House of COMMONS









Tuesday 9 October 2007


Evidence heard in Public Questions 150 - 383





This is an uncorrected transcript of evidence taken in public and reported to the House. The transcript has been placed on the internet on the authority of the Committee, and copies have been made available by the Vote Office for the use of Members and others.



Any public use of, or reference to, the contents should make clear that neither witnesses nor Members have had the opportunity to correct the record. The transcript is not yet an approved formal record of these proceedings.



Members who receive this for the purpose of correcting questions addressed by them to witnesses are asked to send corrections to the Committee Assistant.



Prospective witnesses may receive this in preparation for any written or oral evidence they may in due course give to the Committee.


Oral Evidence

Taken before the Treasury Committee

on Tuesday 9 October 2007

Members present

John McFall, in the Chair

Mr Graham Brady

Mr Colin Breed

Mr Philip Dunne

Mr Michael Fallon

Ms Sally Keeble

Mr Andrew Love

Mr Sin Simon

Mr Mark Todd

Peter Viggers


Memorandum submitted by Financial Services Authority


Examination of Witnesses


Witnesses: Sir Callum McCarthy, Chairman, and Mr Hector Sants, Chief Executive, Financial Services Authority, gave evidence.

Q150 Chairman: Sir Callum, welcome to the Committee. Can you identify yourselves for the shorthand writer, please?

Sir Callum McCarthy: Callum McCarthy, Chairman of the FSA.

Mr Sants: Hector Sants, Chief Executive of the FSA.

Q151 Chairman: How much responsibility do you accept as an organisation for the recent damage caused to the UK financial system?

Sir Callum McCarthy: I think that you have to look at the responsibilities of the FSA in relation to Northern Rock in respect of two periods. One is the way in which we discharged our responsibilities of supervision up to the time when market conditions became turbulent and difficult in August and the way in which we have acted since then. I am happy to describe, and I hope our memorandum to the Committee has described, how we went about it in both those periods.

Q152 Chairman: How do you respond to the suggestion by the BBA that "our reputation as a country will not have been strengthened as a result of the wall-to-wall coverage of the queues" at Northern Rock?

Sir Callum McCarthy: I have made clear that I regard the events of Northern Rock as having been damaging.

Q153 Chairman: Do you think that the Bank was too wedded to the concept of a moral hazard and that liquidity operations should have begun earlier?

Sir Callum McCarthy: Those are questions which, I think, have to be addressed to the Bank rather than to the FSA, but I would say that our responsibility in relation to the period when the difficulties of Northern Rock became clear were essentially three. One was to monitor the position carefully, the second was to give advice to the Chancellor in relation to insolvency and in relation to the systemic importance of Northern Rock and the third was to investigate whether there was a possible private sector solution, and I think that we did all three of those.

Q154 Chairman: The reason I ask that question, Sir Callum, was quite simple. There was a tripartite agreement with you talking to the Bank, talking to the Governor; so no doubt during these private discussions you would have had a view on this concept of moral hazard?

Sir Callum McCarthy: Indeed, yes, Chairman.

Q155 Chairman: What was your view?

Sir Callum McCarthy: I think that there it is an important question of balance between the issues of moral hazard, which the Governor addressed very clearly in his memorandum to this Committee and what I would call the problem of damaged innocent bystanders in the sense that there is a problem associated with a worldwide liquidity drying up, which affects not only people who have played a part in arguably irresponsible behaviour, which is the Governor's concern, but much more widely in terms of other people who can possibly be harmed by that event.

Q156 Chairman: So you agree 100% with the Governor?

Sir Callum McCarthy: No, the Governor's document was his document. I am saying it is a question of balance.

Q157 Chairman: I am asking if you agree 100% with the Governor on that subject.

Sir Callum McCarthy: I think that it is possible for people to have different views, and my own view of the balance between the moral hazard arguments and the other instances is slightly different from the Governor's.

Q158 Chairman: In what way is it different? Could you speak up, please?

Sir Callum McCarthy: It is different because I place a slightly different weight on the difference.

Q159 Chairman: In what way is it different? The reason I am asking this is to ensure that we get a satisfactory solution to the future and we never see a bank run again.

Sir Callum McCarthy: I very much hope that we avoid future bank runs actually.

Q160 Chairman: What is the difference between your view and the Governor's?

Sir Callum McCarthy: The question that I was trying to explain, Chairman, is the balance between the moral hazard arguments, which are clearly important, and equally the importance of making sure that when there is a liquidity problem there is a means of dealing with it.

Q161 Chairman: So I can take from that that you would have dealt with it in a different way from the Governor?

Sir Callum McCarthy: No, I do not have the responsibilities that the Governor has; I do not have the requirement to weigh up the general monetary policy questions that the Governor has to weigh. I have a different set of responsibilities.

Q162 Chairman: I understand. Did you ever conduct a war-game type exercise of a similar scenario to the Northern Rock crisis?

Sir Callum McCarthy: We have conducted a series of war games but they have been different because the nature of the problem that we have dealt with in this instance has been different. What we have looked at in the past has been institutional-specific problems, whereas this has been a very different sort of problem. It has been a worldwide drying up of liquidity, and that gives rise to very different questions.

Q163 Chairman: You conducted war-games scenarios for avian flu. Is that correct? Did you conduct any war-game scenarios for a run on a bank?

Sir Callum McCarthy: Yes.

Q164 Chairman: So why did not things operate smoothly then?

Sir Callum McCarthy: Because the circumstances that we looked at---

Q165 Chairman: Because war-games are of no use?

Sir Callum McCarthy: No war-games are useful. I think that the ability of us to work together has been significantly improved by the fact that we have practiced. It is almost impossible to anticipate in advance the particular circumstances of any particular crisis.

Q166 Chairman: Why did you not discover the problems of launching a covert lender of last resort operation in the war-game simulation?

Sir Callum McCarthy: The positions that we looked at were rather different from the position that occurred in relation to Northern Rock.

Q167 Chairman: The Governor said to this Committee that he stumbled on four pieces of legislation which frustrated his ability to support Northern Rock in his preferred covert way. Do you agree with the Governor's interpretation on those four pieces of legislation?

Sir Callum McCarthy: I agree with him that each of those four problems are significant problems. I would add that when we conducted a particular exercise with the Treasury and the Bank in February we had identified in particular the problem of having a means of dealing with banking problems and the need to deal with the question of bank insolvency problems and also the question of the compensation arrangements.

Q168 Chairman: So the Market Abuse Directive was an impediment?

Sir Callum McCarthy: We knew---. I do not think it is simply the legal requirements of the Market Abuse Directive which is an impediment.

Q169 Chairman: I did not say that.

Sir Callum McCarthy: I think there are also a variety of other practical questions which made covert operations difficult.

Q170 Chairman: Let me focus on the Market Abuse Directive because the Commission came out with a statement that was contrary to what the Governor said. Was it flashing up in red lights to the tripartite body that the Market Abuse Directive was an impediment and something had to change there?

Sir Callum McCarthy: No. I think that what was clear to the tripartite authorities, and certainly clear to us, was that there would be obligations of disclosure on a publicly quoted company which would have to be taken into account.

Q171 Chairman: But it was not a complete impediment?

Sir Callum McCarthy: The obligations for disclosure are very much specific to the circumstances of any case. It is impossible to say in all circumstances.

Q172 Chairman: With Northern Rock was it not an impediment?

Mr Sants: If I might just explain a little bit further. As Sir Callum has indicated, each individual judgment has to be situation specific. It was certainly known to us both during any war-games and, of course, generally during the course of our normal business that there would be certain sets of circumstances which would require disclosure. The disclosing circumstances revolve around, of course, the extent of the support being offered and the relevance of that support to the long-term viability of the company and in terms of the knowledge in the market place at that given point, and so, of course, the nature of support which came into penalty would have an impact on its future profitability and so forth. So there are a set of inter-related circumstances which means that a support operation of that type needed to be disclosed at that time.

Q173 Chairman: I understand, but I am trying to get a simple answer to this. When the Governor came he said "there were four pieces of legislation here that stopped us in our tracks". The Market Abuse Directive was mentioned. The reason I am asking this is quite simple, Sir Callum, because the Governor said that this took place in 2005, I think. If that was a big problem, (a) was everyone in the tripartite agreement alive to that and (b) if they were alive, was some legislative programme implemented to change it so that in your war-games, when you are doing your simulations, you say, "Look, if a bank run occurs, then this Market Abuse Directive is a problem and we really need to get on top of that"?

Sir Callum McCarthy: The point I was trying to make, Chairman, is that there is a legal position which, as Hector has explained, is specific to any set of circumstances. It does not necessarily mean that in every single circumstance there would have to be an announcement. With the position of Northern Rock, in the particular circumstances, the Board took the view that they had to make an announcement and we believed there was no legal basis for preventing them. If I look quite apart from the law, there is also a series of practical questions which I think also have to be recognised - for example the need to discuss funding with credit rating agencies, the probability that that would become public in a different route - so there are both legal and practical questions which are important.

Q174 Chairman: So there was no legal impediment in terms of the Market Abuse Directive?

Sir Callum McCarthy: I am not sure what the legal impediment is to.

Q175 Chairman: In other words, the Market Abuse Directive was not stopping everything happening in terms of the Northern Rock situation?

Mr Sants: In those particular set of circumstances we saw no reason to disagree with the Board's view that it was necessary for them to make an announcement. Of course to some degree this is a moot point, because once it had been leaked the night before they certainly had to make an announcement in relation to that set of circumstances.

Q176 Chairman: In a sense there is simplicity to this, that if the Market Abuse Directive was a problem, it was discussed in 2005 and nothing was done about it, then you were behind the curtain?

Sir Callum McCarthy: The point that I am trying to make, Chairman, is that there were disclosure obligations, which we accept, which have been accepted by the British Government and the British Parliament. There was also a series of practical questions and, as Hector has just said, the important thing (I think it bears out my point about the practical importance of these constraints), the thing that actually happened in relation to Northern Rock was the leaking of this information on the evening of the thirteenth and the coverage of that in the news. So, irrespective of whether we had sought to conceal it or not, it was actually in the public domain.

Mr Sants: I think it would be clear to us that it was not going to be the case that all support operations could be covert. It would be clear from the Market Abuse Directive that there would be sets of circumstances when that was not going to be possible, and that would be clear from the point the Market Abuse Directive came into force.

Q177 Chairman: Would you have preferred a covert lender of last resort operation to save Northern Rock?

Sir Callum McCarthy: I think that if that had been a practical possibility it would have had some attractive features. Unfortunately it was not a practical possibility.

Q178 Chairman: Sir John Gieve is a non-executive member of the FSA Board, due to his position as Deputy Governor in charge of financial stability. How well did having this connection work during the crisis?

Sir Callum McCarthy: Perhaps I could just explain what we have done to strengthen the links between the Bank and the FSA in relation to financial stability questions. We have ensured that there is FSA representation or attendance at the Financial Stability Board at the Bank, which looks at largely the macro-economic questions associated with financial stability although the Bank has a very specific set of responsibilities in relation to payment systems because so many of the important payment systems pass across the balance sheet of the Bank. They also have particularly important positions in terms of various international bodies. They are, for example, leading the work in Basle on liquidity. In terms of the FSA one of the things that I arranged was for the Risk Committee of the Board to have John Gieve on it to ensure that there was a proper interlinking between the analysis that is made at the Bank and the analysis that is made at the FSA. If I look at the actual work during the time of the post 9 August problems, I think that the clarity of information between FSA and bank was quite clear and I think that the transmission of information in both directions worked well. From essentially 9 August we set up a daily tripartite meeting in which we compared notes and information and identified problems. So I think that overall those arrangements worked well.

Q179 Chairman: Sir John gave us the impression that the FSA Board on which he sits was not greatly engaged. Sir Callum, you sit on the Court of the Bank of England. Do you believe that the Court non-executives were kept fully informed and consulted throughout or were the independent members equally supine?

Sir Callum McCarthy: I am sorry, I would like to make clear that I would not accept in relation to FSA non-executive directors the adjective supine. I think that the non-executive directors of the FSA do the task that they are required to do and that is not a detailed involvement in particular decisions in relation to the firms in the most part.

Q180 Chairman: Were the non-executives in both the FSA and the Court of the Bank of England kept fully informed at all times on this issue?

Sir Callum McCarthy: Can I explain what we did in terms of the FSA? After the liquidity problems developed in August I wrote to all Board members explaining what we were doing. I wrote to them again in September and gave them a warning that we had a particular problem with an unnamed institution. We briefed them on 13 September and there have been, since then, a series of board meetings in which aspects of Northern Rock have been discussed.

Q181 Chairman: Back to the initial question: do you believe that the non-executives in both the FSA and the Court of the Bank of England were fully informed at all stages?

Sir Callum McCarthy: I believe, if I can speak for the FSA---

Q182 Chairman: You can speak for the Court of the Bank of England because you are on that.

Sir Callum McCarthy: Yes, but I do have some specific responsibilities as Chairman of the FSA which are different from my responsibilities as a member of the Court; but if I speak as the Chairman of the FSA in relation to the FSA Board, I believe that they were appropriately involved at all stages.

Q183 Chairman: Appropriately?

Sir Callum McCarthy: Yes.

Q184 Chairman: The Court of the Bank England, giving you a non-executive role there, were they kept informed at all stages.

Sir Callum McCarthy: They were informed and took a particular decision, which was an important decision of the Court, at a Court meeting on the evening of 13 September.

