meet its financial commitments. Nevertheless, this rating, in common with our other ratings, is not intended to act as an assurance that there is no possibility of default. Instead, our respective ratings are designed to show the relative probabilities of default, so that the risk increases as the rating lowers. 3.5 Transition studies of our historical ratings demonstrate a strong correlation between our various rating categories and the rates of default that have actually occurred. For example, for the period from 1978 to 2006, the weighted average five-year default rate for investment grade structured securities rated by S&P is less than 1%, while for speculative grade securities it is slightly over 15%. By comparison, over a comparable period (1981 to 2006), the weighted average five-year default rate for investment grade corporate issuers is 1.19% and for speculative grade issuers it is 18.07%. 3.6 The following table illustrates, as of 28 October 2007, the cumulative five-year default rate for the initial RMBS ratings that we have issued over a 30 year period.
Initial Rating % of Default AAA 0.04 AA 0.24 A 0.36 BBB 1.30 BB 2.89 B 3.48 Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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3.7 Public ratings are made available in real time. When a public rating is assigned or changed, the announcement is made on our publicly available website and a press release may also be provided to news outlets and other media. Currently there are approximately 9 million current and historical ratings available on RatingsDirect, which is a subscription-based product. In addition, there are as many as 1.3 million active ratings available for free on our publicly available website: www.sandp.com.
4. S&P’s Ratings for Residential Mortgage-Backed Securities 4.1 S&P has been rating RMBS for approximately 30 years and has developed specific processes and models for evaluating the creditworthiness of these transactions. Our track record of assessing RMBS credit quality has been strong as can be seen from the table at 3.6 above. 4.2 When rating RMBS, S&P uses default and cashflow models specially designed for the purpose and made commercially available to the public. With the assistance of these models, S&P rates RMBS by analysing creditworthiness and cash flow aspects of the structure. These models are regularly amended and enhanced over time and those modifications are also made commercially available. S&P also reviews the practices, policies and procedures of originators and servicers as well as the legal documents of the securities to be listed. 4.3 In response to deteriorating sub-prime performance, S&P has adjusted its criteria and assumptions to increase its credit enhancement requirements for certain transactions, having identified certain sub-prime loans as being more likely to default than others. S&P has also heightened the stress levels at which it rates and surveils transactions to account for deteriorating performance as evidenced by data which it has received and has increased the frequency of its review of rated transactions. 4.4 At the same time as we were modifying our models to reflect our observations about the sub-prime market, during the period from early 2006 onwards, we issued a series of publications in which we repeatedly and consistently warned the market of our concerns about the deteriorating quality of RMBS transactions. Furthermore, we also took rating actions where appropriate in response to sub-prime deterioration. 4.5 In July and October 2007 S&P again took steps in the light of increasingly poor performance data. This included increasing the severity of the surveillance assumptions we used to evaluate the ongoing creditworthiness for RMBS transactions and downgrading those that did not meet these stress test scenarios within given time-frames. We will continue to take rating actions, as appropriate, to reflect the continuing evolution of the position and our assessment of the RMBS market. 4.6 What has happened in the sub-prime market and the US housing market generally has been more severe and more precipitous than anyone had anticipated. Furthermore, recent sub-prime transactions have been performing significantly worse than transactions from earlier periods, even for transactions sharing similar underlying characteristics. Delinquencies and defaults in the sub-prime mortgage market have increased significantly. This has been ascribed to a number of factors, including in particular stretched underwriting standards, possible fraud in the origination process, sharply rising interest rates and an unexpectedly steep drop in house prices in the US. In addition to these underlying factors, other new trends have occurred. For example, individuals who purchase homes have historically paid their mortgages before paying oV their credit cards, but that now appears no longer to be true to the extent that it once was. Similarly, individuals who live in the homes that they purchase have historically repaid the mortgages on those homes more readily than those who live elsewhere, but this long-standing pattern also now appears to be changing. 4.7 S&P regards factors such as these as significant changes of behaviour, particularly at a time of substantial falls in property prices. It was these factors and trends, among others, that led S&P to downgrade some of its RMBS ratings, even though there had been no substantial losses on the pools of assets that back the sub-prime RMBS. 4.8 It is important however to put these developments in context. While the “credit crunch” was serious, the fact is that the market has not to date witnessed widespread defaults of mortgage-backed securities.
5. Lessons Learned 5.1 S&P is committed to learning lessons from the events that have led to the recent turmoil in the credit markets, including any lessons on the role and responsibilities of credit rating agencies. 5.2 S&P is taking steps to ensure that its ratings—and the assumptions that underlie them—are analytically sound in the light of changing circumstances. For example, as indicated above, we have significantly heightened the stress levels which we use in our analytical models and increased the frequency of our reviews of rated transactions. We have also undertaken a survey of originators and their practices, particularly in relation to data integrity and the ability to detect and manage fraud in the origination process. In sum, we are continually reviewing our models and processes in order to consider what further changes may be appropriate. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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5.3 S&P is also maintaining a dialogue with market participants and other interested parties in an eVort to determine the steps that the credit rating agencies and others should take in response to recent events. To this end, we are actively engaging in a number of diVerent fora. We are also holding ongoing discussions with regulators and other policy-makers on the role of credit rating agencies and their treatment of structured products. 5.4 In this context, we have noted with interest the comment made by the Bank of England’s Financial Stability Report about the role of credit rating agencies and its suggestions aimed at facilitating a more sophisticated use of ratings by investors (Issue No. 22, October 2007). We are giving careful consideration to those suggestions.
6. The Regulation of Credit Rating Agencies
6.1 The issue of the regulation of credit rating agencies was recently reviewed by the European Commission (“the Commission”), which published its conclusions in March 2006. The Commission noted that there were already three Directives in place that are relevant to the position of credit rating agencies15 and concluded that no new legislative initiatives were needed. In reaching this conclusion, the Commission noted that in December 2004 IOSCO had developed a Code of Conduct for credit rating agencies and that many agencies had set up their own Codes of Conduct along the lines of the IOSCO Code. 6.2 The Commission concluded that this was an encouraging development, provided that the credit rating agencies implemented their Codes of Conduct in practice, on a day-to-day basis. It therefore asked CESR to monitor compliance with the IOSCO Code and to report back to it on an annual basis. 6.3 In October 2005, S&P replaced its prior Code of Practice and Procedures with a new Code of Conduct in order to align further its policies and procedures with the IOSCO Code. S&P and certain other credit rating agencies have also agreed to adhere to the following framework for monitoring compliance with the IOSCO Code: (a) each agency sends an annual letter to CESR (which is made public) outlining how it has complied with the IOSCO Code and explaining any deviations from the Code; (b) CESR holds an annual meeting with each agency to discuss any issues related to its implementation of the IOSCO Code; and (c) each agency provides an explanation to the national CESR member where any substantial incident occurs with a particular issue in its market. 6.4 The framework established by this agreement is already in place, and in December 2006 CESR published its first report to the Commission on the compliance of credit rating agencies with the IOSCO Code (S&P subsequently revised its Code in response to CESR’s comments). S&P and other credit rating agencies are continuing to participate in this framework and CESR is due to publish its next annual report by mid-May 2008. 6.5 The framework established by IOSCO, the Commission and CESR is a relatively new one, but one that S&P believes provides an eVective, flexible and transparent mechanism for ensuring that credit rating agencies comply with a clearly defined and comprehensive set of external standards. November 2007
APPENDIX
S&P Publications on Northern Rock Listed below are the most relevant publications from 2005 to date:
Date Description 12 October 2005 Change from A (stable outlook) to A (positive outlook). 1 August 2006 Upgrade from A to A! (stable outlook). 27 June 2007 Change from stable to negative outlook in light of profit warning. 14 September 2007 Downgrade to A (negative outlook). 19 September 2007 Downgrade to A" (negative outlook). 26 September 2007 Placed on CreditWatch with developing implications.
15 These Directives are the Market Abuse Directive, the Capital Requirements Directive and the Markets in Financial Instruments Directive. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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Supplementary memorandum from Standard & Poor’s This memorandum reponds to the Committee’s requests at the evidence session on 13 November 2007. These responses contain information which is available to Ratings Services in the time given.
Fees Received from Northern Rock [Q977] The Committee has asked for details of fees received from Northern Rock plc. We have always been transparent that we are paid by the issuers that we rate and have always been transparent as to the means by which we ensure that potential conflicts of interest are managed. That transparency deos not extend, however, to our disclosing confidential and commercially sensitive details of the fees received from particular issuers. For that reason we are not in a position to disclose that information. By way of response to your subsequent question, however, we can confirm that the fees received from Northern Rock plc were set in accordance with our normal commercial arrangements.
Information on the Ratings Accorded to Particular Instruments and Institutions by Category [Q1053] The Committee has asked for information on our ratings by rating category, by type of issuers, by number of issuers and by volume. Please find annexed to this letter, tables showing: (1) the total volume of global issuance rated by Ratins Services by rating category in US $ millions; (2) the total number of global issuers by department and rating category; and (3) the percentage of global issuers by department and rating category. Please be aware that the table showing the total volume of rated issuance by rating category is based on initial maturities. For example, if a transaction has three classes and all three are active and currently rated AAA, the count shows three AAAs and not on transaction. For the table showing the total number of global issuers by rating category, regardless of issuance volume or number, each individual institution was counted once only. Please note that the term “financial institution” is quite broad. It ranges from commercial banks to development agencies to issuers of covered bonds. Some financial institutions benefit from national, state or regional guarantees which elevate their ratings. Due to varying regulations, some issuers set up funding entities in multiple locations. The data has been calculated as at 28 November 2007 by reference to long term issuer ratings, but excluding national scale ratings and US public finance ratings in order to be responsive to your request. This is a point in time data set and no trends can be deducted from it. Please also not that bond insured transactions, mostly rated AAA, are included in the universe. By way of response to Mr Dunne’s specific question, using the above definitions approximately 43% of the debt at issue rated by Ratings Services globally is rated AAA.
Views or Ratings Services on the Specific Statements and Proposals Made by the Bank of England You referred to the suggestion, in the Bank of England’s October 2007 Financial Stability Report, that some investors may not have “fully appreciated that rating agency assessments are currently intended to cover only credit risk”. While we cannot speculate as to the extent to which investors utilised structured finance credit ratings to address issues other than credit risk, we have always been very clear that our credit ratings speak only to the default risk associated with an issuer or an issue and that they do not speak to other factors such as their likely market performance or the amount that may be recovered in a post-default scenario. We seek continually to enhance our communications on this point. In relation to the Bank’s specific “suggestions for improvement”, at page 57 of its Financial Stability Report, we would make the following comments in relation to each of the suggestions, which are included below for ease of reference. Please note that in light of the fact that these suggestions were only published last month, we have not yet had an opportunity to discuss them in detail with the Bank of England. “Agencies could publish the expected loss distributions of structured products, to illustrate the tail risks around them. Agencies have made significant eVorts over the past few years to increase the transparency of their rating methodology for structured finance products, through publication of research reports describing their modelling methodoloty and their assumptions on correlations and recovery rates. But published distributions could provide a visual reminder of the fatter tails embedded in the loss distribution in structured products”. A Standard & Poor’s rating assigned to a structured finance security reflects our opinion of the likelihood that the security will pay timely interest over its remaining lifetime and/or full principal no later than its final maturity date. In other words, it is an opinion on the security’s default risk. Our ratings currently do not seek to quantify default risk explicitly, for example, by associating a given rating level with a certain “probability of default” estimate. Rather, the performance of our ratings over time is demonstrated by the ex post probability of default of the assigned ratings as shown in our published default and transition studies. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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Similarly, our current rating methodologies for most structured finance asset classes do not model the probability of default for a given security or involve deriving a probability distribution for possible losses incurred by holders of the security. However, as noted above, we are still reviewing this proposal and may have additional views at a later time. Our existing CDO rating analysis does generate modelled loss distributions for the asset portfolio backing the transaction, though not for the rated securities themselves. This information is already available as an output from our freely-distributed credit model, CDO Evaluator. “Agencies could provide a summary of the information provided by originators of strcutured products. Information on the extent of originators’ and arrangers’ retained economic interest in a product’s performance could also be included. Such a summary may satisfy investors that incentives are well aligned or encourage investors to perform more thorough risk assessments”. Our rating analysts publish pre-sale and post-sale reports for the majority of transactions that we rate publicly. These reports include summary information relating to the transaction’s characteristics, which may include information provided by originators, as well as details of our rating analysis. To the extent the originator is provided explicit support to the transaction, these aspects of the originator’s risk will be disclosed. However, to the extent the originator is holding some of the securities, and these securities are saleable in the market, we are aware of no current way to monitor which market participants hold of sell any given security at any give time during the life of those securities. Much of the information we receive when rating a transaction is also disseminated to market participants by the issuer in various forms, eg in the transaction’s oVering circular. Most of the information we receive that is not disclosed in this way is confidential. Our analysts are bound by our Confidential Information Policy and the relevant provisions of the IOSCO Code (incorporated in our own Code of Conduct). For these reasons, we believe the extent to which data is made available to investors in structured finance securities is ultimately a decision for issuers or originators taking into account applicable regulations, which are a matter for government and regulators. However we will continue to consider whether we could provide the market with a summary of information provided by originators in a way that would not call into question our confidentiality undertaking and still provide meaningful information. Originators or arrangers often have an ongoing involvement in structured finance transactions: for example, the arranger may also act as a swap counterparty. In these cases—where the originator’s or arranger’s credit standing may have implications for the tranches’ default risk—we analyse their involvement and consider their creditworthiness in the same way that we would analyse any other entity performing the same role. In general, the identity of investors in the tranches of a structured finance transaction does not have a bearing on those tranches’ default risk. Similarly, the level of originators’ or arrangers’ retained economic interest in this sense (eg in cases where the originator retains some of the rated securities) does not generally have a bearing on our rating analysis. “Agencies could produce explicit probability ranges for their scores on probability of default. Probability ranges would provide a measure of the uncertainty surrounding their ratings. Although such figures are already available retrospectively as transition matrices, an explicit probability range would allow investors to monitor agencies’ performance when rating diVerent asset classes”. As noted above, our ratings currently do not correlate to an explicit probability of default range. However, we are still reviewing this possibility. An eVective way to monitor rating agencies’ performance when rating diVerent asset classes is via historic default statistics. These are published as part of our regular transition and default studies, which are available on our public website at www.standardandpoors.com. This historic data shows that structured finance ratings have been successful diVentiators of default risk. For example, between 1981 and 2006, the average three-year default rate for “AAA” strcutured finance securities was around 2 basis points (bps), compared to 168 bps for “BBB” rated securities. Regarding comparability of ratings across asset classes, our intention is that ratings should provide a reasonably consistent framework for assessing default risk across diVerent sectors. This is also borne out by historic data. For example, the equivalent average three-year default rates for “AAA” and “BBB” corporate issuers have been 9 bps and 132 bps respectively, ie broadly comparable with the structured finance data mentioned above. While such long-term average default rates are useful proxies for rating performance, default rates over a shorter timeframe must be interpreted with caution. Significant variations in default rates can occur over time, even if ratings are assigned with great precision. This is because default rates are derived by observing the co-movement of multiple ratings, whose behaviour may be more or less correlated, depending on the sample used. “Agencies could adopt the same scoring definitions. Currently, some use probability of default, some loss given default and others a combination. Converging on a single measure would reduce the risk of misinterpretation by investors”. We believe the presence of multiple rating agencies in the structured finance market aVords a valuable diversity of opinions and choice for the users of our ratings. For example, an investor may decide they most value the opinion of one agency when making investment decisions in CNBS, whereas they most value the Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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opinion of a diVerent agency when making similar decisions in CDOs. On balance we would see little merit in enforcing a homogeneous analytical framework on multiple institutions working in parallel. Indeed, such homogeneity would deprive the market of the variety of opinions that exist today. We believe investors are capable of understanding what the ratings of diVerent agencies mean, what they can infer from them, and how they incorporate them into their investment decision-making process. It is also important for agencies to work with markets so participants understand their rating definitions and methodologies. Ratings Services continues to make eVorts in this regard via multiple media, including publication of research articles, teleconferences, and investor seminars and meetings. “Finally, rating agencies could score instruments on dimensions other than credit risk. Possible additional categories include market liquidity, rating stability over time or certainty with which a rating is made. Clear scores on there dimensions could encourage more sophisticated investment mandates and easier monitoring of non-credit risks in a portfolio. It would clearly take some time and money for agencies to develop the necessary expertise on these other risks, but some agencies have already proposed these additions”. As discussed above, we believe it is positive for the structured finance market for investors to be oVered a wide range of risk assessment tools and opinions. We believe it is important that credit ratings continue to meet market expectations by addressing credit risk. We continue to consider ways in which we would further serve the needs of structured finance market participants, including in the areas of liquidity and rating stability. We note that rating agencies (or any other organisations) already have an incentive to bring such new products to market if they are commercially viable. The fact that no publicly available third party assessments of diVerent sectors’ liquidity risks, for example, are currently in widespread use, may be a reflection of the practical challenges in forming such assessments with a suYcient level of confidence, even though there may be demand for such a product. Nevertheless, as part of our ongoing assessment of ways in which we could potentially further serve the needs of structured finance market participants, we continue to consider possible additions to our current product range. December 2007 Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
Treasury Committee: Evidence Ev 279 468 642 5,184 1,561 15,606 650,138 7,312,394 9,455,227 11,321,374 ) illions % (US $ M ssue I ssuers ssuers as a I I lobal lobal G G mounts as A lobal umber of umber of G DeptCorporate RatingsN DeptCorporate Ratings 336,892 546,054 1,642,888N AAA 2,344,489 1,160,597DeptCorporate 973,161 Ratings AAFinancial Institutions Ratings 277,001Insurance RatingsSovereigns and International Public FinanceStructured Finance Ratings 6,058 A 327 1,534 BBB AAA 221 23,719 26.28 BB AA 790 30.34 5.25 B 1,377 23.50 A 16.40 6.31 60.35 CCC 959 5.92 BBB 6.84 45.74 AAA 13.64 4.26 CC 1,175 26.64 20.50 7.48 BB 15.24 AA 9.29 294 26.17 C 6.53 5.34 26.56 8.36 B 25.55 A 18.50 13 4.61 0.00 D CCC 3.40 8.26 BBB Grand Total 22.67 0.58 0.00 3 2.95 CC 4.83 5.67 BB 0.06 0.00 1.26 25 1.71 C 0.25 0.00 0.21 B 0.13 0.16 0.06 D 0.32 CCC 0.01 Grand 100 Total 0.00 0.48 CC 0.63 100 0.78 100 C 100 100 D Grand Total Financial Institutions RatingsInsurance RatingsSovereigns and International Public FinanceStructured Finance RatingsGrand Total 10,953,552 6,279,815 10,340,689 3,869,608Financial 251,078 Institutions Ratings 2,849,339Insurance RatingsSovereigns 318,666 and 2,170,690 International Public FinanceStructured Finance 9,307,585 Ratings 113,040 377,942Grand Total 742,632 48,614 137,014 551,369 223.769 40,861 463,067 242.546 24,516,250 123 8,057 134,262 10,641,609 14,948,183 95,829 3,532,406 57,056 82 142 200 1,768,810 18,217 1,200,316 31,586 9,418 16,198 320,294 256 110 3,508 38 3,650 2,128 119,873 9,956 1,360 714 32 28,376,712 1,514 1,450 2,894 171 190 28,949 9,988 175,126 320 1,304 35 57,115,845 168 2,918 102 530 25 164 3,232 1,071 72 460 3,197 54 1,679 197 9 31 1,763 20 1 11 511 1 35 1 98 1 5 4 134 5 23,461 Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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Memorandum from Moody’s
Executive Summary 1. Moody’s is a credit rating agency and publishes credit ratings and research reports on fixed income securities and issuers of fixed income securities. Moody’s credit ratings are forward-looking opinions that address solely the probability that a debt instrument will default and the amount of loss the debt-holder will incur in the event of default. 2. Our ratings are expressed according to a simple system of letters and numbers, on a scale that has 21 categories ranging from Aaa to C. The lowest expected credit loss is at the Aaa level. 3. Our credit ratings do not address many other factors in the investment decision process, including the price, term, likelihood of prepayment, liquidity risk or relative valuation of particular securities. 4. When rating a bank, Moody’s analyses the intrinsic financial strength of the bank on a stand-alone basis and then factors in the likelihood and extent of external support in the event of financial diYculty. 5. Moody’s has been rating Northern Rock since 1996 and maintains a published rating opinion on the bank. Prior to this summer’s market turmoil, Northern Rock was rated Aa3 for deposits and senior bonds. The bank specific factors that supported this opinion were the nationwide mortgage franchise of the bank, its good asset quality, a history of stable earnings and satisfactory profitability. We identified the funding model and the maintenance of its asset quality standards as the two main challenges to the credit quality of Northern Rock. Moody’s rating also factored in the possibility of support from the UK Government. 6. Following the announcement by Northern Rock on 14 September, Moody’s placed Northern Rock’s rating on review, direction uncertain. This rating action reflects Moody’s opinion that the arrangements put in place by the Bank of England would mitigate the liquidity problems and recognises the uncertainties associated with the future of Northern Rock. 7. The turmoil in the credit markets that began this summer has adversely impacted investor confidence. Moody’s is in favour of initiatives that would lead to enhanced market transparency and improved market practices in order to restore confidence. 8. For our part, Moody’s continues fully to support measures that enhance transparency in the credit rating agency industry and we therefore welcome the EU’s endorsement of the international standards for rating agencies which have been implemented in the EU through a self-regulatory framework for rating agencies. The implementation of this framework is monitored by the Committee of European Securities Regulators.
Introduction to Moody’s 9. Rating agencies occupy a narrow but important niche in the investment information industry. Our role is to disseminate information about the relative creditworthiness of, among other things, financial obligations of corporations, banks, governmental entities, and pools of assets collected in securitised or “structured finance” transactions. 10. Moody’s is the oldest bond rating agency in the world, having introduced ratings in 1909. Today, we are one of the world’s most widely utilised sources for credit ratings, research and credit risk analysis. Our ratings and analysis track debt covering more than 100 sovereign nations, 12,000 corporate issuers, 29,000 public finance issuers, and 96,000 structured finance obligations. We maintain oYces in most of the world’s major financial centres and employ approximately 3,000 people worldwide, including more than 1,000 analysts. 11. Moody’s is a subsidiary of Moody’s Corporation (MCO), a listed company on the New York Stock Exchange. 12. Moody’s credit ratings are forward-looking opinions that address just one characteristic of fixed income securities—the likelihood that debt will be repaid in accordance with the terms of the security. They reflect an assessment of both the probability that a debt instrument will default and the amount of loss the debt-holder will incur in the event of default. In assigning our credit opinions, Moody’s analysts adhere to published rating methodologies, which we believe promote transparency and consistency of our global ratings. 13. Our ratings are expressed according to a simple system of letters and numbers, on a scale that has 21 categories ranging from Aaa to C. The lowest expected credit loss is at the Aaa level, with a higher expected loss rate at the Aa level, an even higher expected loss rate at the A level, and so on down through the rating scale. (See Annex 1 for more details). Moody’s rating system is not a “pass-fail” system. After all, if we could know the future, we would have only two ratings: “will not pay” or “will pay”. Rather our ratings are an assessment of the relative risk of credit loss as measured by the increasing probability of such loss with each lower rating level. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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14. Moody’s credit ratings are widely and publicly available at no cost to investors and the general public. We publicly disseminate our ratings through press releases and also make them available on our website. They are simultaneously available to all market participants regardless of whether or not they purchase products or services from Moody’s. The public availability of ratings helps “level the playing field” between, for example, large and small investors, enhances the transparency and eYciency of financial markets, and allows the market and all users of ratings to assess independently the aggregate performance of our rating system. 15. While Moody’s ratings have done a good job predicting the relative credit risk of debt securities and debt issuers, as validated by various performance metrics including published rating accuracy ratios and default studies, they are not statements of fact about past occurrences or guarantees of future performance. Furthermore, ratings are not investment recommendations. The likelihood that debt will be repaid is just one element, and in many cases not the most material element, in an investor’s decision-making process for buying credit-sensitive securities. Credit ratings do not address many other factors in the investment decision process, including the price, term, likelihood of prepayment, liquidity risk or relative valuation of particular securities.
Moody’s Approach to Rating Banks 16. In forming an opinion on the relative creditworthiness of a bank (ie the risk to bank depositors and bondholders of a default and the extent of loss in the event of such default) Moody’s considers first the intrinsic financial strength of a bank on a stand-alone basis. This is set out in a Bank Financial Strength Rating (BFSR) on a scale of A to E with A being the highest intrinsic financial strength. Full details of the rating scale can be found in Annex 1. 17. Based on this analysis, we next assess the likelihood and extent of external support being provided to the bank in the event the bank’s stand-alone financial strength is insuYcient to prevent a default. Such support may come from a variety of sources, including a parent company, a regional government or a central government. 18. When forming an opinion on the stand-alone financial strength of a bank, Moody’s analysis, as set out in a publicly available methodology, considers five key factors: (a) Franchise value. This analysis focuses on the bank’s market share, geographical diversification and the stability and diversification of its earnings. (b) Risk positioning. Management’s approach to managing risks—be they credit, market, trading, reputation, or operational, to cite a few—underpins the strategic decisions and the chance of such decisions succeeding. We look to see to what extent risk discipline is aligned with the bank’s strategy. (c) Regulatory environment. A strong regulatory environment combining eVective regulations, active supervision, and aggressive and prompt enforcement can promote sound banking practices and limit excessive risk taking. (d) Operating environment. A bank’s performance is frequently constrained by its operating environment and, where conditions are particularly diYcult, banks could often be said to be the victims of their environments. (e) Financial fundamentals. This analysis focuses on the bank’s profitability, liquidity, capital adequacy, eYciency and asset quality. 19. When forming an opinion on the likelihood of external support from the government being provided to the bank, Moody’s analysis would involve a two step process: (a) First, to identify the overall willingness of the government to support troubled banks. Moody’s determination of system-wide support focuses on the country’s history of bank-deposit defaults, as well as the importance of the banking system to the national economy and the overall strength of the banking system. (b) The second step is to evaluate the probability and extent of support that would be provided to an individual bank. Moody’s examines the significance of the bank’s role in the payments system, its overall importance to the national economy, and the size of the bank’s deposit and loan market shares. 20. In order to arrive at a credit rating opinion, both dimensions of Moody’s analysis are presented to a rating committee of Moody’s analysts. Credit ratings are determined through rating committees, by a majority vote of the committee’s members, and not by any individual analyst. The composition of the rating committee varies based on the nature and complexity of the credit rating being assigned. It includes the Chair, who acts as the moderator of the committee, the lead analyst, who presents his or her recommendation and the analysis supporting it, and other participants, which can include support analysts, other specialists or senior-level personnel, as are deemed appropriate. 21. Once a credit rating is assigned, it is then disseminated to the market and subsequently monitored, as necessary, to ensure that it continues to reflect Moody’s opinion of the creditworthiness of the bank. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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Northern Rock 22. Northern Rock has been publicly rated by Moody’s since 1996, initially as a building society and subsequently as a listed bank. Before this summer’s market turmoil, its long term debt and deposit ratings were rated Aa3 by Moody’s, which means a very low credit risk to depositors and senior bond holders as compared to other entities rated on our 21 scale rating system. In arriving at this opinion, Moody’s factored in the possibility of support from the UK Government in the event of diYculties, based on the systemic importance of the bank to the UK economy. 23. Moody’s opinion on the stand-alone financial strength of Northern Rock, which excludes all elements of external support, was B".16 In our view, the factors that supported the rating were the solid mortgage origination franchise of the bank, its good asset quality, and a history of stable earnings and satisfactory profitability. 24. We identified Northern Rock’s funding model, with its reliance on the wholesale markets and its inability to match asset growth with retail deposits, as one of the weaknesses of the bank. As at end 2006, retail deposits accounted for 24% of total funding compared to 43% for securitisation, 7% for covered bonds and 26% for other non-retail sources. Based on the analysis of the financial fundamentals, this meant a “liquidity score” of D! for Northern Rock with E being the lowest possible score. 25. However, while we expressed concerns about the funding model, we saw the diversity of secured and unsecured wholesale funding available to the bank, including securitisation and covered bonds, as a mitigating factor. We attached a very low probability to a scenario of prolonged and complete shutdown of the wholesale markets, importantly including the structured finance market. 26. The maintenance of good asset quality was also flagged as a credit challenge in the light of the rapid growth of the mortgage book and the shift in origination toward riskier products. 27. On Friday 14 September, Northern Rock announced that, in the light of the continuing extreme conditions in global liquidity, it had reached an agreement with the Bank of England that it could raise such amounts of liquidity as might be necessary by either borrowing on a secured basis from the Bank of England or entering into repurchase facilities with it. 28. At 7 am on Monday 17 September, Moody’s published a rating action on Northern Rock. With the availability of emergency liquidity support from the Bank of England, Moody’s believed that Northern Rock would be able to meet obligations as they fell due. 29. Moody’s announced that the long term rating of Aa3 was placed on review, “direction uncertain”. By indicating “direction uncertain”, Moody’s signalled to the market that within the next three months there was a possibility of the rating either being upgraded or downgraded. The direction would depend on whether or not an acquisition took place, the financial profile of any such acquirer and the stand-alone credit profile of Northern Rock under a revised business model. 30. At the same time, the stand-alone financial strength rating was downgraded from B" to C" (see footnote 1 above). This downgrade reflected Moody’s opinion about the impact of the rescue on Northern Rock’s stand-alone credit profile, including the impairment to its franchise and the challenges the bank would face in reconfiguring its business model, which Moody’s believes is likely to lead to a significant decline in overall profitability going forward. 31. Moody’s rates Northern Rock’s residential mortgage backed securitisation issues, most of which are undertaken through its special purpose vehicle—Granite Master Issuer. Northern Rock also uses the securitisation market to protect itself against losses on its mortgage book and securitisations through its Graphite and Whinstone issues respectively. Moody’s rates some of the tranches of these issues. Moody’s also rates the eight covered bonds issued by Northern Rock with total outstandings on the bonds of £8.6 billion as at end September.
