Select Committee on Treasury Fifth Report

3  The regulation of Northern Rock

Northern Rock's regulation as a high impact firm

35. According to Mr Sants, Northern Rock was treated by the Financial Services Authority, as "a high impact bank, under close and continuous supervision".[110] The Financial Services Authority outlined the importance of the ARROW process:

    Our framework for assessing the risks to our objectives posed by individual firms is called "ARROW". Full ARROW risk assessments are an integral part of this supervisory process; they are intensive stocktakes of individual firms and are supplemented by a number of other monitoring techniques. We have designated Northern Rock and more than a hundred comparable businesses as high-impact firms.[111]

However, Northern Rock, despite being a high-impact firm, was not scheduled to have another ARROW impact assessment until three years after its most recent assessment.[112] Its regulatory period was due to run from January 2006 until January 2009.[113] Mr Sants acknowledged that this proposed interval between assessments was "inadequate".[114] The FSA nevertheless stressed that, while there was a significant gap between full ARROW review, a "close and continuous" relationship remained:

    This [close and continuous supervision] is characterised by very regular dialogue with the firm on the full range of supervisory issues, through ad hoc meetings and regular telephone conversations and email traffic. Our workstreams in supervising Northern Rock over the last two years have included: reviewing strategic and business developments through discussions with the firm; attendance at results presentations; monitoring the market; assessing the ongoing validity of our risk assessment; monitoring financial data, supervisory returns and management information; reacting to specific requests from the firm-such as the Capital Requirements Directive (CRD) waiver request which was a major workstream during this period; and undertaking the formal review process which sets the capital requirements of the firm on the basis of the risks identified by the firm and the FSA. We also carry out thematic reviews-projects to review practices in a range of firms in a specific area of their business. Northern Rock was subject to thematic reviews in the same way as other similar firms.[115]

36. Mr Sants told us that 3 members of the FSA's staff were assigned to the direct supervision of Northern Rock.[116] However, Mr Sants went on to explain that the number of FSA staff who would come into contact with Northern Rock would have been higher, observing that:

    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 [than 3].[117]

Potential warnings

37. Two potential signals of the vulnerability of Northern Rock prior to its problems were identified during our inquiry. The first was the rate of growth in Northern Rock itself to which we have already referred.[118] Professor Wood expressed his surprise that the FSA had missed this signal from the rapid growth of Northern Rock:

    The FSA … was asleep on the job; that is manifestly right. A very clear signal of a bank running a big risk is rapid expansion. Northern Rock was giving that signal quite clearly; it really is remarkable that [the FSA] missed it.[119]

Although Mr Sants acknowledged that Sir Callum McCarthy had characterised Northern Rock's business model as "extreme" and accepted that "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", Mr Sants did not regard the recent growth in Northern Rock as a critical issue.[120] He stated that:

    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.[121]

38. However, the Chancellor of the Exchequer noted that it was reasonable for regulators to look at companies that appeared to be expanding quickly. He told us that:

    I have said before that regulators should concern themselves not just with institutions that do not appear to be doing terribly well but also with institutions that do appear to be doing terribly well because, if they are out of line, it may be they are doing a very good job but they ought to just be sure that that is the case.[122]

39. The second potential warning signal was the fall in Northern Rock's share price, especially in comparison to other banks, after the profits warning issued in late June 2007, and well before the announcement of the Bank of England support operation.[123] The extent of this fall is apparent from Chart 1.

Chart 1: Northern Rock closing share price, January 1997 to September 2007

Source: Northern Rock website

40. As Professor Buiter noted in his written evidence, "There is some information surely in the fact that Northern Rock's share price had been in steep decline since February of this year, well before the financial market turmoil hit".[124] The British Bankers' Association (BBA) also highlighted the fall in the share price:

    During the course of 2007, the market had become increasingly aware that there were issues surrounding Northern Rock's business model … In its profit warning of 27 June 2007, Northern Rock stated it was suffering from a 'structural mismatch between LIBOR [London Interbank Offered Rate] and bank base rates' and its share price fell by 10% on that day. This was therefore a very clear signal both to the market and to the authorities that Northern Rock was experiencing increasing difficulties in respect of its funding as the 'credit crunch' speedily impacted inter-bank lending arrangements generally. By mid-July the share price was some 30% lower than at the start of the year. [125]