Q185 Chairman: One final question from me. On the day we had the Governor of Bank of England in (20 September), the Financial Times did a front-page story where it was talking about property: "Hector Sants urged the banks to lend to each other, but Mr King did not respond fully." Why did your spinners in the FSA feel it was necessary to go to the Financial Times that morning before the Bank of England came along?

Sir Callum McCarthy: I am sorry, it is not a reporting of events that I understand. I believe that that refers---

Q186 Chairman: John must have been telling me the FSA's risk people and spinners were out fully just before they came to our Committee. That just seems to undermine the tripartite agreement with the Bank of England that the FSA are supposed to work in tandem?

Sir Callum McCarthy: All I can say, Chairman, is you are making statements which I do not recognise.

Q187 Chairman: You should read the Financial Times of 20 September. If you read those statements, you would see yourself that it was the FSA getting their oar in first.

Sir Callum McCarthy: I repeat, these are allegations which I do not know.

Chairman: I do not think you can react as simply as that, Sir Callum, when you read that report. Michael.

Q188 Mr Fallon: Could we turn now to the events leading up to this fiasco. In your letter you admit that you had not carried out a full risk-assessment of Northern Rock since February 2006. That is 18 months ago. Why was that?

Sir Callum McCarthy: Because it is---. I think I would draw a distinction between the formal examination that we do under something called an "arrow process" which, as you say, was carried out on a particular date, and the interim work that was done. If I may, I will ask Hector to describe that interim work.

Q189 Mr Fallon: I just want to know why a full assessment was not done in the 18-month period between the last one and the problems that Northern Rock ran into?

Mr Sants: I will be happy to answer that. There are two points to make, first of all. The full arrow assessment, even for high impact firms under close and continuous supervision, of which Northern Rock is one, is not done at a frequency greater than every 12 months or so in terms of normal practice.

Q190 Mr Fallon: Every 12 months?

Mr Sants: Between 12 and 18 months. The most frequent assessment we would do would be 12 to 18 months. What we do, however, is engage very closely with specific thematic issues of concern, and Northern Rock were regularly visited by supervisors, roughly speaking (and I do have a full list here), on two to three months or so intervals. If I may finish, I would like to say something about our supervisory practices.

Q191 Mr Fallon: Can you just answer the questions that we put to you. I want to know when was the next full assessment due?

Mr Sants: The next full assessment due would have been three years after the one in question, and, in my opinion, that is inadequate.

Q192 Mr Fallon: You are dealing with a bank which is lending quadrupled from 25 billion to 100 billion, that was taking one in five of the mortgage market, and you only did a full assessment every three years.

Mr Sants: As we lay out in the statement we put before you, I completely agree with you. I think there are lessons to be learnt here with regard to our supervisory practice and I think we do need to look back over our engagement with this particular company and do a lessons-learned exercise, particularly with regard to particular areas. I think we need to look into our assessment of probability with regard to the set of scenarios that actually did develop. We did have this organisation as a high-impact organisation, but in terms of the probability of it getting into difficulty we had it as low-probability, and there was no question, of course, looking at the way events transpired, that that probability analysis has been proved to be incorrect, so we had some serious lessons to be learned in terms of the way we went about measuring our probability, and linked into that, which I think links into your point about the Arrow risk assessment, which I completely agree with, is that we need to look more carefully at the stress testing issues in relation to this company. I think the question is not: did we understand the Northern Rock business model? I think we did completely understand the Northern Rock business model and I would not, by the way, agree with your analysis of how the Northern Rock business model worked, but what I would agree with absolutely is that we did not engage in our supervised process in a way to my satisfaction with regard to the stress testing scenarios, because the stress testing scenarios which they were operating with did not envisage the set of circumstances that transpired in August, which was complete closure to them of all reasonable funding mechanisms, including the repo market. I have to say, I do not think any reasonable professional would have anticipated that set of circumstances, but I think as a regulator we should have engaged with that in an extreme stress test. Indeed, we had been saying over the previous period, in anticipation of market conditions declining, that we wanted firms to take a more extreme view of their stress testing; and we had that engagement with Northern Rock in July when we went to visit them with regard to their stress test and pointed out that we were not comfortable with their scenarios, but, regrettably, as is apparent to us all, that was rather late in the day. So, we take the view that we should look at our supervisory practices and we agree with you to that point.

Q193 Mr Fallon: That is quite a long answer. Could you answer the questions as briefly as you can? You have a budget of 300 million; you employ 2,659 staff. How many were supervising Northern Rock?

Mr Sants: In terms of direct supervision it, it would be three, which is standard practice for high impact firms, and, of course, they are drawing on groups of specialist individual in the area such as stress testing and risk-management and these areas would also contribute to the visit programme.

Q194 Mr Fallon: Was Northern Rock treated as a small bank?

Mr Sants: No, it was treated as a high impact bank under close and continuous supervision - one of our top 160 high impact close supervision organisations - so it was treated at the same level as the other major UK banks in terms of its supervisory engagement.

Q195 Mr Fallon: Why do you think now its exposure to a freeze in new securitisations was not picked up earlier?

Mr Sants: As I said before, I think that the set of circumstances that transpired in the market were highly unusual and was not, I think, in fairness, anticipated by any regulators around the world; nor, indeed, if you look at the individual commentators. Some, of course, or a number, may have been pointing out the share price was too high; there was nobody really anticipating that set of circumstances. It is not just a question of the securitisation market being closed to them for a prolonged period, it is also a question of other mechanisms of wholesale funding, in particular the repo market being closed. As we indicated, they had high quality assets - there is no suggestion here this is an organisation taking on poor quality assets - and it really is an extraordinary set of circumstances which lead to them being unable to repo those assets for a period of six weeks or so as well as the combined closure of the securitisation. One final point, if I may, because I think it is important to understand, they did not actually have a complete closure of the wholesale funding market here. As we pointed out in our note, what happened was the duration of that funding shortage shortened to the point that they were funding over night. They were not not funding this themselves. What happened, however, was that with the duration shortening the Board very properly (and I think quite rightly, and we would agree with that) took the view that they needed the insurance of opening up a facility with the Bank of England. They would not have had to use that facility, or it may well have been that they would not have had to use that facility unless there had been a retail run. So, to focus solely on the securitisation issue and the fact that market was closed is the sole driver in the set of circumstances that have taken Northern Rock to where it is now would be incorrect. We need to look at it as a combination of circumstances which included the retail run as a major driver of their problem. They were not using the Bank of England facility until the retail run.

Q196 Mr Fallon: Why were they allowed a waiver under the Basle II Directive? Why were they allowed a waiver in June?

Mr Sants: The Basle II waiver is standard procedure of the implementation of the CRD and was the standard procedure we were going through with any bank who wished to apply for one at that stage. The actual change in their regulatory Basle II surplus at that point as a result of that waiver was only some 30 million, which I do not think in the context of the problem that we are talking about is significant, but that was basically a standard process. It should not be seen as a one-off special exercise on their behalf.

Q197 Mr Fallon: But in their interim report it says, "This means that the benefits of Basle II enable us to increase our 2007 interim dividend by 30%. You allowed them to weaken the balance sheet and, as a result, they increased their dividend?

Mr Sants: It clearly is the case, as the statement makes clear, that it gave the Board confidence in relation to their dividend increase, or at least that is how the statement describes it, but I will be clear, under their Pillar 1 capital, even under Basle I, they could have paid that dividend. As I say, this was a standard procedure that we were going through at that time in terms of implementation of the CRD.

Q198 Mr Fallon: Paul Tucker from the Bank sent you a memo in early July warning of the potential dangers of a liquidity freeze. Why was nothing done until early August when the retail market dried up?

Mr Sants: It was actually 1 August, the memo in question, and I completely agree with the contents of the memo. Indeed, as we pointed out when I took over the chief executive role at the end of July, I made a great point in the press conference that I thought market conditions were deteriorating. I do not think that the content of the Paul Tucker memo is materially different from the general sentiment that I was expressing in that press conference. I completely agree with him. I think, once we saw the beginnings of the problems in the US sub-prime market beginning to develop, it was reasonable to assume that we were moving into a more difficult period here in the UK and, as I have mentioned earlier, we did already step up our engagement with the market place, convening more regular meetings around the current issues, and as I mentioned earlier as well, we were actually in dialogue with Northern Rock over their stress testing scenario during the course of July. Paul Tucker's memo I say is actually the first week of August.

Q199 Mr Fallon: But there was already a profits warning from Northern Rock; you had the memo on 1 August; why did it take until 14 August for you to alert the tripartite and Treasury ministers as to the problems that Northern Rock had? Why was there a gap?

Sir Callum McCarthy: I was simply saying that it was the events around 9 August which resulted in the fundamental drying up of so many markets, both in terms of securitisation and asset-backed, commercial paper, asset-backed, and in so many geographical markets and currencies, and I think the speed with which we have responded to that is perfectly reasonable.

Q200 Mr Fallon: Why was there a five-day gap from 9 August to 14 August before you alerted the Treasury?

Sir Callum McCarthy: Because the identification of Northern Rock was a reasonable thing for us to consider. The ninth to the fourteenth does not seem to me of particular materiality in this. You may take a different view.

Mr Sants: If I can maybe amplify a little bit. Certainly as of the ninth we were in regular discussion with Northern Rock in monitoring their liquidity, but if you look at their liquidity availability in terms of days, which is a way of looking at their liquidity regime, you are not actually looking at a significant deterioration in their profile until well over 14 August. So we properly identified that, because of their dependence on securitisation, which required them in general to do around five billion of securitisation in a quarter, with the closure of the markets this was potentially an at-risk firm, but the actual deterioration in the profile does not occur until well into September and, indeed, it was not until 10 September that they reached a conclusion that securitisation was not going to be possible. They were actually in negotiation, as you know from our memo, with a number of banks about the possibility of doing under-written securitised transactions during that period. So, in terms of alerting the Treasury to the fact that we anticipated a significant issue with Northern Rock, which was done by myself on 15 August, I would say that was very early to alert them to specific concerns about a specific firm in the light of the liquidity information we had available and not in the light of our knowledge of the business model. So I think we very quickly identified that that business model was at risk. Also in passing, whether we had told the Treasury on the fifteenth or a few days earlier would not have made any difference to the set of circumstances that transpired.

Q201 Mr Fallon: Sir Callum, you were quoted on a BBC website in September as describing Northern Rock's heavy reliance on short-term loans to fund its mortgage business as "extreme". When did you first come to the conclusion that Northern Rock's business model was extreme?

Sir Callum McCarthy: I actually said the business model was extreme but it was in relation to the fact that they had a heavy dependence overall on what I will loosely describe as wholesale funding. Their overall pattern of funding was around more 70% from securitisation, covered bonds, long-term, and in that respect they are an outlier in terms of most British banks, though not necessarily banks in other countries. I would point out that that is not necessarily a source of vulnerability, the long-term funding, because those long-term funds can match the assets that people have.

Q202 Mr Fallon: What is the answer to my question? When did you first realise that this model was extreme?

Sir Callum McCarthy: In terms of its reliance on securitisation in terms of the overall balance sheet, that was something that was well-known. I do not know what time in the last two years, three years I became aware of it, but it was well-known that that was a particular feature.

Q203 Mr Fallon: You were in charge of supervising Northern Rock, you were aware that its business model was extreme, yet over the last two years nothing was done to prevent this particular crisis.

Sir Callum McCarthy: No, that is not a description of events that I would recognise. I have tried to explain that my comment on "extreme" related to the overall balance sheet of Northern Rock. The particular problem, as Hector has explained, related to the short-term funding, and the short-term funding is a problem which has been acute but has been caused by the fact that they had access to securitisation, to covered bonds, to commercial paper and had high quality assets to repo, and they did that in euros, in dollars, in sterling, and all those markets, including the repo market, closed and that is an exceptional, indeed unprecedented, set of events to have occurred for the duration and severity that has occurred. I absolutely accept, as Hector has said, that we did not identify the probability of that happening. I would also say that very few people and no regulator that I know anywhere round the world have succeeded in identifying that.

Q204 Chairman: To clear up, Mr Sants, you said you had three supervisors for high impact banks of which Northern Rock was one and there are 160 institutions that are high impact. Is that correct?

Mr Sants: Yes, I am saying that depending on the high impact institution, the number of supervisors tends to vary between about two and six so three was a fairly standard number within our normal range for high impact banks. Even the biggest UK financial institution would not have more than six or seven supervisors.

Q205 Chairman: I have spoken to a number of the biggest UK financial institutions in the past week in preparation for this inquiry and one of them in particular told me that FSA have had a line side-team dedicated to them and over a year they could see 1,000 to 1,200 people in the FSA in terms of supervision. The group risk director is almost in intimate contact with the FSA almost on a daily basis and the FSA are coming in for themed visits - for example safety, private equity - so there is intensity there. That was described to me, that intensity. Are you saying the same intensity was provided to Northern Rock?

Mr Sants: I am saying that certainly in the period in question during the second half of 2006 and early 2007, yes, I was answering the very direct question, possibly not giving a full answer in that respect of the precise number of dedicated supervisors in our supervisory group, but the supervisory model is like that of other investment banks, as I have indicated earlier, namely you have coverage supervisors, you have the relationship with the bank and then you have a series of specialist teams who regularly visit the bank on particular issues. So, the question, for example, of stress testing would be addressed by a specialist team who come and visit to look at the stress test, and that was the visits that were carried out in this case in April and May 2007 and, indeed, we also have teams looking at the securitisation process and so forth during that period. So, if you are asking the question about the total number of people involved in the FSA engaged with Northern Rock, you would have a much higher number.