Overall Functioning of Financial Markets 32. Over the past 40 years, the global financial system has evolved from a slow paced world of fixed exchange rates, capital controls, bank-dominated financial flows and modest domestic and international capital markets into one in which capital flows freely across borders, investors and borrowers invest and borrow globally, and capital is allocated by the securities market rather than by banks. 33. Deregulation, disintermediation and financial innovation have created a financial system that is vastly more eYcient than before, and which allow excess savings in one country or region to finance investment in a completely diVerent location. Such free flow of capital has contributed significantly to the growth of the global economy. 34. Prior to the disintermediation of the markets, credit crunches occurred when the central bank brought the oYcial rate above the time deposit interest rate ceiling to slow the economy. This action caused funds to flow out of the banking system, which in turn forced banks to restrict credit.
16 Banks rated in the B range (B!,B,B") are considered to possess strong intrinsic financial strength. Typically, they will be institutions with valuable and defensible business franchises, good financial fundamentals, and a predictable and stable operating environment. Please see Annex 1 for Moody’s Bank Financial Strength Rating Scale and definition. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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35. Modern credit crunches are caused by an unexpected exogenous shock that destroys market confidence eg: a geopolitical event—the Iraq conflict (1990–91); a sovereign default and the near-collapse of a big hedge fund (1998); major accounting frauds and associated defaults—the technology bubble (2001–02); or the unexpected re-valuation of a large asset class—U.S. sub-prime bubble (2007). The transmission mechanism in the modern credit crunch is not bank credit or interest rates, but rather sudden changes in market risk premia as expressed in credit spreads and credit availability. 36. The 2007 shock relating to U.S. subprime mortgages and consequent global credit market liquidity problems have, as with previous shocks, invited comment about the role, function and performance of credit rating agencies. Many recognise the unprecedented combination of forces driving mortgage delinquencies in the U.S.: the decline and eventual reversal in home price appreciation, the sharp contraction in credit available for refinancing, the deterioration in mortgage underwriting processes and the now-apparent extent of misrepresentation in the mortgage application process. 37. Recent events have again proven that markets can change rapidly and dramatically. The opportunity to improve market practices, including credit analysis and credit-ratings processes, must be pursued vigorously and transparently if confidence in, and the healthy operation of, credit markets are to be restored. 38. Moody’s continuously reviews and enhances its working practices to take account of experience. There are four areas where Moody’s is currently considering making changes within its own business: (a) Increasing market awareness of the meaning and limitations of Moody’s ratings. A Moody’s rating assesses solely the risk of credit loss. This is an important element of the risks facing investors when they buy a security. However, the price of a security is aVected by many factors other than credit, including liquidity risk, interest rate risk and currency risk. Therefore, a Moody’s rating is an imprecise and incomplete proxy for the price of a security17 if used alone. (b) Enhancing our transparency. Moody’s will explore enhancements in particular in relation to our assumptions about macroeconomic factors and scenarios and our opinions on third parties and their documentation that Moody’s relies on when rating transactions. (c) Developing additional measurement tools. Moody’s is developing potential supplemental tools for investors to assess risks beyond expected credit loss, including valuation and pricing services for the structured finance market. Such tools would enhance transparency and strengthen secondary markets for structured products. (d) Further strengthening of conflict of interest protections. Moody’s has a number of measures in place to protect the integrity of our rating opinions. These protections are described in our Code of Professional Conduct, which is attached to this submission. While we believe these protections are robust and transparent, we also believe that we should continually work to enhance the means through which we avoid or mitigate the potential conflicts of interest inherent in our business model. 39. There are also potential market-level changes that Moody’s believes would further facilitate the restoration of market confidence and mitigate future credit market disruption. (a) Disclosure requirements. In a number of areas, Moody’s believes that disclosure requirements should be reviewed, particularly in relation to: (i) the assets held by unregulated but systemically important institutions; (ii) the performance of asset pools underlying securitisation transactions; (iii) valuation practices; and (iv) bank exposures to oV-balance sheet vehicles. (b) Accounting issues, particularly in relation to the consolidation of oV-balance sheet funding vehicles.
Regulation of Rating Agencies 40. In December 2004, the International Organisation of Securities Commissions (“IOSCO”) adopted its Code of Conduct Fundamentals for Credit Rating Agencies (the “IOSCO Code”). It provides a global framework of principles for the behaviour of credit rating agencies and for transparent disclosure of their procedures, rating methodologies and rating performance metrics. 41. In June 2005, Moody’s adopted its Code of Professional Conduct, which was closely modelled on the IOSCO Code. In October 2007, Moody’s issued an updated version of its Code of Professional Conduct. The changes made reflected Moody’s continuing eVorts to clarify and enhance its policies and processes for ensuring the integrity, objectivity and transparency of its ratings processes, in a manner consistent with the IOSCO Code.
17 When interest rates rise 0.25%, the price of government bonds will generally fall. The credit risk of the government bonds will be unchanged. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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EU 42. In Europe, regulators supported the IOSCO Code. Following an evaluation in 2005 by the Committee of European Securities Regulators (“CESR”), the European Commission (the “Commission”) issued a communication in March 2006.18 The communication favoured self-regulation by credit rating agencies based on the standards of the IOSCO Code and the provisions of relevant EU securities laws that apply to all market participants, including rating agencies. Furthermore, the Commission asked CESR to monitor the rating agencies and their adherence to the IOSCO Code and to report back to the Commission on an annual basis. 43. CESR’s first report on rating agency adherence to the IOSCO Code was published in January 2007. In this report CESR concluded that the rating agency “codes comply to a large extent with the IOSCO Code”.19 In undertaking its review, CESR consulted with market participants as well as the credit rating industry. 44. CESR has commenced its 2007 review. CESR is evaluating the areas identified in its 2006 report, which include the impact of the US Reform Act on the credit rating business in the European Union, and the role of rating agencies in the structured finance process. The report will also respond to specific questions sent to CESR by Commissioner Charlie McCreevy following this summer’s market turmoil. CESR plans to publish a draft of its 2007 report in February 2008 for consultation. The final report is due to be published in May 2008. November 2007
Annex 1
MEANING OF MOODY’S RATINGS
Moody’s Long-term Rating Scale
Aaa Judged to be of the highest quality, with minimal credit risk. Aa Judged to be of high quality and are subject to very low credit risk. A Considered upper-medium grade and are subject to low credit risk. Baa Subject to moderate credit risk. They are considered medium grade and as such may possess certain speculative characteristics. Ba Judged to have speculative elements and are subject to substantial credit risk. B Considered speculative and are subject to high credit risk. Caa Judged to be of poor standing and are subject to very high credit risk. Ca Highly speculative and are likely in, or very near, default, with some prospect of recovery of principal and interest. C Lowest rated class of bonds and are typically in default, with little prospect for recovery of principal or interest. Note: Moody’s appends numerical modifiers 1, 2, and 3 to each generic rating classification from Aa through Caa. The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category.
Watchlist Moody’s uses the Watchlist to indicate that a rating is under review for possible change in the short-term. A rating can be placed on review for possible upgrade (UPG), on review for possible downgrade (DNG), or more rarely with direction uncertain (UNC). A credit is removed from the Watchlist when the rating is upgraded, downgraded or confirmed.
Bank Financial Strength Rating Definitions
A Banks rated A possess superior intrinsic financial strength. Typically, they will be institutions with highly valuable and defensible business franchises, strong financial fundamentals, and a very predictable and stable operating environment. B Banks rated B possess strong intrinsic financial strength. Typically, they will be institutions with valuable and defensible business franchises, good financial fundamentals, and a predictable and stable operating environment.
18 Communication from the Commission on Credit Rating Agencies (2006/C 59/02). 19 CESR’s Report to the European Commission on the compliance of credit rating agencies with the IOSCO Code Ref: CESR/ 06-545. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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C Banks rated C possess adequate intrinsic financial strength. Typically, they will be institutions with more limited but still valuable business franchises. These banks will display either acceptable financial fundamentals within a predictable and stable operating environment, or good financial fundamentals within a less predictable and stable operating environment. D Banks rated D display modest intrinsic financial strength, potentially requiring some outside support at times. Such institutions may be limited by one or more of the following factors: a weak business franchise; financial fundamentals that are deficient in one or more respects; or an unpredictable and unstable operating environment. E Banks rated E display very modest intrinsic financial strength, with a higher likelihood of periodic outside support or an eventual need for outside assistance. Such institutions may be limited by one or more of the following factors: a weak and limited business franchise; financial fundamentals that are materially deficient in one or more respects; or a highly unpredictable or unstable operating environment. Note:Where appropriate, a “!” modifier will be appended to ratings below the “A” category and a “"” modifier will be appended to ratings above the “E” category to distinguish those banks that fall in the higher and lower ends, respectively, of the generic rating category.
Supplementary memorandum from Moody’s This memorandum responds to the Committee’s requests at the evidence session on 13 November 2007. I deal with each area in turn.
1. Fees Received from Northern Rock PLC20 [Q977] As Moody’s has indicated on previous occasions, we have an “issuer-pays” business model. In general, issuers pay for the ratings that we assign to their debt securities. We recognise that this model creates potential conflicts of interest that must be managed eVectively. That is to say, if Moody’s rates a given company and is paid by that company, then we must protect against the company’s potential influence on the initial rating process and potential interference in future rating actions. The market broadly understands this potential conflict21 and we believe that Moody’s manages our business model to a global best practice standard.22 In specific response to the Committee’s concern about Moody’s relationship with Northern Rock, we can confirm that Moody’s has not provided consulting or non-rating services to Northern Rock. This assertion holds equally true for the subsidiaries of our corporate parent, Moody’s Corporation (“MCO”). The only fees earned by MCO were for the provision of Credit Rating Services23 by Moody’s of which 95% was for the provision of credit ratings and 5% for the sale of related research. Because of confidentiality reasons and competitive concerns, we are unable to provide you with the exact fees charged to Northern Rock. However, Moody’s assigned over the last five years first time ratings to Northern Rock, its subsidiaries or its related special purpose vehicles as follows: 1. Eight covered bond issues. 2. Twenty one structured finance deals principally relating to the Granite issuance programme. In addition Moody’s had five distinctive fundamental ratings on Northern Rock PLC (Deposit, Bank Financial Strength, Short Term, Subordinated Debt and Hybrid). Moody’s was paid rating fees for these ratings. To provide further context for the Committee, we note that the total fees earned by MCO from Northern Rock in 2006 accounted for less than 0.1% of MCO’s total revenues.24 Furthermore, in 2006, the fees earned from Northern Rock were significantly below the average and median fees earned by Moody’s from other top 10 UK banks, as sized by total assets.25
20 When referring to Northern Rock we include any of it subsidiaries and all special purpose vehicles related to Northern Rock. 21 We would note that under an alternative business model in which bond investors rather than issuers pay for ratings, it is also likely that a large investor paying fees to Moody’s would have an incentive to apply pressure to influence the rating process— especially an investor holding concentrated positions. Rating actions often have implications for an entity’s equity valuation, and so investors who also hold equity positions may be doubly motivated to influence rating actions. 22 For a detailed discussion of the various policies and mechanisms we have in place that manage and mitigate the potential conflicts in our business model please see “Moody’s Investors Service Report on the Code of Professional Conduct”, April 2006 (hereafter “Moody’s Report”). The report is available on our website, www.moodys.com at: http://www.moodys.com/moodys/cust/research/MDCdocs/11/2005600000424173.pdf 23 As defined in the Moody’s Code of Professional Conduct: “Credit Rating Services are those products and services that are derived from the Credit Rating process and include, but are not limited to, the production and sale of Credit Ratings and related research, data products and related analytical tools”. The Code is available on our website, www.moodys.com at: http://www.moodys.com/cust/content/Content.ashx?source%StaticContent/Free%20Pages/Regulatory%20AVairs/ Documents/professional-conduct.pdf 24 Moody’s fees earned from Northern Rock peaked in 2005. This reflected the number of structured finance transactions issued by Northern Rock. The fees in 2005 were some 40% higher than in 2006. In 2002, 2003 and 2004 Moody’s earned fees that were some 30%, 40% and 20% lower respectively than in 2006. 25 Northern Rock is a top 10 UK bank. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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Moody’s would not sacrifice our reputation with the investor community for providing credible and reliable ratings, which has been built over 100 years, for any rating relationship.
2. Ratings by Category [Q1053] For the information requested on ratings accorded to particular instruments and institutions, please see Annex 1.
3. Our Views on the Five Suggestions for Improvement from the Bank of England Moody’s welcomes the Bank of England’s important contribution to the current international dialogue relating to credit rating agencies. It is our understanding that these suggestions are considered to be ideas that merit consideration rather than reflecting the final position of the Bank of England. We set out below our current thinking about the Bank of England’s suggestions. It would be premature, however, to provide the Committee with our definitive position on these suggestions because of the developing nature of the global dialogue on the role and function of rating agencies. In this regard, the Committee should be aware that Moody’s is fully engaged with numerous market participants, including issuers, investors and regulatory authorities in exploring the appropriate set of responses to the issues arising from the current market turmoil.
Suggestion 1: Rating agencies could publish the expected loss distributions of structured products “Agencies could publish the expected loss distributions of structured products, to illustrate the tail risks around them.26 Agencies have made significant eVorts over the past few years to increase the transparency of their rating methodology for structured finance products, through publication of research reports describing their modeling methodology and their assumptions on correlations and recovery rates. But published distributions could provide a visual reminder of the fatter tails embedded in the loss distribution in structured products.” It is our understanding that this recommendation, if implemented, would ask for credit rating agencies to provide a simple metric that alerts the investor to the nature of the tail risk. Moody’s already publishes much, if not, all of the relevant information necessary for assessing tail risk. Having said that, we appreciate that there is market interest in such a simple metric. We are currently exploring a number of possible approaches to this issue. At this point, however, we have not been successful in reducing such complex information into a meaningful metric and we are concerned that simple metrics might themselves be misleading. Nevertheless, we are working on means to improve investor understanding of the potential uncertainty that surrounds the expected credit performance of diVerent rated securities. This work includes careful consideration of how we present our already available public information.
Suggestion 2: Rating agencies could produce a summary of the information provided by originators “Agencies could provide a summary of the 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. Such a summary may satisfy investors that incentives are well aligned or encourage investors to perform more thorough risk assessments.” Credit rating agencies are one of many participants with historically well-defined roles in the structured finance market. Our role is fundamentally the same as the role we have played over the last hundred years in the corporate bond market: we provide a public opinion (based on both quantitative and qualitative information) that speaks to one aspect of the securitisation, specifically the credit risk associated with the securities that are issued by securitisation structures. Our credit opinions are based on information made available to us, which we analyse in accordance with our methodologies. The Committee should note that, in cases where we believe we do not have suYcient public and private information, our practice is either not to issue a credit rating in the first place or, following a rating committee deliberation, to withdraw a previously issued rating and make the reason for such withdrawal public in a press release.27 Consequently, any enhancements in the quality and level of issuer information disclosure would, in turn, enhance the quality of our credit ratings. Because our role is that of a user of information provided by others, Moody’s has always supported transparency, both in the corporate market and in the structured finance market.
26 Bank of England footnote: “The risk that extreme losses are more likely than what would be expected from a normal distribution”. 27 A decision to withdraw a rating is made by a rating committee. Language similar to the following typically would appear in such a press release: “The rating has been withdrawn because Moody’s believes it lacks adequate information to maintain a rating. Please refer to Moody’s Withdrawal Policy on moodys.com”. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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If authorities would like to increase the level and quality of transparency in the market by requiring that summary level data on a structured product and the level of economic interest in that product’s performance is retained by the originator, we would suggest that rating agencies are not the appropriate entity on which to place such disclosure obligations. While we fully support the Bank of England’s enhanced transparency recommendation, we believe that issuers are the logical entity to provide such information to the market. Our suggestion is based on several reasons. From a practical perspective, requiring rating agencies to disclose issuer-level information may have a detrimental aVect on the quality of our credit ratings. Issuers provide certain information to us with the understanding that the information will be held in confidence. If they believed that credit rating agencies would disclose it to the market, the issuers might provide less information to us. This outcome could adversely aVect the quality of our opinions, since they would be based on potentially incomplete data. More importantly, only the issuer has complete access to its own data and, consequently, only the issuer has the ability and appropriate expertise to assert that the summary data disclosed is an accurate and complete representation of its financial and economic status.
Suggestion 3: Rating agencies could produce explicit ranges for their scores on probability of default “Agencies could produce explicit probability ranges for their scores on probability of default. Probability ranges would provide a measure of the uncertainty surrounding their ratings. Although such figures are already available retrospectively as transition matrices, an explicit probability range would allow investors to monitor agencies’ performance when rating diVerent asset classes”. This suggestion seems very close in spirit to Suggestion 1. The suggestion invites the credit rating agencies to illustrate potential elements of credit risk that go beyond those envisaged by the rating itself. A Moody’s credit rating is a probabilistic opinion about future events. Our opinions are by their nature the product of a range of probabilities based on our assumptions of various factors and expectations about a transaction’s future creditworthiness. Furthermore, in many cases, investors can access models developed by Moody’s. These models allow investors to change various assumptions and estimate the impact on a published rating. Consequently, we believe that there is a risk that, if we were to adopt this suggestion, it might lead to results that are inconsistent with the nature of our ratings. Having said this, there might be demand for us to provide some guidance on how widely we might expect the performance of pools of similarly rated securities within specific sectors to vary over time in the future. On the question of performance of our ratings, the Committee should note that Moody’s already publishes idealised expected loss tables which, rather than indicating a range of loss expectations, identify an idealised target expected loss rate. This information already allows the market to measure our historical performance and the overall quality of our ratings.
Suggestion 4: Rating agencies could adopt the same scoring definitions “Agencies could adopt the same scoring definitions. Currently, some use probability of default, some loss given default and others a combination. Converging on a single measure would reduce the risk of misinterpretation by investors”.28 Moody’s believes that rating agencies should not be required to harmonise their processes, methodologies, rating opinions or rating definitions. Because credit ratings are forward-looking opinions about creditworthiness that address inherently uncertain future events, Moody’s believes that there is no single approach that should be adopted for developing and publishing them. Two rating agencies looking at the same set of facts may legitimately reach diVerent conclusions based on their individual points of view, understanding of market behaviour, or analytical methodologies. Moreover, capital markets constantly evolve, with changes in financial products, issuers and the credit environment. Measures that specify a particular approach may create a static, inflexible system. Even if initially aligned with market practices, such a system would require or promote harmonisation of rating opinions and could ultimately make rating agencies less capable of responding to innovations and meeting demands in a continuously evolving market. Over time, diversity of opinion would suVer, and the motivation and ability of rating agencies to compete on the basis of improving credit analysis would be materially eroded. We can confirm to the Committee that we are endeavouring to explore means of more clearly and transparently identifying the limitations and attributes of our credit ratings.
28 Bank of England footnote: “Moody’s announced in 2006 that it would start disaggregating some of its long-term ratings into their two key components—loss given default and probability of default (www.moodys.com/cust/content/loadcontent.aspx?source%staticcontent/free%20pages/LGD/lgdadpage.htm, 22 June 2006)”. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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Suggestion 5: Rating agencies could score instruments on dimensions other than credit risk “Finally, rating agencies could score instruments on dimensions other than credit risk. Possible additional categories include market liquidity, rating stability over time or certainty with which a rating is made. Clear scores on these dimensions could encourage more sophisticated investment mandates and easier monitoring of non-credit risks in a portfolio. It would clearly take some time and money for agencies to develop the necessary expertise on these other risks, but some agencies have already proposed these additions”.29 Moody’s already provides several non-credit scores. Examples include those which assess operational quality of managed funds, alternative liquidity of corporate entities, and, as discussed in our evidence before the Committee, financial strength of banks. Recently we introduced a “fundamental value” product based on discounted cashflow analysis for structured finance securities. This product should also allow scope for volatility analysis based on changes to assumptions. We will continue to explore areas where we believe we can provide tools that would be useful to the market. 6 December 2007
Annex 1
SUMMARY OF MOODY’S GLOBAL PUBLIC RATINGS BY RATING CATEGORY AND BY SECTOR
RATINGS AS AT 01/01/07
Sovereign & Subsovereign Corporates Financial Institutions Issuer level Amount % Amount % Amount % Aaa 58 26 40 1 89 4 Other investment grade 119 53 1,540 44 2,015 88 Count Speculative grade 46 21 1,919 55 188 8 Total 223 100 3,499 100 2,292 100
Aaa 7,496,513 41 134,111 3 3,995,976 37 Original Other investment grade 9,934,707 55 3,222,974 63 6,434,874 60 Face Value* Speculative grade 719,772 4 1,724,502 34 294,376 3 Total 18,150,991 100 5,081,587 100 10,725,226 100
Corporates Financial Institutions Structured finance Security level Amount % Amount % Amount % Aaa 1,067 5 44,492 48 46,276 51 Other investment grade 12,863 66 45,243 49 37,461 41 Count Speculative grade 5,602 29 2,517 3 7,297 8 Total 19,532 100 92,252 100 91,034 100
Aaa 185,586 4 4,897,983 46 8,084,619 85 Original Other investment grade 3,238,946 64 5,565,493 52 1,307,901 14 Face Value* Speculative grade 1,657,055 33 261,749 2 134,118 1 Total 5,081,587 100 10,725,226 100 9,526,638 100 * Original Face Value of Long-Term Bonds & Loans Outstanding (USD Mil). For structured finance securities, original face value overstates, by perhaps 60%, the total amount outstanding due to amortization and prepayments of principal.
Memorandum from the Investment Management Association (IMA)
Executive Summary 1. The IMA’s members, managing over £3 trillion of assets and undertaking no proprietary trading, characteristically take a long-term investment view and support measures that enhance the long-term stability and depth of financial markets. 2. The diYculties identified with Northern Rock were caused by a loss of confidence in wholesale markets that meant a credit crisis in one part of the global economy impacted liquidity even at the level of inter- bank lending. 3. IMA raises concerns about the operation of the tripartite system after the initial protection of depositors.
29 Bank of England footnote: “Moody’s is considering issuing measures of liquidity risk and market risk alongside traditional ratings for complex financial instruments (Source: Financial Times, 17 September 2007)”. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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4. The need to preserve confidence requires further work on the conflicts of interest to which credit rating agencies (CRAs) may be subject. 5. Care must be taken to resist an over-reliance upon CRAs by regulators and investors for determining capital treatment and eligibility for inclusion in portfolios. 6. The complexity of modern derivative products is such that it is hard to look through to see the true economic drivers, from where gains and associated risks actually derive. Institutional investors commonly take great care that there is suYcient dispersal of risk, that is to say that diVerent risks are not correlated and that there is no over-concentration in any one risk. Simply, the market response over the summer revealed that participants felt they could no longer (if they ever could) ensure that risk could be judged eYciently and priced appropriately in several key markets. 7. Transparency alone is not enough, the limitations of risk models in dealing eVectively with the unexpected should be a factor that is kept in the forefront of regulatory focus upon capital strength and resilience to shocks. There are growing concerns that current models focus overly upon normal distributions of risk and are not just weak but fail in what are often perceived as “abnormal” or “unexpected” markets. 8. There is a role for regulators to ask afresh whether some of the market structures serve investors well. Even when liquidity dried up, it is worth remembering that there were still customers in the market. However these customers had diYculty in accessing any form of market support, or indeed each other. This does not tend to indicate a robust market structure from the investor perspective, featuring as it does a block on the operation of the market imposed by the principal intermediaries. Whilst these intermediaries acted separately, in reality the freeze on the market revealed the very substantial concentration that exists within the credit markets and the eVective marginalisation of the outer circle of investors. 9. In conclusion, IMA would encourage regulators and legislators: 9.1 to encourage market-led improvement in transparency, disclosure and conflict management at CRAs; 9.2 to address afresh the risks involved in over-reliance upon ratings (being based upon default probability) for prudent risk-management and capital adequacy assessments, especially as regards resilience and sensitivity to a default; 9.3 to work with industry to consider the adequacy of valuation techniques for today’s highly complex derivative products, especially in what are seen as highly improbable circumstances.
Introduction 10. The IMA welcomes the opportunity provided by the Treasury Select Committee to give evidence concerning financial stability and transparency. 11. The IMA represents the UK-based investment management industry. IMA members include independent fund managers, asset management arms of banks, life insurers and occupational pension scheme managers and are responsible for the management of over £3 trillion of assets. These assets are invested on behalf of clients globally. Our members undertake no proprietary trading and their entire investment business is conducted on behalf of others. 12. The Committee has welcomed written evidence under three principal topics: 12.1 Northern Rock; 12.2 deposit protection; and 12.3 the overall functioning of financial markets. 13. The comments below are principally restricted to the third point, the overall functioning of the financial markets. We have focused our comments upon issues which we consider relate both to the sub- points identified by the Select Committee and to the particular circumstances which led to the diYculties most obviously demonstrated with Northern Rock. 14. As regards the particular matter of Northern Rock, from experience, IMA is confident that the authorities will ensure there is a robust review of practices and that FSA will address any shortcomings in supervision. We would however caution against any hasty revision of the tripartite-nature of the system for safeguarding financial stability. 15. IMA has no criticism of the guarantee provided to depositors as at the date of announcement, despite the risk that future behaviour of banks may be conditioned by a belief that Government will bail depositors out above and beyond any then-existing deposit protection scheme. However, we do have a real concern as to the wisdom of then extending protection to new depositors. Intervention under the tripartite system should be restricted narrowly to issues of financial stability, including stopping contagion. In the present case, such intervention could be seen as now prioritising the continuance of business as a going concern in order to facilitate a sale. With hindsight this may turn out to be successful, but it would be a real concern if all it did was postpone a failure. It must not be forgotten that many other members of the public are Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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directly and indirectly invested in Northern Rock. Passive investment managers, including FTSE tracking ISAs for example, are almost bound to remain invested at this time. Beyond protection of the then existing depositors, there is no need to protect a bank from the judgement of the market merely because it is a bank.
