Select Committee on Treasury Fifth Report

7  Lessons learned

Our inquiry and other reviews

267. Our inquiry, and in particular our analysis of the events in August and September 2007, has been based on the evidence that we have received and our published evidence and other publicly-available information. Although the Governor of the Bank of England told us that he would be willing for the text of a letter of advice he wrote to the Chancellor of the Exchequer to be made public,[519] the Chancellor of the Exchequer told us that the letter contained sensitive information and it was his judgement that it would not be in the public interest to release that letter or the letter he had received from the Chairman of the FSA at present.[520]

268. The FSA told us that it was conducting its own review of lessons to be learned from its regulation of Northern Rock.[521] This is intended to be published in March 2008, but may not be published in full.[522] We think it wrong in principle that the Financial Services Authority should be investigating its own failure. We recommend that the FSA ensure that there is an independent component in the analysis of the decision-making of the FSA in relation to Northern Rock.

The roles of the Tripartite authorities and the overall functioning of the Tripartite arrangements

269. The roles of the Tripartite authorities are set out in the Memorandum of Understanding, signed initially in 1997 by the Bank of England, the Financial Services Authority, and HM Treasury. This memorandum was updated on 22 March 2006.[523] The memorandum states that:

    The division of responsibilities is based on four guiding principles:
  • clear accountability - Each authority must be accountable for its actions, so each must have unambiguous and well-defined responsibilities;
  • transparency - Parliament, the markets and the public must know who is responsible for what;
  • avoidance of duplication - Each authority must have a clearly defined role, to avoid second guessing, inefficiency and the unnecessary duplication of effort. This will help ensure proper accountability;
    • regular information exchange - This helps each authority to discharge its responsibilities as efficiently and effectively as possible.[524]

Under the Memorandum of Understanding, the Bank of England's responsibilities are summarised as contributing "to the maintenance of the stability of the financial system as a whole".[525] The FSA's powers and responsibilities stem from the Financial Services and Markets Act 2000, and the FSA has the responsibility of authorising and supervising individual banks.[526] HM Treasury has responsibility for the institutional structure of the financial regulatory system, and the legislation behind it.[527] In a crisis, the Financial Services Authority would, according to the Memorandum of Understanding, be responsible for "the conduct of operations in response to problem cases affecting firms, markets and clearing and settlements systems within its responsibilities" which it may undertake by "the changing of capital or other regulatory requirements and the facilitation of a market solution involving, for example, an introduction of new capital into a troubled firm by one or more third parties".[528] However, the Bank of England would remain in charge of "official financial operations … in order to limit the risk of problems in or affecting particular institutions spreading to other parts of the financial system".[529]

270. Some witnesses criticised the division of responsibilities under the Memorandum of Understanding. Professor Buiter argued that:

    The very structure of the Tripartite agreement was flawed so I disagreed with the Tripartite agreement before they even started doing anything. The notion that the institution that has the knowledge of the individual banks that may or may not be in trouble would be a different institution from the one that has the money, the resources, to act upon the observation that a particular bank needs lender of last resort support is risky. It is possible, if you are lucky, to manage it, but it is an invitation to disaster, to delay, and to wrong decisions.[530]

Both Professor Buiter and Professor Wood suggested two potential solutions to this separation. One was to provide the Financial Services Authority with a line of credit from the Bank of England, to allow the Financial Services Authority to provide support for institutions undergoing liquidity squeezes. The other was to return liquidity regulation to the Bank of England.[531]

271. The BBA was less keen on such a radical reform of the current assignment of responsibilities, arguing that:

    Any decision to, for example, move banking regulation in its entirety back to the Bank of England would therefore result in significant co-ordination issues with the FSA for the purposes of, at the very least, securities regulation and conduct of business rules. Alternatively, reducing even further the role of the Bank of England would be disadvantageous to the reputation of the UK overseas.[532]

Ms Knight suggested that the resources devoted to financial stability in the Bank of England and HM Treasury were insufficient. She thought that "there is a lot of work being undertaken on financial stability within the FSA but there are not all that many people on that side within the Bank of England, and as far as financial services and the Treasury is concerned, we would like to see that side strengthened as well".[533]