Q206 Chairman: The question I am asking, before we go on, was it of the same intensity as your relationship with say the big banks?

Mr Sants: Yes, for our high-impact institutions we have the same coverage model, which includes all the specialists that you refer to.

Q207 Mr Todd: Can I get some procedural stuff straight. In your annual report you refer to stress testing: "We reviewed the stress testing practices in ten large firms in the banking, building society and investment bank sectors. Was Northern Rock one of those ten?

Mr Sants: No, it was reviewed in May.

Q208 Mr Todd: So it was reviewed after this report was concluded?

Mr Sants: Yes.

Q209 Mr Todd: So you did have a stress test under this model that is referred to in your annual report in May?

Mr Sants: We reviewed their stress test in the context of their Basle application, and it was that review which led to the conclusion being reached in July, which I referred to earlier, that their stress testing could take into account more extreme scenarios than they were and, as I have already acknowledged in the earlier statement, I think, in terms of our lessons-learnt exercise, we do need to return to our supervisory engagement with the stress test.

Q210 Mr Todd: You have said what is later said in your annual report in the same paragraph in which you say (and this was after seeing the ten firms which did not include Northern Rock, and so presumably you had already worked out some of the inadequacies in your stress testing then) that further improvements were needed, particularly where firms were not fully taking into account severe but plausible scenarios when making strategic all-risk management decisions. So you already had some intelligence from the stress testing models that you had applied elsewhere than Northern Rock on the perhaps limited compass of that exercise. Did that not give you any hints as to the insight you ought to apply to a business model which I think Sir Callum was not alone in regarding as an outlier in this market place?

Mr Sants: I agree with you. As I said before, if you look at the type of stress test Northern Rock was using, they were not anticipating closure of the securitisation market and the repo market. The only set of circumstances actually which they had in which those type of closures occurred were operational failures rather than market failure and, as I said earlier, I think that type of scenario should be in a stress test; and we would like to see more extreme stress tests and we were making those points, as you kindly point out, in the document in question, and it is incumbent on us to make sure that we carry that through with all the major firms that we regulate, and I think that lessons learnt point, as I have said before, needs to be picked up in our supervisory practices and we will be returning to---

Q211 Mr Todd: My point was a slightly different one, which was that from what one can understand from your annual report, which refers to a period before this, you were already learning some of those points about the lack of testing of severe but plausible scenarios. Presumably this particular scenario did not fit into your category of severe but plausible. You regarded it as wholly implausible, did you?

Sir Callum McCarthy: I think it was unprecedented, and I would say that we have for some time been emphasising the importance of severe but plausible. I would also point out that that is a matter of judgment, it is particular to any institution and it is quite difficult to decide what level of stress to test against.

Q212 Mr Todd: Can I follow this line of argument a little further? We have got again in your annual report, if you turn to 66, 67, the role of the risk committee of the FSA - and you have already referred to one of the august members we met earlier. In the list of risks that the committee does consider one can see some resemblances to some of the issues that have occurred in this particular case. Is it perhaps the case that this risk committee treated this as a rather academic exercise of running through risks in a routine way or did not actually consider this in the depth that one might expect? What was this risk committee actually up to?

Sir Callum McCarthy: Perhaps I could describe the risk committee of the Board. It is chaired by Hugh Stevenson; its members are Deidre Hutton, Peter Fisher, who is ex New York-fed, New York based, both an ex-central banker and an investment banker nowadays, David Miles, whose proper title, I think, is the European economist for Morgan Stanley, and John Gieve.

Q213 Mr Todd: They are not lightweights.

Sir Callum McCarthy: They are absolutely not lightweights and were carefully chosen for that reason.

Q214 Mr Todd: They have big reputations anyway!

Sir Callum McCarthy: If I may say so, the idea that they were looking just at what I think you described as academic points is absolutely not the case. They looked at a variety of issues and those included the credit risk, derivative risk, the sub-prime risk in the US; so they were examining those---

Q215 Mr Todd: I have got that. We are tight for time. I just want to explore the linkage between your risk committee and the stress testing models that you have used. Is there some linkage? You have just touched on one issue, sub-prime markets and its possible implications. Is there any linkage in which the risk committee communicates to those who deliver this process on the ground?

Sir Callum McCarthy: Yes, indeed. One of the responsibilities of the risk committee is to examine the way in which the FSA mitigates against the risks that have been identified.

Q216 Mr Todd: You prepare fact books. Was there a fact book on Northern Rock?

Mr Sants: A fact book is a very particular statement about a particular set of data which we are preparing for the tripartite, and that is an electronic set of data which is held on a particular IT system and is not yet completed for any institution currently in terms of a central IT depository. We carry data of the same nature on all major high-impact institutions. So the answer in that sense is yes.

Q217 Mr Todd: I am sorry, the answer is yes but you sound as if you are at an early stage. It sounds as if the answer is no actually.

Mr Sants: I am slightly confused by your question. If you are asking me is the FSA holding the same set of data on Northern Rock as it does on the other major UK institutions, the answer is yes. If you are asking a very particular question about an IT system, the answer is no because it is not generally ready, it is in development.

Q218 Mr Todd: Even though actually this was referred to as to something that was needed back in October 2005?

Mr Sants: Yes, I agree. It would be a useful tool for speedy decision-making.

Q219 Mr Todd: It is one of these projects which is rolling away gently in the background.

Mr Sants: Yes. It would be a useful tool for speedy decision-making, but in the context of this issue, which arose over a long period of time, I do not think it is a relevant gauge of our handling of it.

Q220 Mr Todd: When Michael was asking you about Basle II he perhaps did not ask you a rather blunt question because you, I must admit, implied it was a box-ticking exercise; the normal sort of thing, "We thought that was okay and would not have made any difference anyway because it was a small sum of money." Is that the way you appraise your approach to this? It was delivered actually only shortly before the crisis hit this business and it did give a signal of apparent health. I do not know whether you recognise that, particularly the way the company responded, which was bumping up their dividend. Do you appreciate the linkage between your decisions and market reactions to what a company does?

Sir Callum McCarthy: Could I explain a little bit about the Basle I to Basle II change, which is to try and have a much greater granularity and a much greater accuracy for the estimate of the capital that individual financial institutions require. I do that because I think the description that you gave of it as a box-ticking exercise is absolutely incorrect. It is a rather detailed analysis but it was concerned with capital and the capital requirements of Northern Rock have remained intact during the whole of this period. So, this is not a capital requirements problem, this has been a liquidity problem and the fact that Hector has said, I believe completely correctly, that the change is immaterial to the problem should not be taken as in any way saying that we treated this in a lightweight way.

Mr Sants: If I could be clear here, the issue of the CRD in Basle, which, of course, is a European directive and international agreement, is relevant here. If we are asking that question, we need to bear in mind that we are talking about a liquidity issue here, not a credit issue, and we actually do agree that the liquidity regime could be modernised. We do not want to in any way not indicate there are some other lessons to be learnt here.

Q221 Mr Todd: Let me turn to the liquidity issue. You have just sent out liquidity questionnaires to banks and building societies.

Mr Sants: With due respect, I think that is a misreporting by the press.

Q222 Mr Todd: Let us get the record straight then.

Mr Sants: I think the press were a little confused in that particular case. Obviously, from the moment that the market conditions deteriorated, we intensified our liquidity communications with the major institutions. That was being done on a regular basis. I think the press either picked up on the fact that that was one of the weekly reports that we had requested or, and I hesitate---

Q223 Mr Todd: So you have not changed your practice at all?

Mr Sants: We have significantly increased our practice from the beginning of August, and they only noticed it when they reported that article and gave the impression that was the first time that we had so done. Secondly, I think they may have possibly confused it with a different piece of paper that we had recently sent out to some sub-prime lenders. So I think, to be honest, it was a complete misreporting of the facts.

Q224 Mr Todd: It sounds as if there was something there actually.

Mr Sants: With due respect, no.

Q225 Mr Todd: Obviously you have explained that it was not an entirely novel activity, and I would have been shocked if it were, but the impression one gets is that you have significantly ramped up your activity since August.

Mr Sants: Yes.

Q226 Mr Todd: So the point stands that clearly you felt that you had inadequate intelligence on this. You have correctly drawn the distinction between the capital base of the business and liquidity, but the important issue of liquidity was an area where your intelligence was presumably relatively weak before August because otherwise you would not have been significantly improving the catch on it now?

Mr Sants: No, I think that is not right, is it? What we are trying to do is monitor regular and get real-time feel in a crisis. You would expect us to respond to a crisis differently than the way we respond to business as usual. I think you would not expect us to be asking for minute to minute, real-time information from our banks in normal business as usual circumstances. I think you would feel that was over regulation. In the circumstances of a crisis you would expect us to be carefully monitoring their liquidity positions, as we were doing.

Q227 Mr Todd: But obviously not as carefully as you now are. Mr Sants, I think it would be helpful, bearing in mind the time, if you can produce a paper for us on the distinction between your practice before this crisis and your practice now so we clearly understand your point about the press not understanding quite what you were doing.

Mr Sants: I would be very happy to do so.

Chairman: Again, it amuses some of the large banks because they mentioned to me that this questionnaire seemed a bit monotonous. So it is very important, Mr Sants, that we probe that because we will be coming back to these things in the future and no doubt we will be seeing you again sometime.

Q228 Mr Breed: Briefly, because we have concentrated rather a lot on one side, obviously liquidity and the liabilities, but it has been said by you this morning and, indeed, in the Chancellor's written statement yesterday that Northern Rock had a good quality loan book. There are various tests of that and one of the essential tests would normally be arrears, repossessions and so on. It does seem somewhat strange to many of us that an organisation which has a lending criteria somewhat outlying, reported to be five or six times income and such, even lending up to 125% of the property, apparently has arrears statistics and repossession figures somewhat lower than the industry average, and that does not seem to ordinary, sensible people to be a likely scenario. We keep on saying this wonderful thing about the good quality loan book and such. Have you really looked into the actuality of the statistics within the loan book to satisfy yourself that there was indeed a good quality loan book on an organisation which has lent five to six times income and up to 125% of a property?

Sir Callum McCarthy: If I look at the assets of Northern Rock, of course we were concerned to look at its record. If I look at, for example, the three month arrears figure, although it has increased slightly over the last year, it is still running at less than half the industry average. Northern Rock has no exposure to the sub-prime market because it laid off all that exposure to another institution. If you take the particular 125%, which actually has got some limits within it which have to be recognised, the record of bad debts and arrears on that was also very limited relative to the industry average. The loan to value is not excessive. So, in all those respects, we believe that it is correct to say that the loan book was a good quality loan book.

Q229 Mr Breed: But it was not a means of the way in which they constructed their lending to individuals in respect of the mortgage and the personal loan, the secured and the unsecured and the way in which the unsecured proportion could actually assist the repayment of the mortgage monthly figure, thus ramping up, on an unsecured basis, the lending to an individual whilst at the same time appearing to, of course, satisfy the arrears statistics on the mortgage itself?

Mr Sants: The difficulties they have got into, as we have all reflected on, was their difficulty in achieving a securitisation programme, or repaying the mortgage book, or in some way or other sensibly raising funding on those asset base. In addition to us having obviously looked at those assets and, of course, as you would no doubt expect, also the Bank, of course commercial banks were in negotiations with them during this period in respect of their endeavours to do a securitisation or a repo and at no point have we heard from any of those parties any suggestions that the loan book is anything other than Sir Callum has described. So I think there is no suggestion here that the problem is that their loan book is anything other than, generally speaking, a good quality loan book that can, indeed, be turned into rated paper; the problem is with the failure or the reluctance of the market to take any of this rated paper.

Q230 Mr Breed: But you base that upon the statistics or returns provided to you by the company not in an investigation?

Mr Sants: No, we have been to see the company and, as I mentioned before, we know the commercial banks that have been looking at that mortgage book.

Q231 Chairman: You are aware that the Northern Rock funding was carried out through off-balance sheet special purpose vehicles, a lot of that funding?

Mr Sants: Yes.

Mr Breed: That is the other side?

Q232 Chairman: I know it is the other side, but you are aware of that.

Mr Sants: Indeed we are.

Q233 Chairman: Was it clear to the FSA that that was just a means of shifting the risk into unregulated entities beyond the view and the scope of the FSA?

Mr Sants: As Sir Callum has indicated, we need to be here careful that we do not inadvertently stigmatise wholesale funding operations as necessary bad for banks. In order to have a securitisation programme which, once a securitisation is done, creates long-term secure funding, you need a special purpose vehicle which provides the avenue.

Q234 Chairman: Were you aware it was done through a Channel Island subsidiary?

Mr Sants: The visibility, the content of the programme was perfectly visible to the FSA.

Q235 Chairman: So you were aware of that?

Mr Sants: Yes.

Q236 Chairman: What was the subsidiary in the Channel Islands?

Mr Sants: We are fully aware of the content of the special purpose vehicle.

Q237 Chairman: What was the subsidiary in the Channel Islands it was under? Do you know that?

Mr Sants: Under. I am sorry?

Q238 Chairman: The Channel Island subsidiary.

Mr Sants: Granite.

Q239 Chairman: It was under Granite?

Mr Sants: Yes.

Q240 Chairman: That was actually established under charity law and actually owned by a Channel Island subsidiary of the Law Debenture Corporation. Does that not seem a totally artificial construction to shift liability and avoid responsibility? Did the FSA not smell a rat?