IMA Review of the Liquidity Crisis 16. IMA’s board has commissioned an internal review of the impact of the summer’s liquidity crisis and the lessons to be learned amongst asset managers. That review is currently under way. However early indications are that our members’ investment styles positioned them to continue to manage assets under their care largely unaVected and in contrast to firms that may have taken a more short-term approach to enhancing yield. This memorandum addresses what might be seen as a cause of the crisis and how that may lead in the lines of inquiry into the wider operations of the financial markets.
The Interest of IMA Firms in Clean,Stable Markets 17. The members of IMA are concerned with the management of assets for occupational pension schemes, local government pension schemes, other institutional funds, life funds, individual portfolios, and charities as well as assets in UCITS and other pooled investments, such as unit trusts and OEICs. Individual consumers are, therefore, the underlying beneficiaries of most of the assets managed by IMA members. Characteristically our members take a long term investment view and support measures that enhance the long-term stability and depth of financial markets. Put simply, one day’s gains are of little value if they come at the cost of returns over a five year outlook. Nevertheless, individual consumers can be disadvantaged by short-term market disruption eg if it is on that day that a person’s pension is valued for buying an annuity.
The Need to Preserve Confidence 18. Although Northern Rock is understandably the focus of this enquiry, due to the impact upon its depositors and because this has been the first very public test of the tripartite agreement, at its heart IMA considers that the recent crisis could be described as deriving from a loss of confidence in the wholesale market. Regulators and government are rightly spending time and money seeking to preserve and improve consumers’ confidence in the markets. But the first regulatory objective for the FSA in the Financial Services and Markets Act 2000 is the market confidence objective; and that is described as “maintaining confidence in the financial system”. The recent crisis exhibited failures in three critical areas for the wholesale markets: confidence, concentration and correlation. These are explored below. Although the impact may have been keenly felt on a wide public basis through retail reliance on, and exposure to, the banks, in fact the damage to the operation of financial markets, and therefore the wider economy, was already done. 19. As the description produced by the Bank of England in the MPC minutes of 5–6 September 2007 and comments by SEC’s Commissioner Nazareth both suggest, the current crisis is one that evolved from a revaluation of credit risk in one sector of the financial market into a wider liquidity crisis. 20. The importance of looking at the underlying causes is twofold; first, it may assist in determining whether regulatory, government and market responses to such events could be improved; and secondly, it may assist in determining whether such events could be better predicted and what role regulators, government and markets might play in providing such early warnings. 21. A question to ask is whether the liquidity crisis was expected or unexpected and whether or not there was a great deal that regulators at various levels within the financial system internationally could have done to plan for, or prevent, the developments that have taken place since July. If the precise form that the crisis took was not foreseen, still there are legitimate questions to be asked as to precisely how unexpected was some form of problem resulting from lending practices in parts of the US real estate market and the way in which these were packaged and sold as financial products. Whilst the Northern Rock crisis hit the UK in late August 2007, the US sub-prime problems had been publicly reported since early spring. In this respect, the risk of a credit crunch could be said to be a “known unknown” as opposed to an “unknown unknown”, which would imply a truly unexpected development within the US sub-prime market. 22. In a speech in April 2005, Alan Greenspan spoke of the widespread adoption of more advanced credit scoring models and stated [our emphasis applied] “where once more-marginal applicants would simply have been denied credit, lenders are now able to quite eYciently judge the risk posed by individual applicants and price that risk appropriately. These improvements have led to rapid growth in sub-prime mortgage lending; indeed, today sub-prime mortgages account for roughly 10% of the number of all mortgage outstanding, up from just 1 or 2% in the early nineties”. The argumentation was not wrong, but what may have been in doubt was the assertion that the credit scoring models did actually allow lenders to “quite eYciently judge the risk posed by applicants . . . and price that risk appropriately”. Whatever the position may have been in the US sub-prime market, belief in the general assertion that risk can be judged eYciently and priced appropriately underpins confidence across financial markets, regardless of product or strategy. 23. This need for confidence was even more necessary in the specific context of the recent US sub-prime market. As Federal Reserve Board Governor Frederic Mishkin has noted, a challenge arose from the distance between a loan originator in the United States and the ultimate holder of the debt (increasingly to Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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be found outside the United States).30 The most problematic part of the distance was not geographical, but generated by the way in which loans were securitised and re-packaged, which diminished the incentives on originators to protect the ultimate holders of the debt from potential risk. 24. Having introduced the connection between confidence and assessment and pricing of risk, we explore this under three headings: 24.1 the role of credit rating agencies (“CRAs”): “conflicts and confidence”; 24.2 the transparency and complexity of many financial products: “correlation, concentration and confidence”; and 24.3 the Blind Watchmaker model of market development.
The Role of CRAs:“Conflicts and Confidence” 25. Commissioner Nazareth in her speech on 19 October 200731 indicates one of the phases in the collapse: “Investors stopped buying CLOs [collateralised loan obligations] in July, however, because of fears that they—like the asset-backed securities tied to sub-prime—were not the safe bet that their investment grade ratings would imply”. 26. The roles and responsibilities of CRAs have been in discussion for many years. In February 2005, IMA submitted a response to CESR’s consultation paper on technical advice to the European Commission on possible measures concerning CRAs. Then, as now, the importance of CRAs grows as corporate debt and complex instruments displace equities in most portfolios. Recently CRAs have been relied upon to describe or circumscribe asset allocation in clients’ mandates or funds’ definitions. 27. IMA remains of the view that more competition in the ratings process will encourage a higher level of analytical input and thereby improve the quality of ratings overall. IMA members have a considerable interest in transparent and robust practices at CRAs. IMA does not advocate regulation in this area. Forms of registration and regulation raise barriers to entry when arguably the role of the regulator should be to encourage more competition. There are areas however which must remain under continuous consideration. 28. Firstly, with respect to conflicts of interest, as happens in UK-regulated firms, the IMA believes that CRAs should put in place policies and procedures to identify, manage and, where incapable of being managed out, disclose conflicts inherent in their individual business models. Group-wide links to the issuer’s client base and the provision of other services to those for whom they provide credit ratings are all necessary disclosures. 29. Secondly, IMA strongly supports eVorts to enhance the transparency of the credit rating process and the publication of CRAs’ methodologies. The temptation to which CRAs must be subject is to establish a credible rating so that a bond can be issued rather than to challenge aggressively the veracity of the information with which they have been provided. Some of that information is non-public and therefore is not available to an investor and is unverifiable. Classically, a fund manager being presented with such information would challenge it as part of his due diligence. Publication of methodologies reassures markets that CRAs are designing, applying and monitoring those methodologies with independence and consistency. All these factors again emphasise the importance of conflict management within the CRAs. 30. Accordingly, IMA believes regulators and the legislature should encourage market-led improvement in transparency, disclosure and conflict management at CRAs. 31. Having noted that conflict management at CRAs and the transparency of their methodology remain areas that must be kept under review, risks also arise from perceptions that CRAs do something more than they actually do. Whilst frequently important opinion providers, there will always be a range of opinions amongst practitioners in the wider market about any particular borrower or bond issue. CRAs would say that their ratings are restricted to the likelihood of there being a default. In this sense a “AAA” rating might be seen by some as a “safe bet” but likelihood of default is not the same as a measure of the recovery level that might be expected were there to be a default and the sensitivity of these recovery levels to external market conditions. In seeking to ensure that risk can be judged eYciently and priced appropriately, it may be that a lesson from the recent crisis is that a rating addresses only a part of what a market ought to know. CRAs have an interest in promoting their services; regulators, market participants and investors more widely need to be aware of the real limitations to this. 32. Though IMA does not advocate registration or regulation of CRAs, it is important that CESR, the US SEC and IOSCO remain alert given the role of CRAs in the market. However CRAs are merely one opinion in the market. The more weight, or reliance, is put on an opinion, the more diYcult it is for a credit analyst to adapt to changing circumstances, so slowing down opinion forming. Forms of registration and regulation may not only raise barriers to entry but regulation may have the unexpected eVect of slowing down opinion formation. Additionally, a moral hazard can arise where there is regulatory oversight of CRAs because investors may then be misled as to the role, quality and nature of a rating.
30 Governor Frederic S Mishkin, Speech to the Money Marketeers of New York University, New York, New York, 10 September 2007. 31 SEC Commissioner Annette L Nazareth: Remarks Before The Los Angeles County Bar Association 40th Annual Securities Regulation Seminar 19/10/07. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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33. But even without regulation in the EU, CRAs play an important role in determining how international regulators treat some assets for capital purposes. Regulators must remain alert to providing favourable capital treatment based overly upon the rating of an investment. For example, the standardised approach to credit risk under the Capital Requirements Directive is reliant upon the credit assessment of a recognised credit rating agency. A firm may benefit from a capital requirement of 20% for exposure to a high rated entity; whereas a similar exposure to a lesser rated entity would warrant a 150% capital charge. It is worth noting also that whilst the largest credit institutions will rely upon their own internal models for assessing credit risk, these models are not immune from reliance on ratings, for instance in respect of collateral. 34. Accordingly, IMA would encourage regulators and legislators to address afresh the risks involved in over-reliance upon ratings (being based upon default probability) for prudent risk-management and capital adequacy assessments, especially as regards resilience and sensitivity to a default.
The Transparency and Complexity of Many Financial Products:“Correlation,Concentration and Confidence” 35. Although only anecdotal, some IMA members have commented that once liquidity concerns arose, investors started to exit a wide range of investments and sought safe investments. The range of asset-backed securities (ABSs), collateralised loan obligations (CLOs) and equities included many that with hindsight ought not to have been significantly aVected by the market turmoil. This cannot merely be dismissed as characteristic of any moment of panic, but rather it reveals two other critical characteristics of the modern financial markets. First, the drive to maximise earnings leads to every available asset being put to work such that when liquidity dried up in one part of the market, the eVect was felt in uncorrelated assets. For instance, even equities had to be sold by some investors to raise cash to meet their obligations, including with respect to regulatory capital. Secondly, it revealed that the interposition of conduits and structured investment vehicles (SIVs) between ultimate investment and investor, driven as it commonly is by regulatory treatment of issuing banks’ balance sheets, may have exacerbated investors’ lack of confidence as it impeded their understanding of what exactly were the risks to which their money was exposed. 36. The complexity of modern derivative products is such that it is hard to look through to see the true economic drivers, from where gains and associated risks actually derive. Institutional investors commonly take great care that there is suYcient dispersal of risk, that is to say that diVerent risks are not correlated and that there is no over-concentration in any one risk. Simply, the market response over the summer revealed that participants felt they could no longer (if they ever could) ensure that risk could be judged eYciently and priced appropriately in many ABSs, CLOs and asset-backed commercial paper issued by SIVs. Re-investment was re-directed as the need for liquidity and capital security over-rode the search for short-term yield and ultimately that led to banks being unwilling to lend to one another except in the very- short term. 37. Whilst markets will re-evaluate and re-price these complex products, it may be instructive for regulators to learn what it was that investors in these products thought they were relying upon—credit ratings, their own due diligence, the brand name of the issuing bank or a mere promise of returns. 38. As an aside, it is in this context that IMA has recently called upon HM Treasury and the FSA to re- think their proposals for introducing a recognised covered bond regime into UK regulation. We fear that the FSA and HMT have not suYciently recognised the risk to quality that the current proposal could have on funds and we are concerned with the lack of prior engagement with investors. HMT identifies a risk of this regime as being to the depositors of the issuing bank. IMA agrees but considers there could be wider investor risk as well under the current proposals. 39. Returning to the wider concern as to the limitations upon assessing risk in complex derivative products, this does not merely depend upon transparency. There are growing concerns that current models focus overly upon normal distributions of risk and are not just weak, but fail, in what are often perceived as “abnormal” or “unexpected” markets. This is a very deep issue which goes to the heart of modelling techniques that have been in existence for years. It relates not only to the models themselves but also raises questions as to the use to which they are put by senior managers who are either not fully aware of the technicalities of the models on which they are dependent, or who are incentivised (by their own managers and ultimately by shareholders) to seek return enhancement ahead of risk reduction. 40. In her speech, Commissioner Nazareth went on to say [again our emphasis supplied]: “As these hedge funds sold their equity positions, it did more than drive down equity prices. Instead, in early August it changed market dynamics in a way that some fund managers thought was statistically impossible—the prices of the securities the quant funds owned tended to decline, and the prices of those they sold short tended to increase. Regardless of whatever statistical improbability may have existed, these events occurred, and the hedge funds performed very poorly as a result”. 41. The limitations of models in dealing eVectively with the unexpected should be a factor that is kept in the forefront of regulatory focus upon capital strength and resilience to shocks. Benoit Mandelbrot, creator of the eponymous mathematical set, and others have described their unease with any widespread Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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dependence upon the Gaussian distribution (or Bell curve).32 These are highly technical issues but a real example may illuminate what the debate is about. An approach based on the standard Gaussian distribution would expect the Dow Jones Industrial Average to have moved more than 3.4% during a single day only 58 times over 90 years. Instead, such a wide swing had been seen on 1,001 occasions. Put another way, the under-representation of unlikely events is a growing risk in evermore complex and interlinked financial markets. To repeat Commissioner Nazareth’s phrase “Regardless of whatever statistical improbability may have existed, these events occurred”. 42. Accordingly, IMA would encourage regulators and legislators to work with industry to consider the adequacy of valuation techniques for today’s highly complex derivative products, especially in what are seen as highly improbable circumstances.
The Blind Watchmaker Model of Market Development
43. The dominant paradigm of market regulation has been to secure transparent, clean and orderly markets. As such, regulatory intervention has been determinedly agnostic as to the market structure. Legislative intervention in the EU has focused upon fostering competition; as an introductory recital from MiFID states: “A coherent and risk-sensitive framework for regulating the main types of order-execution arrangement currently active in the European financial marketplace should be provided for. It is necessary to recognise the emergence of a new generation of organised trading systems alongside regulated markets which should be subjected to obligations designed to preserve the eYcient and orderly functioning of financial markets”. 44. The unspoken statement is that new organised trading systems will emerge. Competition for the business carried by the traditional exchanges, and other trading systems, is seen as good and markets are left to determine which trading systems will survive. This is undoubtedly the right approach in principle. But the operation of trading systems needs to meet standards laid down by regulators, whether operating as an EU regulated market, a multi-lateral trading facility, market maker or other liquidity provider. The liquidity crisis over the summer should cause market participants to consider how diVerent trading systems withstood the market impact and whether some models were more resilient to shock than others. The liquidity squeeze acted as a salutary reminder that the availability of liquidity, and the ability to value assets, go hand in glove. The overriding feature of the recent problems was the banks’ apparent loss of confidence in each others’ valuation models, possibly also their own, and the complete freeze in credit markets that this engendered. It is worth pointing out that there were customers in the market. However these customers had diYculty in accessing any form of market support, or indeed each other. This does not tend to indicate a robust market structure from the investor perspective, featuring as it does a block on the operation of the market imposed by the principal intermediaries. Whilst these intermediaries acted separately, in reality the freeze on the market revealed the very substantial concentration that exists within the credit markets and the eVective marginalisation of the outer circle of investors. 45. This may lead to a conclusion that some standards need re-emphasising so as ensure that markets can keep operating in times of crisis. Ultimately, however, if confidence evaporates in any market, then there is little any participant can be expected to do save to look after their own short-term interests. If that means no longer providing liquidity, then the market will stop functioning until participants once again can judge risk eYciently and price it appropriately. This does, nonetheless, indicate very significant weaknesses in the operation and structure of any market driven to such a resort. Indicators of this kind should weigh heavily with regulators when they consider the risk assessment presented by individual credit institutions in respect of their credit operations. 46. In conclusion, IMA would encourage regulators and legislators: 46.1 to encourage market-led improvement in transparency, disclosure and conflict management at CRAs; 46.2 to address afresh the risks involved in over-reliance upon ratings (being based upon default probability) for prudent risk-management and capital adequacy assessments, especially as regards resilience and sensitivity to a default; 46.3 to work with industry to consider the adequacy of valuation techniques for today’s highly complex derivative products, especially in what are seen as highly improbable circumstances. November 2007
32 The (Mis)behavior of Markets: A Fractal View of Risk, Ruin and Reward, by Benoit Mandelbrot and Richard L Hudson published by Profile Books. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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Memorandum from the British Bankers’ Association
Introduction 1. The British Bankers’ Association (BBA) is the leading UK banking and financial services trade association and acts on behalf of its members on domestic and international issues. Our 225 banking members are from 60 diVerent countries and collectively provide the full range of banking and financial services. They operate some 130 million accounts, contribute £50 billion to the economy and together make up the world’s largest international banking centre.
Executive Summary 2. The Treasury Select Committee inquiry into the circumstances of the Northern Rock aVair is well named: it is an inquiry into financial stability and transparency. Financial stability should be the paramount aim of everyone in the UK’s burgeoning financial services sector. Transparency should be pursued as far as possible without providing messages which might be misunderstood by an anxious public. 3. The BBA was active during the Northern Rock aVair in emphasising to the public that the UK banking system remained robust throughout. It also produced a paper on the so-called credit crunch and its implications (reproduced here as Annex I). It oVers the following observations to the Treasury Select Committee. 4. The high profile, international media coverage garnered by the queues at Northern Rock risks permanently damaging the UK’s reputation as a leading financial centre. The Government, working with the financial services industry, needs to develop a proactive strategy aimed at rebuilding the UK’s reputation across the globe. 5. On the tripartite regulatory structure (comprising HM Treasury, the Financial Services Authority and the Bank of England), we note that such a structure exists with varying degrees of formality in most countries: it is very unlikely that any banking problem would be handled by a single regulatory authority. However, there was insuYcient clarity in the allocation of roles, responsibilities and authority among the Tripartite authorities and no one entity had clear power to take the lead. What the UK needs is the retention of our current tripartite structure to minimise disruption, but with a thorough review in terms of regulatory oversight, focusing on providing clarity of issue ownership, co-ordination of leadership and responsibilities, intervention policies (including dealing with crises), and the balance sought between transparency and confidentiality. 6. On the framework of the money markets, the virtual disappearance of liquidity from mid-August tested the limits of the current arrangements and we wonder whether the Bank of England no longer met its core objective in terms of providing an eYcient, safe and flexible framework for banking system liquidity management. The Bank of England oVers a standing facility at a penalty rate of 1% above the base rate: a lower rate of between 0.25% and 0.5%, particularly during stressed or abnormal market conditions, should be considered. The range of collateral accepted by the Bank should be reviewed: a formal consultation should be initiated on expanding the list of eligible collateral. We are also concerned about the adverse publicity which now accompanies any application for borrowing from the Bank of England. This stigma should be removed by separating the Bank’s day to day lending from its crisis management role. The Bank of England should recognise the need at times to strike the right balance between transparency and confidentiality in order to maintain an orderly market. 7. On liquidity, the FSA is using the internationally-recognised tools to assess banks, although these evidently failed in the case of Northern Rock. An exercise should be undertaken to determine why this was so, and whether earlier intervention would have been possible. However, this needs to be done in the context of the various other international reviews that have already been launched (Basel, IMF etc). 8. On depositor protection, HM Treasury’s current review should be part of a wider review into regulatory supervision and crisis management and not just focus on a narrow remit of the deposit protection aspects of the Financial Services Compensation Scheme. Deposit guarantees are only necessary when the regulatory system fails a financial institution and its customers: therefore the emphasis of any review should be on the earlier stages of the regulatory process. 9. We also recommend that accounting conventions be reviewed to ensure structured investment vehicles and disclosures about them are properly reflected in the figures.
Northern Rock 10. The reasons for the diYculties faced by Northern Rock and the events that led up to the run on the bank are now becoming increasingly well documented. Northern Rock concentrated almost exclusively on mortgages, it had little diversified product range, a comparatively small deposit base, a very high exposure to the wholesale markets when considering both the liquidity and the securitisation requirements, it had Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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sought to grow business strongly over a short period of time and was particularly dependent upon short term borrowing. It was therefore vulnerable in a number of diVerent ways to changes to market conditions but appropriate scenario planning was evidently not undertaken. 11. During the course of 2007, the market had become increasingly aware that there were issues surrounding Northern Rock’s business model. We are aware that the FSA reviewed Northern Rock’s stress testing processes in May 2007. Furthermore, in its profit warning of 27 June 2007, Northern Rock stated it was suVering from a “structural mismatch between LIBOR and bank base rates” and its share price fell by 10% on that day. This was therefore a very clear signal both to the market and to the authorities that Northern Rock was experiencing increasing diYculties in respect of its funding as the “credit crunch” speedily impacted inter bank lending arrangements generally. 12. By mid-July the share price was some 30% lower than at the start of the year. Sterling LIBOR was clearly demonstrating the absence of liquidity in the market, particularly through the overnight and three month rates, and discussions were being held between the industry and the Bank of England both to reduce/ remove its “penalty rate” and to broaden the range of acceptable collateral. These proposed changes to the money market regime were requested in order to restore reasonable liquidity but were not accepted by the Bank. As the BBA owns LIBOR, the problems associated with the money market were evident to us as was the position in the US and in the eurozone via the $ and ƒ fixings. Again, this information was widely known and publicly available. Indeed throughout June, July and August we received a historically high number of enquiries relating to LIBOR.
The Tripartite Agreement 13. The functioning of the tripartite system, including the Memorandum of Understanding and the actions undertaken by the Tripartite authorities during the crisis, both in relation to the overall market and the situation regarding Northern Rock, requires explanation. 14. Tripartite agreements, whether formalised as in the case of the UK or not, operate in most countries. It is very unlikely that a banking problem would only be handled by one authority, for example the regulator, without reference to and consultation with the other two authorities, namely the central bank and the government. 15. From the perspective of the BBA and irrespective of the precise nature of the tripartite agreement, the external impression received was that there was: — a lack of true appreciation of the exposure to wholesale markets of the Northern Rock by the members of the Tripartite; — a lack of appreciation of the interconnection between liquidity and solvency; — an adoption of a “wait and see” attitude when, based on the same fact pattern, the market assumption was that the tripartite was taking action; — no one entity clearly in the lead; — insuYcient clarity in the allocation of roles, responsibilities and authority of the parties to the Tripartite authorities; — a lack of awareness of the likely reaction of the consumer to a perceived problem with Northern Rock; — no attention given to the complex and obscure message in the Lender of Last Resort Statement; and — a lack of preparedness by the authorities to explain and communicate their Lender of Last Resort statement either at the point at which the leak took place or once the formal announcement had been made the following morning. 16. Although, there have been a number of proposals for moving bank regulation to one or other of the tripartite authorities, the services that banks oVer are multi-faceted and complex. Any decision to, for example, move banking regulation in its entirety back to the Bank of England would therefore result in significant co-ordination issues with the FSA for the purposes of, at the very least, securities regulation and conduct of business rules. Alternatively, reducing even further the role of the Bank of England would be disadvantageous to the reputation of the UK overseas. 17. As a result, we believe that the least disruptive option is to retain the current arrangements but fully review them, particularly in terms of supervisory oversight, and paying close attention to what changes need to be made, especially in the areas of: — clarity of leadership; — clarity of responsibilities and ownership of issues; — clarity of remit; — senior representative participation in the Standing Committee; — co-ordinating the regulatory requirements and ensuring no gap or overlap; Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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— intervention policies (including responding to particular crises); and — confidentiality policies.
Money Market Framework 18. The new system, introduced this year, has generally worked well and, through the maintenance of remunerated reserve accounts, has expanded the range of counterparties with which the Bank of England deals. The system has been mostly successful, until the onset on money market turbulence, in narrowing the borrowing spread on overnight money, and thereby reducing volatility. 19. More recently, during the credit crunch, Sterling money market rates, as measured by the BBA’s sterling LIBOR benchmark, have been driven upwards. There has been a noticeable diVerential with euro and US dollar rates as also quoted on BBA LIBOR. While some of these problems can be put at the door of institutions safeguarding their liquidity and being reluctant to lend to their usual counterparties at any price, we believe that there may be technical and other impediments to ensuring that the Sterling market operates in a less stressed manner during periods of turbulence. We question whether the Bank of England contributed towards this nervousness, through failing to follow its objectives for Sterling Money Market Operations, and particularly its core objective in terms of providing an eYcient, safe and flexible framework for banking system liquidity management. 20. We therefore call on the Bank of England to re-examine the key features of the present system, in three particular respects:
The Interest Rate Corridor 21. First, we believe the Bank of England should review whether the standing facility (and the deposit) rate is set at an appropriate level. In the consultation phase for the Sterling Money Market Reform, the BBA argued that a much narrower corridor, 25 or 50 basis points around base rate, should have been established and we believe this should be revisited. In particular, it is suggested that the Bank should review whether it should maintain a degree of flexibility around the corridor during stressed or abnormal market conditions. It could consider either: — waiving the “penalty” rate above the Bank rate altogether (as the ECB did during its August and September market operations); or — reducing the margin over the Bank rate significantly (as the Federal Reserve did on 17 August in relation to its Primary Credit Rate by 50 basis points). 22. We suggest that market institutions could be usefully consulted over which mechanism they would prefer. Clearly reaching an understanding in general with the market about what range of funding could be available, but without tying the authorities’ hands, is important. A particularly important public policy aspect is to avert stigmatisation for institutions being obliged to seek funds at a “penalty” rate.
Diversifying Collateral 23. We propose that the Bank of England should review its philosophy on collateral, and launch a consultation on extending the list of eligible collateral which can be placed with it. We believe that a range of additional instruments such as sterling certificates of deposit (CDs) and commercial paper (CP) should be accepted in the weekly and monthly money market operations, and that the Bank should also review the range of collateral, including non-Sterling, it is prepared to accept during stressed conditions, both as to the type of instrument (eg mortgage backed securities), and to maturity. We considered that, had the Bank acted in this vein at the beginning of August, then many of the problems aVecting the money markets in general and Northern Rock in particular might have been mitigated. While we welcomed the Bank’s statement on 19 September that it was prepared to oVer three month funds against a further range of collateral during a series of £10 billion auctions, the question of whether the standing facility rate is applied to these facilities needs to be revisited. We believe there is appetite in the market for three month money and that the extension of these correctly priced arrangements should be made permanent. 24. Ensuring greater consistency between the range of collateral that can be deposited with the central banks in the major financial centres (the Bank of England, the Bank of Japan, the ECB, and the US Federal Reserve) is also desirable from this perspective. Greater collateral inter-changeability could well assist in the maintenance of liquidity pools and in smoothing the financial transmission mechanism.
Transparency and Disclosure 25. We understand well the reasons why the central bank is reluctant to reveal publicly which institutions it engages with in relation to weekly and monthly money market operations, and more specifically when an institution has been obliged to obtain funds under the standing facility. We remain concerned at the adverse publicity given to one bank which was obliged to seek standing facility funding because of a system technical glitch in August, and the statement on 14 September that Northern Rock was obtaining “emergency” Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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funding, also under the standing facility was wholly detrimental. A situation has now resulted whereby the stigma attached to this facility renders it unusable. Ceasing to use the terms ‘emergency funding’ and ‘lender of last resort’ would help to avoid panic in these situations, as would separating the Bank’s day to day lending from genuine crisis management activity. 26. Whilst it is well recognised that transparency in this area as in others has brought a greater clarity to the operation of the market, nevertheless there are times when confidentiality is essential in order to bring about a result which otherwise would either be diYcult or impossible to achieve. Furthermore, there is evidently a requirement for a broader range of money market operation options, a clear articulation that the use of “non standard” options equates to stressed market conditions and not institutional problems and that, whilst there may well be a justification for the application of a penalty rate under certain circumstances, this is not necessarily appropriate and particularly in extreme market conditions. 27. Lastly, the regional and global nature of the banking industry means that where central authorities operate diVerent policies in respect of their money market, banks operating in more than one jurisdiction will access that market which is providing them with liquidity at the best price. For smaller banks operating in one jurisdiction only, in this case the UK, that option was not available to them. The diVerence in the operation of the money market by the Bank of England compared with that of the ECB is widely known, and particularly amongst policy makers and the industry. This diVerence has added to the sense of disquiet internationally over the authorities’ handling of the Northern Rock problem. 28. We would therefore urge the Bank of England and the Tripartite Authorities to undertake a full review which clarifies: — the nature of any underlying disclosure requirements applying to either the Bank or the aVected institution. — the areas for which confidentiality is necessary. — the terms (maturity, coupon), instruments and rates of the money market facility; and — the timing of any announcement that is required.