272. The Tripartite authorities defended the division of responsibility for the regulation of financial institutions and the provision of liquidity between two institutions. The Governor of the Bank of England did not believe that "one institution-a central bank-can manage in today's world both monetary policy and the entire range of financial supervision".[534] Mr Sants suggested that the location of the supervisory department for banks would not have "made any difference to the set of circumstances which transpired prior to July, nor would it have made any difference to the information being passed over to the relevant part of the bank with regard to monetary operations during the course of August and September".[535] Sir Callum McCarthy said that "the idea of transferring banking supervision separately from insurance and security supervision is an idea that has severe disadvantages".[536] He also opposed the idea of the Financial Services Authority receiving a credit line from the Bank of England, telling us that:

    There is a question about whether the only route providing finance should be via the Bank of England or whether the Government should have other agencies that it could use. I think that is something which is a possible route. I should make clear that I am not arguing for the FSA to have a very large balance sheet. That is the last thing I want.[537]

273. The Chancellor was also convinced that there was a need for the separate roles of the institutions of the Tripartite arrangement, stating his view that:

    Fundamentally the structure we have in this country, where you have the Financial Services Authority which is responsible for the prudential supervision of individual institutions, is right. We have the Bank of England which is responsible for the stability of the financial system. I would take a great deal of persuading that you should merge these two. I think that would be very problematic and certainly I do not think anyone would argue we should go back to where we were ten years ago when we had seven or eight different regulators.[538]

274. However, the members of the Tripartite authorities did accept there was some scope for change within the current structure. While one of the guiding principles of the memorandum of understanding is the 'avoidance of duplication', Sir John Gieve told us that "we have been deliberately careful under the [Memorandum of Understanding] not to get involved in assessing individual institutions because that has been the FSA's job, but there is a question about whether it would be helpful for us to go a little bit further in drawing out the lessons for particular institutions where that would help the FSA in their task of identifying vulnerabilities".[539] The Chancellor of the Exchequer accepted that "there are changes that need to be made, particularly in the interface between the Bank and the FSA".[540]

275. One of the 'guiding principles' within the Memorandum of Understanding is that of 'regular information exchange'. When asked to consider how well the Tripartite system had worked in its response to the events of Northern Rock, Sir Callum McCarthy told us that:

    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.[541]

This view was supported by the Governor of the Bank of England, who told us that "my own view, for what it is worth, is that the [Memorandum of Understanding] worked well and it is very sensible to have the responsibilities laid down so that you know what we are accountable for".[542]

276. We cannot accept, as some witnesses have suggested, that the Tripartite system operated "well" in this crisis. In terms of information exchange between the Tripartite authorities, the system might have ensured that all the Tripartite authorities were fully informed. However, for a run on a bank to have occurred in the United Kingdom is unacceptable, and represents a significant failure of the Tripartite system. If the system worked so "well", the Tripartite authorities should take a closer look at the people side of the operation.

277. Although we have concerns about the operation of the Tripartite system, we do not believe that the financial system in the United Kingdom would be well-served by a dismantling of the Tripartite system. Instead, we want to see it reformed, with clearer leadership and stronger powers.

War games and lessons learnt

278. One criticism raised of the Tripartite authorities was that they appeared not to have prepared fully for a crisis such as that which arose in August 2007. We had heard at the time of our session on 'Financial Stability' in February 2007 that the Tripartite authorities undertook scenario tests of the financial system, and that these had been useful in understanding how the Tripartite authorities would work together. Mr Sants told us then that:

279. During the current inquiry we learnt that in 2005 a crisis scenario test at Deputy level identified weaknesses in the legislative framework for failing banks.[544] In late 2006, after a crisis exercise undertaken at principal level, it was agreed that a work programme was needed to work on these "key issues".[545] According to the Governor of the Bank of England, work on this programme had begun at the Treasury by the time of the Northern Rock crisis.[546] Minutes said that it had been classed as "urgent".[547] When questioned whether the Treasury was "dragging its feet", the Governor downplayed this urgency, and also suggested that it was necessary to ensure that the legislation was right:

    I do not believe it has been dragging its feet, no. I could perfectly well have written in June and said, 'Look, what is going on with this?', and we asked about it, but I think this is a matter where it was important to persuade people, including you, to look at the experience of other countries and recognise that maybe this is one case where we can learn something from the rest of the world; but to win opinion over and to get new legislation through is not an easy or quick matter and it may not be sensible to rush it. There did not seem at the time any obvious reason for this to be urgent in 2007 as opposed to 2008.[548]

The Chancellor reiterated these points when we questioned why action had not been taken quicker to counteract these deficiencies in the legislative framework. The Chancellor told us that:

    As the Governor said, in 2006 it was identified that there were weaknesses, there were things that needed to be done, and work streams were put in place because this is complex. When you see our proposals when they are published at the end of this month, there will be a lot of people who will say, 'Look, this is very complicated. You need to have a lot of thought about this. You won't have got it right first time', so that work was being carried out, but, as the Governor himself said in December when he appeared before you, at that time, simply because the present situation was not an immediate contemplation, he said that he did not attach that degree of urgency which, with the benefit of hindsight, others are now demanding.[549]

280. The Memorandum of Understanding clearly states that responsibility for the legislative framework rests with the Treasury. Two years ago a weakness in that framework appears to have been identified and by late 2006 had been classed as requiring "urgent" action. Between late 2006 and mid-2007, the measures to rectify this weakness appear to have been pursued by the Tripartite authorities with insufficient vigour. We address methods of dealing with this in Chapter 8.


281. One of the criticisms of the operations of the Tripartite authorities is that it appeared to lack a leadership structure. The Memorandum of Understanding states that, when a support operation is being considered:

The memorandum also states that "Ultimate responsibility for authorisation of support operations in exceptional circumstances rests with the Chancellor".

282. The BBA suggested several weaknesses in the Tripartite command structure. Their written evidence states that there was "no one entity clearly in the lead" and that there was "insufficient clarity in the allocation of roles, responsibilities and authority of the parties to the Tripartite authorities".[551]

283. When we questioned the Tripartite authorities as to who was in charge, the Governor's first reply was "What do you mean by 'in charge'? Would you like to define that?".[552] When we further questioned him as to who was responsible, he replied "We are each responsible for the various responsibilities that we have been given under the [Memorandum of Understanding]".[553] Sir Callum McCarthy made a similar point, telling us that:

    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.[554]

The Chancellor of the Exchequer, however, acknowledged that the ultimate responsibility lay with him. When asked who was in 'overall charge', he replied:

    Ultimately it is the Chancellor. As I said in the House of Commons a couple of weeks ago, I am pretty clear about that. There are discrete responsibilities. As I said, the FSA on prudential supervision and the Bank in relation to financial stability through its market interventions, but the whole point of having a committee is to allow all three institutions-because the Treasury is the backstop, if you like, in all these things-to be intimately involved.[555]

284. While we welcome the Chancellor's admission that he was ultimately in charge of the decision making process relating to Northern Rock, we are concerned that, to outside observers, the Tripartite authorities did not seem to have a clear leadership structure. We recommend that the creation of such an authoritative structure must be part of the reforms for handling future financial crises and this informs the recommendations we make in the next Chapter.