Mr Sants: It is possible with regard to the Granite structure. We would probably have to come back to you with the detail of that proposition. I am not totally convinced. We might be talking at cross purposes here, so let me give you a written reply with regard to the Granite structure.

Q241 Chairman: I would welcome correspondence on that. Have you spoken to the Northern Rock auditors to find out why they were content with this and, if you have not, can you include that in your correspondence to us?

Mr Sants: We would certainly be happy to do that.

Q242 Mr Love: Can I just be clear from one of your earlier answers, Sir Callum, that what you said was that the reason why Northern Rock has got a high quality loan book is that they have passed on all the bad risk to others?

Sir Callum McCarthy: No, I said that one part of it is that the sub-prime business that they do, which is very limited in scale, has actually been passed on to others. That is true, but that is not the only component that results in their having a quality set of assets.

Q243 Mr Love: Going back to questions that were asked earlier on, we know that Northern Rock were taking up one in every five mortgages; so there was a massive expansion in the loan book. We know from American experience that because a lot of these banks like Northern Rock were passing on the risk through securitisation, the lending practices had become somewhat suspect. Are you concerned about that in the Northern Rock instance?

Sir Callum McCarthy: We are concerned about that across the board, which is why, since we took responsibility for mortgage brokers, we have been consistent in looking at the standards that have been used and have taken significant enforcement action across the board.

Q244 Mr Love: If I extend the American experience, I think almost all commentators say that the high-risk, if you like, sub-prime mortgage effect grew exponentially in the last months before the crisis hit. Is that the case? Have you been able to track the quality of the loans that Northern Rock were making as they grew to consume one in every five mortgage and is that a continuing concern for you?

Sir Callum McCarthy: Can I just deal with the fact that Northern Rock did get a significant increase in market share in the first half of this year. The first point I would make is that the mortgage market is a competitive market which has quite considerable swings in market share from quarter to quarter, and that is not unusual and it is not something which in itself we should take action about; this is a competitive market. What we should be concerned about is the effect of that on the actual financial ability or capabilities of any firm, and I think that is something which we looked at the carefully and I think Hector has got the figures on it.

Mr Sants: Yes, as you rightly point out, clearly the balance sheet for loans to customers did grow in the first half of 2007 something of the order of 10.7 extra billion loans net to customers. It is an increase, but I think we need to put it into perspective. The second half of 2006 was 9.3, so clearly an increase, as you say, growth, but I think we need to have a context there. But also, critically, back to our earlier conversation, if I may, we are talking about the vulnerabilities which resulted from that business expansion to its funding process and actually where you look there, a degree of that was covered by increased retail deposits, probably around two billion or so, and the actual amount of quarterly securitisation which, back to our earlier conversation, of course, was what they failed to do when they subsequently encountered the market turbulence, in terms of volume did not change hugely. In the first half of 2006 that was about 5.8, in the first half of 2007 it was 5.6. So their dependence on what we previously identified as being the issue here, the securitisation volume, did not actually materially change too much at the time their balance sheet was expanding. So, yes, absolutely, a period of growth should well be a signal for regulators to take increased interest (back to my earlier point there) but I think if you look at the actual impact on the securitisation programme, that growth has not really been the point at issue here.

Q245 Mr Love: Before I come to the securitisation programme I just want to be absolutely clear. Of course, in general terms, competition is a good thing but there is also a negative impact of competition in that in the desperation to sign up mortgages the lending practices will be set aside to some extent. Was there any concern in the FSA in relation to that?

Mr Sants: I think, as you rightly point out, you should always be concerned where you see market share growth and the question always has to be asked, therefore, around the conduct around that. Of course, being able to tell at this stage whether or not there were improper practices in terms of the quality of the mortgages, it is traditional when you are bagging mortgages to wait for a period of seasoning to see what happens to the performance. So, in terms of looking at the financial data, it is difficult to tell at this point. In terms of mortgage practise, from our point of view we have no evidence of this at this stage to say that their practices were out of line with quality market delivery. Do bear in mind on this sub-prime point that we are only talking here in the UK around 8% of the UK market being sub-prime relative to around 25% in the US. We do not have any particular signs of the sub-prime market growing, and, indeed, probably as a result of recent market events it will contract a bit, and there is a genuine social purpose in the sub-prime market, which is to deliver affordable housing to some. It is a question of whether the practices that go alongside with that are reasonable.

Q246 Mr Love: Let me ask you: looking at it now should the FSA have reigned in the aggressive growth strategy that Northern Rock has been pursuing?

Mr Sants: I think relative to the funding issue which was the cause of the problem that they have put themselves into, it does not seem to me that the particular market share increase in those few months was a trigger that we should have been particularly concerned about. I do think we should have been concerned around the stress testing issues that I referred to earlier. So, I am more than happy to indicate, I think there are some significant lessons to be learned, but I am not sure that the market share point is particularly the critical point in terms of identifying the driver that led to their problems and the scenario that we should have envisaged.

Q247 Mr Love: I am not absolutely clear. At any stage in your discussions with Northern Rock did you highlight the strategy they were pursuing? Did you say there might be significant risks involved in it? Did you try in any way to discourage them from being as aggressive as they turned out to be? What role did you play? Obviously you were monitoring them. Were you advising them and did that advice include: "Hey guys, this could be very risky for you"?

Mr Sants: Yes, but as I have said earlier, I think the intensity of that dialogue, at the time of the original arrow visit and subsequently, should have been more forceful. I think those points were being identified by July when we were engaging in the discussion around their stress test, but obviously at that point in time events overtook the firm. I want to be clear here, and I know you are questioning the FSA, but let us remind ourselves, it is the Board's responsibility to run a company prudently and the stress test scenarios are designed by the Board, not by us. We do not give prescriptive stress tests to firms; we think it is the job of firms to identify the right set of stress for themselves, but I agree with you, yes, we should have been in more intensive dialogue with the company earlier.

Q248 Mr Love: Is there any evidence to suggest that they changed any of their practices, any of their aggressive growth strategy as a result of the discussions they had with you, because we cannot see any. Is it the case that they ignored entirely what you were saying to them?

Mr Sants: As I have said before, I think the stress test that they were operating with and their funding policy statement set out in 2006 did not anticipate the severity of the market downturn, and when we get to July 2007 that was still the case, which is why we were intensifying our dialogue with them.

Q249 Mr Love: There have been suggestions that actually you should not have treated Northern Rock as a bank but more as a finance company. They took in mortgages for mortgage brokers and they securitised them. That is effectively the direction in which they were going very aggressively. Do you have any sympathy with that argument and should you have dealt with them slightly differently from the way you would deal with ordinary retail banks?

Mr Sants: As we have mentioned before, the use of wholesale funding is not in any way an unreasonable tool in the funding proposition for a bank and, indeed, scrutinisation programmes per se which create long-term secure funding are in fact a very good source of funds. May I remind you here that the ultimate problem here is a retail run and retail so reminds us that we should not necessarily equate retail deposits with having greater stability than long-term securitisation products. I think in terms of the way we address this supervisory issue, I realise I am repeating myself and I do agree with you, I think the stress test should have been looked at.

Q250 Mr Love: Let me ask you finally, Victoria Mortgages has gone into administration now. We all accept that was a very small bank, that it was completely in securitisation, but are there any other problems out there of a larger nature that you are aware of and are concerned about?

Mr Sants: I think in terms of the wider public interest you can reasonably expect me to say that would not be a question I would ever want to answer in terms of particular companies. I am sure you appreciate that.

Q251 Mr Love: Are there any other continuing problems in the market place?

Sir Callum McCarthy: Could I make clear that that is an answer which Hector or I would give in good times or bad times. It is, as a question of principle, a question that should not be answered and I do not believe would be answered.

Chairman: That is okay. I anticipated that would come from your lips. Do not worry about that. You mentioned about Northern Rock. We are having the company before us next week, so I will be sending you a letter after this hearing in terms of your relationship with the Northern Rock Company so we can be ready for that. We then go to Peter.

Q252 Peter Viggers: When the so-called tripartite system of regulation was set up in 1997 by the former Chancellor of the Exchequer some commentators said the system would prove inadequate in a crisis, and, of course, so it is proving. Of the three authorities you are quite specifically made responsible for the prudential supervision of banks and building societies, so if something goes wrong it is your fault. I assume you would not wish to disagree with that.

Sir Callum McCarthy: I absolutely accept, and I think Hector has made clear, that we believe that there are lessons to be learned which we are busy identifying and will apply in respect of the supervision of Northern Rock. In that respect I agree. In one respect, I think it is important to recognise that we cannot run and do not run what is called a zero-value regime, because if we were to do that we would insist upon a degree of avoidance of risk across financial services which would be deeply damaging to the economy.

Q253 Peter Viggers: If I probe the chronology, it is simply so that we can understand the manner in which this works. The crisis emerged on 9 August and in the memorandum to us you say that from 9 August onwards senior management held daily meetings, increased supervisory activity, passing daily telephone calls. It does not sound to me like very much co-ordinated action at that point until 14 August when the Bank of England was informed.

Sir Callum McCarthy: No. If I may say so, from 9 August we set up a daily, and sometimes more frequently than daily, meeting, which was a telephonic meeting, of the Bank, the Treasury and the FSA. We exchanged information - I believe that information exchange has worked well - we identified problems and we have agreed actions.

Q254 Peter Viggers: I put it to you that, whilst you have the duty of supervision, many of the actions that need to be taken by government lie elsewhere and that real action in seeking to find a solution only emerged after 16 August when you set up a project team with the other two regulatory bodies?

Sir Callum McCarthy: No, I think it was appropriate. I think Hector gave an account of the developing liquidity problems. I do not believe that it was a mistake not have to set up those project teams before 16 August and I think that there was no indication that the date of 16 August was too late a date.

Q255 Peter Viggers: So who was negotiating with Northern Rock? Who was discussing actively on a personal basis the solutions that might emerge? Was it you or was it the other members of three regulatory authorities, the Treasury and the Bank of England?

Sir Callum McCarthy: It was principally the FSA, and we can give you details of the various discussions and who conducted them if you would like.

Q256 Peter Viggers: What was your position as to whether Northern Rock should be taken over?

Sir Callum McCarthy: I am sorry?

Q257 Peter Viggers: What was your position as to whether Northern Rock should be taken over?

Sir Callum McCarthy: One of the responsibilities that we have under the tripartite arrangements are to identify whether there is a possibility of a private sector solution. We did that and encouraged and closely monitored discussions that took place between Northern Rock and potential acquirers.

Q258 Peter Viggers: The Governor of the Bank of England has spelled out to us a number of statutory and regulatory matters which prevented a takeover of Northern Rock or an orderly solution to the problems of Northern Rock. Were you inhibited by those statutory and regulatory matters?

Sir Callum McCarthy: In relation to the acquisition of Northern Rock by a potential acquirer, I do not believe that those legal problems were particularly significant in relation to that possible outcome and my recollection of the Governor's evidence to this Committee is that he was commenting on those legal obstacles in relation to the lender of last resort.

Mr Sants: We were quite properly identifying potential private sector solutions prior to the need to apply to the Bank of England for a facility. In that prior a period I do not believe that there were any barriers to those takeovers taking place in relation to takeover rules. It would have been done in the conventional fashion through the normal framework.

Q259 Peter Viggers: You said in your memorandum to us that no acceptable structure for a takeover was identified. What were the main barriers to such an operation being successful?

Sir Callum McCarthy: I think there were two issues which were significant in terms of the most serious indication of support. One was the question initially whether the bidding bank would receive support from the Bank of England, the second was the terms on which any support would be given and, as I think the Governor has made clear and has elucidated in a letter to the Chairman of this Committee, there was a decision that it would be improper to give support to a bidding bank. There was subsequently clarity that after the lender of last resort facilities had been announced for Northern Rock those would be available on the same terms if Northern Rock were acquired by a new bidder.

Q260 Peter Viggers: Do you think that lessons have been learned about the tripartite method of supervising banks and building societies?

Sir Callum McCarthy: I think that one of the things that we need to do is undoubtedly to look at the lessons of the tripartite arrangements, and I am particularly concerned about issues affecting financial compensation and the need to have a bank insolvency route which enables us to deal with a bank in difficulty in a way which gives clarity and certainty to its customers so that the probability of the anxieties that led to the queues for Northern Rock is something that we can deal with. So I think those are very real issues.

Q261 Peter Viggers: Would that involve the Financial Services Authority being given more authority or more power which is currently held by another body?

Sir Callum McCarthy: Not necessarily. The issues that I have been dealing with I think are wider than that.

Q262 Mr Brady: The Governor of the Bank when he came before us was very specific, that he believed there was the interaction of four different pieces of legislation that caused difficulties in the response to the Northern Rock crisis: the Market Abuse Directive, the takeover code, the nature of the insurance scheme and the way in which deposits are frozen in the event of administration. The answer you were giving a few moments ago seemed to suggest that you do not share that view?

Sir Callum McCarthy: No. I am sorry, if I gave that impression it was not the impression I was trying to give. I was trying to reply to the earlier question in saying what are the issues, and two of the issues that I identified, namely the compensation scheme and what I described as bank insolvency but in fact another way of rephrasing it is the way you have rephrased it, are two of the four that were identified by the Government.