Enhancing London’s Competitiveness 29. The high profile, international media coverage garnered by the queues at Northern Rock risks permanently damaging the UK’s reputation as a leading financial centre. The Government, working with the financial services industry, needs to develop a proactive strategy aimed at rebuilding the UK’s reputation across the globe. 30. There is a further point in that London as an international financial centre may lose out. Most smaller-sized overseas institutions that tap the Sterling markets have found conditions in recent years hard going, notably with the decline in FX spreads, relative illiquidity of the Sterling money market in periods above one or two weeks, the squeeze on Gilts and the narrow range of Sterling collateral accepted in money market operations. Their treasuries have found it genuinely diYcult to make a decent turn on capital and they are beginning to question whether it is worth maintaining a presence in the London market to source Sterling borrowing. This particular sentiment has been exacerbated by the credit crunch, with Sterling market rates rising and funding diYcult. Institutions have compared the London market unfavourably with, for instance, the availability of funding from the ECB’s expanded money market operations, which they believe UK-based institutions have heavily taken advantage of. 31. So allied to the point on about more consistency about the range of collateral that key financial market central banks are prepared to accept, we believe that this will also assist in maintaining London’s attractiveness as a funding centre.
Liquidity
Basel II—The Right Regulatory Tool 32. Basel II which has been introduced in Europe via the Capital Requirements Directive in 2007 is more risk sensitive than the predecessor Basel 1 capital requirements regime. As such, it is welcomed by banks because it more accurately matches regulatory capital needs to the risks they face. It is likely that Northern Rock has benefited from its introduction as under Pillar 1 of Basel II banks are generally required to hold less capital against less risky assets, such as mortgages, which comprised the great majority of its business. At no time did Northern Rock’s available capital fall below its regulatory capital requirement. The problems it faced were caused by lack of access to liquidity. 33. Since the beginning of 2005 banks have been required to undertake stress testing and scenario analysis, to have in place contingency funding plans and to document them adequately. Under Pillar 2 of Basel II, banks are required to assess regularly and regulators to review their liquidity funding plan in a stressed situation. The FSA had reviewed Northern Rock’s stress testing processes in May 2007 and has already accepted that there are lessons to be learnt about the level of its supervisory engagement with stress Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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testing. So although they are still novel and the execution of the new Pillar 2 stress testing processes failed in the case of Northern Rock, regulators do have the right policy tools to quiz banks about their stressed liquidity plans.
Policy for Early Intervention 34. With the knowledge in the market, analyst reports, the FSA’s own work in May and the profit warning of 27 June, it is essential that an exercise is undertaken to determine what alternative actions the FSA could have taken (including in conjunction, where necessary with the other members of the Tripartite) to determine whether a more orderly outcome to the Northern Rock problem could have been achieved if “intervention” rather than “wait and see” policies had been followed. 35. No substantive decisions should be made without such work both being undertaken and made publicly available. There is a growing market belief that timely, decisive action by the FSA in conjunction with easing the money market conditions could have resulted in a more appropriate outcome than that which was achieved.
Liquidity Regulation—The Wider Context 36. There is no global standard for liquidity regulation other than under Pillar 2 of Basel II, meaning that banks face diVerent liquidity requirements for their local operations in diVerent countries. In the UK two parallel quantitative liquidity regimes exist: the Sterling stock regime for 17 larger UK banks and building societies; and the mismatch regime for all others. These regimes were introduced in 1996 and banks and regulators alike recognise that they are due an overhaul. 37. In other countries there is a mix of quantitative and qualitative requirements. In the EU, the Netherlands, Germany and Ireland have recently reformed their liquidity regulation, which is the only remaining area of banking supervision that is host rather than home state regulated. We believe that such a parochial approach can lead to trapped pockets of liquidity and collateral which can compound, rather than mitigate, liquidity risk problems within specific banks that are active across international borders or at times of systemic stress. 38. Work is currently being undertaken by the Basel Committee for Banking Supervision (BCBS) to review the liquidity regimes used by diVerent countries and to examine how they performed in the recent credit crunch, with the objective of considering whether its February 2000 Sound Practices for Managing Liquidity in Banking Organisations should be revised. 39. Banks believe that regulation of liquidity in cross-border banking groups is best managed according to a set of principles proportionally applied by the home state regulator, recognising that in the complex world of liquidity management there is no one-size-fits-all answer. Any reform to the regulatory liquidity requirements in the UK should wait until the BCBS review is complete to ensure that it is aligned with any consequent international developments. Liquidity management has global ramifications—a UK centric solution may be counter productive. 40. Recommendations: — Banks and regulators should focus more on liquidity stress testing in the Pillar 2 review process— which is the appropriate regulatory tool to mitigate the risk of a Northern Rock type event recurring. — Any reforms of the UK liquidity regime should wait for the conclusions of the current BCBS review and recognise that liquidity is managed on a global basis by large internationally active banks.
Depositor Protection 41. In respect of the current position regarding the Government’s guarantee to the Northern Rock’s depositors, the BBA believes that this is not tenable for anything other than a short-term emergency period. We note that concerns over this guarantee and the associated funding, even though collateral is received in return, are increasing particularly in the EU. We look forward to an early resolution of this problem. Evidently had actions been taken earlier in respect of both the money market and the regulatory intervention, then this Government guarantee may well not have been required. 42. The BBA has commissioned the consultants Oliver Wyman to assist with its consideration of options for the Deposit Protection Scheme, including no change other than that which has already been announced. As of responding to this request for evidence, that work is not yet complete. When it is, we will share it with the Committee. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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43. However, deposit protection cannot be considered in isolation from the regulatory framework and the supervision of the financial entity. It is not known whether, for example, if a high calibre FSA team had intervened earlier by at least challenging Northern Rock, questioning its Board and ensuring that better stress testing and lines of credit were in place, the issues would have been capable of resolution, in conjunction with a sensible money market framework, in a more orderly manner. 44. The authorities as a matter of priority must therefore undertake an exercise to determine an answer to this question, to then identify what aspects of the regulatory framework may need to be changed and what do not. 45. In addition, changes to the deposit scheme, especially the level of cover, need to be considered alongside the other tools of crisis management as well as the insolvency regime for banks. 46. We note that in every country for which we have information it is considered that either some banks are too big to fail or that no bank should be allowed to fail at all, for example in Germany where recent intervention prevented the failure of Land Sachsen Bank and IBK. Furthermore, it is self evident that in this current environment it is diYcult to envisage the authorities allowing the failure of a retail deposit taker. 47. We need to be clear about what compensation can and cannot do. The Financial Services Compensation Scheme cannot create a zero failure regime and will not be able to cope with the failure of a systemically significant bank. Such a bank would need to be rescued to eVectively protect depositors and limit systemic risk. The authorities need to be clear about which institutions they would look to rescue and how this would be achieved. 48. We note that the preferred option of the Bank of England is to change insolvency legislation to provide a special regime for UK deposit takers that allows early intervention to take place, deposits to be frozen and then released quickly under the administration of another entity. Such an option is currently reflected within part of the US process where a separate organisation, the Federal Deposit Insurance Corporation (FDIC), has responsibility for intervening within a deposit taking institution and taking the necessary action. To the best of our knowledge such regimes do not exist in major eurozone countries. 49. It is essential to properly investigate both the operation of this model and other options before making the next step decisions on the future of the UK deposit protection scheme. The exploration of special administration arrangements for UK banks would need to consider the interaction of company, insolvency and tax laws together with corporate governance and deposit protection arrangements. Equally, the arrangements would need to reflect cross-border scenarios given the locus of the large international banks. 50. The BBA would like to highlight the following key points: — To date we have not yet found a country which has an investor protection scheme that is as comprehensive as the Financial Services Compensation Scheme in the UK. Whilst there are many examples of deposit protection, typically there is either no protection for other investments, or it is of a very limited nature. It is therefore important that in any changes that may be considered as a result of Northern Rock problems, not only is the broad coverage fully recognised but also that the banking community contributes substantially to many other parts of the scheme as well as the protection of deposits. — The UK deposit protection scheme sits within the umbrella of the Financial Services Compensation Scheme (FSCS) and, following the recent changes made by the Treasury and FSA, protects 100% of deposits to a maximum of £35,000 per individual per bank net of any “set oV” of loan or other borrowing with the bank. Although the statistical work is not yet complete, figures given to the BBA indicate that £35,000 covers in excess of 95% of all individuals deposits with the major UK banks, before any “set oV” of borrowings has taken place. When the statistical work is complete the BBA will provide the information to the Committee. — In providing deposit protection up to £35,000, the UK is covering approximately twice that of the EU directive requirement and is one of the more generous schemes in Europe. In its financial stability report of October 2007, the Bank of England (Page 66, Table 4b) highlighted the coverage limits per depositor of the G10 countries. From that table it can be seen that the UK is by no means low in adopting the current limit. Furthermore, although the UK no longer has the 90:10 co- insurance model, nevertheless some other countries have still retained this. — The UK scheme also measures up favourably internationally. — Northern Rock has not failed. However the current deposit protection scheme has paid out on a number of occasions to failed credit unions—the latest of which is StreetCred Credit Union with an estimated 3,000 members. Banks pay for these credit union failures. Although some schemes are pre-funded, these are both typically small amounts (eg, Norway ƒ6,000 for a maximum of 50,000 customers) and have been built up over a long period of time. The US, for example, covers up to $100,000 (approximately £50,000); the fund has been built up over 50 years and is an integral part of the insolvency regime for banks. — In most jurisdictions, deposit protection is for retail customers defined as individuals. However in the UK the FSA has and continues to define retail as including small businesses up to a turnover of £5.6 million. This has the eVect of making protection more expensive and more widespread in the UK than comparable requirements elsewhere. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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— The UK scheme is a post-funded scheme, not a pre-funded one. However, all regulated firms who are members of the FSCS are required to make a payment into the scheme from an annual assessment made by the Executive of the FSCS and at any other time should the scheme or part of the scheme require. This assessment is based on its known and/or estimated requirements. For deposit protection, this is currently up to a maximum of 0.3% of protected deposits on a cumulative basis in perpetuity, which is expected to be replaced by an annual limit of £1.8 billion for all deposit takers from April 2008. — In our view, the current post-funding model is proportionate and should remain and that any reform must be aVordable for the industry. — Work in America has shown that the presence of the $100,000 limit has resulted in changing consumer behaviour in that individuals will keep deposits with more than one bank in order to keep below the insurance level. This has in turn had the eVect of maintaining independent financial institutions which under other circumstances would have consolidated.
Overall Functioning of Financial Markets
Valuation and Accounting
51. The banking industry agrees that fair value measurement provides an appropriate accounting base for financial instruments held for trading purposes or otherwise managed on a fair value basis. However, valuations in financial statements are merely snapshots at the reporting date and the key issue is not the accounting model used but uncertainty over asset values. Prices can change rapidly as investors reassess their views based on new information; past valuations were not necessarily incorrect but reflected market conditions at that time. 52. It must also be emphasised that consideration of additional disclosures must take into account the disclosures required by IFRS 7 and Basel II Pillar 3 that will be provided to the market by banks in the near future. 53. In our view, relevant questions include whether: — the requirements of IAS 39, IAS 27 and SIC-12 in respect of the accounting treatment of structured investment vehicles and disclosures about them are proper and adequate; — the guidance on fair value measurement given in IAS 39 results in appropriate valuations in markets experiencing temporary liquidity diYculties; — the enhanced disclosures introduced by IFRS 7 (Financial Instruments: Disclosures) will ensure the provision of appropriate information on liquidity risk or whether the standard should be revised or supplemented by industry practice; and — the fair value rules recently proposed by the IASB mirroring those in US SFAS 157 (Fair Value Measurement) would help or hinder and whether the fair value hierarchy provides an appropriate approach. November 2007
Annex A
BBA PAPER: THE CREDIT CRUNCH, THE NORTHERN ROCK: OME IMPLICATIONS AND CHANGES REQUIRED 1. As the credit crunch continues to wash through, the most obvious casualty to date in the UK is the Northern Rock. This paper analyses a number of the issues that surround that case and looks at reviews required and solutions, both on a global and local basis. 2. The BBA believes that however uncomfortable it may be, it is necessary to deal with the issues as they are and answer the question that is being asked by the international community about the handling of the Northern Rock—“did it really have to be done like this?” 3. It is well recognised that a number of factors combined together to bring about both the liquidity problem that the Rock experienced and also the subsequent customer panic. The BBA believes that the most appropriate way forward is for a clear examination of the points raised in this paper, an open and considered review and sensible changes made where it is appropriate to do so. 4. The BBA has been examining the implications for the banking industry, from a regulatory and structural point of view, and proposes that the following steps are taken. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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5. At the Global Level 6. Reviewing institutions’ liquidity, market and credit risk practices: This would particularly cover their risk management and treatment of complex credit products and their exposure to oV-balance sheet vehicles such as conduits and SIVs. We believe that this should be closely aligned to the Pillar 2 framework under Basel II, and particularly the Internal Capital Adequacy Assessment Process (ICAAP) and the Supervisory Review and Evaluation Process (SREP) which are in the process of being introduced and which already provide a basis on which to develop this assessment. Although the ICAAP is an institution’s specific tool, in order to broaden its usefulness to regulators and the system as a whole, it will require significant investment in terms of both training and experience for regulators to make it truly eVective. This is particularly true in relation to the ICAAP for liquidity, and we also make a specific suggestion below in relation to the supervision of institutions’ liquidity. 7. Reviewing accounting and valuation practices for financial derivative instruments, particularly complex, narrowly traded products which become diYcult to price in times of stress. There needs to be a review of how these instruments are valued, what market benchmarks can be used, and how value impairment is accounted for. A further feature is that conventional stress testing techniques, for instance “normal” confidence intervals, may not capture the full amount of exposure in abnormal markets, and institutions and regulators should examine what further re-assurance—particularly in relation to risk management practices and value impairment accounting—is needed in this respect. 8. Reviewing basic oversight principles for regulated financial entities: this would especially cover oV- balance sheet items, including contingent claims. We suggest here that this issue should again be closely linked to the existing Basel II framework. A particular concern is whether regulators have concentrated, in recent years, on capital adequacy at the expense of liquidity risk management. Institutions manage liquidity on a centralised and global basis, but often regulatory requirements are determined at a local or national level. We therefore call on trans-national regulatory agencies such as the Basel Committee and the Committee of European Banking Supervisors (CEBS) to complete work on ensuring that institutions can take advantage of their existing centralised liquidity management practices, including modelling techniques. It is particularly important that any developing framework should be well thought out, should not be fragmented into local approaches, and does not penalise institutions through additional regulatory requirements. We particularly commend in this context the liquidity risk management principles developed by the International Institute of Finance (IIF). 9. Reviewing the role of Credit Rating Agencies (CRAs) in the valuation of structured credit products: CRAs play an important role in the global financial system, with ratings providing a proxy for the assessment of risk in the underlying counterparty. In general terms, this system works well—for instance in a Pillar 1 of Basel II capacity, or acting as a haircut for the acceptance of collateral in a central bank’s monetary operations. That said, we welcome the Financial Stability Forum’s examination of this issue, and support the work of IOSCO and others in bringing greater transparency and disclosure to the main features of these products. This can only assist institutions and investors in their assessment of the risk characteristics of such products. 10. It should be borne in mind that CRAs issue opinions based on the probability of default and delinquency. They should be judged on this basis rather than on price or liquidity of such instruments. An in depth study of ratings transitions over time and through this crunch period should be carried out before any additional measure or regulation is considered. By definition ratings that are lower down the scale are both more likely to be delinquent or to default but also by their nature are more unpredictable and therefore likely to be upgraded or downgraded. 11. The BBA has been involved in the consultation process carried out by IOSCO, the Committee of European Securities Regulators (CESR), and the European Commission. We would expect that in the current review of CRAs being carried out by CESR they will not focus heavily on the initial rating of a structured finance instrument but rather investigate the issues around the surveillance and monitoring that go into maintaining that rating. We believe that questions could be asked about: — the seniority of staV which “maintain” a rating; — the extent to which CRAs receive all the information they should from trustees on a transaction and who rely on a much more qualitative, as opposed to quantitative, review of that information; — similarly issues of staV turnover, and the numbers of deals that staV are required to review on an ongoing basis in what has been a rapidly expanding market; and — finally, we would put forward that CESR/IOSCO should consider the drivers within rating agencies given the revenue attributable to new ratings as opposed to the surveillance and monitoring of old ratings. 12. Re-examining whether EU and the global crisis assessment and management arrangements are adequate: Recent events have been diVerent in that problems in the US sub-prime market and resulting liquidity constraints have been transmitted globally. It will be important to understand the transmission mechanisms by which this contagion is spread and why some markets appear to have been aVected in a more serious manner than others. We welcome the conclusions of the September Informal ECOFIN Council that the financial authorities in the EU will be reviewing their Memorandum of Understanding to encompass the Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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assessment of financial stability. In relation to EU supervisory arrangements, in general, we believe these are fit for purpose and should be developed along the lines of the Lamfalussy four level system. (See BBA paper “Giving Europe a Regulatory Advantage”). 13. During this period of turbulence the financial system infrastructure, notably the payment and settlement system, has been resilient, proving more than capable of dealing with the increased volatility and the markedly higher transaction volumes, whether traded, cleared or settled. We believe that there are no particular recommendations to make in this sphere, save to continue the work that is being undertaken to develop an eYcient and risk neutral system for settling non-exchange traded funds and investment products.
In the United Kingdom 14. We expect the UK authorities, with their global counterparts, to fully play their part in examining and, where necessary, re-shaping regulatory and other requirements, and that their eVect on the UK system of regulation is mitigated. That said, there do appear to be specific lessons for the UK which, in the light of the problems aVecting Northern Rock during the course of 2007, need to be addressed: 15. Re-examining the regulatory framework for institutions’ liquidity risk management: as noted above, we recommend that the FSA play its part in the shaping of centralised and global liquidity risk management requirements for institutions. As part of this process the FSA will need to ensure that the best features of the existing Sterling Liquidity Stock requirement are retained. 16. Re-visiting some features of the Sterling Money Market framework: The new system, introduced this year, has generally worked well and, through the maintenance of remunerated reserve accounts, has expanded the range of counterparties with which the Bank of England deals. The system has been generally successful, until the onset on money market turbulence, in narrowing the borrowing spread on overnight money and thereby reducing volatility. 17. More recently, during the credit crunch, Sterling money market rates, as measured by BBA Libor have been driven upwards. There has been a noticeable diVerential with euro and US Dollar rates as also quoted on BBA Libor. While some of these problems can be put at the door of institutions safeguarding their liquidity and being reluctant to lend to their usual counterparties at any price, we believe that there may be technical impediments to ensuring that the Sterling market operates in a less stressed manner during periods of turbulence. 18. We therefore call on the Bank of England to re-examine the key features of the present system, in three particular respects. First, we believe the Bank should review whether the standing facility (and the deposit) rate is set at an appropriate level. In the consultation phase for the Sterling Money Market Reform, the BBA argued that a much narrower corridor, 25 or 50 basis points around base rate, should have been established and we believe this should be revisited. Second, we suggest that the Bank should review its philosophy on collateral, in launching a consultation on extending the list of eligible collateral which can be placed with it. 19. We believe that a range of additional instruments such as sterling certificates of deposit (CDs) and commercial paper (CP) should be accepted in the weekly and monthly money market operations, and that the Bank should also review the range of collateral, including non-Sterling, it is prepared to accept during stressed conditions, both as to type of instrument (eg mortgage backed securities). We in particular welcome the Bank’s statement on 19 September that it was prepared to accept another range of collateral during stressed conditions. We in particular welcome the Bank’s statement on 19 September that it was prepared to accept up to £10 billion of wider collateral against three-month funds. These arrangements should be made permanent. We consider that, had the Bank acted in this vein at the beginning of September, then many of the problems aVecting the money markets in general and Northern Rock in particular might have been mitigated. 20. We also refer to our comments about institutions managing liquidity on a centralised and global basis. Ensuring greater consistency between the range of collateral that can be deposited with the three major central banks (the Bank of England, the ECB, and the US Federal Reserve) is also desirable from this perspective. Greater collateral inter-changeability could well assist in the maintenance of liquidity pools and in smoothing the financial transmission mechanism. 21. We need to clarify the nature of any disclosure requirements applying to either the Bank or the aVected issuer, bearing in mind that in this case disclosure had a clear and significant adverse eVect on consumer confidence at a time when all of the regulators were insisting that Northern Rock was solvent and depositors’ money safe. 22. Evaluating the implications of the credit crunch on the move to principles-based regulation: The BBA supports this initiative from the FSA, notably through our MiFID Connect project. There is no reason why this move from rigid hard-coded rules and regulations and detailed guidance in the FSA Handbook should be discontinued. But there may well be areas that, in the light of recent events, do require firm, explicit and continued regulatory advice. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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23. Safeguarding the interests of depositors and the financial system: there are three aspects to our recommendations, which are broadly intertwined: — Reviewing deposit protection arrangements: we share HMT and FSA’s view that this needs to be reviewed. Considerable numbers of depositors and savers in Northern Rock clearly did not trust the authorities’ reassurances about the solvency of Northern Rock and hence the safety of their savings. A further feature peculiar to the Northern Rock is that many individuals had considerable sums deposited in the Northern Rock: a factor in deciding to withdraw their funds was the relatively low amount of maximum compensation. We suggest therefore that these aspects be examined and consideration given to whether a simpler and faster system can be introduced. We are aware that the FSA is reviewing the funding arrangements for the Financial Services Compensation Scheme (FSCS). We regard post-event funding as proportionate and believe that the scheme should continue on this basis. We note also that, at the EU level, the results of a recent EU consultation were that member states generally believed that the pan-EU arrangements worked well. — When initial assurances about the solvency of the Northern Rock and the significance of the Bank of England backing proved not to be resilient, the Government issued a statement guaranteeing all of Northern Rock’s deposits. While successful in reducing the level of panic among depositors, this has also led to further confusion about what was being guaranteed (which deposits, and for how long, and whether the rest of the financial system was covered). The eVect of such a move is also unclear, for instance whether this eVectively “nationalised” Northern Rock. Again, we suggest that greater clarity about these issues is needed. — Clarifying the Operation of Bank of England facilities to the banks. We believe that some confusion existed in the public’s mind about the use of these. What Northern Rock appeared to access were the Bank of England’s Standing Facilities, at a so-called 1% “penalty” rate above the Bank Rate. Had the authorities been clearer about what giving access to this facility to the Northern Rock was meant to achieve, this confusion might have been avoided. — We consider that clarifying the operation of normal money market operations, the standing facility, and the lender of last resort role is required. We recommend that the authorities examine whether the current arrangements are fit for purpose. They should begin by clarifying publicly, in a paper or a speech, what range of assistance is available to institutions and how this diVers from day-to-day monetary operations. A particular aspect is the need for clear and precise terminology, and an explanation of the various lending rates and maturities. In addition, the authorities should review how assistance is made and how this is communicated to the market, if at all (see also below). — A further aspect is confidentiality. According to the Governor, the Bank was obliged to disclose its support operation because of obligations in relation to the Market Abuse Directive (“MAD”) and other EU legislation. The European Commission has refuted the Bank’s legal interpretation in relation to the MAD, so this aspect clearly needs to be reviewed. In the past, the Bank’s support operations for the banking sector, notably during the “Lifeboat” operation in the 1970s, have been kept confidential and we suggest that this should be possible again. Such confusion over whether or not to disclose support operations would not have occurred in other EU Member States. — Reviewing the Tripartite Memorandum of Understanding Arrangements: From a technical point of view, we would wish to understand how these—and particularly the Standing Committee’s role— have worked, and notably the decision in arriving at the funding support for the Northern Rock and the timing for that decision. — It is, however, without doubt that the authorities could have better managed the communications aspects of oVering re-assurance to the markets. We notably mention the Bank of England and FSA’s refusal to comment until some days later. We suspect that the authorities were caught by the speed of events and believe that greater eVorts should have been made at the time of the leak and immediately after to make key personnel—in addition to the Chancellor—available to explain to the media and the public why the facility from the Bank of England was necessary, and its implications.
Memorandum from the Building Societies Association
Introduction The Building Societies Association (BSA) represents all 59 building societies in the United Kingdom. Building societies have total assets of just under £325 billion and, with their subsidiaries hold residential mortgages of around £250 billion, approximately 20% of the total outstanding in the UK. Societies hold just under £210 billion of retail deposits, accounting for about 20% of all such deposits in the UK. Building societies also account for over 37% of all cash ISA balances. Building societies employ over 50,000 full and part-time staV and operate through more than 2,100 branches. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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The BSA welcomes the opportunity to contribute written evidence to the Treasury Committee’s inquiry. The events to which the inquiry relates are, of course, still unfolding and it would be premature of us to seek to draw firm conclusions. Accordingly, the evidence we oVer in this submission is, of necessity, very much of a preliminary nature.
Northern Rock
The reasons for the diYculties faced by Northern Rock, and the events that led up to the run on the bank
1. The market conditions that led to the run on the Northern Rock bank have been well documented and have their roots in the United States market for sub-prime mortgages. Many US sub-prime mortgages were securitised and it is clear now that the price of such securities did not fully reflect the risk of default on the underlying assets. During July 2007 rising default rates in the US sub-prime market caused the markets to reassess the risk of holding asset-based securities. By early August the market in asset backed securities eVectively ground to a halt. This was due to uncertainty among investors about the exposure of the issuers of such securities to losses in the US sub-prime market. Such uncertainty was compounded by the inherent structure of securitisations, which meant that the holders of the asset-backed securities were not party to the information about loan quality and default rates to which the institutions which originated the loans had access. 2. Liquidity was squeezed further as the commercial banks hoarded cash and restructured vehicles that had been major purchasers of asset-backed securities, or took them back onto their own balance sheets. This process employed the banks’ liquidity, thereby restricting further the availability of credit to other banks. 3. Northern Rock was particularly vulnerable to the credit squeeze created by the US sub-prime crisis. This was in part due to its extreme business model—more than 75% of its funding came from the wholesale markets. It relied on securitising its mortgages and in the first half of 2007 it raised more money from the securitisation of its mortgages than any other UK bank. Northern Rock’s securitisations funded very fast growth of its lending. In the first half of 2007 its lending was up 31% on the comparable period in 2006. This compares to growth of 13% in building society lending in the same period. Northern Rock’s share of the market for new mortgage lending grew to 19%—a substantial proportion given that its market share of outstanding loans at the end of 2006 was only 7%. Concern about the quality of Northern Rock’s loan book—and in particular the quality of the lending that underpinned its dramatic growth in early 2007—is likely to have contributed to the diYculties it faced in obtaining wholesale funding in August. In essence, the liquidity on which Northern Rock relied to carry on its day-to-day business dried up so that it was unable to meet its commitments as these fell due. 4. Whilst they are often a more expensive option for banks and building societies—due to the higher acquisition costs associated with a retail banking operation—retail deposits are generally a steadier source of finance than wholesale funding; reliance on predominantly retail funding tends to promote steadier growth than is possible using the wholesale markets. 5. Most of the other high street banks and all building societies have a much lower proportion of wholesale funding than Northern Rock. Building societies are explicitly prevented from having as high a proportion of wholesale funding as Northern Rock. The Building Societies Act 1986 requires all building societies to derive at least 50% of their funding from their members, (ie essentially from the retail market). This means that in theory it would be possible for building societies to be 50% funded from the wholesale markets. In practice, the proportion of building society wholesale funding is much lower than this, typically around 25% to 30%. It is interesting to note that Virgin Group, in announcing its interest in taking over Northern Rock last month, said it wants to make the bank “more like a building society”. This indicated recognition of the need for a back-to-basics approach, a return to the values to which Northern Rock used to adhere before it demutualised 10 years ago. 6. A note explaining the diVerences between banks and building societies is appended; this has been posted in a prominent position on the home page of the BSA’s website since mid August. 7. Northern Rock’s funding model and its dramatic growth explain how it got into diYculty but they do not explain the run on the bank. The run can be attributed to three other factors that combined to exacerbate the impact of the liquidity problems faced by Northern Rock bank: — Firstly, the publicity surrounding the Northern Rock’s approach to the Bank of England for liquidity, under lender of last resort arrangements, and the alarmist terms in which Northern Rock’s actions were portrayed in sections of the media, were instrumental in undermining depositor confidence in the bank. — Secondly, Northern Rock’s falling share price worried depositors. This was illogical, as it had no impact on the safety of their savings, but it served to add to their sense of unease. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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— Thirdly, the bank’s regulators failed to communicate eVectively to reassure depositors. In essence, they failed to speak plain English: assurances from the FSA that Northern Rock was, for example, “solvent” cut no ice with the bank’s retail customers because it is not a term that is widely understood by non-technicians. (Whilst it is questionable whether better communications could have avoided a run on Northern Rock, given the impact of other factors, the poor quality of communications seems likely to have contributed to depositor unease).
