Select Committee on Treasury Fifth Report

Conclusions and recommendations

1.  We welcome the Government's commitment to taking full account of our Report before making its legislative proposals in response to the run on Northern Rock. We consider it crucial that, insofar as possible, measures in this area are taken forward on a cross-party basis. This Report is being agreed unanimously and we believe that it forms the basis for cross-party agreement on such legislative proposals. (Paragraph 6)

2.  The directors of Northern Rock were the principal authors of the difficulties that the company has faced since August 2007. It is right that members of the Board of Northern Rock have been replaced, though haphazardly, since the company became dependent on liquidity support from the Bank of England. The high-risk, reckless business strategy of Northern Rock, with its reliance on short- and medium-term wholesale funding and an absence of sufficient insurance and a failure to arrange standby facility or cover that risk, meant that it was unable to cope with the liquidity pressures placed upon it by the freezing of international capital markets in August 2007. Given that the formulation of that strategy was a fundamental role of the Board of Northern Rock, overseen by some directors who had been there since its demutualisation, the failure of that strategy must also be attributed to the Board. The non-executive members of the Board, and in particular the Chairman of the Board, the Chairman of the Risk Committee and the senior non-executive director, failed in the case of Northern Rock to ensure that it remained liquid as well as solvent, to provide against the risks that it was taking and to act as an effective restraining force on the strategy of the executive members. (Paragraph 31)

3.  The business model of the Board of Northern Rock was clearly stated. It is unfortunate that the shareholders who acquired their shares as part of demutualisation and the staff of Northern Rock have suffered significantly from the fall in the value of Northern Rock shares. However, it is not possible to make a distinction between types of shareholders in the circumstances of Northern Rock. In a market environment shareholders as a whole must be viewed as taking a risk from which they sought a reward and for which they are now paying a price. (Paragraph 34)

4.  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. (Paragraph 42)

5.  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. (Paragraph 45)

6.  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. (Paragraph 52)

7.  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. (Paragraph 59)

8.  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. (Paragraph 63)

9.  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. (Paragraph 66)

10.  The Bank of England, the European Central Bank and the Federal Reserve each pursued a different course of action in response to the money market turmoil in August 2007. Only the Bank of England took no contingency measures at all during August, in order to protect against moral hazard, that is, the fear that an injection of liquidity would offer incentives for banks to take on more liquidity risk, secure in the knowledge that the Bank of England would step in to resolve future liquidity crises. The European Central Bank appeared to attach far less weight to the moral hazard argument than the Bank of England. Instead, it adopted a proactive approach in resolving what it saw as a practical problem of a faltering market resulting from banks losing confidence in each other. Although the European Central Bank injected no net additional liquidity in August, it did alter the timing and term profile of its regular operations, front-loading its credit supply towards the start of August, and draining this liquidity before the end of the maintenance period. In doing so, the European Central Bank appeared to satisfy the immediate liquidity demands of the Eurozone banking sector, whilst UK banks' sterling demands went unmet. We are unconvinced that the Bank of England's focus on moral hazard was appropriate for the circumstances in August. In our view, the lack of confidence in the money markets was a practical problem and the Bank of England should have adopted a more proactive response. (Paragraph 89)

11.  We accept the Governor's comments that the Bank of England injected additional liquidity into the money markets in September, when the ECB and Fed did not. This was not a decision on the part of the Bank, but a consequence of banks being able to choose their reserve requirement for each maintenance period. The Bank of England should set out, in its response to this Report, the rationale for having a voluntary reserves system, rather than a system that stipulates reserves requirements for each bank. (Paragraph 90)

12.  We cannot know whether an open market liquidity operation of the kind asked for by a number of banks in August would have prevented Northern Rock's need for emergency support from the Bank of England in September. It is most unlikely that any such lending operation in September, following the stigmatisation of Barclays which we deal with later, could have been of a sufficient scale to ensure that Northern Rock could have received the liquidity it then required. Such an operation would also have raised severe 'moral hazard' concerns, signalling to the banking sector as a whole that public sector support would be made available in the event of any bank facing distress. (Paragraph 95)

13.  The fact that the European Central Bank accepted a wide range of collateral, including relatively illiquid assets, certainly assisted European banks, throughout the period of turmoil. The broadening of acceptable collateral by the Bank of England in September similarly assisted UK banks. The Governor depicted the Bank's decision as being finely balanced between giving the banks the liquidity they wanted and moral hazard. If the Bank were always to accept a wider range of collateral, banks would have an incentive to alter their asset portfolios away from the safest classes and towards higher-risk classes, and we consider this moral hazard argument to be important. Nevertheless, with the benefit of hindsight, we have concluded that the Bank of England should have broadened the range of acceptable collateral at an earlier stage in the turmoil. (Paragraph 97)