Mr Sants: It is clear we had no consumer confidence in the authorities here, and that was no doubt a factor contributing to the bank run, and we need to give careful consideration to addressing those mechanisms for improving consumer confidence, which takes us back to the FRCS and the bank administration scheme. I think there is a strong argument that says that we might not have had those queues if consumers had had the confidence their deposits were safe.

Q263 Mr Brady: So do you share the Governor's view that those four pieces of legislation need to be changed?

Sir Callum McCarthy: I share his view that they are all important things to look at.

Q264 Mr Brady: In answering questions earlier about the Market Abuse Directive specifically, I think it was Mr Sants who was saying that the inhibition appeared to arise really on the part of the responsibilities on the Board of Northern Rock rather than the regulatory authorities or the Bank. Would that be accurate?

Mr Sants: The initial responsibility as to whether disclosure should be made undoubtedly rests with the board of a company, and in this particular case they felt disclosure should be made. We have, as you say, no reason to challenge that conclusion they had reached, that is absolutely right, and I would repeat the point I made earlier. I think it was clear that there could be sets of circumstances in which disclosure would have to be made and we ended up in one in this particular case.

Q265 Mr Brady: Is it your view that under Article 7 of the Directive, which exempts central banks from its provisions, that that exemption is---

Mr Sants: Does not apply to these circumstances.

Q266 Mr Brady: So there was no impediment on the Bank acting as a covert lender of last resort, except that it would not remain covert because of disclosure from Northern Rock?

Mr Sants: Correct, in relation to the circumstances they were in and concerned as to the implication of that facility in terms of its magnitude and implication for their profits forecast, and of course I repeat this is all a moot point once the leak had occurred. A more general point here might well be that it is very difficult going forward to imagine in modern society that it would be that easy to keep a covert operation of that size covert for any length of time anyway. There are other obligations here, particularly to credit agencies.

Q267 Mr Brady: So do you think it would be sensible to look at changing the disclosure rules or not?

Sir Callum McCarthy: I think the point that we both have been trying to make is, quite apart from the legal obligations, there are fundamental practicalities which are at least as important as the legal concerns.

Q268 Mr Brady: So if the Directive had different provisions it might not have helped?

Mr Sants: It might not have helped, no. We are expressing a view that it seems unlikely in the overall set of circumstances that prevail in the market-place today that keeping an operation of this size and complexity covert for any length of time is realistic, independent of the standing of the Market Abuse Directive.

Q269 Mr Brady: But consideration was clearly given to that covert lender of last resort possibility. When it was decided that it would not be a viable possibility, did your advice change within the tripartite authorities?

Mr Sants: No, our advice had been consistent. In this set of circumstances if they transpired we would be not wish to disagree with a company conclusion that was reached.

Q270 Mr Simon: Sir Callum, have you ever boxed?

Sir Callum McCarthy: Twice in my life.

Q271 Mr Simon: It strikes me that this morning when confronted with uncomfortable truths you have consistently said "that is not a description that I recognise". I am going to present you with another description because it has also struck me that you may well be the Herol "Bomber" Graham of the financial services industry, a medium ranking British boxer who could not punch, who was the very antithesis of hard-hitting but upon whom it was impossible to lay a glove, you could not hit Herol "Bomber" Graham under any circumstances. It strikes me that during this fiasco the Governor and the Bank have got it spectacularly in the neck whereas you, who actually were responsible for looking after this organisation, this bank, seem to have absolutely no responsibility for any of this at all. Who was in charge of this bank? Who was in charge of making sure this did not happen?

Sir Callum McCarthy: If I may be clear, I think both Hector and I have made it absolutely clear that the responsibility for supervising Northern Rock lies with the FSA, that is point one; and if that is not clear can I now make it clear to the Committee. We have also made it clear that we believe that there are things we need to look at again to make sure that we discharge those responsibilities in a way which recognises the lessons that we should learn from Northern Rock. If you have taken the impression that we are avoiding responsibilities that are properly ours, can I make it quite clear that we are not.

Q272 Mr Simon: I was not asking who is responsible for supervising the institution; I was asking who is responsible for this crisis, this fiasco, this debacle? Which of the tripartite authorities ultimately was responsible the most?

Sir Callum McCarthy: I am afraid that, rather like the Governor who answered the question, (I believe correctly) by saying here are the responsibilities of the Bank; here are the responsibilities of the FSA and here are the responsibilities of the Chancellor and the Treasury, I will give the same answer.

Q273 Mr Simon: Do you think the tripartite arrangements work?

Sir Callum McCarthy: I think that they do work. If I look at the exchange of information which has taken place between the FSA, the Bank and the Treasury, I think that that exchange of information has been clear. I think that each of us has discharged our responsibilities.

Q274 Mr Simon: So as a Committee we are supposed to conclude that these arrangements worked and that is why it all went so well?

Sir Callum McCarthy: You are not supposed to conclude that things have gone well. If I may say so, Chairman, you will come to whatever conclusions you come to.

Q275 Mr Simon: We are not likely to conclude that it worked very well, are we?

Sir Callum McCarthy: You will come to whatever conclusion you come to.

Q276 Mr Simon: There was a run on a bank; the nation was a global laughing stock; and you say that the arrangements worked?

Sir Callum McCarthy: Sorry, I have said that the tripartite arrangements in terms of what was done by each of the parties were clear in responsibilities, and in relation to the FSA, for which I take responsibility, I believe that we discharged our responsibilities. I also believe - and I repeat this - that we consider what has happened and particularly what happened in the supervision of Northern Rock up to the time that these problems developed, are things that we have to learn lessons from and make changes and respond to.

Q277 Mr Simon: Given that you have said the arrangements worked, do you think they would have worked even better if one of the tripartite parties had had more responsibility than the others, if there was somebody with whom the buck ultimately stopped (presumably not you)?

Sir Callum McCarthy: If I look at the decision to extend facilities, it was a decision taken by the Chancellor on the basis of advice from both the Governor and the FSA, and I think that there is clarity of that responsibility. I am not quite sure what lies behind your question.

Mr Sants: What is true, if you look at the period prior to the regrettable situation developing of the queues outside the bank - and I think, as we have indicated earlier, there are a number of contributory factors to that such as the limitations of the FSC Scheme and the Bank Administration Scheme which should be properly looked at - if you look at the period prior to that and ask the question could something have been done between the development of the global crisis which led to the freezing up of the access to liquidity and the bank applying for its facilities, realistically the only solution to the disappearance of commercial credit would have been the provision of some type of central credit. That is axiomatically true. There was a decision made not to do that, but if you look at the logical sequencing of events that is probably the only other thing that could have happened. A judgment was made not to do that. Let us just be clear, in terms of was there an option that was not considered and missed, then the answer to that is no. Were there options which were considered and the decision made for wider policy reasons not to do them, then the answer to that is yes. It is not obvious to us that there is some action that could have been taken by the FSA in that period that would have led to a different set of circumstances at the point the facility was leaked.

Q278 Mr Simon: Relations between the FSA and the Bank have been described recently as "poisonous". What do you say about that?

Sir Callum McCarthy: I would say that I have a good and clear relationship with the Governor. I believe that Hector and senior colleagues work effectively and well with their opposite numbers in the Bank, and it is a description which I in no way recognise.

Mr Sants: I would say absolutely not true.

Q279 Mr Simon: I thought we would get to "descriptions that you did not recognise", which reminds me of your answer to the Chairman, which I thought was disingenuous when he asked you about the spinners, you just said, "Spinners I do not know anything about spinners." Are you telling us now, on the record, that either the FSA does not employ people who spin on its behalf or that it does but you do not know anything about it?

Sir Callum McCarthy: No, I am saying if, as I believe is the import of your questions, you are suggesting that the FSA goes around briefing against the Bank of England ---

Q280 Mr Simon: That is what the Chairman suggested.

Sir Callum McCarthy: Could I just make it clear that if I knew of anybody within the FSA doing that I would fire them.

Q281 Mr Simon: Will you undertake to find out?

Sir Callum McCarthy: I have no reason to believe that what you are suggesting has any truth. If I discovered that it were true, I would take action.

Q282 Mr Simon: What kind of things would need to happen to you to make you believe? Everybody else in this room knows that this has happened; you are the only person here who does not believe it. What would we need to do to convince you that this kind of thing goes on and that your organisation that you are supposed to be in charge of is doing this and has been doing it so disgracefully that the Chairman of the Treasury Committee mentioned it to you right at the top of his remarks and you just say, "I do not know anything about it. I do not get involved in that sort of thing." You are involved in that sort of thing.

Sir Callum McCarthy: If you could provide chapter and verse and evidence other than assertion, I would take it seriously.

Q283 Mr Simon: But without chapter and verse and evidence you do not take it seriously?

Sir Callum McCarthy: I am afraid it is an assertion which is so contrary to the clear policy that is established at the top of the FSA, and which has been made absolutely clear, that I do not believe it is true. I do not know if you want to add to that, Hector?

Mr Sants: No, I think you are very clear on our position.

Q284 Chairman: How many press officers do you have, Sir Callum?

Sir Callum McCarthy: Do you know the answer?

Mr Sants: Not to the precise one. I think we have a quantum of ten to 15, about a dozen or so, covering a variety of different issues, which of course include retail issues and consumer communications.

Chairman: In your responses before next week in your letter to us, if you could look at that report that was in the Financial Times and give us your comments on it and consult your press officers, that would be helpful to us in our inquiry. George?

Q285 Mr Mudie: I think there can be some criticism of not anticipating what happened before it happened and your supervision role, but I would like to just push further on what you said, Hector, about there was a big option and you were working against a decision by one of your partners which was not to put liquidity into the situation. That seems to me something that exacerbated and brought on the crisis, which has not happened in Europe and has not happened in the States because the central banks behaved differently. Would you care to comment?

Mr Sants: I think it is logically true and I have already indicated that, and I would agree with you, from the narrow question of would we be in the position we are now in with regard to Northern Rock, it clearly is the case that if liquidity in smaller amounts had been made available to Northern Rock earlier, then it is quite possible it would not then have subsequently needed to apply to the lender of last resort facility. In terms of that narrow question of that particular institution, for the reason I have just said, clearly the public markets were closed to it. Its problem was a liquidity problem - we have discussed that - and therefore if it had been able to find a source of liquidity prior to applying for a lender of last resort facility then it might not have needed to have done that, and that absolutely has to be case.

Q286 Mr Mudie: That is the situation, if there had been the liquidity engineered by the central bank, you would not have needed to be seen or classed as a lender of last resort. You would have gone to the market the same way as any other bank could have gone, taken the money, freed yourself from your short-term financial difficulties and got on with life, and we would not have had these queues and this crisis.

Mr Sants: I think, as I have just said, I am agreeing with you with regard to the narrow point of Northern Rock. There are two particular ways that could have been addressed, either an issue where the wider collateral should be more generally available, or some specific approach taken with regard to less general facilities but nevertheless still of a more generic nature, however, questions are rightly to be taken by the Bank in the context of their overall policy framework, as to your question for Northern Rock, I think the answer is yes.

Q287 Mr Mudie: It goes beyond Northern Rock. Let us take the tripartite arrangements, did at any time the FSA, as part of that, raise the question of the central bank putting some liquidity into the system generally? Yes or no? I think we are entitled to know what the FSA's view is. You have been hauled over the coals today for a situation which was maybe somebody else's creation, so did you at any time during these arrangements as the crisis developed say this could be sorted if you come off your high moral platform and just do what the Fed did or the ECB did?

Sir Callum McCarthy: May I make two points. One is I would point out ---

Q288 Mr Mudie: No, Sir Callum, just answer the question in terms of was this specific approach/strategy raised?

Sir Callum McCarthy: One of the things that was done was, as you would expect us to do, after meetings that were held at chief executive level with some of the major British banks where they expressed their views (meetings that were attended by Bank of England officials) we reported the views of those people very clearly to the Bank.

Mr Sants: We clearly are very aware of our responsibility to interface with the market. I think you rightly point out that the majority of the market held the view you have just described and we very properly made sure, as the banks expected us so to do, that those views were communicated on to the Bank on a regular basis.

Q289 Mr Mudie: And would you not agree that for the Governor to spell out in written form in such a lengthy way to this Committee the fact that liquidity would not be given, when you all knew you were in an advanced stage of a crisis, was not helpful?

Sir Callum McCarthy: I would point out that at the time the Governor wrote to this Committee he knew that there was the probability of a lender of last resort facility being made available and his paper for this Committee specifically discussed that. I am sorry, I do not have the Governor's paper with me.

Q290 Mr Mudie: But that is the point, if the Governor knew that the various pieces of legislation stopped him acting as a lender of last resort or stopped a rescue of a specific institution, another alternative would be to do what the Fed had done and the ECB had done, and put liquidity into the system. What stopped the Governor doing that or what stopped it happening?

Sir Callum McCarthy: Could I point out that on the problems that the Governor identified of a legal nature, I think his points were specifically about that preventing a confidential covert lender of last resort.

Q291 Mr Mudie: Sir Callum, I understand all that, and I had words with the Governor, but it seemed to me the Governor was saying, "I can't do this; I can't do that" and my criticism of the Bank if England is, fine, if we accept all these arguments, what were you suggesting you would do other than just watch the crisis develop? The obvious thing, which was done within a week, is put liquidity into the system, and since he has taken that decision, in fact the last tranche was not taken up such is the confidence of the banks in liquidity. Does that not prove if that decision had been taken earlier you would have been spared this sort of inquisition and the Northern Rock depositors would have been spared all that worry?