The functioning of the Tripartite system, including the memorandum of understanding, and the actions undertaken by the Tripartite authorities during the crisis, both in relation to the overall market, and the situation regarding Northern Rock
8. It is diYcult for those not closely involved in the Northern Rock crisis to assess the extent to which the problems that occurred and the mistakes that were made were due to the tripartite system—and the degree to which these could have been avoided under a diVerent approach. But, what is clear is that: — Northern Rock pursued a risky business model, notwithstanding regulatory scrutiny from the FSA. — The publicity surrounding the Bank of England’s lender of last resort arrangements meant it could not operate eVectively and it is questionable whether future support for individual institutions is possible under the MoU as it is currently constructed. — Communication from the parties to the tripartite agreement appeared disjointed particularly in the early days of the crisis, and added to the sense of confusion. This was perhaps reflective of a lack of emphasis, in the tripartite Memorandum of Understanding, on the importance of eVective communication. One of the MoU’s four guiding principles is transparency, but under this principle the document refers to the public’s understanding of each authority’s responsibilities, rather than to how communication takes place in a crisis. — The apparent change in the Bank of England’s policy of not oVering three month liquidity to banks that encountered diYculty as a result of the credit crunch created uncertainty and contributed to the panic among Northern Rock savers.
Changes that may be required to the regulatory requirements regarding liquidity
9. The main high level requirements for banks and building societies on liquidity risk systems and controls are in chapters SYSC 4, 5, 6, 7 and 11 of the Senior Management Arrangements, Systems and Controls part of the FSA Handbook. The current, separate, detailed liquidity requirements for banks and building societies have been in place for a number of years, pre-dating the establishment of the Financial Services Authority.
10. It is essential that any changes to the liquidity regime arising from the current crisis are not designed solely to address the funding model of Northern Rock, but are tailored to take account of the funding models of building societies and others.
11. Earlier this year both the Basel Committee on Banking Supervision and the Committee of European Banking Supervisors started looking at international requirements for bank liquidity. There are a number of diVerent liquidity regimes for deposit-takers around the world (and within Europe), and it would be appropriate for any changes that may be thought useful in light of the Northern Rock experience to be viewed in the context of the regimes applying elsewhere. We understand the FSA is preparing a discussion paper for issue later this year on possible changes to current UK liquidity requirements.
Lessons for Lender of Last Resort operations conducted by the Bank of England
12. The main lesson to be drawn from the Northern Rock experience is the need for the Bank’s lender of last resort operations—and other liquidity operations—to be carried out with the maximum possible discretion. If the industry is to have confidence in the process in the future, it is essential that all contact between the Bank and individual banks and building societies is conducted as confidentially as possible, and with due regard to the public’s possible reaction if and when the news breaks. Ultimately, it was public perception of Northern Rock’s appeal to the Bank of England for an injection of liquidity—compounded by widespread and possibly alarmist media coverage—that led to the run on the bank. This must be avoided in the future. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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Any other regulatory changes that may be required in the light of recent experience within the financial system 13. The overriding principle governing any regulatory response to the current financial crisis is that it should be proportionate and well-thought through. There are real dangers in any regulatory overreaction. 14. One lesson of the US sub-prime crisis is that there is a need for greater transparency in relation to asset-backed securities. This is necessary so as to provide better information to the holders of ABSs about the performance of the underlying assets, in order to ensure more accurate pricing of risk and help prevent major jolts to the market and stasis, such as that created over the past few months by uncertainty about the extent of institutions’ exposures to the risks represented by ABS holdings. 15. In light of uncertainty surrounding the respective responsibilities of the parties to the tripartite MoU, there is speculation that HM Treasury will assume a more controlling role. This is unlikely to be an optimal outcome. Whilst the Treasury has access to taxpayers’ funds necessary to eVect any bailing out, those best placed in a crisis are likely to be those with detailed hands-on knowledge of the financial institutions involved, ie FSA, and those charged with safeguarding financial stability, ie the Bank of England. The answer may lie not in a shift of responsibility to HM Treasury, but in greater clarity in the respective roles of all three parties.
2. Depositor Protection
The current position regarding Northern Rock’s depositor guarantees, and the Government’s balance sheet 16. A distinction should be drawn between the Government’s guarantee of those Northern Rock deposits that were extant at the time of the run on the bank and the guarantee on all subsequent deposits. 17. The Government’s guarantee of Northern Rock deposits extant at that time—which it announced on 17 September (and clarified on 20 September)—was probably unavoidable in order to stop the run on Northern Rock and minimise the potential for wider contagion. It also provided necessary confidence to Northern Rock’s market counterparties to roll-over pre-existing lines of credit to the bank. 18. The case for the extension of the Government’s guarantee to all subsequent deposits, announced on 9 October, is far less clear-cut. The BSA is concerned about the impact this may have on the market for retail savings, in which building societies are direct competitors of Northern Rock. The Government itself acknowledged—in its press release of 20 September—that to extend the guarantee arrangements to future deposits would “be unfair to other banks and building societies”. 19. Although the extension of the Government’s guarantee to future deposits was accompanied by assurances of safeguards to ensure that Northern Rock would not be able to exploit the guarantee to its advantage, the pricing of some of the bank’s products suggests this may not have been as eVective in suppressing the pricing of Northern Rock products as might have been hoped. This is a matter the BSA continues to monitor. 20. It is not in the interests of the wider market for the Government guarantee to remain in place longer than is necessary. Equally, it is clear that the Government guarantee cannot be removed—for existing Northern Rock customers—without risking a further run on the bank. Accordingly, it is essential that Northern Rock is taken over as soon as possible by a company that is able to meet all its liabilities and restore customer, and market, confidence in the bank. Any prospective new owner of Northern Rock is likely to need reassurance that Government guarantees will remain in place for a period after any transfer of ownership. The Government needs an exit strategy but, currently, it is hard to imagine what this might be.
Possible modifications to the Financial Services Compensation Scheme, including, but not limited to, limits of deposit protection, funding of the scheme and payout times, in the light of the publication by the Tripartite Authorities on 11 October of a document entitled Banking reform—protecting depositors: a discussion paper 21. The BSA is currently considering the discussion paper on depositor protection and we plan to respond to the Tripartite Authorities by their December deadline. We recognise, of course, that the Northern Rock problem may well have damaged consumer confidence in other banks and, possibly, in the wider deposit- taking sector. However, it is essential that all issues surrounding the Financial Services Compensation Scheme are considered thoroughly. For example, in considering whether to increase the limit of deposit protection beyond £35,000, certain important factors should be judged carefully; namely— — The £35,000 limit gives 100% cover to a very high proportion of depositors. BSA analysis of the distribution of savings within the building society sector shows that approximately 95% of individuals saving with a building society have balances of £35,000 or less. — The FSCS is not a substitute for good regulation. The Financial Services Compensation Scheme is part of a wider jigsaw of investor protection and financial stability. Other elements include robust but flexible insolvency laws, the need for the great majority of firms to be prudently managed, and good regulation. The FSCS is no substitute for the regulator taking reasonable steps to seek to ensure that firms have the crucial building blocks of prudential regulation in place, including prudent levels of liquidity and capital. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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— Market distortions and “moral hazard”. There is a risk of market distortion if the compensation levels for customers of one class of financial services provider are disproportionately high. It is also the case, as was illustrated by savings and loans organisations in the US during the 1980s, that an excessively high compensation limit can cause moral hazard for both firms and customers alike. — The Funding Review changes. We await a policy statement from the FSA and revised rules, following the recent FSCS Funding review. However, the proposed general retail pool, if implemented, is designed to further strengthen the FSCS and should reduce the need for other fundamental changes to the structure of the Scheme.
3. Overall Functioning of Financial Markets
Lessons learnt from the eVect of US sub-prime mortgage lending defaults on financial institutions and financial stability 22. The lessons to be learnt from the US sub-prime experience have two main components. First, lessons for the UK lending market arising from the US sub-prime experience. Second, and perhaps more importantly, lessons arising from the globalisation of financial markets. 23. There are fundamental diVerences between the UK sub-prime lending market and the US market, which support a conclusion that a crisis, on the lines of that encountered in the US sub-prime market, is much less likely to be suVered in the UK. These include: — Significant diVerences in the products available in the two markets. In particular, products with heavily discounted initial interest rates that are prevalent in the US sub-prime market are much less common in the UK. — The conduct of business of the whole of the UK sub-prime mortgage market is regulated by the FSA. In the United States less than half of sub-prime lending is federally regulated. — Compared to the US, the UK housing market continues to be relatively robust and the continuing shortage of housing is likely to sustain this. 24. The globalisation of financial markets—and, in particular, the close alignment of the UK and US wholesale markets—means that the institutions that comprise the main market for the asset backed securities sold by US sub-prime mortgage lenders are likely to be the same institutions upon which Northern Rock depended to buy its mortgage-backed securities. The erosion in confidence in the quality of ABSs issued by US sub-prime lenders had an indirect—but swift—impact on the ability of Northern Rock to conduct business. Such interconnectivity has brought into sharp relief the need for all interested parties— and in particular all UK-authorised financial institutions—and their principal regulator, the FSA—to take full and proportionate account of all relevant risk. November 2007
APPENDIX A copy of the text published on the BSA homepage (www.bsa.org.uk) since mid August 2007:
What’s the diVerence between a building society and a bank? A building society is a mutual institution. This means that most people who have a savings account, or mortgage, are members and have certain rights to vote and receive information, as well as to attend and speak at meetings. Each member has one vote, regardless of how much money they have invested or borrowed or how many accounts they may have. Each building society has a board of directors who run the society and who are responsible for setting its strategy. Building societies are diVerent from banks, which are companies (normally listed on the stock market) and are therefore owned by, and run for, their shareholders. Societies have no external shareholders requiring dividends and are not companies. This normally enables them to run on lower costs and oVer cheaper mortgages, better rates of interest on savings and better levels of service than their competitors. See the BSA’s recent report on Customer Service http://www.bsa.org.uk/publications/industrypublications/customer–satisfaction.htm The other major diVerence between building societies and banks is that there is a limit on the proportion of their funds that building societies can raise from the wholesale money markets. A building society may not raise more than 50% of its funds from the wholesale markets. The average proportion of funds raised by building societies from the wholesale markets is 30%. To view a full list of building societies please use link below http://www.bsa.org.uk/aboutus/buildsocmember.htm To view a full list of former building societies that have converted to banks please use link below http://www.bsa.org.uk/consumer/factsheets/100010.htm Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
Ev 308 Treasury Committee: Evidence
Memorandum from the Council of Mortgage Lenders
Introduction 1. The Council of Mortgage Lenders (CML) welcomes the opportunity to provide written evidence to the Treasury Committee Inquiry on Financial Stability and Transparency. 2. The CML is the representative trade body for the residential mortgage lending industry. Its 163 members currently lend over 98% of the residential mortgages in the UK mortgage market.
Background 3. The events we have witnessed in global debt capital markets since early August have been exceptional. A widespread reassessment of the compensation investors require for bearing risk followed unexpectedly severe credit losses in the US sub-prime mortgage market. Most US sub-prime loans are packaged into residential mortgage backed securities (RMBS) and sold to investors across the globe, often being repackaged into other investments such as collateralised debt obligations (CDOs). Although this process can disperse risk, it turned out that some investors, including banks, had unexpectedly large exposures. 4. The realisation that some banks had unexpected exposures to US sub-prime debt created a loss of confidence in the interbank lending and commercial paper markets, triggering a requirement for banks to absorb on to their balance sheets the assets of structured investment vehicles (SIVs) which they had set up. This, coupled with other unexpected demands on bank liquidity, exacerbated the reduction in liquidity in the interbank market. The net result has been a serious strain on the global financial system and on bank and non-bank lenders which has not yet been resolved. 5. It is important that the underlying causes of these fragilities are analysed and addressed as highlighted in the separate response by the British Bankers Association (BBA). It is clear that a market failure has occurred in international financial markets in the sense that RMBS markets have shut, even for prime mortgage assets over which there seems to be no discernable concerns on credit quality. The need for analysis and, if deemed appropriate, a policy response is given added urgency because the lack of available liquidity that led Northern Rock, a solvent institution with a high quality loan book, to approach the Bank of England is still in evidence.
Illiquidity in Debt Capital Markets 6. Wholesale debt markets do experience periods when investor demand is reduced to the extent that issuance ceases to take place. These periods have tended to follow disruptive events such as the Asian financial crisis and subsequent Russian government default in 1998. However, past episodes have been resolved relatively quickly with the assistance of central bank liquidity. 7. Evidence from the market turmoil that began this August suggests that the reduction in liquidity in private sector RMBS markets is more severe and likely to take much longer to resolve than previous episodes. The implications of an on-going wholesale market illiquidity are potentially widespread not only for mortgage lenders and borrowers but also for policymakers and the wider economy. Roughly 20% of UK mortgages are funded through the RMBS market, including a significant proportion of prime mortgages originated by the larger banks. The proportion of mortgages funded through RMBS is higher still in the adverse credit and buy-to-let markets. Having the RMBS market shut for a prolonged period will create further risk of damage to the UK financial system on top of that resulting from the Northern Rock announcement, which itself was a direct result of the market ceasing to function in August. 8. Policymakers should note that throughout this period, the US RMBS market for prime “conforming” mortgages has remained open because of the perceived government backing for the large mortgage funding institutions, Fannie Mae and Freddie Mac, which dominate this market. The structure of the US mortgage industry has largely insulated the prime market from the problems of the sub-prime. This is not the case in the UK prime secondary mortgage market which has suVered a greater contagion eVect than the US prime market. This is an insidious result of the current turmoil in funding markets and one that warrants a response from UK policymakers to aid the recovery of secondary market liquidity for prime UK mortgages.
The Northern Rock situation 9. One very high profile result of the extreme illiquidity of global RMBS and interbank markets was Northern Rock requesting financing assistance. We welcomed the decision by the tripartite authorities to provide robust support for Northern Rock. The government rightly made clear that it is a solvent well capitalised bank, and as such support was fully justified. The credit quality of Northern Rock’s loan assets has been good. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
Treasury Committee: Evidence Ev 309
10. It is vital to confidence in the UK banking system that depositors feel secure and therefore right that the government moved quickly to reassure Northern Rock depositors that their money was guaranteed and to provide a facility which enabled Northern Rock to continue to operate and meet its commitments. Had support (the emergency funding line from the Bank of England and the guarantee to the retail depositors and senior unsecured wholesale creditors) not been forthcoming, the damage to the UK’s financial system and reputation would have been very much greater than it was. 11. It is accepted that this support cannot, and must not, be open-ended, not least because assistance of this kind for one bank distorts competition. What is less clear is how the government will be able to extricate itself from the support it has given. Although it has made clear its desire to see Northern Rock taken over by another financial institution, any potential bidders will need time to evaluate the proposition, undertake due diligence and raise the necessary funding. In the meantime, the emergency funding line is gradually reducing Northern Rock’s profitability as a business as it commands a penalty interest rate. 12. We believe that it would be wrong for the government simply to await the outcome of the sale process at Northern Rock. Although the longer term solution may be for Northern Rock to be taken over, the more immediate solution lies in the re-establishment of a rationally priced liquid secondary mortgage market. It is in the interests of UK mortgage borrowers, the financial sector and the wider economy to re-establish a functioning secondary mortgage market.
Re-establishing a Functioning RMBS Market
13. An agreed strategy on the part of market participants and the tripartite bodies to restore rational pricing and liquidity in the UK secondary mortgage market is one way forward. Investors, including the large issuers, would need to commit to return as RMBS purchasers but the authorities would also need to play a facilitating role. 14. The Bank of England could assist the re-establishment of a functioning RMBS market through targeted support by making available a term repo facility exclusively against new RMBS and mortgage covered bond issues (those undertaken after the facility was announced). This facility would need to be made available at a commercial interest rate—a rate that provided the Bank of England with a commercial return based on the credit risk it was taking on, but one that incentivised lenders to use it. 15. The rate made available to banks repoing the RMBS of other institutions would be more advantageous than for banks repoing their own RMBS to encourage public issuance. The repo facility could be of three months or more maturity, but the Bank of England would need to confirm its intention to maintain the facility until market conditions improved. To be eligible for the facility, the securities would have to meet certain criteria. It could be applied only to highly rated tranches backed by prime mortgages with lower loan-to-value (LTV) ratios. 16. Such a solution would have a number of benefits over current arrangements. It would be a market wide solution, reducing moral hazard and ensuring that support was not focused exclusively on one institution. It should allow Northern Rock to resume funding through the RMBS market, allowing it to reduce its emergency funding line from the Bank of England, potentially smoothing the transition to new ownership. Most significantly, it would show that the UK was prepared to take targeted action to restore confidence in the wholesale funding markets for prime UK mortgages, recognising the credit quality of residential assets in the UK is high and should not be tainted by developments in the US.
Bank of England Sterling Money Market Operations
17. We welcomed the announcement from the Bank of England on 19 September that it would provide funds of three month maturity secured on a wider range of collateral, including RMBS and mortgages subject to certain criteria. We believe this was an important change in the Bank of England’s approach to market support. It recognised the potential benefit to banks at a time of stress of central bank term funding. We also recognise that the Bank of England views such a facility as a response to a specific need and that it wishes to avoid the situation where commercial banks become dependent on such liquidity support. That is why the facility carried a penalty rate of 1% above Bank base rate. But such a high rate exacerbated the potential for stigma for banks that may have used the facility, preventing it from being an eVective source of liquidity. 18. By accepting RMBS as collateral, the Bank of England has potentially created an important bridge between the money and RMBS markets at a time when the RMBS market is not functioning normally. We believe that the use of repo support collateralised against RMBS can be used to provide targeted support to re-establish a functioning RMBS market for UK prime mortgages. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
Ev 310 Treasury Committee: Evidence
19. The BBA has led the response from lenders to the tripartite on the provision of liquidity by the central bank and we support the BBA’s submission on liquidity and its recommendations. Lessons from the US sub-prime crisis 20. We strongly support the Building Societies Association’s (BSA) submission in its response on this issue. There are significant diVerences in the US and UK sub-prime mortgage markets but the interconnected nature of wholesale funding markets has left UK lenders, indeed even those operating in the prime mortgage market, vulnerable to events in the US over which they have no control. November 2007
Memorandum from Professor Willem H Buiter, London School of Economics and Political Science
Introduction
According to a report in the Financial Times, “European nations are to draw up radical proposals to improve transparency in financial markets and to change the way credit rating agencies operate in an attempt to prevent any recurrence of the financial turmoil arising from the credit squeeze”.33 Are transparency in financial markets and better rating agencies indeed key to preventing the recurrence of the kind of mess we have been experiencing in the world’s most developed financial systems for these past three months? I intend to take a romp through the crisis to see what lessons it holds for policymakers and market participants. The problems we have recently seen across the industrialised world (but not, as yet, in the emerging markets), was by a “perfect storm” bringing together a number of microeconomic and macroeconomic pathologies. Among the microeconomic systemic failures were: wanton securitisation, fundamental flaws in the rating agencies business model, privately rational but socially ineYcient disintermediation, and competitive international de-regulation. Proximate drivers of the specific way in which these problems manifested themselves were regulatory and supervisory failure in the US home loan market and excessive global liquidity creation by key central banks. In the UK, the problems were aggravated by: 1. a flawed Tripartite arrangement between the Treasury, the Bank of England and the Financial Services Authority (FSA) for dealing with financial crises; 2. supervisory failure by the FSA; 3. flaws in the Bank of England’s liquidity-oriented open market policies (too restrictive a definition of eligible collateral and an unwillingness to try to influence market rates at maturities longer than overnight, even during periods of serious lack of market liquidity; and 4. flaws in the Bank of England’s discount window operations (too restrictive a definition of eligible collateral; only overnight lending; too restrictive a definition of eligible discount window counterparties).
Both shortcomings in the Bank of England’s operating arrangements and procedures were due to a flawed understanding of the nature and determinants of market (ill)liquidity, of the Bank of England’s unique role in the provision of market liquidity because of its ability to create unquestioned liquidity instantaneously and costlessly, of the conditions under which there is a trade-oV between moral hazard (bad incentives for future bank behaviour) and the ex-post provision of liquidity to (a) markets and (b) specific individual institutions, to prevent collateral damage to the financial system and the real economy.
Among the macroeconomic pathologies were the following: (1) An ex-ante global saving glut, brought about by the entry of a number of high-saving countries (notably China) into the global economy and a global redistribution of wealth and income towards commodity exporters that also had, at least in the short run, high propensities to save. (2) Excessive liquidity creation by the world’s leading central banks and by the desire of many new industrialising and oil and gas exporting countries to limit the appreciation of their currencies. The behaviour of the central banks may be in part explained as a response to the Keynesian eVective demand weaknesses that resulted from (1).
33 Financial Times, 8 October 2007, EU plans market reforms to avert crisis, Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
Treasury Committee: Evidence Ev 311
1. Securitisation
Origins Traditionally, banks borrowed short and liquid and lent long and illiquid. On the liability side of the banks’ balance sheet, deposits withdrawable on demand and subject to a sequential service (first come, first served) constraint figured prominently. On the asset side, loans, secured or unsecured to businesses and households were the major entry. These loans were typically held to maturity by the banks (the “originate and hold” model). Banks therefore transformed maturity and created liquidity. Such a combination of assets and liabilities is inherently vulnerable to bank runs by deposit holders. Banks were deemed to be systemically important, because their deposits were a key part of the payment mechanism for households and non-financial corporations, because they played a central role in the clearing and settlement of large-scale transactions and of securities. To avoid systemically costly failures by banks that were solvent but had become illiquid, the authorities implemented a number of measures to protect and assist banks. Deposit insurance was commonly introduced, paid for either by the banking industry collectively or by the state. In addition, central banks provided lender of last resort (LoLR) facilities to individual deposit-taking institutions that had trouble financing themselves. In return for this assistance and protection, banks accepted regulation and supervision. This took the form of minimum capital requirements, minimum liquidity requirements and other restrictions on what the banks could hold on both sides of their balance sheets. In the 1970s, Fannie Mae (Federal National Mortgage Association), Ginnie Mae (Government National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) began the process of securitisation of residential mortgages. Asset securitisation involves the sale of income generating financial assets (such as mortgages, car loans, trade receivables (including credit card receivables) and leases) by a company (the originator of the financial assets) to a special purpose vehicle (SPV). The SPV, which might be a trust or a company, finances the purchase of these assets by the issue of bonds, which are secured by those assets. The SPV is supposed to be bankruptcy-remote from the originator, that is, it has to be an oV-balance sheet entity vis-a`-vis the originator. Cash-flow securitisation works in a similar way, as when the UK government agreed to create the International Finance Facility which was supposed to securitise future development aid commitments. Private institutions, especially banks, immediately took advantage of these securitisation techniques to liquefy their illiquid loans. The resulting “originate and distribute” model had major attractions for the banks and also permitted a potential improvement in the eYciency of the economy-wide mechanisms for intermediation and risk sharing. It made marketable the non-marketable; it made liquid the illiquid. There was greater scope for trading risk, for diversification and for hedging risk.
Problems There are three problems associated with securitisation (and the generally associated creation of oV- balance sheet vehicles). 1. The greater opportunities for risk trading created by securitisation not only made it possible to hedge risk better (that is, to cover open positions); it also permitted investors to seek out and take on additional risk, to “unhedge” risk and to create open positions not achievable before. When risk-trading opportunities are enhanced through the creation of new instruments or new institutions, and when new populations of potential investors enter the risk-trading markets, we can only be sure that the risk will end up with those most willing to bear it. There can be no guarantee that risk will end up being borne by those most able to bear it. 2. The “originate and distribute” model destroys information compared to the “originate and hold” model. The information destruction occurs at the level of the originator of the assets to be securities. Under the “originate and distribute” model the loan oYcer collecting the information on the creditworthiness of the would-be borrower is working for the Principal in the investing relationship (the originating bank). Under the “originate and distribute” model, the loan oYcer of the originating banks works for an institution (the originating bank) that is an Agent for the new Principal in the investing relationship (the SPV that purchases the loans from the bank and issues securities against them). With asymmetric information and costly monitoring, the agency relationship dilutes the incentive for information gathering at the origination stage. Reputation considerations will mitigate this problem, but will not eliminate it. 3. Securitisation also puts information in the wrong place. Whatever information is collected by the loan originator about the underlying assets remains with the originator and is not eVectively transmitted to the SPV, let alone to the subsequent buyers of the securities issued by the SPV that are backed by these assets. By the time a hedge fund owned by a French commercial bank sells ABS (asset backed securities) backed by US subprime residential mortgages to a conduit owned by a small German Bank specialising in lending to small and medium-sized German firms, neither the buyer nor the seller of the ABS has any idea as to what is really backing the securities that are being traded. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
Ev 312 Treasury Committee: Evidence
Partial solutions The problems created by securitisation can be mitigated in a number of ways. 1. Simpler structures. The financial engineering that went into some of the complex securitised structures that were issued in the last few years before the ABS markets blew up on August 9, 2007 at times became ludicrously complex. Simple securitisation involved the pooling of reasonably homogeneous assets, say residential mortgages issued during a given period with a given risk profile (subprime, alt-A or prime, say). These were pooled and securities issued against them were tranched, with the higher tranche having priority (seniority) over the lower tranches. This permitted the highest tranche secured against a pool of high-risk mortgages, say, to achieve a much better credit rating than the average of the assets backing all the tranches together (the lower tranches, of course, had a correspondingly lower credit rating). However, second-tier and higher-tier-securitisation then took place, with tranches of securitised mortgages being pooled with securitised credit-card receivables, car loan receivables etc. and tranched securities being issued against this new, heterogeneous pool of securitised assets. Myriad credit enhancements were added. In the end, it is doubtful that even the designers and sellers of these compounded, multi-tiered securitised assets knew what they were selling, knew its risk properties or knew how to price them. Certainly the sellers did not. There is a simple solution: simpler structures. This will in part be market-driven, but regulators too may put bounds on the complexity of instruments that can be issued or held by various entities. 2. “Unpicking” securitisation. This “solution” is the ultimate admission of defeat in the securitisation process. A number of American banks with (residential mortgage-backed securities on their balance sheet have been scouring the entrails of the asset pools backing these securities and have sending staV to specific addresses to assess and value the individual residential properties. This inversion of the securitisation matrix is, of course, very costly and means that the benefits from risk pooling will tend to be ignored. It is an ignominious end for the securitisations involved. RMBS 3. Retention of equity tranche by originator. When the originator of the loans is far removed from the ultimate investor in the securities backed by these loans, the incentive for careful origination is weakened. One way to mitigate this problem is for the originator to retain the “equity tranche” of securitised and tranched issues. The equity tranche or “first-loss tranche” is the highest-risk tranche—the first port of call when the servicing of the loans is impaired. It could be made a regulatory requirement for the originator of residential mortgages, car loans etc. to retain the equity tranche of the securitised loans. Alternatively, the ownership of the equity tranche could be required to be made public information, permitting the market to draw its own conclusions. 4. External ratings. The information gap could be closed or at least reduced by using external rating agencies to provide an assessment of the creditworthiness of the securitised assets. This has been used widely in the area of RMBS and of ABS. This “solution” to the information problem, however, brought with it a whole slew of new problems.