14.  The usual penalty rate was charged on the 3-month operation announced on 19 September. The penalty rate should not be viewed as a punishment for recalcitrant banks, but rather a reminder to banks to manage their liquidity risks in an appropriate manner. (Paragraph 98)

15.  We recommend that the Bank of England, in its response to this Report, set out the rationale behind the design of its standing facilities, and any changes to them that it is considering making. (Paragraph 100)

16.  There are many circumstances where UK banks might be able to participate in money market operations conducted by the European Central Bank and the US Federal Reserve, although the fact that such operations would neither be conducted in sterling, nor accept sterling-denominated collateral, is a significant obstacle to UK banks extending their use of these facilities. In these circumstances, the Bank of England's policy on money market operations cannot be reviewed in isolation from those of other central banks. In view of the fact that some, but not all, UK banks have access to the money market operations provided by foreign central banks, the review of the Bank of England's money market operations should be informed by an awareness of the case for closer alignment of the Bank of England's money market operations with those of the European Central Bank and of the Federal Reserve. (Paragraph 103)

17.   'Stigmatisation', whereby financial institutions will not approach the central bank for assistance for fear of being regarded by the market as weak, appears to be a substantial problem in money markets across the world. Although this problem is not unique to the UK, we recommend that the Bank of England place particular emphasis, in its further reforms of its money market operations, on measures to deal with stigmatisation. (Paragraph 107)

18.  With the benefit of hindsight, the financial support enquired about by a potential buyer of Northern Rock prior to 10 September may conceivably have represented a better deal for the taxpayer than the financial support that has been provided since 14 September. Unfortunately we received conflicting evidence from Northern Rock and the Tripartite authorities over the details of the support facility requested by the potential bidder for Northern Rock. This unresolved conflict prevents us from drawing any firm conclusion on whether a safe haven was possible. What also remains unclear is how proactive the Tripartite authorities were in pursuing this option. Clearly the amount and type of State aid was a major factor but equally so was the question of whether the Takeover Code inhibited Tripartite attempts to facilitate a private sector solution for the troubled bank. In any event, it needs to be borne in mind that the consequences of any announcement that might have been made relating to a potential takeover would have been unpredictable. Furthermore, it is not evident that the State could, or should, underwrite a safe haven option, where a single, presumably profitable, bank received State support (in the form of a lending facility) to undertake, or at least announce the takeover of Northern Rock. (Paragraph 118)

19.  The Chancellor of the Exchequer's decision in the first half of September to make a support facility available to Northern Rock should the need arise was the right one. Had he chosen not to do so, there would have been a significant risk of substantial disadvantage to Northern Rock depositors and a very real prospect of "contagion", whereby the public would lose confidence in the security of holdings across the United Kingdom banking system. In view of the weaknesses of the legal framework for handling failing banks at that time, the Tripartite authorities were right to view Northern Rock as posing a systemic risk. Had any other decision been taken, it is quite possible that the events that unfolded from mid-September onwards could have been more damaging to consumers and to the United Kingdom financial system than those that have actually taken place. (Paragraph 122)

20.  On the basis of the texts cited in the preceding paragraphs, we accept that the provisions of the Market Abuse Directive and the implementing Directive relevant to market disclosure in the case of Northern Rock in September 2007 were properly transposed into United Kingdom law. It is evident from the texts of both the Directive and of the FSA Handbook that any decision to delay disclosure, even in the case of an issuer that is in grave and imminent danger, is subject to provisos relating to the need for the issuer to be satisfied that such a delay would not be likely to mislead the markets and that the issuer is able to ensure the confidentiality of that information. The Governor of the Bank of England received legal advice through the FSA from lawyers working for the Tripartite authorities indicating that the Market Abuse Directive was a barrier to a covert operation, even if information could be kept confidential, and, as such, the Governor was justified in regarding the legal interpretation of the Market Abuse Directive shared by the Financial Services Authority and Northern Rock's legal advisers as a material factor in consideration of a covert operation, although it was not necessarily the leading factor in the final decision that a covert operation was not possible. (Paragraph 137)

21.  In the circumstances of Northern Rock in early September 2007, the barriers to a covert support operation were real. Any large scale support operation for Northern Rock would have become known to many market participants. In the febrile and fevered atmosphere of that period, media speculation would have followed. The leaking of news of a support operation that was intended to remain covert for a period of time would have been potentially as damaging as the premature disclosure of an overt operation. The practical risks of a leak are linked to the legal difficulties, insofar as covert support operations only appear to be permitted under the Market Abuse Directive in instances when the issuer can be assured of confidentiality. We consider later in this Report whether there are circumstances when a covert support operation should be considered in future, and what legal and other changes might be necessary to facilitate such an operation. (Paragraph 141)