Sir Callum McCarthy: I am not sure if I can say anything other than the point that Hector has made ---

Q292 Mr Mudie: Well, Hector agreed with me! I will settle for that. It is all right, Chairman, he is a good man!

Mr Sants: I think I said that the market agreed with you and we properly reflected the market's views.

Mr Mudie: The market is king!

Q293 Chairman: Following Mr Mudie's point, were you just an interface or did the FSA support the banks in their plea for additional liquidity?

Sir Callum McCarthy: We made it quite clear to the Bank of England the strength of feeling that was being expressed, but I would say that I believe that that was well-known to the Governor.

Q294 Chairman: Okay, so let us get a straight answer, Sir Callum, we are looking for one this morning, give us one. Did you support the banks in their plea for more liquidity?

Sir Callum McCarthy: In terms of the position of the FSA, the responsibility for making decisions on monetary policy (of which this is one) lies with the Bank and it is for them to make ---

Q295 Chairman: Sir Callum, this is getting absurd, it really is, because here we have a situation where some people are saying if you had put extra liquidity in would not have had this run and we would not have had deckchairs outside the 76 Northern Rock branches. We are just asking you in terms of an orderly and efficient market (which is your responsibility) did you support the banks in their plea for more liquidity? Give us a "yes" or give us a "no" or say "we are not going to answer", but make it simple.

Sir Callum McCarthy: Of those three choices, Chairman, I am afraid I am not going to answer

Q296 Chairman: That is better, that is fine; it is on the record.

Sir Callum McCarthy: Because in relation to the conversations that we had within the tripartite group I think it is proper that they should be conducted in private.

Chairman: It is dead easy, Sir Callum, if you do answer a question simply. We understand it now. Sally?

Q297 Ms Keeble: In terms of going forward, to what extent do you think the current problems in the credit market mean that there should be a re-think of the regulation of the credit ratings agencies?

Mr Sants: I think we should definitely take a look at our credit ratings agency regime. There are a number of different issues around that. There is the perennial one of course of whether or not the credit ratings agencies conflict in the sense that they are being paid by those who they are rating, but of course that issue has been around for some time, and there has been a code of practice put in place (IOSCO) which we supported. I think the question obviously that has been raised by more recent events is two-fold: one, to some degree as to how effective are their processes in reaching the conclusions which they reach; and also, just as critically actually, how effective are the institutions in using that information and fully understanding what it is they are being told about. They are being told essentially about a credit rating, of course, not a liquidity rating, and I think there is also a risk to some degree that there has been far too great a reliance placed on credit ratings by institutions and investors as a shorthand way of reaching quick judgments, and that is one of the reasons why the market-place froze up, I think.

Q298 Ms Keeble: There are a couple of things. You said that the issue about the conflict of interest between the advisory and the risk assessment functions are a problem that has about been around for a while. There have been discussions in the United States obviously about regulation and also in Europe. Given the fact that it has to be done internationally, have you talked with your partners elsewhere about what is happening, and how quickly would it be moved forward so that we are not left then several years down the line with still nothing being done?

Mr Sants: We certainly have been talking to our partners and I think, as you rightly point out, this is not an issue that could be addressed nationally, not least because these credit ratings agencies are not even based here.

Q299 Ms Keeble: Could you just detail the discussions that you have had and the timetable for action?

Mr Sants: We had a discussion last month. There already is a working group within IOSCO, which is the main securities global co-ordinating agency, which had a meeting this month, and we are working on taking forward those issues. They have a code of practice and it was agreed in the IOSCO fora that we would be looking again at that code of practice to see what lessons could be learnt from recent events. There has also been debate here within the SESAR context and the European context as well. There will be a number of different strands but we will be looking to take them forward as quickly as possible. International work does not happen as quickly as national work but I agree with you, it should be treated as a matter of urgency.

Q300 Ms Keeble: The code of practice is presumably voluntary. Given the issues that have been raised about people not being aware of the risk and the comments that you have made this morning about risk assessment, do you think there is a need for something more substantial and robust than a code of practice?

Sir Callum McCarthy: I think you will find since we are dealing with a limited number of credit ratings agencies that there will be no problem, once we identify what we want, getting them to accept it. I do not think that is going to be a problem.

Q301 Ms Keeble: Sorry, that kind of agreement between a small number of people can have other names other than a code of practice: it can be a gentlemen's agreement, a cartel, it can be all kinds of things. If we are talking about transparency of information and certainty, do you think there is a need for something that is more robust?

Sir Callum McCarthy: If we get a robust code of practice I believe that we will be able to implement it effectively.

Q302 Ms Keeble: Okay. Do you think that there is a need, and Hector you have hinted at this, for a look again at the liquidity rules, because Northern Rock was within the rules and a number of other banks have got similar profiles to Northern Rock?

Mr Sants: There are two separate points. On the credit agency point, we completely agree with you, there is work needed to be done as to what use are the institutional investors making of credit agency material, how do they engage with it, and is that properly understood and is there proper transparency with regard to the purposes and backdrop to the conclusions of the credit agencies' work. If - and I may be misunderstanding and I apologise if that is the case - you are referring back to my earlier comment about are we satisfied with the way that we approached the stress testing work that was done in Northern Rock, I think I have made clear, no, we are not satisfied with that, and I think we need to address that, and that will be something I will place as a priority agenda from my point of view.

Q303 Ms Keeble: It was just that you referred a bit earlier to the need for a look at the rules around liquidity requirements to which the Governor also referred?

Mr Sants: Yes.

Sir Callum McCarthy: There is work going on, led by the Bank of England in the Basle Committee on trying to establish what should be the basis for a new liquidity regime. One of the difficulties about doing that on a national basis, which goes back to Hector's comment about it takes longer to do things internationally than nationally, if you look at any of the major institutions which operate internationally they run their liquidity on a global basis and they are very hostile to having separate national liquidity regimes. We believe it is a good thing to try and get an international agreement on it, and that is what we are working to do, and that is what we will intensify our efforts to do.

Mr Sants: We should try to use the regrettable circumstances that have occurred to get fresh impetus behind that initiative. It is one that we have been supporting, and indeed the Bank of England co-chairs the key Basle Committee here, but I think there is clearly an opportunity to use this regrettable set of circumstances to put fresh impetus behind the agenda.

Q304 Ms Keeble: Obviously what everybody wants to make sure of is that this does not happen again. I wondered how you see the risk if there is future fall-out from the risks of the sub-prime market in the US and if you feel that you have got a proper assessment of where the risks are in the system, and if you have got a proper way of managing them. I think it comes back to perhaps some of the points that Sin Simon was raising about who is going to take the lead on this and how are you going to make sure that you have got robust enough systems in place. So far you have only talked about the stress testing as being the one real, substantial lesson that you have learned from this.

Sir Callum McCarthy: I think you raise a lot of very big issues in your question. One is that we have long recognised that risk is now much more widely distributed than previously through the origination and distribution model that many banks adopt. One of the issues that has always concerned us was what was the mechanism for reconcentration of that risk. One of the things, for example, that has become clear in relation to major financial institutions is their use of conduits or special investment vehicles. One of the things that Basle II will help with is a better identification of the way in which risk can come back from that on to the major banks, and that, for example, is an area which I think is also an area (quite apart from the work on stress testing which Hector described) that we will want to do a lot more work on.

Mr Sants: We should not underestimate the specifics of Northern Rock and the implications there for consumer confidence and the FSCS scheme of administration, but of course the FSCS scheme is within the remit of the FSA and we have committed ourselves to re-review that. These issues to do with the wholesale market were components of what happened and at the end of the day I repeat the point that the retail run was the critical element that placed Northern Rock in the situation it is now in, but absolutely, we need to look at a number of aspects of the framework of the wider wholesale market.

Q305 Mr Dunne: I would like to probe a little bit further the comment you just made, Hector, because, as you explained, the Northern Rock crisis was essentially a liquidity problem, not a problem with the asset base, and the problem stemmed internationally from the drying up of wholesale markets due to the extreme uncertainty over liquidity, security and value of AAA-rated off balance sheet paper. Do you agree that the wider collateralised debt obligation market was the primary trigger to the drying up of the wholesale market?

Mr Sants: Yes, and I think your point identifies the other aspect of this which was singular and unusual which is what actually happened as a result of the problems you have graphically described was the mainstream and institutional investors, who traditionally purchase commercial paper, which is a fairly vanilla sort of product, lost confidence in the system, so it is a curious combination not just of structural elements of actual credit failure but then we had a confidence failure in mainstream investors which then led to a liquidity problem. Of course your analysis of the origins of this confidence failure is absolutely right, and I think that takes me back a little bit to the credit point that when they lost their confidence, because these are very complex instruments (which I think takes us back to where we were a minute ago) they were very nervous to go out and buy the related revenue flows dependent on those complicated instruments.

Q306 Mr Dunne: So when was the FSA first concerned about price and risk within the CDO market?

Sir Callum McCarthy: I think you will find that the FSA has been concerned for some time about the pricing of risk generally, because one of the problems that we have encountered over the last two years is because of the extent of liquidity in the world, there has been a mispricing of risk, and that has been repeatedly a point we have made. It applies to CDOs but it applies more generally than that. The work that we did for example on leveraged buyouts was concerned about that and other pieces of work were also concerned.

Mr Sants: And, as you know, we have done a huge amount of work with regard to operational risk in relation to the credit derivative market, reflecting our understanding that where you had a credit issue one potential knock-on effect was operational concerns. This aspect of the crisis was not the unexpected part; it was the confidence ---

Q307 Mr Dunne: In that case, you did not answer the question as to when you identified this problem?

Mr Sants: We were clear in our February Financial Risk Outlook, which is one of our more recent publications. I was clear, I believe, in the press conference in July. I believe my predecessors have been clear in various other publications prior to that really for the last couple of years that there was a significant build-up of risk in this area and a gradual mispricing of that risk that needed to be corrected.

Q308 Mr Dunne: Had you discussed these concerns with the SEC and other international regulators?

Mr Sants: Absolutely.

Q309 Mr Dunne: Throughout this period?

Mr Sants: Yes.

Q310 Mr Dunne: So why was nothing more done by yourselves and other international regulators to slow the growth of this market if you had such fundamental concerns about it?

Sir Callum McCarthy: I am not sure what mechanisms you believe are available to us to actually constrain global markets.

Q311 Mr Dunne: Possibly Basle considerations.

Mr Sants: I have made the point that under Basle II the treatment of off balance sheet capital in SIVs and conduits will be brought back and more accurately reflected, so that will be done.

Q312 Mr Dunne: Are you saying that the regulators have no powers to control the spread of derivative instruments, which are not well understood either by the market or by the regulators, there are no tools in your toolbox?

Mr Sants: As a national agency there are clear limitations on our ability to address those risks. What we seek to do - and I think this is an explanation I offered the Committee when we were talking about financial stability earlier in the year - is to control and regulate the central transmission mechanisms within the UK economy, which are the large banks and, as Sir Callum himself said, recently the large banks have gone into this period of market turbulence well capitalised and well set up to withstand these market shocks. We also place increased emphasis on our banking sector having effective stress tests, which takes us back to where we were earlier in the discussion, but our ability to actually curtail the growth in OTC credit derivatives markets are clearly limited by our national --- Indeed, you have to argue it is debatable whether that is necessarily desirable given the wider arguments about risk dispersion. I think we need to be clear here that what has happened was a collapse in confidence, particularly of CP purchasing, and we need to be careful that we do not undermine some of the beneficial aspects of the growth in the derivative market as a result of looking at the lessons learned from this particular period.

Q313 Mr Dunne: Within your risk management specialist teams do you have individuals who have direct experience of trading in these derivative markets and understand the nature of security and risk?

Mr Sants: Yes.

Q314 Mr Dunne: Good. You have touched on the low probability of Northern Rock getting into difficulty given the quality of its loan book. Given the role that you have as banking supervisors, what emphasis do you place on looking at a bank's share price as a determinant of concerns in the market about its performance? Would you like to comment on the fact that the Northern Rock share price declined some 40% in the period from April to the middle of August in a pretty straight line, against the bank sector indices, as an early warning sign that something was going seriously wrong?

Mr Sants: Yes, I think that share prices are indicators of a variety of different potential issues and should be scrutinised by regulators. Share prices also, may I say just in passing, impact retail confidence as well, so there is a variety of the reasons why we should be properly focused on the share price. Clearly we saw acceleration of that trend with the profits warning, to use a colloquial term, and we significantly intensified our regulatory engagement with Northern Rock at that point. I completely agree with you that share prices should be closely monitored by regulators, and they are.

Q315 Mr Dunne: The business model of Northern Rock was heavily reliant, as we know, on the wholesale markets and you have just touched on commercial paper. The commercial paper market is of a one to three-month duration typically. For a bank as significant as this with long-term obligations stretching out many years in the mortgage market, do you think it is wise for funding sources to be so reliant on the short end, and is this not one of the fundamental tenets of bank practice that you do not borrow short to lend long?

Mr Sants: To some degree of course, that maturity transformation does have its uses but actually in the context of Northern Rock the figures do not suggest that it was an outlier in respect of its dependency on very short-term funding. We have discussed previously the fact that - and I am happy to go back over the ground if you would like me to - its bigger risk factor was its dependence on the use of the securitisation products which was the market that froze. The actual percentage of its funding which was dependent on three months or under was not a particular outlier, and also just to remind us again, I think it is important to remember that it did not actually fail to fund itself is this period. What happened was its maturity shortened back into the overnight period to the point at which the Board thought it prudent to seek the lender of last resort facility, and we are all aware of the regrettable consequences of that in terms of consumer confidence, but it was not actually an outlier in respect of short-term funding ratios, it was an outlier in respect of overall wholesale funding, as Sir Callum indicated earlier, which included the securitisation component.