Mr Applegarth ascribed the fall in the share price to:

    The tightening of the credit markets, so you saw the price of funding increase, you saw a slowdown of our lending in the second quarter and therefore clearly people were assuming that in volume terms our profits would be lower over the next two years than had previously been the case, and indeed that was confirmed when we did a pre-close statement to the market at the end of June.[126]

Mr Sants said that share prices were monitored by the Financial Services Authority:

    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.[127]

41. The Chancellor of the Exchequer summed up the criticism of the Financial Services Authority's monitoring of the potential signals of vulnerability at Northern Rock by stating:

    In hindsight, it would have been much better, would it not, if the FSA when first looking at Northern Rock had said, 'Hold on, what exactly is your fallback position?' and when Northern Rock said, 'We haven't got one' they did something about it.[128]

42. The FSA has acknowledged that there were clear warning signals about the risks associated with Northern Rock's business model, both from its rapid growth as a company and from the falls in its share price from February 2007 onwards. However, insofar as the FSA undertook greater "regulatory engagement" with Northern Rock, this failed to tackle the fundamental weakness in its funding model and did nothing to prevent the problems that came to the fore from August 2007 onwards. We regard this as a substantial failure of regulation.

The Basel II waiver

43. When adopting the Basel II requirements for capital adequacy, a bank may choose to adopt certain 'advanced approaches' to their management of credit risk. The Basel Committee on Banking Supervision explains the choice faced by banks under the Internal Ratings-Based Approach to the management of credit risk:

The adoption of an advanced approach requires a waiver from the Financial Services Authority.[130] On 29 June 2007, Northern Rock was told by the FSA that its application for a Basel II waiver had been approved.[131]

44. Due to this approval, Northern Rock felt able to announce on 25 July 2007 an increase in its interim dividend of 30.3%. This was because the waiver and other asset realisations meant that Northern Rock had an "anticipated regulatory capital surplus over the next 3 to 4 years".[132] Mr Applegarth explained how Northern Rock had achieved this waiver. The company had come to the end of a two and a half year process, during which period Northern Rock had undergone several stress tests, a matter we consider further later in this chapter.[133]. As well as this, in order to obtain a Basel II waiver Northern Rock had to "show that [Northern Rock could] dynamically manage scorecards from new lending all the way through to arrears and possessions and put that information back into [Northern Rock's] front end score cards".[134] Mr Applegarth explained that the waiver had led to a dividend increase because:

    when you get your Basel II approval, the relative risk weighting of certain assets in your balance sheet changes. So what we had, because of the quality of the loan book, was you saw our risk weighting for residential mortgages come down from 50% to 15%. That clearly required less capital behind it, so that links to why we were able to increase the dividend.[135]

45. Mr Sants was keen to point out that the waiver was "basically a standard process" and not "a one-off special exercise on [Northern Rock's] behalf".[136] Sir Callum McCarthy strongly rejected the notion that the Basel II waiver process was a "a box-ticking exercise".[137] He also thought that "the change [from the Basel II waiver was] immaterial to the problem" at Northern Rock.[138] Mr Sants pointed out that, while the crisis at Northern Rock was one of liquidity, the Basel II waiver was related to the capital held by Northern Rock.[139] The Basel II waiver, and the dividend increase this allowed to Northern Rock, came at exactly the wrong moment. While we accept that Basel II is a capital accord and the problems at Northern Rock that soon became all too evident were ones of liquidity, it was wrong of the FSA to allow Northern Rock to weaken its balance sheet at a time when the FSA was itself concerned about problems of liquidity that could affect the financial sector.