Communications strategy with the public

285. In our evidence session on Financial Stability in February 2007, Jon Cunliffe, then second Permanent Secretary to the Treasury identified that a Tripartite basis for formulating a communications strategy was an important part of dealing with crisis. He stated that:

Several witnesses argued that the Tripartite authorities had lacked a coordinated, effective communications strategy, especially around the time of the announcement of the support operation in mid-September. The BBA criticised the communications strategy. Their written evidence noted two deficiencies in the communications issued by the Tripartite authorities:

    no attention given to the complex and obscure message in the Lender of Last Resort Statement;

    a lack of preparedness by the authorities to explain and communicate their Lender of Last Resort statement either at the point at which the leak took place or once the formal announcement had been made the following morning.[557]

Professor Buiter argued that:

    Following the announcement of the Liquidity Support Facility, there should have been a joint appearance by the Prime Minister, the Chancellor of the Exchequer, the Governor of the Bank of England, the Chairman of the FSA and the CEO of the FSA, looking solemn and reliable, and intoning jointly: 'your money is safe'. It might not have prevented the banana-republic-style bank run that started on the 14th, but it was worth a try.[558]

286. Mr Coles also suggested to us that the communications lacked a clear command structure:

    It was not clear who was actually in charge of making that communication …. Who is in charge of communication when you have got a crisis problem and where there is a crisis of confidence, which is essentially a communication issue, is a very important improvement that needs to be made to the [Memorandum of Understanding].[559]

287. Professor Wood suggested that some of the terminology used by the Tripartite authorities was inappropriate. He told us that "Calling [the Bank of England liquidity support operation] emergency lending was I suppose asking for trouble".[560] And the Building Society Association, while acknowledging that a better communications strategy might not have prevented a run on Northern Rock, also suggested that the terminology used was unhelpful. They pointed out that "[regulators] failed to speak plain English: assurances from the FSA that Northern Rock was, for example, 'solvent' cut no ice with the bank's retail customers because it is not a term that is widely understood by non-technicians".[561]

288. The Financial Services Authority accepted that the communication strategy had been imperfect. Mr Sants told us that "there are significant lessons to be learned in terms of the way the Tripartite authorities communicate around these types of issues, both the terminology and the way we handle the release of the news, and we have already started to learn from those lessons and continue to so do".[562] The Governor of the Bank of England, while stating that the communications strategy had been placed under pressure by the premature disclosure of the support operation, acknowledged that "clearly, we need to think further about [the communication strategy]".[563]

289. There was no sign of a communications strategy of the Tripartite authorities during the crisis of September 2007. We believe that this was a contributory cause of the run on the bank. The Tripartite authorities must learn the lessons of the failure or absence of a communications strategy between 10 and 17 September. We recommend that the Tripartite authorities revise their communications arrangements for future crises, to ensure a single, coherent and coordinated message, which was absent in the crisis in September 2007. This message needs to take into account the public's likely reaction, and be in language people can readily understand.

Damage to the Tripartite authorities and UK economy

290. The financial services industry plays an important role in the economy for the United Kingdom. The images of people queuing outside a UK financial institution were therefore damaging to the reputation of UK financial services. When asked to assess this damage, Ms Knight was very critical, telling us that:

Professor Buiter in his written evidence stated that:

    The way the crisis unfolded damaged the prestige and international standing of the City of London—the financial capital of the world—more than the other leading financial centres. The damage is manageable and remediable, but only if effective steps are taken to correct the many manifest weaknesses of the UK financial system that were brought to light by the crisis.[565]

291. The Chairman of the Financial Services Authority acknowledged that the events around Northern Rock had been "damaging".[566] However, the Governor of the Bank of England appeared to be more sanguine about the damage to the UK banking system from the Northern Rock crisis:

    I do not believe that in a years time people will look back and say there was any lasting damage to the British banking system. It is very well capitalised, it is very strong, and, as I explained before, although the banks at present are having to pay a bit more for their liquidity than they would wish, they will be able over the coming months to take these vehicles and conduits they have set up back onto their balance sheets and they will be strong. Headlines come and headlines go and even television pictures come and go, and I cannot believe and I do not believe that there is any lasting damage to the reputation of the British banking system, although I fully understand that the impact of the pictures on television last weekend came as a shock to many.[567]

292. The events surrounding the crisis at Northern Rock have been damaging to the financial services industry in the United Kingdom, and for the Tripartite authorities. It is important that the lessons are learnt from this crisis, and that the changes that result from this process are implemented swiftly, given the continuing problems in the world's financial markets and the desirability of ensuring that the damage to the United Kingdom's reputation as a financial centre is minimised.