2. Rating Agencies A small number of internationally recognised rating agencies (really no more than three: Standard & Poor’s, Moody’s and Fitch) account for most of the rating of complex financial instruments, including ABS. They got into this business after for many years focusing mainly on the rating of sovereign debt instruments and of large private corporates. They have been given a formal regulatory role, (which will be greatly enhanced under the about-to-be-introduced Basel 2 Capital Adequacy regime) because their ratings determine the risk weighting of a whole range of assets bank hold on their balance sheets. Their role raises a number of important issues because it creates a number of problems.
Problems 1. What do they know? This is a basic but important question. One can imagine that, after many years, perhaps decades, of experience, a rating agency would become expert at rating a limited number of sovereign debtors and large private corporates. How would the rating agency familiarise itself with information available only to the originators of the underlying loans or other assets and to the ultimate borrowers? How would the rating agency, even if they knew as much about the underlying assets as the originators/ultimate borrowers, rate the complex structures created by pooling heterogeneous underlying asset classes, slicing and dicing the pool, tranching and enhancing the payment streams and making the ultimate pay-oVs complex, non-linear functions of the underlying income streams? These ratings were overwhelmingly model-based. The models used tended to be the models of the designers and sellers of the complex structures, who work for the issuers of the instruments. Models tend to be useless during periods of disorderly markets, because we have too few observations on disorderly markets to construct reasonable empirical estimates of the risks involved. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
Treasury Committee: Evidence Ev 313
2. They only rate default risk. Rating agencies provide estimates of default risk (the probability of default and the expected loss conditional on a default occurring). Even if default risk is absent, market risk or price risk can be abundant. Liquidity risk is one source of price risk. As long as the liquidity risk does not mutate into insolvency risk, the liquidity risk is not reflected in the ratings provided by the rating agencies. The fact that many “consumers” of credit ratings misunderstood the narrow scope of theses ratings is not the fault of the rating agencies, but it does point to a problem that needs to be addressed. First, there has to be an education campaign to make investors aware of what the ratings mean and don’t mean. Second, the merits of oVering (and requiring) a separate rating for, say, liquidity risk should be evaluated. 3. They are conflicted. Rating agencies are subject to multiple potential conflicts of interest. (a) They are the only example of an industry where the appraiser is paid by the seller rather than the buyer. (b) They are multi-product firms that sell advisory and consulting services to the same clients to whom they sell ratings. This can include selling advice to a client on how to structure a security so as to obtain the best rating and subsequently rating the security designed according to these specifications. (c) The complexity of some of the structured finance products they are asked to evaluate makes it inevitable that the rating agencies will have to work closely with the designers of the structured products. The models used to evaluate default risk will tend to be the models designed by the clients. It’s not just the problem that marking to model can become marking to myth. There is the further problem that the myth will tend to be slanted towards the interest of the seller of the securities to be rated.
Partial solutions
There is no obvious solution other than “try harder and don’t pretend to know more than you know” for the first problem. The second problem requires better education of the investing public. The third problem can be mitigated in a number of ways. 1. Reputational concerns. Reputation is a key asset of rating agencies. That, plus the fear of law suits will mitigate the conflict of interest problem. The fundamental agency problem cannot be eliminated this way, however. Even if the rating agencies expect to be around for a long time (a necessary condition for reputation to act as a constraint on opportunistic and inappropriate behaviour), individual employees of rating agencies can be here today, gone tomorrow. A person’s reputation follows him/her but imperfectly. Reputational considerations are therefore not a fully eVective shield against conflict of interest materialising. 2. Remove the quasi-regulatory role of the rating agencies in Basel 2 and elsewhere. Just as the public provision of private goods tends to be bad news, so the private provision of public goods leaves much to be desired (“the best judges money can buy etc”). The oYcial regulatory function of private credit risk ratings in Basel I and II should be de-emphasized and preferably ended altogether. I may get my wish here, because Basel II appears fatally holed below the waterline. It was long recognised to have unfavourable macroeconomic stabilisation features, because the capital adequacy requirements are likely to be pro-cyclical (see Borio, Furfine and Lowe (2001), Gordy and Howells (2004) and Kashyap and Stein (2004)). On top of this, the recent financial turmoil should that the two key inputs into Pillar 1, the ratings provided by the rating agencies and the internal risk models of the banks are deeply flawed. As regards internal risk models, there are two problems. The first is the unavoidable “garbage in— garbage out” problem that makes any quantitative model using parameters estimated or calibrated using past observations useless during times of crisis, when every crisis is diVerent. We have really only had one instance of a global freeze-up of ABS markets, impairment of wholesale markets and seizure of leading interbank markets simultaneously in the US, the Eurozone and the UK. Estimates based on a size 1 sample are unlikely to be useful. Second, the use of internal models is inherently conflicted. The builders, maintainers and users of these models are perceived by the operational departments of the bank as a constraint on doing profitable business. They will be under relentless pressure to massage the model to produce the results desired by the bank’s profit centres. They cannot be shielded eVectively from such pressures. Chinese walls inside financial corporations are about as eVective in preventing the movement of purposeful messages across them, as the original Great Wall of China was in keeping the barbarians out and the Han Chinese in—that is, utterly ineVective. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
Ev 314 Treasury Committee: Evidence
3. Make rating agencies one-product firms. The potential for conflict of interest when a rating agency sells consultancy and advisory services is inescapable and unacceptable. Even the sale of other products and services that are not inherently conflicted with the rating process is undesirable, because there is an incentive to bias ratings in exchange for more business in functionally unrelated areas. The obvious solution is to require any firm oVering rating services to provide just that. Having single-product rating agencies should also lower the barriers to entry. 4. End payment by the issuer. Payment by the buyer (the investors) is desirable but subject to a “collective action” or “free rider” problem. One solution would be to have the ratings paid for by a representative body for the (corporate) investor side of the market. This could be financed through a levy on the individual firms in the industry. Paying the levy could be made mandatory for all firms in a regulated industry. Conceivably, the security issuers could also be asked to contribute. Conflict of interest is avoided as long as no individual issuer pays for his own ratings. This would leave some free rider problems, but should get the rating process oV the ground. I don’t think it would be necessary (or even make sense) to socialise the rating process, say by creating a state- financed (or even industry-financed) body with oYcial powers to provide the ratings. 5. Increase competition in the rating industry. Competition in the rating process is desirable. The current triopoly is unlikely to be optimal. Entry should be easier when rating agencies become single-product firms, although establishing a reputation will inevitably take time.
3. Excessive Disintermediation There are no doubt solid economic eYciency reasons for taking certain financial activities out of commercial banks and out of investment banks, and putting them in special purpose vehicles (SPVs), Structured Investment Vehicles (SIVs, that is, SPVs investing in long-term, often illiquid complex securitised financial instruments and funding themselves in the short-term wholesale markets, including the ABCP markets), Conduits (SIVs closely tied to a particular bank) and a host of other oV-balance-sheet and oV- budget vehicles. Incentives for eYcient performance, including appropriate risk management can, in principle, be aligned better in a suitably designed SPV than in a general-purpose bank. The problem is that it is very diYcult to come up with any real-world examples of oV-balance sheet vehicles that actually appear to make sense on eYciency grounds. Most of the oV-balance sheet vehicles (OBSVs) I am familiar with are motivated by regulatory arbitrage, that is, by the desire to avoid the regulatory requirements imposed on banks and other deposit-taking institutions. These include minimal capital requirements, liquidity requirements, other constraints on permissible liabilities and assets, reporting requirements and governance requirements. Others are created for tax eYciency (ie tax avoidance) reasons or to address the needs of governments and other public authorities for oV-budget and oV-balance sheet finance, generally to get around public deficit or debt limits. OBSVs tend to have little or no capital, little or no transparency and opaque governance. When opaque institutions then invest in opaque financial instruments like the ABS discussed earlier, systemic risk is increased. This is reinforced by the fact that much de-jure or de-facto exposure remains of the sponsoring banks to these oV-balance-sheet vehicles. The de jure exposure exists when the bank is a shareholder or creditor of the OBSV, when the OBSV has an undrawn credit line with the bank or when the bank guarantees some of the OBSV’s liabilities. De-facto exposure exists when, for reputational reasons, it is problematic for the bank to let an OBSV that is closely identified with the bank go under. Banks in many cases appear not to have been fully aware of the nature and extent of their continued exposure to the OBSVs and the ABS they carried on their balance sheets. Indeed the explosion of new instruments and new financial institutions so expanded the populations of issuers, investors and securities that many market participants believed that risk could not only be traded and shared more widely and in new ways, but that risk had actually been eliminated from the system altogether. Unfortunately, the world of risk is not a doughnut: it does not have a hole in it. All risk sold by someone is bought by someone. If the system works well, the risk ends up being born by those both willing and most able to bear it. Regrettably, it often ends up with those most willing but not most able to bear it.
Partial solutions Mitigation of the problems created by excessive disintermediation will be part market-driven and partly regulatory. 1. Re-intermediation. Either Conduits, SIVS and other OBSVs are taken back on balance sheet by their sponsoring banks, or the ABS and other illiquid securities on their balance sheets are sold to the banks. The OBSVs then either wither away or vegetate at a low level of activity. 2. Regulation. We can anticipate a regulatory response to the problem of opaque instruments held by opaque OBSVs in the form of reporting requirements, and consolidation of accounts requirements that are driven by broad principles (‘duck tests’) with constant adaptation of specific rules addressing particular institutions and instruments. For instance, if the Single Master Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
Treasury Committee: Evidence Ev 315
Liquidity Enhancement Conduit (M-LEC) proposed by JPMorgan Chase, Bank of America and Citigroup ever gets oV the ground, it is questionable whether the US regulators will permit the participating banks to keep it oV-balance-sheet for reporting purposes, including earnings reports.
4. Competitive Global Deregulation
Regulators of financial markets and institutions are organised on a national basis and are, in part, cheerleaders and representatives of the interests of their national financial sectors. While regulation is national, finance is global. The location of financial enterprises and markets is endogenous. A thriving financial sector creates jobs and wealth, and is generally environmentally friendly. So regulators try to retain and attract business for their jurisdictions in part by oVering more liberal, less onerous regulations. This competition through regulatory standards has led to less stringent regulation. There have been occasional reversals in this process. The Sarbanes-Oxley Act of 2002 was a response to the corporate governance, accounting and reporting scandals associated with Enron, Tyco International, Peregrine Systems and WorldCom. It undoubtedly contributed to a loss of business for New York City as a global financial centre. Because Sarbanes-Oxley compliance is mainly a matter of box-ticking (like most real-world compliance, especially compliance originating in the USA), it has not materially improved the informational value of accounting or the protection oVered to investors. Is this global competitive deregulation process a welcome antidote to a tendency to excessive and heavy- handed regulation or a race to the bottom in which everyone loses in the end? I believe the jury is still out on this one, although I am inclined, if pushed, to suggest that the following are likely to be true: — Principles-based regulation (allegedly what we have in the UK) vs. rules-based regulation is an unhelpful distinction. You need both. You need principles that spell out the fundamental “duck test”: (a) Does the institution lend long and borrow short? (b) Does it lend in illiquid form and borrow in markets that are liquid in normal times although they may turn illiquid during period of market turbulence? Do banks have substantial exposure to it? If so, it should be either consolidated for reporting purposes with the bank or treated as a bank it its own right. Then you need rules that are constantly adapted to keep up with developments in instruments and institutions. — Self-regulation is no regulation unless backed up credibly with the threat that, unless eVective self- regulation is implemented, external regulation will be imposed. — Voluntary codes of conduct are without significance unless they can be and are used by the regulator (through “comply or explain” rules) to impose and enforce standards. That means that if the explanation is not to the regulator’s satisfaction, compulsion can be used. — The UK’s “light-touch” regulation has become “soft-touch” regulation and needs to be tightened up in a large number of areas.
Partial solutions 1. Greater international cooperation between regulators. This is a no-brainer, but very hard to achieve. 2. A single EU-wide regulatory regime for banks, other financial institutions and financial markets. National financial regulators in the EU should go the way of the dodo. An EU-level FSA would be a good idea, although the central banks (the ECB and for the time being still 14 national central banks) should collect more information about individual banks than the Bank of England has done since it lost banking supervision and regulation in 1997 when the Bank became operationally independent for monetary policy. 3. A crackdown on “regulators of convenience”. This requires tough measures towards “regulation havens”, some found in the Caribbean, others closer to the UK. One eVective approach would be the non-recognition and non-enforceability of contracts, court judgements and other legal and administrative rules from non-compliant jurisdictions.
5. The Global Macroeconomic Setting
The macroeconomic background to the crisis is the “Great Moderation”—low and stable global inflation, high and stable global real GDP growth of the past decade. Actually, this moderation is more apparent from the inflation figures than from the GDP figures. Figure 1 shows the spectacular decline and recent stability of global inflation. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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Figure 1
Inflation
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1982 1981 Source: IMF (excludes Zimbabwe) 5 0 40 35 30 25 20 15 10 % Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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Figure 2 demonstrates two points.
Figure 2
Real GDP Growth (PPP) Real GDP Grown (Market) Real GDP
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and the BRICs won’t save us this time (yet) 1990
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Things were never as good we thought they - 1988
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Global Read GDP Growth Rates at PPP and Market /exchange Rates Growth Rates at PPP Global Read GDP 1984
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6 5 4 3 2 1 0 Actual % Growth % Actual Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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First, the stability of global GDP growth does not appear to have increased since the early 1980s. Second, the common belief that global growth over the past four years has averaged over 5% is based on the wrong statistics—that is, on data that weight national GDPs at purchasing power parity (PPP) exchange rates rather than market exchange rates. PPP exchange rates are the best conversion factors if comparisons between national standards of living are made. To get the best estimate of developments in global economic activity, market exchange rates should be used. GDP growth at market exchange rates has averaged around 3.5% per annum over the past few years. The diVerence between the two measures is due to the fact that PPP exchange rate give a much greater weight to developing countries and emerging markets than do market exchange rates. Since emerging markets (China, India, Vietnam, South Africa) have been the fastest growers by far over the past decade, global growth measured at market exchange rates has been well below global growth measured at PPP exchange rates. This is confirmed by the observation that by 2006, the global share of investment in GDP was only slightly above its previous peak value achieved in 1994 (see Figure 3).
Figure 3 Global Investment Share in GDP (%) 24
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19.5 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: IMF Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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Another striking feature of the global macroeconomic environment has been the declining level of real interest rates since 1001, and specifically the marked decline since the bursting of the tech bubble at the end of 2000. This is shown clearly by Figure 4, which is taken from Desroches and Francis (2007).34
Figure 4
Global Saving, Investment and Real Interest Rate % of GDP %
26 7
6 25 5
4 24 3
23 2
1 22 0
-1 21 -2
20 -3 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003
Investment (LHS) Savings (LHS) World real interest rate (RHS)
Sources: World Bank, BIS, IMF, Bank of Canada calculations.
The proximate determinant of the trend decline in global real interest rates is an ex-ante saving glut, caused by the rapid growth of new emerging markets like China, which have extraordinarily low propensities to save, and, in more recent years, the global redistribution of global wealth and income towards a limited number of producers of primary energy sources (especially oil and natural gas) and raw materials. For a number of years, the absorptive capacity of the beneficiaries could not keep up with their new-found wealth, and vast amounts of savings had to be recycled. The extreme financial conservatism of many of the big savers (in China, Japan, India, Russia, and most South East Asian and Latin American countries and in the Gulf states, these often were the central banks) meant that much of the increased demand for financial assets was directed towards default-risk-free financial instruments, especially US Treasury bonds. With no response of supply, risk-free real rates fell very low indeed (see Caballero (2006)). In addition, the response of the US monetary authorities to the bursting of the tech bubble, the continued liquidity trap in Japan and, for a while also the rather relaxed monetary policy in the Euro area resulted in massive and excessive global liquidity growth, especially from 2003 till the end of 2006. Many rapidly growing and high-saving emerging markets and a number of key oil producers (including the six members of the Gulf Cooperation Council) pursued policies of undervalued nominal exchange rates and sterilized intervention, which although only partially eVective, resulted in an unprecedented accumulation of foreign exchange reserves and, until recently, growing demand for high-grade sovereign debt instruments. As a result of this, not only were long-term risk-free nominal and real interest rates extraordinarily low since 2003, but unprecedentedly low credit risk spreads (that is, default risk spreads) prevailed across the board. There was also an explosion of leverage, although interestingly enough not in the non-financial corporate sector. Households leveraged up and so did the financial sector. Prima facie, commercial banks did not increase their leverage very much. The increased leverage in the financial sector took place outside the commercial banks in investment banks, hedge funds, private equity funds and a whole range of new financial institutions (SIVs, conduits etc), often using the new securitisation-based financial instruments discussed earlier. It was insuYciently appreciated, by regulators, by the banks and by the new financial institutions themselves, that being oV-balance-sheet for certain regulatory, auditing and reporting purposes, does not mean that there is no substantive (and potentially substantial) financial, commercial and economic exposure.
34 Nothing much can be concluded from eyeballing the ex-post saving and investment rates in Figure 4. They are supposed to be identically equal, and any diVerence represents just measurement error. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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Partial Solutions
Low global risk-free real interest rates have been rising since the end of 2006, as the absorptive capacity of the oil and gas exporters has risen and as central banks at last lost control of the management of the external assets acquired in the high-saving emerging markets. The transfer of these resources to sovereign wealth funds with a much greater willingness to take risk and a thirst for returns, means that at first the incremental flows, but increasingly also the existing stocks of external assets are being shifted away from high-grade sovereign obligations and into such things as equity, infrastructure and other riskier but higher- yielding investments.
As regards excessive liquidity creation, it looks as though both Japan and the US may be repeating (or be about to repeat) the policies of the beginning of the decade. Japan appears to be sliding back into recession, with renewed deflationary pressures and no prospects for an early normalisation of nominal interest rates. The Bernanke Fed has turned out to be more like the Greenspan Fed than I would have expected or hoped, and has, since the crisis started in August 2007, cut the Federal Funds target rate by 75 bps and the primary discount rate by 100bps, despite the presence of serious inflationary pressures. While the exchange rates of many oil and gas producers have appreciated somewhat against the dollar, there has been considerable intervention to keep down the rate of appreciation. The same has been true in China and India. It looks as though the foundations for the next global liquidity glut are being laid while the world is still struggling with the (market) liquidity crunch that started this summer.
6. The Onset of the Financial Crisis
Facts can be ignored for a long time, but not forever. The realisation that risk may have been underpriced dawned first in the USA to holders of securities backed by sub-prime mortgages. During the second half of 2005, the delinquency rate on these mortgages began to creep up from a low of 10% at an annual rate (see Figure 5).
Figure 5
US residential mortgage delinquency rate(a) per cent 18
16 Sub-prime 14
12
10
8
All mortgages 6
4 Prime 2
0 1998 99 2000 01 02 03 04 05 06 07
Sources: Mortgaga Bankers Association and Thomson Datastream. (a) 30+ deliquent
During 2006, the delinquency rate rose further and by early 2007 it had reached 15%. It became clear that, because many of the mortgages granted in 2005 and 2006 had up-front “teaser rates”, which during 2007 and 2008 would reset at much higher levels, there was only one direction delinquencies were going to go: up. Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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The prices of sub-prime mortgage credit default swaps began to fall late in 2006 (see Figure 6) and dropped like a stone by the middle of the year, indicating higher perceived default risk for the underlying assets.
Figure 6 0 90 80 70 60 50 40 30 20 110 100 US$ AAA BBB AAA BBB- (a) A 2007 SouPrices of US sub-prime mortgage credit default swaps 2006 July Sep Nov Jan Mar May Source: JPMorgan Chase & Co. (a) 2006 H2 vintage Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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The widening of credit risk spreads that followed was not confined to sub-prime related instruments and institutions. As is clear from Figure 7, which shows the behaviour of Sterling corporate bond spreads by rating, the global underpricing of risk had aVected virtually every private financial instrument, and the sovereign instruments issued by all but a small number of highly creditworthy sovereigns.
Figure 7
Sterling corporate bond spreads by rating(a)
Basis points 600 AAA AA A BBB 500 BB B
400
300
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0 Jan Apr July Oct Jan Apr July Oct 2006 07 Source: Merrill Lynch (a) Option-adjusted spreads over government bond yields
The US sub-prime mortgage crisis was just the trigger of the global crisis. To illustrate, early in 2007, a large amount of unsecured household debt (consumer credit) had to be written down/oV by UK banks. In August 2007, we say something we had never seen before. The simultaneous global freezing up of virtually all wholesale capital markets, including the interbank markets, CDO markets, markets for asset- backed-commercial paper (ABCP) (where the crisis hit Canada first) and markets for all but the very best asset-backed securities. Global new CDO issuance dropped precipitously (see Figure 8) and it became impossible to roll over outstanding stocks of commercial paper, especially asset-backed commercial paper, which as a result declined sharply (see Figure 9). Processed: 30-01-2008 12:02:02 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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Figure 8 0 80 60 40 20 120 100 US$ billions (a) Global CDO issuance Funded Unfunded 2006 07 Oct Nov Dec Jan Feb Mar Apr May June July Aug Sep(b) Source: JPMorgan Chase & Co (a) Funded CDOs refer to instruments backed by corporate bonds, unfunded credit swaps (b) Unfunded date fo rSeptember not available Processed: 30-01-2008 12:02:02 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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Figure 9 US$-denominated commercial paper outstanding US$ billions 2,250 Non-financial Financial 2,000 Asset-backed 1,750
1,500
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0 2002 03 04 05 06 07
Source: Board of Governors of the Federal Reserve
7. How did the World’s Leading Central Banks Respond to the Crisis? None of the world’s leading central banks exactly covered themselves with glory, although some did better than others, and the Bank of England probably did the worst job.
The Federal Reserve After the crisis erupted on 9 August, the Federal Reserve decided to reduce its (primary) discount rate by 50 basis points from 6.25% to 5.75% on 16 August. This was at best a meaningless gesture. There were no US financial institutions for whom the diVerence between able to borrow at the discount rate at 5.75% rather than at 6.25% represented the diVerence between survival and insolvency; neither would it make a material diVerence to banks considering retrenchment in their lending activity to the real economy or to other financial institutions. It was a reduction in the discount window penalty margin (previously 100 basis points) of interest only to institutions already willing and able to borrow there (because they had the kind of collateral normally expected at the discount window). It was small subsidy to such banks—a small treat for their shareholders. A possible rationalisation of this action—that it was a way for the Fed to say “we feel your pain; we know and we care”, without doing anything substantive, like a cut in the Federal Funds target rate—really makes little sense, as from a substantive viewpoint, the Fed’s action on 16 August was cheap talk. Subsequently, on 18 September, the Fed cut the Federal Funds Rate by 50 basis points, with a further reduction of 25 basis points following on 31 October. In both cases, the Discount rate was reduced by the same amount. The Fed also extended the maturity of loans at the discount window from overnight to up to one month. It also injected liquidity into the markets at maturities from overnight to three-month. The amounts injected were somewhere between those of the Bank of England (allowing for diVerences in the size of the US and UK economies) and those of the ECB. Throughout the three months of the crisis, it is diYcult to avoid the impression that the Fed is too close to the financial markets and to leading financial institutions. This was definitely the case for the Greenspan Fed, but came as a surprise to me as regards the Bernanke Fed. There is an always-present danger of a regulator getting too close to the industry it is supposed to be regulating in the public interest. Even if conscious regulatory capture is avoided, the regulator is at risk of internalising the objectives, fears and worldview of the regulated industry to such an extent that it interferes with the regulator’s ability to make an impartial judgement about what actions are most likely to serve its oYcial mandate. Processed: 30-01-2008 12:02:03 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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There can be no doubt in my view that the Fed under Greenspan treated the stability, well-being and profitability of the financial sector as an objective in its own right, regardless of whether this contributed to their legal triple mandate of maximum employment, stable prices and moderate long-term interest rates. While the Bernanke Fed has but a short track record, its rather panicky reaction and actions in August and September suggest that it too may have a distorted and exaggerated view of the importance of the financial sector for macroeconomic stability. “Time will tell”.
The ECB The European Central Bank injected liquidity both overnight and at longer maturities on an very large scale indeed, but with limited success (see Figure 10 below). It did not cut the policy rate or its discount rate, but it refrained from raising rates as it had planned to do, and had eVectively pre-announced following its last pre-crisis Governing Council rate-setting meeting on 2 August. Since then there have been three more meetings where rates have been kept on hold, but where the rhetoric strongly hints at a bias towards further rate increases. The longer talk without action persists along these lines, the lower the credibility of the forward-looking statements of President Trichet.
The Bank of Japan The Bank of Japan did nothing in particular, but did it very well. This is justified if the absence of evidence (of significant exposure of Japanese banks to sub-prime-backed securities or to other devalued financial instruments) is indeed evidence of absence (of such exposure). There is, unfortunately, a long history of Japanese banks not owning up to asset impairments, and refusing to write down underperforming assets. Japanese banks continue to be opaque, even by the modest standards of the rest of the banking sectors of the advanced industrial countries.
The Bank of England The Bank of England cut neither its discount rate nor its policy rate. It injected liquidity on a modest scale, at first only in the overnight interbank market. Rather late in the day, it reversed this policy and oVered to repo at three-month maturity, but subject to an interest rate floor, that is, eVectively at a penalty rate. No one came forward to take advantage of this facility. The Bank now manages the Liquidity Support Facility for Northern Rock, although the Treasury is on the hook for any losses the Bank may suVer through its exposure to the mortgages that it is taking from Northern Rock as collateral for its use of the Facility. Just before the Northern Rock crisis blew up, on 12 September 2007 (in a Paper submitted to the Treasury Committee by Mervyn King, Governor of the Bank of England) the Bank told the world the following: “ . . . the moral hazard inherent in the provision of ex post insurance to institutions that have engaged in risky or reckless lending is no abstract concept”. On 13 September 2007, the announcement came that the Bank of England, as part of a joint action by HM Treasury, the Bank of England and the Financial Services Authority (according to the Memorandum of Understanding between these three parties), had bailed out Northern Rock, a specialist mortgage lender, by providing it with a credit line (the purpose-designed Liquidity Support Facility). Without this, Northern Rock, which funds itself mainly in the wholesale markets, would not have been able to meet its financial obligations. Even today we don’t know how any of the details of how this reported credit line is secured, or how any draw-downs of this credit line are collateralised. If Northern Rock had suYcient collateral eligible for rediscounting at the Bank of England’s Standing (collateralised) Lending Facility, it presumably would have done so, rather than invoking this emergency procedure involving the Bank, the FSA and the Treasury. Collateral eligible for rediscounting at the Standing Lending Facility consists of sterling and euro- denominated instruments issued by UK and other European Economic Area central governments, central banks and major international institutions rated at least Aa3 (and, exceptionally, US Treasury bonds). Such assets are said to be scarce on the balance sheet of Northern Rock. The severity of the penalty rate (relative to the policy rate of 5.75%) charged Northern Rock will also be important in determining the long-term moral hazard damage caused by this operation. The Bank’s 12 September Paper recognises conditions when this kind of bail out is justified: “ . . . central banks, in their traditional lender of last resort (LOLR) role, can lend ‘Against good collateral at a penalty rate’ to any individual bank facing temporary liquidity problems, but that is otherwise regarded as solvent. The rationale would be that the failure of such a bank would lead to serious economic damage, including to the customers of the bank. The moral hazard of an increase in risk-taking resulting from the provision of LOLR lending is reduced by making liquidity available only at a penalty rate. Such operations in this country are covered by the Processed: 30-01-2008 12:02:03 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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tripartite arrangements set out in the MOU between the Treasury, Financial Services Authority and the Bank of England. Because they are made to individual institutions, they are flexible with respect to type of collateral and term of the facility”.
The MOU states in paragraph 14:
“14. In exceptional circumstances, there may be a need for an operation which goes beyond the Bank’s published framework for operations in the money market. Such a support operation is expected to happen very rarely and would normally only be undertaken in the case of a genuine threat to the stability of the financial system to avoid a serious disturbance to the UK economy”.
It is clear that the conditions for a justifiable bail out, as specified in the MOU and reiterated in the Bank’s 12 September Paper, were not satisfied.
First, no evidence has been oVered to support the frequently-heard assertion (from Northern Rock, the Treasury, the Bank of England and the FSA) that Northern Rock (total assets £113 billionn as of 30 June 2007) suVered just from illiquidity rather than from the threat of insolvency. Delinquencies on its mortgages are said to be below the average of the UK mortgage lending industry, and that indeed is good news.