The regulation of liquidity

46. The problems affecting Northern Rock were those of liquidity and funding, rather than solvency.[140] The FSA defines liquidity risk as:

    the risk that a firm, although balance-sheet solvent, cannot maintain or generate sufficient cash resources to meet its payment obligations in full as they fall due, or can only do so at materially disadvantageous terms.[141]

Northern Rock operated under the Sterling Stock liquidity regulatory regime,[142] which was introduced in 1996.[143] The FSA in its discussion paper outlines the purpose of the regime:

    The objective of the regime is to ensure that a sterling stock bank has enough highly liquid assets to meet its outflows for the first week of a liquidity crisis, without recourse to the market for renewed wholesale funding, to allow the authorities time to explore options for an orderly resolution.[144]

The FSA went on to explain the potential weakness of this regime. While 'shock' or short term liquidity stresses were well catered for, the Sterling Stock liquidity regulatory regime coped less well with 'chronic' liquidity stresses of long duration.[145] This is exemplified by comments made by Dr Ridley that:

    There were sharp reductions in liquidity after 9/11 in 2001. That lasted for a matter of days. Our model was extremely robust in those conditions. What was not expected was that all global markets would shut down and remain shut down for as long as they have.[146]

47. Following the events in August, and the crisis centred on Northern Rock, the Financial Services Authority published in December 2007 a discussion paper entitled Review of the liquidity requirements of banks and building societies. The Bank of England fully supported the publication of this discussion paper.[147] However, this emphasis on liquidity regulation appears to be new found. Professor Buiter suggested to us that "the FSA is an institution that thinks more about capital adequacy and solvency issues than about liquidity issues".[148] The Chancellor of the Exchequer told us that liquidity regulation appeared to have been less important to regulators:

    I am quite clear that regulators need to start looking far more at liquidity and not just solvency. They tend to be more concerned about solvency.[149]

48. The Governor of the Bank of England accepted that liquidity regulation would have to be taken "much more seriously".[150] The Governor felt that the interest in liquidity regulation had declined over a long period. He informed us that in the "1950s and 1960s as much as 30% of the assets of a bank had to be held in liquid assets", but that now "it is not much more than about 1%".[151] But he warned, using the arguments of Professor Charles Goodhart, that there was "no single number in measuring liquidity that will tell you the true story" of a bank's liquidity position.[152] The Governor went on to say that "It is no good just looking at the amount of liquidity you have got for the next two weeks, or the next four weeks, you need to look at a range of numbers and apply a qualitative judgment as to whether or not the institution has adequate liquidity".[153] In achieving a new regulatory regime for liquidity, the Governor expressed the following hope:

    If we had a system of proper liquidity regulation, although Northern Rock would have shown up as doing very well on the capital side, it would have looked very flawed on the liquidity side, and that would have been picked up.[154]

49. The demutualisation of Northern Rock from a building society to a bank also changed the liquidity regulatory regime under which Northern Rock operated. The regulatory regime for building societies is set out in the FSA's discussion paper:

    Building societies must hold appropriate amounts both of total, and of short term, liquidity. The society's board has to set a range (expressed as a percentage of banking liabilities) within which total liquidity will be maintained—as a result, actual liquidity falls typically between 15% and 25%. The rules do not set a hard minimum for total liquidity, but the range, like other aspects of the policy, is reviewed, and may be challenged, by the supervisor. [The FSA] do, however, set out—as guidance—a matrix of asset types suitable to be held as liquidity by building societies of varying size and complexity. For short-term (up to eight days) liquidity, [the FSA] set a hard minimum for all societies: 3.5% of banking liabilities, and require this to be met from a much narrower list of high quality marketable assets (though not quite as narrow as eligible collateral).[155]

The Building Societies Association, stated that "Building societies are explicitly prevented from having as high a proportion of wholesale funding as Northern Rock".[156] And the FSA discussion paper states that "In practice, building societies' natural caution means that most target to hold liquidity—total and short-term—well above their policy or regulatory minimum".[157] When asked whether Northern Rock would have found itself in such difficulties if it had remained a building society, Mr Adrian Coles, Director-General of the Building Societies Association, replied "Had Northern Rock stayed a building society, it may or may not have been a successful institution but it would not have come to the sticky end that it appears to have come to in the way that it has".[158]