Q316 Mr Dunne: If it is not an outlier, does that not suggest that there are many other banks that are overly dependent on short-term sources of funding and if these dry up there could be contagion across the sector?

Mr Sants: I tread very carefully in this space, but of course, as I have mentioned before, it was specifically the short-term funding failure which was the problem here, it was the absence of the securitisation market, which is a widespread phenomenon, and we need to remind ourselves they were offering good-quality paper, this was not a Northern Rock-specific problem, and it is because they are an outlier in that respect that they put themselves in a position where they became concerned. As a general point, you are right, and now we are back to our stress testing point, it has to be right that our banking sector gives proper consideration to having a diversified set of funding sources across the whole spectrum of maturity which it properly gives consideration to even in extreme circumstances so that they can remain funded for a reasonable duration of time. I am mindful of the other point earlier, that we are not a regime that guarantees there are no failures and we need innovation in financial markets. To say that we should not have had securitisation would not be a good conclusion to draw from this.

Q317 Mr Dunne: Just changing tack a little bit and picking up a point that Sin Simon made, obviously confidence in regulators is critical during a financial crisis. Has the FSA or other members of the tripartite group leaked information to the press during the course of the last month specifically in relation to Northern Rock?

Sir Callum McCarthy: I do not believe that any member of the FSA has leaked any information to the press in relation to Northern Rock.

Q318 Mr Dunne: So are you suggesting then that either the Bank of England or the Treasury leaked information about Northern Rock to journalists?

Sir Callum McCarthy: I am being rather careful about taking the responsibilities which I have, which are for the FSA, and you should not infer from my statement that I am making any comment at all about either the Treasury or the Bank of England.

Q319 Mr Dunne: So if the BBC website was able to report, for example, a decision by the Northern Rock Board as to their dividend announcement recently before the board meeting had even started, you would be prepared to investigate whether that had come through the FSA?

Mr Sants: In that particular case, I am fully aware of the extremely small number of people in the FSA who had the information that it was possible the Board might reach that conclusion, and I have already personally satisfied myself that they did not make any communication with the press in that period.

Q320 Mr Dunne: So I should address that question to either the Treasury, the Chancellor or the Bank of England?

Sir Callum McCarthy: Could I make it clear that that would be a fair inference if those were the only people who had information and the assumption that any leak must come from one of the tripartite authorities is an assumption which I do not believe is necessarily true.

Q321 Mr Dunne: I will have the opportunity to ask Northern Rock themselves next week. If you will indulge me a little bit, Chairman, just turning to the specifics of the regulatory challenge that the Northern Rock situation provided. As we have had the first run on a bank for 150 years and you are the regulators responsible and this has come on your watch, the hard-earned reputation of this country for its financial supervision is essentially at stake at the moment. We have received evidence from the Governor of the Bank of England that following his appearance before this Committee he sought to clarify discussions between the Tripartite Authorities in the run-up to the decision not to extend facilities to Northern Rock whilst they were in the midst of whatever discussions. He confirmed specifically that before 10 September special facilities would not be made available to a purchaser of Northern Rock, and that was based on a discussion which he had with the FSA and with the Chancellor. Can you confirm that those discussions took place and that was a decision that was reached?

Sir Callum McCarthy: I can confirm both of those.

Q322 Mr Dunne: What attitude did the FSA take in those discussions as to whether it would be appropriate to provide a facility to a purchaser given that you had the most detailed knowledge of the situation that Northern Rock was in?

Sir Callum McCarthy: We made clear - and I think I answered this in previous questions - that if a private sector solution was to be pursued, the requirements that we thought would have to be requirements from a potential bidder that would have to be satisfied, so we identified what would have to be done if a private sector solution was to be pursued.

Q323 Mr Dunne: Was a request made by a potential purchaser of Northern Rock for such a facility before 10 September?

Mr Sants: Before 10 September, I was just going to elaborate a bit and say I am clear in my mind that we properly discharged our responsibility to bring a private sector solution to the table, and that the only one that was available was the one you correctly describe, which included public sector funding, and I do not believe any subsequent events, including the various discussions that had been going on, suggested there was some other solution out there that could have been reasonably found in the time in question. We brought the only solution on the table, we made clear what was required to deliver it and there was a decision by the tripartite not to take that suggestion up.

Q324 Mr Dunne: But what was your recommendation?

Mr Sants: I think I am back into the answer I gave a little bit earlier. From the narrow perspective of avoiding the set of circumstances with regard to Northern Rock which then transpired, clearly a private sector solution at that point would probably have avoided that outcome; I make that clear.

Sir Callum McCarthy: Could I also add, because I think it would be incorrect to regard the private sector solution as being a firm, cut and dried offer, it was still at an exploratory stage and there were a number of other issues which would have to be dealt with.

Mr Sants: If it had been a firm approach it would have had to have been declared to the market, so we should be clear about that point.

Q325 Mr Dunne: It is clear that it would have been subject to shareholder approvals and regulatory approvals, et cetera, but it might have provided the comfort to those who were both depositors and shareholders in Northern Rock that there was a solution on the table, and even if it was a contingent that might have settled and reassured the markets and avoided a run on the banks. Sir Callum, you said earlier it was the Chancellor who made the decision to extend facilities at the end of that week. Do you accept that had a different decision been made by the Chancellor we would have avoided a run on the bank?

Sir Callum McCarthy: No, the only different decision by the Chancellor would have been to have not extended facilities.

Q326 Mr Dunne: No, excuse me, there was the opportunity - we have just discussed it - before 10 September when there was a contingent bid on the table for the facilities that were extended a week later to have been available to the bidder and had that happened there would not have been a run on the bank: question?

Sir Callum McCarthy: If there had been an offer which had been carried through successfully, by definition, this problem would not have occurred. That must be true.

Q327 Mr Dunne: But any offerer was not in a position, given the constraints in the credit markets, to be able to take potentially up to 100 billion or so of debt onto its books on an unconditional basis, and therefore operating in the world that we are in with public companies it was inevitably going to be contingent and so you could not have had a completely deliverable bankable proposition, but in terms of providing comfort to the markets that there was a solution in sight, would that not have provided sufficient confidence to depositors and the market alike to have prevented what we are now in which is a calamitous situation where the whole regulatory regime of the United Kingdom is in question? In terms of moral hazard surely that is a more significant issue than allowing the bank to go to the wall?

Sir Callum McCarthy: I go back to describing the position which is as I have described it and as the Governor set it out in his letter to the Committee.

Q328 Mr Dunne: I have got two more quick questions. How many banks in other countries have requested similar liquidity facilities from their regulatory authorities with no distress to their depositors?

Sir Callum McCarthy: I do not know that. I do know that there have been two banks which have had serious problems, one of which has resulted in a bail-out and the other an acquisition in the US. There have been significant problems in the Canadian CP market. There have been other problems in France in different aspects of this, so this has been a global problem.

Q329 Mr Dunne: Are you aware of market rumour that some 150 banks have applied to their regulators around the world for special funding?

Sir Callum McCarthy: All I would say is that the discussions that I have had repeatedly with regulators in other major countries of the world give me no reason to believe that figure.

Q330 Mr Dunne: Is it the case that had Northern Rock had a European subsidiary and was active in the markets on Continental Europe, it would have been able to apply to the EU facilities for sufficient funding to deal with its liquidity crisis?

Sir Callum McCarthy: It could have, I believe, through its Danish branch have done some things; it was a question of the length of time that would take.

Q331 Mr Dunne: So that is a yes?

Sir Callum McCarthy: Sorry, I beg your pardon, I am not trying to be difficult.

Mr Sants: If it had been set up to access the ECB liquidity provision it could have tendered different types of collateral to that which it would have been able to so do in the UK.

Q332 Mr Dunne: So that is another illustration of the failure of our system, in effect, because had it been a slightly larger organisation, it might have been able to apply to the facilities that existed in Continental Europe?

Sir Callum McCarthy: If it had had the capability of organising its assets in the right form.

Q333 Mr Dunne: Looking forward, there is considerable concern in the markets as credit conditions remain tight that another institution might fail. How comfortable is the FSA about the renewal of borrowing facilities for smaller lenders dependent on wholesale funding and how confident is it that we will not see another failure?

Sir Callum McCarthy: I think the answer that both of us have given to the Chairman in terms of not commenting on individual institutions is one I go back to. I would repeat that, on the whole, the British banking sector is well capitalised and has had the benefit of five years of very good, profitable business.

Q334 Chairman: Sir Callum, just a couple of questions arising from that. You raised the issue of takeovers and there have been banks in the news allegedly wanting to take over Northern Rock. There are two issues here: the bidding bank receiving support and the terms of that support. Were you in agreement with the banks on the parameters that should have been offered or should be offered on these two issues?

Sir Callum McCarthy: In terms of the discussions that weekend?

Mr Sants: I think we are back to the answer, at least from my point of view, that I have already proffered that we made clear what the terms were - and they were indicative terms if I may just say - that would possibly lead to the discussions becoming more serious, and those terms were declined by the tripartite.

Q335 Chairman: Let us make it simple: did you agree no support or did you agree the terms of the support? That is really what we are looking for. It is a "yes" answer or a "no" answer or "no answer".

Sir Callum McCarthy: The tripartite decision was that it would be wrong to advance assistance to the bidding bank. It was subsequently made clear after the lender of last resort facilities had been made available to Northern Rock that those facilities would remain available to a bidding bank, if there were a bidding bank.

Q336 Chairman: So you were in agreement with the Bank of England on those two issues regarding the parameters which should be offered, namely the bidding bank receiving support and the terms of that support; you were at one with them?

Sir Callum McCarthy: We explained what would be required if things were to go forward.

Q337 Chairman: So you were at one with them, Sir Callum, you were at one with the Bank on that?

Mr Sants: It was not our decision.

Q338 Chairman: This is a "no answer" again. This is getting really, really unsatisfactory. You are one of the Tripartite Authorities but what seems to us here, Sir Callum, is that you are crawling into your den and you are not answering anything, and if we want to sort out this issue and this problem for the future we really need to know what one of the eminent authorities thinks, so is that another no answer?

Sir Callum McCarthy: I am trying very hard, Chairman, to answer your questions as clearly as I can. The FSA does not have a balance sheet which enables us to offer assistance and so what we did, which is what we are required to do, was to try and identify what would be needed, and a decision was taken that it was inappropriate to proceed on that basis.

Q339 Chairman: The reason why I am asking this, Sir Callum, is very simple, the authorities did not agree to do this and, as a result, the taxpayer is now at risk for 9 billion secured on mortgages which the Bank would never normally accept as adequate collateral, so other than lending to, say, a bank that came in - and from the name of the bank that came in it indicates that they are one of the world's largest and best capitalised banks - the taxpayer has this risk now. If you are interested in orderly markets and seeing them function effectively you should have a view on it, Sir Callum.

Mr Sants: You could say ---

Q340 Chairman: If you are not going to answer the question tell us and then it is on the record.

Sir Callum McCarthy: I do not think I have anything else to say.

Chairman: So you are not going to answer the question. Okay, you are not going to answer it. There are three or four people who want to finish up on the Northern Rock thing before we go on to others, so Colin, Mark, George and Michael quickly.

Q341 Mr Breed: We have got the problems of liquidity and all that sort of thing and hopefully for the next few months that might calm down. However, is there not a real further problem on the horizon that if the pricing of risk becomes stricter, if we have more write-offs, if we have lower profits, as seems likely, then capital adequacy rules are going to be under real pressure, and we are going to find ourselves in a few months' time with many lending institutions finding themselves up against capital adequacy rules, which is going to produce another potential crisis all the way through?

Sir Callum McCarthy: We have clearly been much concerned to look forward as to how this will unwind. We have been particularly concerned, as have our counterparts in other countries, to look at the effect of bringing back on balance sheet the assets which are at the moment in conduits and special investment vehicles. I have no doubt that there will be pressure on capital, but equally I go back to the fact that these banks are well capitalised and that they have the benefit of ---

Q342 Mr Breed: They are well-capitalised under existing rules and existing risk profiles. Once you apply those stricter risk profiles, once they have lower potential profitability, once we have higher write-offs, all of which will affect the capital base as well as bringing in the new rules next year, are we not going to find that a significant - and I am not talking about the very big banks, of course they are - number of potential lending institutions, and I am not going to put it much higher than that, are going to find themselves up against capital adequacy rules which they will not be able to meet and they will not be able to find the capital to continue?

Sir Callum McCarthy: I do not believe that that is the central case at all.

Q343 Mr Todd: You can correct me, Sir Callum, but I recall you described the behaviour of he people in the queues to take out their money from Northern Rock as being "irrational". I think that is right.

Sir Callum McCarthy: Could I correct you, if I may, because I have huge sympathy with the anxieties of the people who queued on that Friday, Saturday (and would have queued on Sunday) and queued on Monday. The comment that I made was made only after the Chancellor had given his guarantee and at that point the situation absolutely changed. As from 5 o'clock, or whatever the time was, on 17 September there was no purpose in anybody queuing because there had been a clear and absolutely unequivocal guarantee given by the Chancellor. That changed the event and I did say that there was no rational cause for anybody after that statement to queue.

Q344 Mr Todd: And I think we all agree with that but you made no comment on their behaviour before that point?