However, the organisation has followed an extremely aggressive and high-risk strategy of expansion and increasing market share, funding itself in the expensive wholesale markets for 75% of its total funding needs, and making mortgage loans at low and ultra-competitive eVective rates of interest. In the first half of 2007, Northern Rock accounted for over 40% of the gross mortgage lending in the UK, and for 20% of the net. It is hard to see how with such a breakneck rate of expansion, it is possible to maintain adequate quality control over the lending process. Creditworthiness vetting must have slipped—there are limits to the speed of organic growth. In addition, the bank reputedly oVered mortgages up to six times annual income, and packages of mortgage and personal loans adding up to 125% of the value of the collateral for the mortgage. That seems reckless and an strategy designed to end up with non-performing loans. There is some information surely in the fact that Northern Rock’s share price had been in steep decline since February of this year, well before the financial market turmoil hit.
In my view, the solvency if Northern Rock is a matter still to be determined. As usual, there is no hard information to go by.
Second, it is hard to argue that the survival of Northern Rock is necessary to avoid a genuine threat to the stability of the UK financial system, or to avoid a serious disturbance to the economy. The bank is not “too large to fail”. As the fifth largest mortgage lender in the UK, it is not systemically significant. When all else fails, the “threat of contagion” argument can be invoked to justify bailing out even intrinsically rather small fish, but irrational contagion, that is, contagion not justified by objective balance sheet and oV-balance sheet realities, is extremely rare in practice, and could have been addressed directly had it, against the odds, occurred, following the insolvency Northern Rock. In a well-designed financial system, Northern Rock would have been taken into public ownership, with the deposits ring-fenced and distributed swiftly to the depositors, and with the bank remaining open to manage existing exposures and commitments. This would give everyone involved time to discover the best longer-term destination for Northern Rock, its assets and stakeholders.
The combination of talking tough but then providing the liquidity support to Northern Rock and of describing liquidity support to the markets at longer maturities as creating moral hazard (an erroneous view, in my opinion) but subsequently oVering to provide such support after all, has undermined the credibility of the Bank. I believe the Bank recognises this and is taking steps to avoid a recurrence of such mishaps.
One of the ironies (and surprises) of this set of events is that despite the contrast between the low-key and small-scale interventions of the Bank of England, the massive liquidity injections at all maturities, including three months, of the ECB, and the rate cuts and continued moderate liquidity injections of the Fed, the eVect of these policies on one key measure of money market distress, the spread between -3 month Libor (the interbank rate) and the three-month OIS rate or Overnight Indexed Swaps, is now about the same for sterling, the euro and the US dollar. Figure 10 makes that clear. The spread of Libor over the Overnight Indexed Swap rate is a better indicator of the market’s view of default risk plus liquidity risk than the spread of Libor over the policy rate, because over a three-month horizon, the policy rate can be expected to change.35 This has obviously been the case for the Federal Funds target rate since the beginning of the crisis.
35 An Overnight Indexed Swap is a fixed/floating interest rate swap with the floating leg tied to a published index of a daily overnight rate reference. The overnight rate is close to the policy rate, so the fixed leg of an OIS swap can be interpreted as the market’s expectation of the policy rate over a three-month horizon. Processed: 30-01-2008 12:02:03 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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Figure 10
Spread of 3-month interbank rate over OIS rate 02/11/06 - 02/11/07 1.2
1
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0.6 UK
% Euro Area US 0.4
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0
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8. Lessons to be Learnt by the UK Authorities The way the crisis unfolded damaged the prestige and international standing of the City of London—the financial capital of the world—more than the other leading financial centres.36 The damage is manageable and remediable, but only if eVective steps are taken to correct the many manifest weaknesses of the UK financial system that were brought to light by the crisis. I believe there are 13 lessons for the UK authorities. (1) The Tripartite arrangement between the Treasury, the Financial Services Authority and the Bank of England, for dealing with financial instability is flawed. Responsibility for this design flaw must be laid at the door of the man who created the arrangement—the former Chancellor and current Prime Minister, Gordon Brown. The Treasury, as the dominant partner in the arrangement, also bears primary responsibility for the way in which the Tripartite arrangement performed operationally. The main problem with the arrangement is that it puts the information about individual banks in adiVerent agency (the FSA) from the agency with the liquid financial resources to provide short- term assistance to a troubled bank (the Bank of England). This happened when the Bank lost banking sector supervision and regulatory responsibility on being made operationally independent for monetary policy by Gordon Brown in 1997. It’s clear this separation of information and resources does not work. There are two solutions. Either banking supervision and regulation are returned to the Bank of England, or the FSA is given an uncapped and open-ended credit line with the Bank of England, guaranteed by the Treasury, so the FSA can perform the Lender of Last Resort function vis-a`-vis individual troubled institutions. The Bank would of course retain the Market Maker of Last Resort Function of providing liquidity to markets and supporting systemically important financial instruments. If the Bank were to regain banking supervision and regulation, two deeply political activities, its independence would be jeopardised, especially its operational independence for monetary policy. One solution to this problem could be to take the Monetary Policy Committee out of the Bank of England. The Governor of the Bank of England would no longer be the Chairman of the MPC, although I suppose he (or she) could still be an external member. The MPC would just set the target rate for the overnight interbank market. The Bank would act as agent for the MPC in keeping the
36 The damage done by weaknesses in the design of the framework for financial stability and the implementation of policy by the three key players, the Treasury, the FSA and the Bank of England should not be exaggerated. The position of London as the world’s primary financial centre is threatened more by its grossly inadequate transportation infrastructure, its excessive cost of living (especially housing) and sub-standard and/or wildly expensive primary and secondary education facilities than by anything connected with the recent financial crisis. Processed: 30-01-2008 12:02:03 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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overnight rate as closely to the oYcial target as possible. Anything else (including liquidity- oriented interventions at maturities longer than overnight, and foreign exchange market intervention) would be the province of the Bank of England, not of the MPC.
(2) Two months after the creation of the Liquidity Support Facility and the granting of deposit insurance cover to Northern Rock (and to any other bank that might fight itself in similar circumstances), Northern Rock is still on life support, having drawn over £20 billion from the LSF—just under 20% of its assets. This is a shambles. First, it never should have been necessary to provide both liquidity support and a deposit guarantee for Northern Rock. By eVectively guaranteeing access to funds for Northern Rock and insuring virtually all unsecured creditors to Northern Rock (and all other UK banks who might find themselves in similar straights), the UK has socialised all risk to both sides of the banking sector balance sheet. Several courses of action would have been preferable. They include the following:
(a) Let Northern Rock sink or swim (ie no Liquidity Support Facility), but guarantee all deposits. This would probably have resulted in the insolvency of Northern Rock.
(b) Let Northern Rock sink or swim, but guarantee all deposits up to £50,000. This would probably have resulted in the insolvency of Northern Rock and a much smaller run on the bank by depositors than actually took place.
(c) Take Northern Rock into public ownership.
(3) The UK deposit insurance arrangements (which have been in place since 1982) are flawed. The amount covered (£2,000 outright and 90% of the next £33,000) was too low; the deductible for deposits over £2,000 was an invitation to run, and the time (allegedly up to six months) it could take for depositors to get their money back was far too long. Responsibility lies with the Chancellor, although the Bank and FSA could have been better advisors and counsellors to the government in these matters. The necessary reforms are obvious.
(4) The FSA did not properly supervise Northern Rock. It failed to recognise the risk attached to Northern Rock’s funding model. Stress testing was inadequate. The “war-games” organised by the three parties to the Tripartite arrangement also seem to have suVered from a lack of imagination.
(5) The much-vaunted “light touch” UK model of regulation (based on principles) turned out to be instead of model of “soft touch” regulation. It is clear that the principles vs rules debate is vacuous. You need both. The principles should state a clear “duck test”. Eg if it borrows short and lends long, if it borrows liquid (during normal times, but with the risk of occasional illiquidity in its usual funding channels) and lends illiquid and if banks are substantially exposed to it, then it will be regulated like a bank, even if it says “Hedge Fund” on the letterhead. The rules should aggressively chase the unceasing attempts to avoid regulation by institutional and instrument innovation.
(6) Bank insolvency law in the UK is flawed. A bank that goes into administration has its deposits frozen. The UK needs a US-style arrangement, where the regulator can take a threatened bank promptly into public ownership, ring-fence its deposits so they can be transferred immediately to the depositors, and reopen the bank immediately to manage its existing activities and commitments while a longer-term plan for is worked out.
Provided a troubled and potentially failing bank can be taken into public ownership, I don’t believe there is any need to give banks a dispensation from the laws governing its take-over by, sale to or merger with another institution. Despite the assertions to the contrary by the Governor of the Bank of England, the EU Market Abuse Directive was never an obstacle to an undercover rescue or support operation for Northern Rock.
(7) Following the announcement of the Liquidity Support Facility, there should have been a joint appearance by the Prime Minister, the Chancellor of the Exchequer, the Governor of the Bank of England, the Chairman of the FSA and the CEO of the FSA, looking solemn and reliable, and intoning jointly: “your money is safe”. It might not have prevented the banana-republic-style bank run that started on the 14th, but it was worth a try.
(8) In case even the joint appearance of the Talking Heads would not do the job, the Treasury should have guaranteed the deposits of Northern Rock at the same time the LSF was announced.
(9) The Bank of England has a flawed liquidity policy, both in the money markets and at the discount window. It accepts as collateral, both at the Standing Lending Facility (discount window), and in liquidity-oriented open market operations (repurchase agreements) only instruments that are already liquid (UK and European Economic Area government bonds, bonds issued by a few highly-rated international organisations and, under exceptional circumstances, US Treasury securities. It should emulate the ECB and the Fed and accept as collateral also private instruments, Processed: 30-01-2008 12:02:03 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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including illiquid and non-traded instruments such as mortgages and asset-backed securities. Provided this collateral is priced severely or even punitively, and has a further “haircut” or discount applied to it, there will be no moral hazard and the Bank can expect not to lose money. The Bank does not need to have superior information to the private sector in order to ensure that the prices it pays for illiquid and nontraded securities are not excessive. Many auctions, including the reverse Dutch auction, are (reservation) price discovery mechanisms. With the Bank acting as a monopolistic buyer at these auctions, it could (provided there is no collusion among the sellers) cream oV most of the surplus over and above the reservation prices of the sellers. The Bank would not have to form a view on the true value of these securities following the auction either. It could simply hold them on its books until maturity. That’s the advantage provided by being the one institution that is never illiquid. (10) The Bank should recognise that the spread between, say, three month Libor and the expected policy rate over the three month period (as measured, for instance, by the spread of three-month Libor over the three-month Overnight Index Swap rate) can reflect liquidity risk premia as well as default risk premia. In its memo to the Treasury Committee of 12 September, it got close to arguing that this spread reflected just anticipated default risk. That makes no sense. Liquidity can vanish today, because market participants with surplus liquidity fear that both they themselves and their potential counterparties, will be illiquid in the future (say, three months from now), when the loans would have to be repaid. A credible commitment by the Central Bank to provide liquidity in the future (three months from now) would solve the problem, but it is apparent that the required credibility simply does not exist. Therefore, the only time-consistent solution, in the absence of a credible commitment mechanism, is to intervene today at a three month maturity. The Bank of England should aim, through repos at these longer maturities, to eliminate as much of the “term structure of liquidity risk premia” as possible. This corrects a market failure. It does not create moral hazard. Points (9) and (10) assign to the Bank the responsibility to be the Market Maker of Last Resort, to provide the public good of liquidity when disorderly markets disrupt financial intermediation and threaten fundamentally viable institutions. (11) The Bank should lend at the discount window at longer maturities than overnight. Loans of up to one month should be available (properly priced and with a short back and sides, and at a punitive rate). Given points (9) and (10), the discount window would become, for all banks and on demand, what the Liquidity Support Facility purpose-built for Northern Rock is now. (12) Northern Rock should have known about the Bank of England’s repo and discount window policy. Given these policies, its funding policies were reckless. No party involved in this debacle comes out smelling of roses. At least the Bank of England appears to be willing to learn, and even to admit that it made some errors. We are still waiting for the Treasury to admit to anything less than perfection. (13) My last observation concerns the failure of eVective Parliamentary scrutiny of and oversight over the laws, rules, regulations and institutions that brought us this debacle. Parliament has done little more than sniping ex-post at the other principals in this drama. Finger-pointing and blame allocation are not, however, substitutes for eVective ex-ante Parliamentary scrutiny of the laws, rules and regulations and institutions, at the point that they can still be moulded and shaped. Where was Parliament when it could have done some good?
9. Conclusion When all the relevant lessons have been learnt and all appropriate recommendations implemented, we still will not have a system in which banks cannot fail or in which systemic instability cannot take hold. Capitalism, based on greed, private property rights and decentralised decision making, is both cyclical and subject to bouts of financial manic-depressive illness. There is no economy-wide auctioneer, no enforcer of systemic “transversality conditions” to rule out periodic explosive behaviour of asset prices in speculative markets. It’s unfortunate, but we have to live with it. The last time humanity tried to do away with these excesses of capitalism, we got central planning, and we all know now how well that worked. Hayek and Keynes were both right. Regulation should try to curb some of the more egregious excesses of a decentralised capitalist market economy, but without killing the goose that lays the golden eggs. In the UK, the pendulum towards de- regulation and self-regulation has probably swung too far. It will, however, be diYcult to tighten up unilaterally, as business would no doubt be lost to other jurisdictions with more relaxed standards. Regulation of financial markets and institutions at the EU level would be a major step forward. After that, intergovernmentalism, that is, cooperation between national (or supranational) regulators and tax authorities, will have to take over, to stop the regulatory race to the bottom from discrediting financial globalisation altogether. Processed: 30-01-2008 12:02:03 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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References Borio, C, C Furfine and P Lowe (2001): “Procyclicality of the financial system and financial stability: issues and policy options”, in Marrying the macro- and micro-prudential dimensions of financial stability, BIS Papers, no 1, March, pp 1–57. Caballero, Ricardo J (2006), “On the Macroeconomics of Asset Shortages”, November 2006. Forthcoming: The Fourth European Central Banking Conference 2006 Volume. Desroches, Brigitte and Michael Francis (2007), “World Real Interest Rates: A Global Savings and Investment Perspective”, Bank of Canada Working Paper 2007–16, March 2007. Gordy, Michael B and Bradley Howells (2004), “Procyclicality in Basel II: Can We Treat the Disease Without Killing the Patient?”, Board of Governors of the Federal Reserve System; First draft: April 25, 2004. This draft: 12 May 2004. Kashyap, A K and J C Stein (2004): “Cyclical implications of the Basel II capital standards”, Economic Perspectives, Federal Reserve Bank of Chicago, First Quarter, pp 18–31.
Memorandum from the National Association of Pension Funds
Introduction 1. The National Association of Pension Funds (NAPF) welcomes the opportunity to submit evidence to the Treasury Committee’s inquiry on the problems which have emerged in financial markets in recent months. It is important for the health of the economy as a whole that policymakers and market participants have a clear understanding of the very complex causes of these diYculties. 2. In making our submission, we have focused our comments on the impact of Northern Rock and the wider credit crisis on pension funds as professional investors and as holders of a wide range of traded assets.
About NAPF 3. The NAPF is the leading voice of workplace pension provision in the UK. Some 10 million working people are currently in NAPF Member schemes, while around 5 million pensioners are receiving valuable retirement income from such schemes. NAPF Member schemes hold assets of some £800 billion, and account for over one sixth of investment in the UK stock market.
Executive Summary 4. Overall, the direct impact of Northern Rock on UK occupational pension funds has been limited. This is because pension funds run diversified portfolios of equities, bonds and other assets, so even those with a direct holding in Northern Rock itself have not faced material loss. In addition, pension funds are long term investors, the liabilities of which often fall due many decades in the future so, over the longer term, even the current market volatility should not harm the ability of pension funds to pay pensions to their members. 5. Nevertheless, pension funds are heavily exposed to the UK corporate sector as a whole (as investors and through their sponsors) so, in so far as recent events in Northern Rock and the wider credit market result in an economic slowdown, there will be a short to medium term eVect on the value of pension funds’ assets. While, as professional investors, we fully accept the risks involved in market investing, attempts by some funds to reduce market risk would be more successful if Government and the corporate sector were to provide greater volumes of long-dated bonds. 6. To an extent, Northern Rock is the victim of global trends, in particular the short term and abrupt credit crunch and the widespread use of leveraged products. However, within the UK context, it is fair to say that some questions may need to be answered regarding the willingness of Northern Rock’s Directors to take on such risk and the eVectiveness of the tripartite regulatory system. On the latter point, we suggest that the Government should consider the eVectiveness of the system and whether any changes are necessary. For example, it may be that the respective roles of each of the participants should be clarified. Alternatively, the bodies involved might need extra resources or additional skills to keep pace with the ever-changing nature of the financial markets. 7. The reaction by the financial sector to the sub-prime and Northern Rock crises, in particular the apparent breakdown of trust in the inter-bank lending market, suggests that there may be a need for greater transparency in the markets for complex derivatives. Processed: 30-01-2008 12:02:03 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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Northern Rock
The Impact of Northern Rock on Pension Funds 8. Pension funds invest for the long term in order to meet liabilities that fall due far into the future so there is every reason to believe that the current market volatility will not impair the ability of pension funds to pay pensions to their members. 9. Where pension funds were invested directly in Northern Rock’s equity and bonds, they were, to some extent, protected from the eVects due to the normal practice of holding a highly diversified portfolio of assets in a wide range of companies. That said, it is likely that a number of funds were “overweight” in financial companies, including Northern Rock (on yield grounds alone) so performance will have been negatively aVected. 10. We have seen no evidence that Northern Rock’s business model was seen as flawed by either the Regulator or the market so, even with the benefit of hindsight, the decision by some pension fund investment managers to invest in Northern Rock seems reasonable.
Causes of the Northern Rock Crisis 11. Northern Rock’s business model relied on being able to undertake short-term borrowing on the capital markets in order to fund its long-term mortgage business via the use of highly leveraged term-funded oV-balance sheet assets. When the supply of credit dried up, due to the unwillingness of the banks to buy each others’ loans, the business model failed. In many ways, the demise of Northern Rock is, therefore, less to do with local factors than with more global trends such as the credit crunch and the widespread use of leveraged products. 12. Questions can perhaps be raised about the way in which this risk was managed both internally by the company’s Directors and externally by the Regulators. 13. With regard to the eVectiveness of the tripartite oversight model, it is unclear to pension funds as “outsiders” whether the system is ineVective. To address this issue, we believe that the Government should consider the current arrangements and see whether they might, in any way, be improved. For example, it may be that roles need to be clarified or additional resources or skills may be needed to eVectively supervise a sector in which practices are constantly changing and evolving.
Depositor Protection 14. NAPF members are substantial depositors with the UK banking system but have always been, and should remain, outside the scope of any depositor protection scheme. It is the role of their managers and advisers to ensure that deposits are suYciently diversified so as to reduce any damage to value from insolvency or illiquidity.
Overall Functioning of Financial Markets 15. Derivatives have been widely used for several years. However, what is new is the extent to which banks have in recent years packaged up diVering forms of debt in securitised form and sold it on. This practice removes credit risk from bank balance sheets, but has lead to uncertainty as to where such risks lie. In recent months, such uncertainty has caused a liquidity crisis as banks have been unwilling to deal with each other (for fear that some have done a worse job than others of shedding credit risk). 16. What is certain, however, is that if the balance sheet problem is rooted in confidence in the wholesale banking market, greater transparency would have been desirable, particularly around the use of certain investment vehicles. Such transparency should answer the questions of who funds them and who carries the risk. 17. While substantial data is available on some structured credit products, the complexity of the data analysis has led to a high reliance on ratings and the agencies that supply them. AAA or top short-term ratings were deemed suYcient assurance for many, but clearly the mark-to-market risk has proven much greater than anticipated (eg the vulnerability to market dislocation and illiquidity). It is likely that the absence of data from previous credit crises in recent years may have resulted in mis-estimation by agencies of correlations and underlying credit risk. However, many professional investors, especially the banks, do not usually rely on the rating agencies for their estimates of the risks posed. Instead, it is common practice for them to make their own assessments of the risks and rewards of such products. 18. The fact that issuers pay for ratings and benefit from high ratings can lead to agency and rating methodology arbitrage by issuers. This is an area for concern—rating agencies and methods with impaired credibility results in seizure in market segments previously reliant on them. 19. In recent years, many UK pension schemes have been reducing their exposure to risk (de-risking) by switching assets from equities, which are relatively volatile, to bonds composed principally of UK Government and investment grade corporate bonds, which better match pension funds’ liabilities. Processed: 30-01-2008 12:02:03 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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Unfortunately, this necessary switching has been impeded by the very limited availability of long-term Government and corporate bonds. In consequence, a small minority of pension funds, in order to gain good returns at lower volatility may have invested in complex derivatives such as Collateralised Debt Obligations (CDOs) and hedge funds. 20. However, the exposure to (and potential losses from) CDO type strategies employed by hedge fund managers will be very small relative to the total pool of pension fund assets. Even where pension funds have opted for more active bond mandates which do involve some exposure to CDOs, and which may include sub prime mortgage debt, industry experts estimate that this exposure amounts to no more than 1–2% of assets. In light of this, the direct impact of exposure to CDOs would be very small. This is confirmed by the NAPF’s own 2006 Annual Survey which shows that UK pension schemes have only a small exposure to hedge funds (circa 1% of total assets in defined benefit schemes). Separately, it has been estimated that the majority of hedge fund assets are held via relatively diversified fund of funds vehicles rather than in isolated individual hedge funds. (Pension Fund Indicators 2006, UBS)
Conclusion 21. The Northern Rock issue is a symptom, rather than a cause of the challenges currently facing the financial sector. At heart, these relate to wider global trends in the availability of credit and the use of leveraged products as well as to the apparent breakdown in trust between the banks. 22. As long term investors, the current troubles should not materially harm the ability of pension funds to pay pensions to their members, although they will aVect asset values in the short to medium term. Nevertheless, the task of paying pensions would be made easier if the Government and the corporate sector were to issue more long-dated bonds. 23. We believe that there is little that the Government or Regulators can do in the short term to address the immediate eVect of the credit crisis as the banks and others aVected will have to work through the consequences of their recent activities. Patience and market-led solutions will deliver but at considerable cost to some organisations, their management and their shareholders. However, it may make sense for the Government to review the current “tripartite” regulatory regime and to consider whether greater transparency can be achieve in the market for structured investment vehicles. November 2007
Memorandum from E Gerald Corrigan, Goldman Sachs The purpose of this statement is to provide a brief summary of my long-held personal views on two closely related subjects; namely (1) systemic financial risk; and (2) the so-called moral hazard dilemma associated with eVorts by public authorities to mitigate such systemic risks.
I. Systemic Financial Risk in Perspective 1. Financial shocks are distinguished from financial disturbances (1a) Financial shocks have the potential to inflict serious damage on the financial system and/or the real economy. Financial shocks are relatively infrequent. (1b) Financial disturbances occur with some regularity but typically are sorted out by the marketplace with limited disruption or damage. 2. Recent history and the long sweep of financial history point to four inescapable conclusions about systemic financial shocks: (2a) First, on balance, the already low statistical probabilities of the occurrence of financial shocks have declined further in recent years, even if such probabilities are still well short of zero. (2b) Second, given the speed, complexities and linkages of contemporary financial markets, the potential for damage caused by financial shocks is greater than in the past even if the probability of occurrence is lower. — Stated diVerently, the threat of contagion is greater. (2c) Third, our collective capacity to anticipate the specific timing and triggers of financial shocks is essentially nil. — To cite a recent example, in the spring of this year almost everyone recognised that credit terms and credit spreads were likely to adjust to more normal standards. — But, human nature being human nature, when markets are robust there is a natural aversion to being the last one in or the first one out. Processed: 30-01-2008 12:02:03 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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— In other words, we sometimes forget that financial market behavior is fundamentally a manifestation of collective human behavior with all of the frailties associated with human behavior. That is why from time-to-time financial markets will overshoot in both directions. (2d) Fourth, because of the three factors cited above, financial market practitioners and policymakers have no choice but to focus unrelenting attention on what I like to call strengthening the “shock absorbers” of the global financial system. — The term shock absorber as used in this context has a very broad meaning in that it applies to the full range of private and oYcial initiatives designed to enhance the stability of the financial system including the key elements of the so-called “public safety net” associated with banking institutions such as oYcial supervision, access to the credit facilities of the central bank and deposit insurance. — And, despite the recent turmoil in credit markets, I believe solid progress is being made in strengthening these shock absorbers even as financial practices become more complex and relatively new classes of financial institutions take on an increasingly important role in the financial intermediation process. 3. Having made the distinction between financial shocks and financial disturbances, the events of the last several months clearly qualify as a financial shock with clear elements of systemic risk. That being the case, there follows a few broad observations regarding the causes of the current financial shock. 4. At one level, it is abundantly clear that the proximate cause or trigger of recent financial events was the excesses in the housing sector in the United States with emphasis on the sub-prime mortgage market. (4a) More fundamentally, it is equally clear—at least with the benefit of hindsight—that the “reach for yield” phenomenon spurred by a long period of abundant liquidity and relatively low interest rates helped to stimulate a surge in the creation and use of multiple forms of structured credit products, many of which are very complex. Often, these structured credit products provided institutional investors access to investment opportunities providing relatively high returns but with correspondingly high risks. 5. Even in the face of early signs of problems in the sub-prime market such as the HSBC acknowledgement of large sub-prime credit losses in February of this year, I think it is fair to say that many observers were slow in recognising the potential scale of the housing and sub-prime mortgage problem and its potential contagion eVects. (5a) It was probably the losses experienced by the Bear Stearns hedge funds in the early summer that brought the problem into sharper focus and served as the wake up call as to the serious nature of the problem and its potential to unleash damaging contagion risk forces. 6. Looked at more broadly, the market turmoil that followed seems to have been driven by two fundamental forces, both of which had important implications for the contagion phenomenon. At the risk of oversimplification, those two fundamental forces were as follows: (6a) First, we experienced a broad-based drive to re-price credit risk which took hold across broad segments of the credit markets that were by no means limited to sub-prime mortgages. The motivation associated with the market-driven eVort to re-price credit risk was to enhance and strengthen credit terms from the perspective of credit suppliers. (6b) Second, in a separate but related development, we witnessed a simultaneous drive across all classes of financial institutions to reduce risk. 7. The drive to re-price credit and to reduce risk in the face of changing market conditions is hardly a new phenomenon. But, in recent weeks and months there were factors at work that made this phenomenon diVerent in degree—if not kind—from earlier episodes. I would cite two factors that at least in degree were diVerent from earlier experience and thus, elevated contagion risk factors. They are: (7a) First, the credit re-pricing process was hindered by the break down in the price discovery process for some classes of complex financial instruments including but not limited to sub-prime mortgages and their derivatives such as CDOs (collateralized debt obligations). And, as the markets for such instruments became illiquid, the price discovery process was further impaired. Obviously, if price discovery is not working, re-pricing credit suVers accordingly. (7b) Second, risk reduction, which necessarily entails reducing position risk and/or leverage, inevitably brings with it added pressures on market liquidity which, in turn, contributes to increased volatility and higher risk premiums. Ironically, such increases in volatility also increase measured risk, thus frustrating eVorts to reduce risk. Indeed, I suspect that for many institutions, increases in volatility were largely oVsetting eVorts aimed at position reduction such that key risk metrics such as “value at risk” were little changed, or may have increased, despite meaningful reductions in position risk and leverage. This phenomenon is not new, but in the face of uncertainties about the value of some financial instruments as discussed above, it certainly did aggravate the turmoil in credit markets. (7c) This analysis leads us inevitably to a troubling conclusion: namely, while experience and history allow us to identify certain common denominators associated with most financial shocks, the Processed: 30-01-2008 12:02:03 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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specific triggers and transmission channels that produce contagion are almost always impossible to anticipate with any meaningful degree of precision. Thus, no matter how smart we think we are, crisis management for practitioners and policymakers alike will always take place in a setting of sizeable gaps in hard information and great uncertainty as to how contagion factors will play out.