50. Unlike capital regulation, there is no international set of regulatory requirements for liquidity, apart from requirements under Pillar 2 of Basel II.[159] The Governor of the Bank of England expressed the regret that:

    at the time when the Basel capital regime was being negotiated the Bank of England did start an initiative to begin a parallel Basel liquidity adequacy regime, and it never got off the ground; other central banks were not so enthusiastic. It is a shame, but maybe we need to get back that.[160]

51. However, the Governor did say that the Bank of England and the FSA "have been pressing that case [for agreement on liquidity regulation] internationally for quite some time".[161] The FSA's discussion paper notes that some international activity on liquidity regulation had begun at the start of 2007. The Committee of European Banking Supervisors had been asked by the European Commission to look into both member countries' liquidity risk regulatory regimes and other factors affecting liquidity risk. The timeframe for this work has been extended given recent developments in international financial markets.[162] The Basel Committee on Banking Supervision had also begun a stock-take of national regulatory regimes for liquidity at the start of the year, and has now been asked to accelerate this work by the Financial Stability Forum, and it was to include "a first assessment of lessons learned from these events and recommendations for the future direction of work on a new international agreement on liquidity".[163] It has been suggested that reform of the regulatory regime for liquidity should await such an international agreement. The BBA recommended to us that:

    Regulation of liquidity in cross-border banking groups is best managed according to a set of principles proportionally applied by the home state regulator, recognising that in the complex world of liquidity management there is no one-size-fits-all answer. Any reform to the regulatory liquidity requirements in the UK should wait until the [Basel Committee on Banking Supervision] review is complete to ensure that it is aligned with any consequent international developments. Liquidity management has global ramifications—a UK centric solution may be counter productive.[164]

In its discussion paper, the Financial Services Authority states that "We would still prefer to develop our policy in line with any emerging international consensus".[165]

52. The current regulatory regime for the liquidity of United Kingdom banks is flawed. That regime did not prevent the problems that arose in relation to Northern Rock in 2007. We welcome the publication of the Financial Services Authority's discussion paper on this issue, and acknowledge the possible benefits of an international consensus on the best way forward. But in light of Northern Rock, reforms of the United Kingdom's system of liquidity regulation cannot wait for international agreement.

Stress testing

53. One of the tools used to test the preparedness of financial companies for shocks to their business models are 'stress tests'. An IMF working paper provides the following explanation of a stress test:

54. Mr E Gerald Corrigan, Managing Director and co-Chair of the firmwide Risk Management Committee of Goldman Sachs, explained the nature of stress testing in relation to financial models:

    models by definition are backward and not forward-looking. That is a reality that we all have to deal with. The way we try to deal with it, with a great deal of impetus from the regulatory side, including the FSA in London, is by trying to enhance scenario analyses, stress-testing and things like that to allow us to try better to look at what we call the tails of these frequency distributions which are the essence of these models. I think we have become better at that. Do I think we are as good as we could be? No.[167]

55. One of the technical problems in stress testing is the need to cope with 'fat tails'. This concept is explained in a paper by Bridget Rosewell and Paul Ormerod. Companies use statistical models based on the assumption of normal distributions to estimate the likelihood of an event occurring, and thus what risk a business model is running. However, such assumptions may be invalid:

    If we use the normal … distribution to estimate probabilities, it seems that institutions such as Northern Rock could not have reasonably anticipated such extreme outcomes. If this analysis is sufficient, then the risk is indeed very unusual and regulators would not expect organisations necessarily to be robust to this situation.

    However, the problem lies in the extreme tails of the distributions. This is exactly the same problem which arose in the collapse of Long Term Capital Management. The data may appear to be normally distributed, but more careful inspection shows that the tails are fatter i.e. there are more extreme observations in the data than the normal distribution allows. Rare events are not as rare as you might think. The bulk of the data follows a normal distribution. It is the extremes which do not.[168]

The FSA acknowledged that the overall understanding of tail risk was weak. Sir Callum McCarthy told us that:

    I think the analysis of tail risks is an extraordinarily difficult issue. By definition you are saying that you expect events which happen very infrequently, that is what you are examining, and anybody who claimed they had a full understanding of the risks associated with tail risks would be open to misleading.[169]