Tripartite influence on companies receiving support

293. In Chapter 9 we will explore the extent to which State support for Northern Rock was matched by state involvement in the running of Northern Rock. In Chapter 5 we set out a range of additional powers that should reduce the need for future relationships between the Tripartite authorities and a failing bank of the kind seen in the case of Northern Rock.

294. Where Government money is advanced to a financial institution, the Government, should take appropriate management control or should ensure that it has sufficient control over the activities of the company to ensure that taxpayers' interests are not prejudiced.

The audit of high-risk financial institutions

295. We discussed with the auditors of Northern Rock, PricewaterhouseCoopers, their role at Northern Rock. Mr Sexton, head of the UK assurance practice at PricewaterhouseCoopers, outlined the conduct of an audit of a firm:

296. Mr Hitchins, a banking audit partner of PricewaterhouseCoopers, explained that the only additional duty of the auditors in relation to the audit of a bank as opposed to another type of company was that there was a "statutory duty to report to the FSA if we [the auditors] become aware of anything that is material to the exercise of the FSA's functions".[569] Mr Hitchins later explained that the auditor's duty of care towards the Financial Services Authority "is to make sure the information in the regulatory returns is consistent with the information we have audited".[570] However, Mr Sexton also noted that the auditor was not under a duty of care to point out certain aspects of the structure of Northern Rock's liabilities to the Financial Services Authority.[571]

297. When asked whether they as the auditors should have picked up on the risks that Northern Rock was taking in its liquidity strategy, the response of the witnesses was that the accounts of Northern Rock accurately portrayed the state of the company. Mr Sexton explained that:

    I believe that the audit process as judged by reference to the specifics of Northern Rock in the annual and interim reports—our opinion on the latter was signed on 25 July—discloses very accurate information about liquidity and other structures within Northern Rock.[572]

One issue we discussed was why the auditors had declared Northern Rock a "going concern". In its memorandum, PricewaterhouseCoopers laid out why it thought that it was right to accept that Northern Rock was a "going concern":

    In the first instance, the directors are responsible for making the assessment that the bank is a going concern. That is normally taken to mean that an entity is ordinarily viewed as continuing in business for the 'foreseeable future' with neither the intention nor the necessity of liquidation, ceasing trading or seeking protection from creditors pursuant to laws or regulations. The 'foreseeable future' is usually taken as meaning the next 12 months. As ISA570 observes at para 6 'When there is a history of profitable operations and a ready access to financial resources, management may make its assessment without detailed analysis.' The bank fell into this category. It had traded profitably and it had a track record of ready access to funds at low spreads over LIBOR indicating a willingness by lending institutions to provide finance. In February 2007 there were no indications in the financial markets that the then extant circumstances were to change dramatically. As the relevant auditing standard observes 'Any judgment about the future is based on information available at the time at which the judgment is made. Subsequent events can contradict a judgment which was reasonable at the time it was made.' [ISA570 para 7] Obviously the future is by its nature uncertain, and the relevant auditing standard therefore requires the auditor to consider whether there is a 'material uncertainty' that 'may cast significant doubt' that the company may not be a going concern.[573]

PricewaterhouseCoopers then discussed whether there was a "material uncertainty" for Northern Rock. They concluded that, having considered the operating plans of the company, external forecasts of the UK domestic mortgage market and the post year-end trading results, "None of these exhibited any features other than to indicate a substantial profit for the bank with every rational expectation that there would be no significant financing difficulties".[574]

298. A second issue we discussed was whether there was a conflict for an auditor between its non-audit and audit work. In its written evidence, PricewaterhouseCoopers stated that of the £1.8 million paid in fees to the auditor by Northern Rock, total audit fees as statutory auditors were £1.1 million, leaving £700000, which was "largely comprised of fees relating to assurance services in connection with the bank's actions in raising finance".[575] These "assurance services" were "comfort letters on the financial information in [the offering] circulars [for securitisiation]".[576] Mr Sexton while acknowledging that more securitisations meant more money for the auditors for these comfort letters, did not accept that this had been encouraged by PricewaterhouseCoopers:

    Under our ethical standards we cannot provide any kind of management input to a company to encourage it to perform one transaction or another. That is completely forbidden under our ethical standards. We cannot create a transaction flow in order to charge fees; it is purely a reaction to the level of transactions that a company may or may not choose to undertake.[577]

As well as this, PricewaterhouseCoopers noted that, for Northern Rock, this balance of fees was actually less weighted towards fees other than those for statutory audits than at other firms. In the case of Northern Rock, the ratio of the auditor's fees for other work against their fees for statutory audit work was less than one, whereas as Mr Sexton pointed out:

    If one looks at the FTSE 100 analysis in the 12 months broadly to 31 December-you will appreciate that year ends are different for different companies-the ratio is of the order of 1.1 to one.[578]

299. A lesson to be learnt from this crisis is that the auditor can only provide an assurance of a snapshot of the past state of the company. We recommend that the accounting bodies consider what further assurance auditors should give to shareholders in respect of the risk management processes of a company, particularly where a company is regarded as an outlier. We are also concerned that there appears to be a particular conflict of interest between the statutory role of the auditor, and the other work it may undertake for a financial institution. For example, PricewaterhouseCoopers received £700,000 in non-audit fees largely comprised of fees relating to assurance services in connection with Northern Rock's actions in raising finance". We note the work being undertaken by the accounting boards in respect of this issue and recommend that both they and the FSA give swift consideration to such particular conflicts in financial institutions.

519   Qq 28-29 Back

520   Qq 851-852 Back

521   Q 192 Back

522   Q 1484 Back

523   HM Treasury Website, Back

524   HM Treasury Website, Back

525   Memorandum of Understanding between the Bank of England, Financial Services Authority and HM Treasury, 22 March 2006, Para 2 Back

526   Memorandum of Understanding between the Bank of England, Financial Services Authority and HM Treasury, 22 March 2006, Para 3 Back

527   Memorandum of Understanding between the Bank of England, Financial Services Authority and HM Treasury, 22 March 2006, Para 4 Back

528   Memorandum of Understanding between the Bank of England, Financial Services Authority and HM Treasury, 22 March 2006, Para 3 Back

529   Memorandum of Understanding between the Bank of England, Financial Services Authority and HM Treasury, 22 March 2006, Para 2 Back

530   Q 854 Back

531   Qq 866, 894 Back

532   Ev 295 Back

533   Q 1572 Back

534   Q 90 Back

535   Q 1506 Back

536   Q 1506 Back

537   Q 1519 Back

538   Q 749 Back

539   Q 1731 Back

540   Q 757 Back

541   Q 178 Back

542   Q 27 Back

543   Financial Stability', HC 292-i, Session 2006-07, Q 8 Back

544   Qq 1616, 1632 Back

545   Qq 1632, 1633 Back

546   Q 1634 Back

547   Q 1642 Back

548   Q 1637 Back

549   Q 1810 Back

550   Memorandum of Understanding between the Bank of England, Financial Services Authority and HM Treasury, 22 March 2006, Para 13 Back

551   Written Ev 295 Back

552   Q 24 Back

553   Q 25 Back

554   Q 272 Back

555   Q 753 Back

556   'Financial Stability', HC 292-i, Session 2006-07, Q22 Back

557   BBA Ev 295 Back

558   Buiter Ev 328 Back

559   Q 1574 Back

560   Q 874 Back

561   BSA Ev 305 Back

562   Q 1533 Back

563   Q 1615 Back

564   Q 1603 Back

565   Ev 327 Back

566   Q 152 Back

567   Q 114 Back

568   Q 1278 Back

569   Q 1279 Back

570   Q 1342 Back

571   Q 1345 Back

572   Q 1301 Back

573   Ev 339 Back

574   Ev 339 Back

575   Ev 340 Back

576   Q 1293 Back

577   Q 1365 Back

578   Qq 1362-1363 Back

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