II. The Moral Hazard Dilemma 8. Intervention by central banks and/or governments in the face of financial crises has been a fact of life for centuries. Not surprisingly, concerns about moral hazard—or the risk that such interventions will protect institutions and investors from loss thereby sowing the seeds for even greater excesses in the future— have also been a fact of life throughout financial history. (8a) While the moral hazard problem is very real, there clearly are extreme circumstances in which oYcial intervention by central banks and other oYcial bodies to mitigate the damage caused by financial crises are justified. — That is the primary reason why many central banks were created. — Moreover, looking at the history of such interventions over the past two or three decades, it can hardly be said that such interventions have protected institutions and investors from losses. For example, the write-downs experienced by a number of major financial intermediaries in recent weeks have now reached tens of billions of dollars and the meter is still running. (8b) Thus, the issue is not whether circumstances may arise from time-to-time in which oYcial intervention is wholly justified but rather (1) the skill and discipline with which central banks and others make the judgment that intervention is justified; and (2) the timing and manner in which that judgment is exercised. — It is important to keep in mind that just as there are consequences of a judgment to intervene, there are also consequences of not intervening. — The decision to intervene, or not, must always be made on the basis of imperfect information and considerable uncertainty. However, in my experience from the perspective of a professional life in both the public and private sectors, information gaps can be narrowed by (1) rigorous and ongoing monitoring of markets especially by central banks; and (2) close and informal communication between monetary authorities and the leaders of key financial institutions, and (3) ongoing communication and coordination between supervisory authorities, central banks and relevant governmental bodies. 9. Faced with the reality of a financial crisis with potential systemic characteristics, the most diYcult judgments that authorities must confront are: (1) the likely speed and reach of contagion; and (2) whether the contagion factor is primarily being driven by market illiquidity considerations as distinct from concerns about institutional solvency. (9a) While the liquidity/solvency distinction is never clear cut, I believe it is fair to say that in the financial crises of 1987, 1998, and the current situation, central bank interventions were motivated primarily by market liquidity considerations or the need to provide the markets with large amounts of temporary liquidity primarily through the use of open market operations. — The use of open market operations provides the advantages that (1) such liquidity support can be reversed with relative ease when the crisis eases; and (2) the marketplace—not the authorities—make the business and credit decisions as to how that liquidity will be allocated among competing uses. (9b) Even when intervention is framed around contagion and market liquidity considerations, the moral hazard dilemma does not disappear although the horns of that dilemma are somewhat muted. 10. On the other hand, the moral hazard problem is considerably more acute if the issue at hand involves a judgment about intervention growing out of an actual or potential insolvency question involving one or more institutions. In such circumstances, monetary authorities will almost always have to make the very diYcult judgment of whether the disorderly failure of such an institution will trigger dangerous contagion eVects on other institutions or on financial markets and/or the economy generally. 11. In these circumstances, decisions to intervene—and the nature of such intervention—must always be made on a case-by-case basis against the backdrop of what, for years, I have called a policy of “constructive ambiguity”. In other words, since it is impossible to anticipate every low probability contingency that may arise, authorities must preserve the flexibility to respond as the circumstances of a given situation require. 12. While the presence of a system of deposit insurance helps to produce a strong tilt against intervention, extreme situations can still arise in which authorities may conclude that circumstances warrant extending protection to depositors (and even other creditors) beyond the limits of deposit insurance. We are all familiar with episodes in major industrial countries—including the 1980’s thrift institutions crisis in the U.S.—in which authorities concluded that such extraordinary intervention was necessary in the face of the threat of a broad-based financial melt-down that could threaten the real economy. Processed: 30-01-2008 12:02:03 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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13. To summarize, the moral hazard problem is very real. By the same token, and even as we continue to strengthen the shock absorbers of the financial system, we know that infrequent financial shocks will occur in the future in which oYcial intervention may be necessary and appropriate even if there should always be a strong bias against such intervention. 4 December 2007
Memorandum from David Pitt-Watson, Hermes Equity Ownership Service Some issues for the Committee to consider.
Background In general, capital markets have served us well. The continuing growth in the world economy, despite commodity price shocks, is a tribute to their eYcacy. Hermes is a significant fund manger, managing and advising around £80 billion, on behalf of pension fund clients. Hermes itself is owned by the BT Pension Scheme. It is well known for its “stewardship” programmes; that is trying to behave as an “owner” of its clients interests, not just a trader of securities. In investment terms we are equally concerned with generating “beta” (absolute market performance) not just alpha (out performance, irrespective of market movements). David Pitt-Watson, is a co-founder of the stewardship activities at Hermes, and Chair of its Equity Ownership Service. He is the author of The New Capitalists, a book which describes how capital markets can be made more accountable and responsible. While recognising the benefit of trading securities, the lack of focus on ownership has contributed strongly to the credit problem.
What Has Happened
The Credit Crisis In the past, if a bank made a loan, it held it on its balance sheet. It owned the loan, and was therefore concerned that its customers were fully credit worthy. However, the capital requirement, and therefore the cost of a bank holding a loan, was higher than if it were held in a special purpose vehicle, oV the banks’ balance sheet. To take advantage of this, many loans are made (originated) by individuals, banks and others, then packaged up and sold on to “the market”. This process is known as disintermediation. Disintermediation has meant that banks had less need to check credit worthiness. Incentives were simply to write more loans, take a fee, and sell the loan, or parts of the loan on to others. This created a perverse incentive of the type which is common in financial services. In order to be assured that loans were creditworthy, the market therefore depended on rating agencies. These are a regulated oligopoly, paid by the issuer of the loan, and therefore cannot avoid concern about conflict of interest. They often sell other services to companies whose bonds they rate. Further, accounting standards have increasingly adopted the “fair value” rule, to valuing securities on the balance sheet. Old principles of prudence can often be sacrificed by adherence to such rules, especially where there is no market for the securities in question. This then can temporarily flatter profits and balance sheets. Holders of these credits behaved as traders. Provided they felt they could “read the market”, and sell on the security, they paid less attention to its fundamental value, (indeed after disintermediation, and possible splitting of packaged loans into their constituent derivatives, it would be diYcult for them to have done so). This is just the way Keynes described the way that stock markets worked. Traders seek alpha, with little concern for beta, even though it is the beta which will ultimately pay our pensions, and alpha is, at best, a zero sum game. The fallout from these practices, particularly in the USA, has still fully to be understood.
Northern Rock Prior to its collapse, Hermes, as part of its stewardship programme, had made contact with Northern Rock, to raise questions about its business model, its remuneration and accounting disclosure. Clearly it could have been more probing and forceful. However, Hermes represented just over 1% of NR’s shares. The Select Committee will doubtless be inquiring what other shareholders did, what the board did, and what the auditor did, to question the very aggressive strategy the bank was following. As a result of NR’s collapse, pensioners and other owners of NR’s shares have now lost £4,000 million, about £150 per household in the UK. Processed: 30-01-2008 12:02:03 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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Perverse incentives may also have been at work at Northern Rock. The eVective guarantee which the government gives to banks would be expected to encourage imprudent money market lending, particularly if it is secured in priority to retail depositors. In addition, banking regulation encouraged the creation of oV balance sheet vehicles, such as Granite. The tripartite system failed, in the sense that the Bank of England had to U turn. Having said that, one must have some sympathy for the need to avoid moral hazard, and the UK regulatory regime is held in high regard.
Where Might Solutions Lie
These problems will not be solved by regulation alone, but in combination with a greater focus on ownership responsibility, and transparency. Certainly there could be value in reviewing banking regulation, and accounting in relationship to oV-balance sheet finance. One could suggest tighter standards for Credit Rating Agencies, (CRA’s), to ensure their independence. The oYcial US oligopoly on CRA’s could be reviewed, especially if they cannot show how they are independent. There could be a review of whether it is appropriate that they sell other products, and if they do, what transparency is appropriate. Investors could initiate and lead this, (and be held accountable for their conclusions). We could slow the dash to IFRS, and its focus on fair value. A challenge could be made to adoption of market based valuations. Investors could be better represented throughout the IASB structures, which is responsible for the standards adopted. We could review the role of investors as owners. Lots of progress has been made here, but much remains to be done. Principally it’s pension funds and their like that lose in financial crises, yet few do much to ensure good stewardship, to oversee, or get someone else to oversee accounting and other regulation. What, for example, does the House of Commons scheme do in this regard? We could ask all public sector schemes to ensure best practice in ownership. We could review bank liquidation procedures. We could review the tripartite system, in particular ensuring the FSA monitors all aspects of banking risk, and is fully appraised of how the Bank of England intends to respond to any failure. The FSA and the board of any bank, particularly its non executives could be in closer conversation about risk. The committee also raised questions about the role of hedge funds. Certainly some of the funds which are described in this way are quite opaque in their investment. Again, it might be helpful if long term investors could ensure that the activities of hedge funds and other vehicles in which they invest are transparent, and do no damage the capital markets upon which all investors depend. Few of these will be achieved by law and regulation, which are likely to be cumbersome, and have unintended consequences. It needs a new mood of responsibility in the capital markets and the fund management industry, which should be led by the individual savers and their fiduciaries, It is their pensions and savings the industry should be seeking to secure. December 2004
Memorandum from PricewaterhouseCoopers This Memorandum responds to the Committee’s requests at the evidence session on 4 December.
1. A detailed commentary of the nature of information sought, and the work carried out, by PwC in relation to Northern Rock’s 2006 Annual Report and the “Going Concern review” in February 2007 [Q1316]
1.1 Q1316 reads “Can you provide us with a summary of how you worked with Northern Rock on the assumptions of impairment that they produced?” This arose in the context of a series of questions about the bank’s loan book as at 31 December 2006. We assume therefore that the question is directed towards our work in relation to impairment, and we have answered on that basis. If we have misunderstood, and the query is directed at the audit process as a whole (which would of course involve a much fuller response), please let us know. Processed: 30-01-2008 12:02:03 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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2006 Annual Report
1.2 Northern Rock prepared its financial statements in accordance with EU endorsed International Financial Reporting Standards (“IFRS”). These standards are a complex mix of prescription and application of subjective judgment in the area of accounting for loan loss impairments. 1.3 It may be helpful first to set out the accounting policy in the 2006 Annual Report as it details the steps the company has to follow in preparing this aspect of the financial statements: “Impairment losses The Group assesses its financial assets or groups of financial assets for objective evidence of impairment at each balance sheet date. An impairment loss is recognised if, and only if, there is a loss event (or events) that has occurred after initial recognition and before the balance sheet date and has a reliably measurable impact on the estimated future cash flows of the financial assets or groups of financial assets. i) Assets held at amortised cost The Group first assesses whether objective evidence of impairment exists individually for financial assets that are individually significant, and individually or collectively for financial assets that are not individually significant. Objective evidence that a financial asset is impaired includes observable data that comes to the attention of the Group about the following loss events: a) significant financial diYculty of the issuer or obligor; b) a breach of contract, such as a default or delinquency in interest or principal repayments; c) the lender, for economic or legal reasons relating to the borrower’s financial diYculty, granting to the borrower a concession that the lender would not otherwise consider; d) it becomes probable that the borrower will enter bankruptcy or other financial reorganisation; e) the disappearance of an active market for that financial asset because of financial diYculties; or f) observable data indicating that there is a measurable decrease in the estimated future cash flows from a portfolio of assets since the initial recognition of those assets, although the decrease cannot yet be identified with the individual financial assets in the portfolio, including: i adverse changes in the payment status of borrowers in the portfolio; ii national or local economic conditions that correlate with defaults on the assets in the portfolio. If the Group determines that no objective evidence of impairment exists for an individually assessed financial asset, whether significant or not, it includes the asset in a group of financial assets with similar credit risk characteristics and collectively assesses them for impairment. Assets that are individually assessed and for which an impairment loss is or continues to be recognised are not included in a collective assessment of impairment. If there is objective evidence that an impairment loss on loans and receivables has been incurred, the amount of the loss is measured as the diVerence between the asset’s carrying amount and the present value of the estimated future cash flows (excluding future credit losses that have not been incurred) discounted at the financial asset’s original eVective interest rate. The carrying amount of the asset is reduced through the use of an impairment allowance . . .” 1.4 It therefore follows that the directors first need to make an assessment as to whether there is objective evidence of impairment firstly at an individual level and secondly at a collective level. If there is evidence of impairment at either level an impairment provision is created being the diVerence between the then carrying value and the net present value of anticipated future cash flows. Although objective measures of the existence of impairment are to be applied there is inherently a range of reasonable latitude in the choice and use of such measures. There is a further element of subjectivity in the assessment of the range of expected future cash flows. Consequently, it follows that there is no single correct answer for the level of impairment provisions rather a range of acceptable values. 1.5 The nature of critical estimates in the process were set out in the Northern Rock 2006 Annual Report as follows: “Impairment losses on loans and advances Individual impairment losses on loans and advances are calculated based on an individual valuation of the underlying asset. Collective impairment losses on loans and advances are calculated using a statistical model. The key assumptions used in the model are the probability of Processed: 30-01-2008 12:02:03 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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any account going into default in the next 12 months, the loss incurred in the event of possession or write oV, the roll rates of borrowers moving from lower levels of arrears to serious arrears and possession or write oV, and the time period from the date of the event causing the loss to the date of realisation of the property or write oV. The probability of accounts going into default is based on application and behavioural scorecards, which are regularly recalibrated to take account of current circumstances. These key assumptions are based on observed data from historical patterns from lending over previous years and are updated regularly based on new data as it becomes available. In addition, management considers how appropriate past trends and patterns might be in the current economic situation and makes any adjustments that it believes to be necessary to reflect current conditions. The accuracy of the impairment calculation would therefore be aVected by unexpected changes to the economic situation, inaccuracies within the models used compared to actual outcomes and assumptions which diVer from actual outcomes. To the extent that the loss given default diVers by !/" 10%, the impairment allowance would be an estimated £9.4 million higher (2005 £12.1 million) or £10.1 million lower (2005 £12.0 million) respectively.” 1.6 The role of the directors, therefore, is to adopt appropriate objective measures of impairment, apply those to the loan book as a whole and then carry out estimations of future cash flows for those loans which may be impaired. In both parts of this process they are applying banking judgements. This is especially so in the case of the expected future cash flows as these will depend upon the manner in which the bankers intend to manage the problem loan. As is clear from the description of the critical estimates above there a number of key parameters that are included in the statistical model referred to above. The directors are responsible for determining the input assumptions to be used in the model described above. 1.7 The role of the auditors is to make an assessment as to whether the directors have acted reasonably and diligently in their application of the requirements of the IFRS (referred to above) such that the resultant provision for impairment is likely to be within the permissible range arising from proper application of the Standard. Consequently, as auditors we look at the assumptions used by the directors in the model above and assess whether they fall within a reasonable range. 1.8 To set the context as to how we obtain audit evidence to assess whether the assumptions are reasonable it is worthwhile explaining the nature of audit evidence as taken from Auditing Standards which govern the conduct of audits in this country. This may assist the Committee in understanding the nature of an auditor’s evidence gathering activities: “In forming the audit opinion the auditor does not examine all the information available because conclusions ordinarily can be reached by using sampling approaches and other means of selecting items for testing. Also, the auditor ordinarily finds it necessary to rely on audit evidence that is persuasive rather than conclusive; however, to obtain reasonable assurance, the auditor is not satisfied with audit evidence that is less than persuasive. The auditor uses professional judgment and exercises professional skepticism [sic] in evaluating the quantity and quality of audit evidence, and thus its suYciency and appropriateness, to support the audit opinion” [ISA (UK & Ireland) 500 para 14—footnote omitted] 1.9 By way of an overview, the audit process adopted for Northern Rock for the 2006 year end in this regard is set out below. It is not practical in a document of this nature to describe every test or procedure adopted or the individual outcomes of those processes. a) We considered the statistical models used by the bank. The models hold data on balances, arrears and security values provided from the company’s systems. They also use external credit reference agency data to provide benchmark information on current credit scores. The model is derived from the Basle II capital adequacy model which obtained specific approval from the FSA for capital adequacy purposes. We also examined the workings of the model at the time of introduction of IFRS for the 2005 year end. (b) In considering the statistical models used by the directors for this purpose, we also considered the internal review processes adopted by the company to control and monitor the inputs and outputs from the models. (c) We reviewed the input data for key parameters in the modelling including the results of examining historical data to support the parameters. In so doing we satisfied ourselves that the company had carefully considered the modelling parameters. Having satisfied ourselves by testing and review that the bank’s systems were a reliable foundation for the production of information, we examined reconciliations of data feeds from the company’s systems into the modelling processes. We then compared the outputs from the models with the impairment provisions actually booked. (d) In addition to the formulaic output from the above models the bank also has a comprehensive and structured system for reviewing the quality of its loan book. Regular reports were produced to the bank’s asset and liability committee (“ALCO”). As would be expected when dealing with about 800,000 loan accounts much of the detail in these comprehensive reports is stratified having regard to the nature of the underlying loan book. Processed: 30-01-2008 12:02:03 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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(e) We considered the procedures used by the bank to produce the ALCO reports from the underlying systems. We concluded that the ALCO reports were a reliable source for considering, inter alia, impairment provisions. We reviewed the analyses, results and trends shown by these comprehensive reports with the bank’s management and directors at a number of levels. We asked questions on those areas where we wished to better understand the data. In particular, we had regard to the levels of arrears reported by the systems and placed that in the context of the results of industry wide analysis in particular that obtained by the bank from the Council of Mortgage Lenders. This showed that the level of arrears experienced by the bank was better than the industry average. (f) We were also aware of the history of the bank’s past assessment of bad and doubtful debt provisions. We considered the economic position generally. We considered the reasoning and development of the methodology as a whole and considered the consistency of the methodology with prior periods. 1.10 Having considered the above matters, and having received satisfactory answers to questions posed, we concluded that the procedures the directors had put in place were indeed likely to produce a provision for bad and doubtful debts within an appropriate range and in compliance with IFRS.
Going concern
1.11 The second part of your request for information deals with “the ‘Going Concern’ review in February 2007”. There was no separate assignment to conduct such a review. The financial statements are prepared on a going concern basis. Auditing standards, specifically ISA (UK & Ireland) 570 and APB Practice Note 19, require an auditor to consider whether the going concern basis is appropriate. In the first instance, the directors are responsible for making the assessment that the bank is a going concern. That is normally taken to mean that an entity is ordinarily viewed as continuing in business for the “foreseeable future” with neither the intention nor the necessity of liquidation, ceasing trading or seeking protection from creditors pursuant to laws or regulations. The “foreseeable future” is usually taken as meaning the next 12 months. As ISA570 observes at para 6 “When there is a history of profitable operations and a ready access to financial resources, management may make its assessment without detailed analysis.” The bank fell into this category. It had traded profitably and it had a track record of ready access to funds at low spreads over LIBOR indicating a willingness by lending institutions to provide finance. In February 2007 there were no indications in the financial markets that the then extant circumstances were to change dramatically. As the relevant auditing standard observes “Any judgment about the future is based on information available at the time at which the judgment is made. Subsequent events can contradict a judgment which was reasonable at the time it was made.” [ISA570 para 7] Obviously the future is by its nature uncertain, and the relevant auditing standard therefore requires the auditor to consider whether there is a “material uncertainty” that “may cast significant doubt” that the company may not be a going concern. 1.12 In addition to the positive trading and financial characteristics mentioned in the preceding paragraph we looked at the post year end trading results, the most recent ALCO reports being those for January 2007 for the year and studied the bank’s operating plans. We also studied external information about forecasts for the UK domestic mortgage markets. None of these exhibited any features other than to indicate a substantial profit for the bank with every rational expectation that there would be no significant financing diYculties. Certainly, nothing that fell into the category of a “material uncertainty” as explained in the auditing standard. Consequently, we concluded that in our opinion there were no matters about the going concern basis of accounting that were required to be reported to shareholders.
2. A detailed breakdown of the “nonıaudit services” performed by PwC for Northern Rock, amounting to a value of £1.3 million as reported in the 2006 Annual Report [Qq 1293–8]
2.1 The total fees received by PwC as reported in the 2006 financial statements was £1.8 million. It is not correct to describe the sum of £1.3 million as being for “non-audit services”. A sum of £0.5 million was received for the audit of the parent company. The £1.3 million is then analysed in the financial statements as follows.
Fees payable to Company auditor and its associates for other services £m — The audit of Company’s subsidiaries pursuant to legislation 0.3 — Other services pursuant to legislation 0.3 — Other assurance services 0.7 Processed: 30-01-2008 12:02:03 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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2.2 Accordingly, an additional £0.3 million was specifically for audit services pursuant to legislation. The second £0.3 million arises from fees in reporting as auditors to the shareholders of the bank or pursuant to professional standards or legislation. The total audit related fees are therefore £1.1 million. The final £0.7 million is largely comprised of fees relating to assurance services in connection with the bank’s actions in raising finance. The fees are analysed in greater detail as follows:
The audit of Company’s subsidiaries pursuant to legislation £ Statutory audits of 5 head oYce companies 34,700 Statutory Audit of Special Purpose Companies or partnership Granite Mortgage Holdings Limited 6,000 Granite Mortgages 00-2 plc 14,750 Granite Finance Trustees 6,000 Granite Finance Holdings Limited 6,000 Granite Finance Funding Limited 16,000 Granite Mortgages 01-1 plc 16,000 Granite Mortgages 02-2 plc 16,000 Granite Mortgages 03-1 plc 16,000 Granite Mortgages 03-2 plc 16,000 Granite Mortgages 03-3 plc 16,000 Granite Mortgages 04-1 plc 16,000 Granite Mortgages 04-2 plc 16,000 Granite Mortgages 04-3 plc 16,000 Granite Master Issuer plc 29,500 Granite Finance Funding 2 Limited 16,000 Dolerite Mortgages Trustees Limited 6,000 Dolerite Funding No.1 plc 14,500 Dolerite Mortgage No.2 plc 14,500 Dolerite Mortgage Trustees No.2 Limited 6,000 Covered Bonds LLP 27,700 Total 325,650
Other services pursuant to legislation £ Interim Review opinion on the results to 30 June 2006 pursuant to APB Bulletin 1999–2004 79,000 Opinion to the board on financial statements pursuant to regulation AB 190,000 Total 269,000
Other assurance services £ Report to, inter alia, the company, the investment bank lead managers (so called “comfort letters”) in respect of four securitisation issues and two pool audits of receivables pursuant to the Granite securitisation programme 400,000 Report to, inter alia, the company, the investment bank lead managers (so called “comfort letters”) in respect of two covered bond issues, two pool audits of receivables and an annual prospectus update pursuant to the bank’s covered bond programme 110,000 Report to, inter alia, the company, the investment bank lead managers (so called “comfort letters”) in respect of a securitisation issue and a pool audit of receivables pursuant to the Whinstone securitisation programme 90,000 Report to the bank and the investment bank lead managers (so called “comfort letters”) in respect of the oVering circular for Medium Term Note programme 100,000 Total 700,000
2.3 In preparing the answer to this question we have observed that Mr Hitchins inadvertently provided incorrect information at Q1341 when he said that £300,000 of fees was in respect of reporting on regulatory returns to the FSA. The above analysis shows the actual position. Processed: 30-01-2008 12:02:03 Page Layout: COENEW [O] PPSysB Job: 386890 Unit: PG10
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3. An account of any non routine activity on the part of PwC with regards to Northern Rock since August 2007 [Q 1377] 3.1 In view of the significant changes in the business and exceptional circumstances facing the company since August 2007 personnel from this firm have advised the bank’s management in the following areas outside the normal audit relationship: (a) an oral report to board on 13 September following limited review of company projections to end 2008; (b) reviewed, commented upon and advised in respect of the company’s short term cash forecasts and its alternative longer term business plan scenarios; (c) the production of a report for the purposes of potential sale of the company, including assisting the company with the creation of a financial forecasting model separate from the company’s accounting records with inputs to the model determined by the company; and (d) the production of a report on potential acquirers of the company.
4. An account of any three-way discussions you have been involved in with Northern Rock and the FSA [Q1340] 4.1 This question is posed in the context of the programme of tripartite meetings the FSA has with banks and their auditors. In respect of the financial year ended 31 December 2006 we did not have any tripartite or bipartite meetings with the FSA and the company. As Mr Hitchins observed in response to Q1338 such meetings do not happen every year, but only at the request of the FSA. 4.2 More information concerning other meetings with the FSA is provided in the response to your next question below.
5.An account of the nature timing and extent of any other involvement with HM Treasury, the Financial Services Authority or the Bank of England in relation to Northern Rock in 2007, including assisting with the valuation of Northern Rock’s assets and liabilities in September [Q1318] 5.1 We answer this question in the context of Q1318 which is in eVect a request for a written response to Q1317 which reads: “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.” 5.2 We did not issue any report on the valuation of the bank’s assets or liabilities in September 2007. Various projections were provided by the company to us in September 2007. We reviewed those projections in a very short timeframe and discussed them with the company. We provided an oral report on our observations to the board on 13 September but did not issue any written report on the projections. We understand those projections, or subsequent variations thereof, were provided by the company to the Bank of England. 5.3 We have not formally reported to the Bank of England, FSA or HM Treasury on any historical or prospective financial information in 2007. The only report we have issued on 2007 financial information of the bank is the normal limited review report dated 25 July 2007 on the interim results to 30 June 2007 pursuant to APB Bulletin 1999–2004. We have attended a number of meetings with one or more of the Bank of England, FSA or HM Treasury since August this year. In all cases we were invited to attend by the company either in our advisory capacity pursuant to one of the engagements above or as auditors of the company. 5.4 In addition, we spoke on a bilateral basis with the FSA on 11 September 2007 about the need to report to the FSA pursuant to the Financial Services and Markets Act 2000 (Communications by Auditors) Regulations 2001. We reported in writing the same day to the eVect that during the normal course of our audit planning activities for our audit of the financial statements of the bank for the year ending 31 December 2007, we had become aware of certain limited information regarding the Group’s financial position which we considered may be relevant to the FSA as the supervisor of the bank. 5.5 This limited information had been supplied verbally by Mr D A Jones, Group Finance Director, Northern Rock plc, in the period 7–10 September 2007 and had not been subject to audit or verification. As a result of this information, we had reasonable grounds to believe that the Company may cease to be a going concern given the current significant pressure on the Group’s liquidity due to its inability to undertake its normal funding programme. We were aware that a potential solution involving the Bank of England had been proposed but had no knowledge of the terms or conditions of that solution or its impact on the Group’s going concern. We understood that Mr Jones had been in regular contact with the FSA about this matter. Processed: 30-01-2008 12:02:03 Page Layout: COENEW [E] PPSysB Job: 386890 Unit: PG10
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5.6 Members of the audit team attended a bi-partite meeting with the FSA on 20 September to discuss our letter of 11 September 2007. We explained the events which had caused us to have to write the letter. The following additional matters were discussed at that meeting in particular: (a) We explained to the FSA the nature of the additional work we were undertaking for the company and the very limited nature of our review of the projections covered by our oral report to the board on 13 September. (b) We were asked to provide our present impressions of the company activity together with Board and management actions. The FSA enquired as to our views on the “going concern” question. We indicated that we were unable to express a view as the work required had not been undertaken. (c) The circumstances surrounding the trading statement on 14 September were discussed The FSA sought our views on our current impressions of the bank, how robust the bank’s processes were, the capabilities of those dealing with the securitization programme, the valuation of Treasury assets, the quality of the asset base, the adequacy of the internal audit function including any previously reported control issues and how the company was responding to FSA requests for information. (d) We were requested, in the context of our duties as auditors, to advise the FSA if our views changed.
6. A statement as to whether PwC raised the issue of the dangers of expansion, using the money markets, with the Audit or Risk Committee of Northern Rock and, if so, what the nature of that warning was [Q 1377] 6.1 We did not attend meetings of the risk committee or report to them. 6.2 To the best of our knowledge and belief the issue was not raised with the Audit Committee. Nor would we have expected it to be raised. We meet with the Audit Committee to discuss matters arising from our audit of the historical financial information rather than matters of company strategy. January 2008
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