Mr Sants then explained to us that this risk around the tail of probability distributions meant that a more nuanced approach to risk management was required than just using past data:

    It is also undoubtedly the case with regard to financial markets, as others have said to you, that relying solely on historical statistical analysis as a method of predicting the future via modelling is not a sufficient way to discharge your responsibilities as a board of directors. You do need to take into account the likelihood that the future will not reflect the past and circumstances will not repeat themselves in the way they have in the past. That is why we continue to reiterate the statements we made in the earlier part of the year which are even more appropriate now than they were, that firms need to seek to run full scenario tests, understand the circumstances under which their business models have come under pressure regardless of whether or not that type of modelling looks particularly probable from a tail risk analysis. They should run their businesses to take into account those risks and, as we said earlier, we do not feel that it was the case that all institutions were taking that approach to risk management in the early part of the year. We believe that recent events and supervisory engagement mean that they are much more focused on this point, but it is still a key factor that they need to properly focus on.[170]

56. The FSA was aware of some deficiencies in the stress testing being undertaken by financial firms. In its 2006-07 Annual Report published in June 2007, the FSA highlighted the findings of a review of ten firms' stress testing practices, stating that the conclusion of this review was that "Most firms had practices that went some way to meeting our requirements but further improvements were needed, particularly where firms were not fully taking into account severe but plausible scenarios when making strategic or risk management decisions".[171] In May 2007, after this review had been undertaken, a separate review of Northern Rock's stress-testing was undertaken as part of its Basel II waiver programme.[172] This review led to the conclusion by the FSA in July 2007 that the FSA were "not comfortable with [Northern Rock's stress test] scenarios".[173] Mr Sants later strengthened this position, telling us that the FSA had pointed out to Northern Rock in July 2007 that it was "very unhappy with [Northern Rock's] stress testing scenarios and asked them to do 'further distinct liquidity tests and scenario tests' and give greater consideration to the impact of accelerated cash flows from a trigger event in a liquidity crisis".[174] Mr Applegarth identified the extra stress tests asked for by the FSA as "primarily to do with credit, such as the example … of the 40% house price fall".[175] The extra stress tests were not focussed around an event "deemed implausible, which was the rapid and long-lasting closure of global markets".[176] Sir Derek Wanless said that these additional stress tests had been considered by the Board of Northern Rock, as part of the Basel II waiver programme:

    It [Basel II accreditation] is an assessment of Northern Rock's own model so [the FSA] made an adjustment to capital in respect of credit concentration risk, which was their major concern. [The FSA] also mentioned pension risk, securitisation risk and stress-testing, in that order of priority.[177]

Sir Derek Wanless told us that Northern Rock's "stress tests at the time were sufficient",[178] and that Northern Rock was

    going through a process at the time of scenario stress-testing which involved looking at 20 scenarios which the Board had signed off. Fifteen of those scenarios involved liquidity risk, including two where securitisation became a particular problem. What did not happen was that we stress-tested the scenario of what has actually happened, which is, as we said earlier, that there was an unprecedented and unpredictable change in the market basis.[179]

57. Mr Sants pointed out that "it is the Board's responsibility to run a company prudently and the stress test scenarios are designed by the Board, not by [the FSA]".[180] However, Mr Sants appeared to accept that there had been a failure of the FSA's stress testing regime in regards to Northern Rock:

    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 [repurchase agreement] 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.[181]

58. Professor Buiter told us that "the [FSA] seem to have done not even the kind of liquidity stress-testing that I would have expected them to do, partly because the FSA is an institution that thinks more about capital adequacy and solvency issues than about liquidity issues".[182] However, Professor Buiter noted that:

    One could have expected that they would have looked at the consequences of some of the markets in which Northern Rock was funding itself simply closing. What happened of course in the case of Northern Rock is that all of the markets in which it funded itself closed, something which had never happened before, so you would have had to have an ultra stress test to capture that.[183]

The BBA also noted that in itself stress testing was a useful tool for regulators, but that it had been inappropriately applied in the case of Northern Rock:

    Since the beginning of 2005 banks have been required to undertake stress testing and scenario analysis, to have in place contingency funding plans and to document them adequately. Under Pillar 2 of Basel II, banks are required to assess regularly and regulators to review their liquidity funding plan in a stressed situation. The FSA had reviewed Northern Rock's stress testing processes in May 2007 and has already accepted that there are lessons to be learnt about the level of its supervisory engagement with stress testing. So although they are still novel and the execution of the new Pillar 2 stress testing processes failed in the case of Northern Rock, regulators do have the right policy tools to quiz banks about their stressed liquidity plans.[184]

59. If the Financial Services Authority was "very unhappy" with the stress testing conducted by Northern Rock, it appears to have failed to convey the strength of its concerns to the Board of Northern Rock, and to secure remedial action. Although the Board of Northern Rock undertook some stress testing of its own business model, it proved to have been thoroughly inadequate. It was the responsibility of the Financial Services Authority to ensure that the work of the Board of Northern Rock was sufficient to the task. The Financial Services Authority failed in its duty to do this.

Qualifications of senior directors

60. The FSA's handbook states that under the 'Fit and Proper test for Approved Persons':

    (1) honesty, integrity and reputation;

    (2) competence and capability; and

61. The FSA Register states that Mr Adam Applegarth, Chief Executive of Northern Rock from 1 December 2001, held three "controlled functions" (CF) at Northern Rock, that of CF1 Director, CF3 Chief Executive and CF8 Apportionment and Oversight, until 13 December 2007 for his CF 1 and CF 3 roles, and until 31 October 2007 for his CF 8 role.[186] However, when we asked Mr Applegarth when he qualified as a banker, he replied "I am not a qualified banker".[187]

62. Sir Callum McCarthy said that the Board of Northern Rock had met the FSA's "authorisation criteria, including the criterion of competence".[188] Sir Callum McCarthy also told us that:

    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.[189]

63. We are concerned that the Chief Executive of Northern Rock was not a qualified banker, although of course he has significant experience. The Financial Services Authority should not have allowed nor ever again allow the two appointments of a Chairman and a Chief Executive to a "high-impact" financial institution where both candidates lack relevant financial qualifications; one indication that an individual has been exposed to the relevant training is an appropriate professional qualification. Absence of such a qualification should be a cause of concern. We therefore recommend that the FSA undertake an urgent review of the current qualifications of senior directors in financial firms (especially of those firms deemed to be "high-impact") and ensure that the current approved person regime requirements are adequate, and respond to us on this by June 2008.


64. The overall regulation of Northern Rock by the Financial Services Authority has been roundly criticised during our inquiry. The Chancellor of the Exchequer outlined the role of the Financial Services Authority:

65. Professor Wood told us that "the FSA does not seem to have carried out its job with the skill and diligence that one might have expected".[191] Professor Buiter argued that:

    The FSA did not properly supervise Northern Rock. It failed to recognise the risk attached to Northern Rock's funding model. Stress testing was inadequate.[192]

Sir Callum McCarthy told us that "I think there are things which the FSA had responsibility for which, as we have both [Mr Sants and Sir Callum McCarthy] made clear, were not done well enough".[193] The Chancellor of the Exchequer also noted that "the FSA have said, and it is right, that they do need to look at their procedures and how they regulate things".[194] We note that the Financial Services Authority has acknowledged that the time periods between comprehensive regulatory review of Northern Rock were "inadequate".

66. The FSA did not supervise Northern Rock properly. It did not allocate sufficient resources or time to monitoring a bank whose business model was so clearly an outlier; its procedures were inadequate to supervise a bank whose business grew so rapidly. We are concerned about the lack of resources within the Financial Services Authority solely charged to the direct supervision of Northern Rock. The failure of Northern Rock, while a failure of its own Board, was also a failure of its regulator. As the Chancellor notes, the Financial Services Authority exercises a judgement as to which 'concerns' about financial institutions should be regarded as systemic and thus require action by the regulator. In the case of Northern Rock, the FSA appears to have systematically failed in its duty as a regulator to ensure Northern Rock would not pose such a systemic risk, and this failure contributed significantly to the difficulties, and risks to the public purse, that have followed.

