House of Commons Treasury Committee The run on the Rock Fifth Report of Session 2007–08 Volume I Report, together with formal minutes Ordered by The House of Commons to be printed 24 January 2008 HC 56–I [Incorporating HC 999 i–iv, Session 2006-07] Published on Saturday 26 January 2008 by authority of the House of Commons London: The Stationery Office Limited £20.00 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]. The run on the Rock 1 Contents Report Page Summary 3 1 Introduction 5 The run on the Rock 5 The conduct of our inquiry 5 The role of our inquiry 6 Our two Reports 7 2 Northern Rock’s business model 10 The importance of Northern Rock in the North East 10 Assets 11 Liabilities 12 The events of 2007 14 Responsibility for the problems at Northern Rock 17 3 The regulation of Northern Rock 21 Northern Rock’s regulation as a high impact firm 21 Potential warnings 22 The Basel II waiver 24 The regulation of liquidity 26 Stress testing 29 Qualifications of senior directors 33 Conclusions 34 4 The events of August and September 35 Introduction 35 The Bank of England’s money market operations until 20 September 37 The decisions on the “safe haven” 50 The support operation, the run and the guarantee 54 5 Dealing with failing banks 73 Why is it important that banks can fail? 73 Why banks are special 73 The potential role of public authorities 74 Who bears the risk of bank failure? 75 Prompt corrective action 77 A special resolution regime? 81 Critical banking functions 85 Lender of last resort 86 6 Depositor protection 87 Introduction 87 Rationale for deposit protection 88 Co-insurance 89 Compensation limit 91 Speedy release of funds 93 Communication 95 Identifying insured depositors 96 Off-setting of loans and mortgages against deposits 97 Funding 98 The run on the Rock 2 7 Lessons learned 104 Our inquiry and other reviews 104 The roles of the Tripartite authorities and the overall functioning of the Tripartite arrangements 104 War games and lessons learnt 108 Leadership 109 Communications strategy with the public 110 Damage to the Tripartite authorities and UK economy 112 Tripartite influence on companies receiving support 113 The audit of high-risk financial institutions 113 8 Reforms 116 Introduction 116 The Deposit Protection Fund 116 Regulatory powers 116 Quis custodiet ipsos custodes? 117 The limits of political control 118 Allocation of the new powers and their relationship to existing responsibilities of the Bank of England 118 Responsibilities of the Office of the Deputy Governor and Head of Financial Stability 121 Operation of the Tripartite arrangements under the new structure 122 Responsibilities of the Treasury 123 9 Northern Rock since September 124 Overview 124 The Bank of England liquidity facility announced on 14 September 124 The deposit guarantees of September and October 125 The additional facilities announced on 9 October 127 The discussions on State aid rules up to early December 129 The further extension of the Government guarantee in December 131 Security of the overall State commitment 132 Reporting and parliamentary accountability 133 Tripartite influence on Northern Rock’s business until December 136 Options for Northern Rock under consideration: September to November 137 Options for Northern Rock under consideration since December 140 Announcement on 21 January 2008 141 Annex 1: Meetings during visit to Stockholm, 26–28 November 2007 162 Annex 2: Relevant meetings during visit to Washington DC, 11–13 December 2007 163 The run on the Rock 3 Summary Overview The period from Friday 14 September 2007 to Monday 17 September saw the first run on the retail deposits of a United Kingdom bank since Victorian times. We analyse the causes and consequences of the run on Northern Rock, and the lessons to be learnt from it. We emphasise the advantages of legislative change on a cross-party basis and make proposals for such change, and for reforms of the Tripartite arrangements, on that basis. Northern Rock and its regulation The directors of Northern Rock were the principal authors of the difficulties that the company has faced since August 2007. The directors pursued a reckless business model which was excessively reliant on wholesale funding. The Financial Services Authority systematically failed in its regulatory duty to ensure that Northern Rock would not pose a systemic risk. Handling the support operation and stopping the run The Chancellor of the Exchequer was right to view Northern Rock as posing a systemic risk to the financial system and to authorise the Bank of England’s support facility. However, the Tripartite authorities did not prepare adequately for that support operation. Those authorities and Northern Rock ought to have strained every sinew to finalise the operation and announce it within hours rather than days of the decision to proceed with the operation. The Tripartite authorities at deputies level failed to plan in advance for the announcement of the Government guarantee on Northern Rock deposits that proved necessary to stop the run. Dealing with failing banks We recommend a series of measures for handling ‘failing’ banks in an orderly manner and in a way that insulates taxpayers and small depositors from the risk of banks failing. We recommend that a relevant authority be given power to acquire information relating to individual financial institutions and to take action in relation to an institution in specified circumstances. We also propose a special resolution regime for failing banks to enable smooth administration of such a bank to be combined with arrangements to ensure that insured deposits are safe and accessible. Depositor protection A deposit protection scheme must be simple and transparent. The “co-insurance” model of deposit protection—whereby small depositors stand to lose some of their money in the event of a bank closing—is discredited. Ensuring the speedy release of funds under any scheme is of critical importance, and we propose measures to provide for this. We recommend the establishment of a Deposit Protection Fund to be funded by participating institutions. 4 The run on the Rock Lessons learned There was a significant failure of the Tripartite arrangements in September 2007, and lessons must be learned from that failure. The financial system in the United Kingdom would not be well-served by a dismantling of the Tripartite arrangements. However, the current arrangements lack a clear leadership structure or a strategy for effective communication with the public. Reforms A single authority ought to be given the new powers for handling failing banks, together with responsibility for the Deposit Protection Fund. There is a need for ‘creative tension’ within the regulatory system, and so these powers and responsibilities should not be granted to the Financial Services Authority. We propose the creation of a new post of Deputy Governor of the Bank of England and Head of Financial Stability. We set out how this new post and the accompanying Office will relate to the existing responsibilities of the Bank of England and to the other Tripartite authorities. The run on the Rock 5 1 Introduction The run on the Rock 1. At 8.30 pm on the evening of Thursday 13 September 2007 the BBC reported that Northern Rock plc had asked for and received emergency financial support from the Bank of England.1 The terms of the funding facility were finalised in the early hours of Friday 14 September and announced at 7.00 am that day.2 That day, long queues began to form outside some of Northern Rock’s branches; later, its website collapsed and its phone lines were reported to be jammed.3 The first bank run in the United Kingdom since Victorian times was underway.4 In this Report we examine what caused the run on the Rock, the consequences of that run for Northern Rock itself and for wider financial stability, the way the events were handled by public authorities and the lessons to be learned.