Sir Callum McCarthy: Absolutely not.

Q345 Mr Todd: Fine. One of the things that certainly struck me out of this whole exercise was that however we discussed this issue, the reaction of the consumer was not properly predicted or understood, and that the signals given by actions taken by the Bank and yourselves were not properly understood always by the consumer who had their money invested in Northern Rock. Do you think there is some work to be done in the future - and I can see Mr Sants nodding - in trying to understand better both the information that consumers require to properly appraise the risk of what they are doing and also what the consumer understands the responsibilities to be of various people who regulate the institutions in which they place their money?

Sir Callum McCarthy: I agree entirely with that line of argument. I would make one point that one of the things that was particularly difficult in relation to Northern Rock was the sheer logistics. It had 72 branches which normally were very small, perhaps with a couple of counters, you had offices where if you got as many as ten customers arrive there was a queue outside. You had a problem about the band width of their Internet banking. Everybody who actually got to the front of the queue got paid off at 100 pence in the pound and everybody who got through on the Internet got their money out. I think the logistics were a problem but much more widely than the logistics was a general problem of first of all the fact that the compensation scheme only gave you 100% up to the first 2,000 and also the need for a facility which produces rapid pay-offs rather than people having to wait for an extended period. I think all those are questions that we have to address and if we address them I think people should have greater confidence in comparable events.

Mr Sants: I would just add, because you noticed me nodding, we have a role in consumer confidence, we have a role here to communicate with your constituents, with the customers, and clearly I think the messaging was not very effective. Our phrases along the lines of "this bank is solvent" and "lender of last resort", this type of terminology ---

Q346 Mr Todd: Were not understood?

Mr Sants: It is a technical terminology and there is a challenge here for us to connect properly with the consumers and there is a consumer confidence issue that goes into the communication.

Q347 Mr Todd: Can I just interrupt and say one of the reasons why other banks have chosen not to take up the offerings of the Bank of England's rather penal liquidity is partly because they quite readily understand the signal that might possibly give to their customers of doing such a thing, so I think what is required is a better understanding of the mechanics of decision-making that consumers take in these sorts of matters, is it not?

Mr Sants: Absolutely.

Mr Todd: Good, okay, that is fine.

Q348 Peter Viggers: Is your supervision of banks, exercised jointly with the Treasury and the Bank of England, weakened by the ability of banks to have access to the European Central Bank or other external financial facilities?

Sir Callum McCarthy: No, I do not believe that our supervision is in any way weakened by that. It is important that we should understand whether any particular institution does have access because it affects the liquidity available to them.

Q349 Mr Simon: Sir Callum, I have revised my view, you are not the Herol "Bomber" Graham of the financial world; you are the Sugar Ray Leonard of the financial services sector; a world-class ducker and diver, bobber and weaver, but let me try one last straight left, if I may. You said that if the person who briefed the FT against the Bank that day turned out to be from the FSA you would sack them. Given how glib and dismissive you have been about this before this Committee today, if that person can be shown to have been from the FSA will you not only sack them but sack Mr Sants and resign yourself?

Sir Callum McCarthy: First of all, can I make clear that I do not believe that I have been glib. If I have been glib I apologise to all this Committee. I have tried very hard to deal with very serious issues as seriously as I can, so can I just put that on the record.

Mr Simon: From what the Chairman has said and I have said that it is very obvious to all of us that this briefing against the Bank has clearly happened and it has clearly come from the FSA, you have just said "Not true, I don't believe a word of it. It simply is not the case. Unless you can prove it I am not having anything to do with it." If that is not glib, what is it?

Q350 Chairman: I am writing to the FSA and that will be public information.

Sir Callum McCarthy: Can I just be clear, Chairman, that I have said that if I found that any member of the FSA had briefed against the Bank I would fire them, and I do not regard that as a glib remark nor an irresponsible remark.

Q351 Mr Simon: The question was whether you would resign yourself having been so glib about it today.

Sir Callum McCarthy: I am sorry, I have repeatedly said I do not regard myself as having been glib.

Chairman: I got the feeling that you want you can come along here resigning, Sir Callum, we have still got an inquiry to be getting on with, so do not worry about that. Andrew?

Q352 Mr Love: I am still trying to search out the essence of the memorandum of understanding between the three different organisations. We have pressed on is there a leadership role for one of them in certain circumstances and that does not seem to apply. We have also been pressing on who takes responsibility and it would appear that what happens is each of the three organisations runs away from things that are not its responsibility. You have said quite clearly in response to all the questions that that is the responsibility of the Governor of the Bank of England. Is there a role for collective responsibility and would the memorandum of understanding work better if there was some collective spirit amongst the three organisations?

Sir Callum McCarthy: If I look at what we have been trying to do since these problems generally developed in August, and in relation to this period of Northern Rock, I think there has been very close and collective work. That is point one. Point two: the point I have made repeatedly is that there are certain decisions which are not decisions for the FSA but are decisions for the Bank of England where we have the responsibility to give information, and I believe that we have done that, and where we may express views to the Bank, but those views, I am afraid, I am going to keep private, and that is I think the position that I have, I hope, explained repeatedly.

Q353 Mr Fallon: Sir Callum, you have implied this morning that you have discharged your responsibilities throughout properly with a rather feeble caveat where I think you said you should have been "more forceful a little earlier". Can I put it to you that you have been responsible for supervising a bank whose business model you yourself described as "extreme" that then became completely illiquid, was then subject to the first run on a bank for 150 years, has now in effect been nationalised, with all the damage to the British banking system that results from that. Is it not the case that the FSA has fundamentally failed in its supervisory duty?

Sir Callum McCarthy: No I do not think we have fundamentally failed in our supervisory duty. I think we have discharged our duties in particular ways and I think, as both Hector and I have repeatedly made clear, that there are absolutely things that we have to do differently and better than we have done.

Q354 Mr Fallon: So you do not accept responsibility for this fiasco?

Sir Callum McCarthy: I am sorry, I accept responsibility in the terms in which I have set it out because I think there are things which the FSA had responsibility for which, as we have both made clear, were not done well enough.

Q355 Chairman: Sir Callum, I looked at the FSA Annual Report which you have given us and in table 5.2 on page 56 is a list of those attending the Risk Committee. Everyone has full or perfect attendance on that Risk Committee other than Sir John Gieve, who attended only two out of four of the Risk Committee meetings. In your correspondence to us will you indicate exactly what dates Sir John missed those Risk Committee meetings please?

Sir Callum McCarthy: If you would like me to I will certainly, sir.

Q356 Chairman: Thank you. The FSA handbook incorporates the concept of approved persons, including executive and non-executive directors; am I correct?

Sir Callum McCarthy: Yes.

Q357 Chairman: In assessing fitness and propriety the FSA has regard to competence and capability; correct?

Sir Callum McCarthy: Yes.

Q358 Chairman: So do you regard the Northern Rock Board as competent and capable and do you still regard them as that given that all these members are still at the driving wheel?

Sir Callum McCarthy: As you say, we authorised, as we authorise non-executives and executives of major banks, all those people. We took a view on the overall corporate governance, and I would point out that for example the Risk Committee or the Liabilities and Assets Committee of Northern Rock was actually chaired by an extremely experienced banker. We looked at all that. We will of course, whatever the shape that Northern Rock evolves into - and there has been an announcement this morning in relation to that - wish to look at the continued authorisation that we have granted, as we do with all people.

Q359 Chairman: Okay, if I could just ask you that again: do you regard all the Board on Northern Rock at the moment as competent and capable?

Sir Callum McCarthy: We believe that they were properly authorised under the processes that we had.

Q360 Chairman: Again, is this a non-answer, Sir Callum? Were they competent and capable? It is a very simple question.

Sir Callum McCarthy: They met our authorisation criteria, including the criterion of competence.

Q361 Chairman: So they were competent and capable?

Sir Callum McCarthy: Under the terms of the authorisation, yes.

Q362 Chairman: Does that mean you thought they were competent and capable and Mr Sants thought they were competent and capable. For God's sake, give us an answer.

Sir Callum McCarthy: Sorry, neither of us was in any way involved in the individual decisions.

Q363 Chairman: But the FSA thought they were competent and capable?

Mr Sants: Clearly the FSA did and where we stand at the moment, just to be quite clear, in respect of the current situation that Northern Rock is in we deem that it is appropriate for them to remain in place and I think that would be a readily understood point that in these sorts of circumstances it is useful to have a management team who are fully understanding of the set of circumstances the firm is in.

Q364 Chairman: We are pulling teeth to get the answer, Sir Callum, we are focusing on Northern Rock and we will come back to you in terms of the non-Northern Rock issues with the FSA, but maybe some of my colleagues would like to ask a quick question to you on that. I do not think we will give due justice to it given the amount of time we have spent on Northern Rock, but if I can try and sum up what you have said to us this morning you would say the lessons learned are: the FSA needs to push the extreme stress testing in banks; is that correct?

Sir Callum McCarthy: Yes.

Q365 Chairman: So there was an element of supervisory failure in that?

Sir Callum McCarthy: In terms of not pushing it further than we did, we should have done more, yes.

Q366 Chairman: So it was inadequate, that is fine. There is also low consumer confidence in the authorities; you have said that. I picked that up as I went along.

Mr Sants: As was demonstrated by the events surrounding the announcement of the lender of last resort facility.

Q367 Chairman: Okay. There are problems with the Financial Services Compensation Scheme deposit protection; that is correct?

Mr Sants: Yes.

Q368 Chairman: Okay. The three-year period between the full regulatory analysis of "high impact" firms is too short?

Mr Sants: No, I said in specific regard to Northern Rock that period proved to be too short and we need to do a lessons learnt exercise more generally on the implications for our overall supervisory regime.

Q369 Chairman: We are talking about Northern Rock this morning. You said it was too short for Northern Rock.

Mr Sants: Yes.

Q370 Chairman: So we can forget your first negative answer there; it was too short?

Mr Sants: I thought you were asking about general supervisory lessons.

Q371 Chairman: It is Northern Rock we are on about.

Mr Sants: I beg your pardon. Three years should have been a shorter period.

Q372 Chairman: That was a trick question. Thank you. Basle II liquidity requirements need modernised; is that correct?

Mr Sants: Basle II and liquidity is a different point. The overall international liquidity regime needs modernising.

Sir Callum McCarthy: Something which we are already working on.

Q373 Chairman: Okay. You perhaps took a different view from the Governor on the four pieces of legislation?

Sir Callum McCarthy: Sorry, I think the main difference which we have discussed is whether the problem of a covert lender of last resort is a legal problem or a practical problem, and we would place greater emphasis on the practical problems whilst not neglecting the legal consequences.

Q374 Chairman: So perhaps you had a different view.

Sir Callum McCarthy: A slight difference of emphasis.

Q375 Chairman: That is fine. In terms of supporting the banks for more liquidity and in takeovers supporting the bidding bank and the terms of supply, that question remains unanswered here?

Sir Callum McCarthy: Yes.

Q376 Chairman: The tripartite system in your opinion worked, everyone played their part?

Sir Callum McCarthy: Yes.

Q377 Chairman: So the question I have got then is if the first bank run for 140 years is success, what is failure?

Sir Callum McCarthy: Sorry, Chairman, I do not think that any of us has described what has happened in terms of a success. You manifestly have not as a Committee and we manifestly have not.

Q378 Chairman: You are telling us everything worked, the tripartite system worked, and yet we have had the greatest cock-up for 140 years.

Sir Callum McCarthy: We have had a problem of global lack of liquidity which has resulted in this country in one bank - a major bank - having an acute liquidity problem and there have been problems, as I have pointed out, in other countries round the world.

Chairman: Okay, we will be coming back to these issues and we look forward to your correspondence certainly before next Tuesday. We are coming back to other non-Northern Rock issues but have any colleagues any particular questions on it just now?

Q379 Ms Keeble: I have one and it was really about the sale and rent back schemes, which are not part of your remit currently but are becoming increasingly important. There are complaints about them but also I have had clear evidence of difficulties with them. Do you have concerns and do you foresee being able to regulate those?

Mr Sants: As you know, I have only taken on this remit at the end of July having previously been on the wholesale side. I am fully aware of the concerns that have been raised and have seen that ---

Q380 Chairman: You are going to have a letter on your desk from me on that.

Mr Sants: I will have a briefing on that and I think it should be looked at. I will have to send you a letter. To be frank, I have been looking at some other things but I will come back to you.

Q381 Chairman: We understand that. Could I finally quickly ask you about inherited estate. How important on the list of FSA priorities is the 14 billion up for reattribution in the Prudential and Norwich Union with-profit funds?

Mr Sants: Very important, and indeed I did write on this very subject only yesterday to convene further meetings and discussions on these issues.

Q382 Chairman: Do you accept that policy holders would be dismayed if the outcome of either of these two reattributions left them as badly off as the AXA policy holders?

Mr Sants: I think there are some serious questions to be addressed and we are in the middle of doing that and, as I say, I yesterday indicated that I wished to take a direct personal interest in the matter and I will happily refer to the Committee with the conclusions I draw.

Q383 Chairman: Are you confident that your rules changes mean that this will not happen?

Mr Sants: I think that is an issue to be looked at.

Chairman: I will tell you what, we will write to you on that as well and if we can get an answer on that that would be very helpful. Sir Callum, Hector Sants, thank you very much for your evidence this morning. We will be having you back on the Annual Report questions, and no doubt we could have you back on this issue, but thank you very much for your answers.