110   Q 194 Back

111   Ev 224 Back

112   Q 191 Back

113   Ev 224 Back

114   Q 191 Back

115   Ev 225 Back

116   Q 193 Back

117   Q 205 Back

118   See paragraphs Error! Reference source not found. and Error! Reference source not found.. Back

119   Q 855 Back

120   Qq 245-246 Back

121   Q 246 Back

122   Q 840 Back

123   Northern Rock website, Back

124   Ev 326 Back

125   Ev 295 Back

126   Q 525 Back

127   Q 314 Back

128   Q 785 Back

129   Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards: A Revised Framework, Comprehensive Version (June 2006), para 245, p 59 Back

130   Financial Services Authority Handbook, BIPRU 1.3, Applications for Advanced Approaches Back

131   Northern Rock's Interim Results, for six months until 30 June 2007, p 14 Back

132   Northern Rock's Interim Results, for six months until 30 June 2007, p 15 Back

133   Q 454 Back

134   Q 538 Back

135   Q 689 Back

136   Q 196 Back

137   Q 220 Back

138   Q 220 Back

139   Q 220 Back

140   Ev 297 Back

141   Financial Services Authority, Discussion Paper 7/07: Review of the Liquidity Requirements for Banks and Building Societies, December 2007, p 8 Back

142   Northern Rock Annual Report 2006, p 51 Back

143   Financial Services Authority, Discussion Paper 7/07: Review of the Liquidity Requirements for Banks and Building Societies, December 2007, p 32 Back

144   Financial Services Authority, Discussion Paper 7/07: Review of the Liquidity Requirements for Banks and Building Societies, December 2007, p 32 Back

145   Financial Services Authority, Discussion Paper 7/07: Review of the Liquidity Requirements for Banks and Building Societies, December 2007, p 33 Back

146   Q 417 Back

147   Q 1608 Back

148   Q 860 Back

149   Q 759 Back

150   Q 1657 Back

151   Qq 1680-81 Back

152   Q 1657 Back

153   Q 1657 Back

154   Q 1691 Back

155   Financial Services Authority, Discussion Paper 7/07: Review of the Liquidity Requirements for Banks and Building Societies, December 2007, p 35 Back

156   Ev 304 Back

157   Financial Services Authority, Discussion Paper 7/07: Review of the Liquidity Requirements for Banks and Building Societies, December 2007, p 35 Back

158   Q 1569 Back

159   Ev 298 Back

160   Q 1682 Back

161   Q 103 Back

162   Financial Services Authority, Discussion Paper 7/07: Review of the Liquidity Requirements for Banks and Building Societies, December 2007, p 14-15 Back

163   Financial Services Authority, Discussion Paper 7/07: Review of the Liquidity Requirements for Banks and Building Societies, December 2007, p 14 Back

164   Ev 298 Back

165   Financial Services Authority, Discussion Paper 7/07: Review of the Liquidity Requirements for Banks and Building Societies, December 2007, p 4 Back

166   International Monetary Fund, 'Stress Testing Financial Systems: What to Do When the Governor Calls' by Matthew T. Jones, Paul Hilbers, and Graham Slack, IMF Working Paper WP/04/127, July 2004 Back

167   Q 1183 Back

168   Paul Ormerod and Bridget Rosewell, 'How Extreme is the Current Gap between Libor and Base Rate?' available at, October 2007 Back

169   Q 1546 Back

170   Q 1547 Back

171   Financial Services Authority Annual Report 2006/07, p 18 Back

172   Qq 207-208 Back

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181   Q 192 Back

182   Q 860 Back

183   Q 860 Back

184   Ev 297-298 Back

185   FSA Handbook, FIT 1.3.1 Back

186   FSA Register, Back

187   Q 666 Back

188   Q 360 Back

189   Q 358 Back

190   Q 787 Back

191   Q 863 Back

192   Ev 328 Back

193   Q 354 Back

194   Q 756 Back

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Prepared 26 January 2008