22.  However we also find it unacceptable that the possibilities for covert action had not been properly considered much earlier. Had this issue been clarified, the authorities could have reacted with more despatch which in itself might make covert action a more realistic option. We return to the state of readiness of the authorities and "war gaming" later in this Report. (Paragraph 142)

23.  In view of the role that fears of a leak of a support operation had played in the decision on Tuesday 11 September that a covert operation was not possible, the Tripartite authorities were unwise initially to accede to Northern Rock's request for the announcement of the support operation to be delayed until Monday 17 September. In the light of subsequent events, it seems evident that the Tripartite authorities and Northern Rock ought to have strained every sinew to finalise the support operation and announce it within hours rather than days of the decision to proceed with the operation. A swift announcement would have been assisted by early preparation of such an announcement. In that context, we find it surprising that high level discussions between the Bank of England and Northern Rock about the support facility did not take place prior to 10 September. (Paragraph 145)

24.  In failing either to make an announcement earlier in the week or to put in place adequate plans for handling press and public interest in the support operation, the Tripartite authorities and the Board of Northern Rock ended up with the worst of both worlds. (Paragraph 148)

25.  We accept that the consequences of an announcement of the Bank of England's support operation for Northern Rock were unpredictable. There was a reasonable prospect that the announcement would have reassured depositors rather than having the opposite effect, particularly prior to the premature disclosure of the operation. However, after the premature disclosure of the support, and against the background of the market reaction to Barclays use of lending a fortnight earlier, it seems surprising that the issues were not urgently revisited. It is unacceptable, that the terms of the guarantee to depositors had not been agreed in advance in order to allow a timely announcement in the event of an adverse reaction to the Bank of England support facility. (Paragraph 165)

26.  The Tripartite authorities were conscious during the planning of the support operation that announcement of that operation might have an adverse effect. In light of this, we regard it as a serious error of judgement that the Tripartite authorities at deputies level failed to plan in advance for the announcement of a Government guarantee and failed to raise some of the issues surrounding such a guarantee with the principals prior to Sunday 16 September. We are also concerned that it did not prove possible to announce the guarantee that was decided upon that day before the markets opened the following day. The cumulative effect of these failures was to delay the guarantee until the evening of the fourth day after the run started and thus to make the run on the deposits of Northern Rock more prolonged, and more damaging to the health of the company, than might otherwise have been the case. (Paragraph 166)

27.  The larger deposit-taking institutions, such as banks and building societies, are 'special' organisations in modern life, similar in some ways to utility providers. Banks should be allowed to 'fail' so as to preserve market discipline on financial institutions. However, it is important that such 'failure' should be handled in an ordered manner, managed in such a way as to prevent further damage to the economy, the financial system and the interests of small depositors. (Paragraph 172)

28.  The taxpayer should not bear the risk of banks failing. Nor do we believe that small depositors should bear such risk. Rather, the risk of failure should be borne by a bank's shareholders and creditors but exclude small depositors. The Government must ensure that the framework for handling failing banks insulates taxpayers and that small depositors should also be protected from the risk of banks failing. (Paragraph 182)

29.  Although the Financial Services Compensation Scheme is portrayed as offering protection to the depositors of all financial institutions, examination of its funding indicates that it would not be able to cope with the failure of a medium-sized, let alone a major, financial institution. If such an event were to occur under present arrangements, only the Government, using taxpayers funds, would be in a position to protect depositors, as it did with Northern Rock. We are concerned that banks and building societies appear to be viewing the Government's support to Northern Rock as an acknowledgement that no bank would be allowed to fail. The Government must take steps to ensure that its framework for maintaining financial stability does not provide free insurance to banks. We do not believe that a deposit protection scheme should apply solely to the very smallest institutions. All banks and building societies should be covered by a deposit insurance scheme, such that, in cases such as Northern Rock, or an even larger bank, the Government would not be required to step in to protect depositors. (Paragraph 183)

30.  We see great merit in the "prompt corrective action" approach adopted in the US and other countries. When a bank or building society shows signs of being in distress, or there has been an unusual change to or extreme development of its business model, it is vital that the relevant authority should not only be in a position rapidly to identify that situation, but also be able to take steps to lessen the wider impact of that financial institution's difficulty. We do not propose that the relevant authority should have unfettered rights to interfere in the business of healthy institutions, but that, given the public interest in preventing banks from failing in a disorderly way, the relevant authority must have full access to the financial accounts of all FSA-authorised deposit-taking institutions, and the right to undertake additional visits and request additional information as needed. (Paragraph 192)

31.  We further recommend that the judgement of the relevant authority, supplemented by a set of quantitative triggers, be used to identify when a bank is either "failing", at risk of failing, or pursuing a business model that is an obvious outlier within the industry. Once a financial institution has been so deemed, the relevant authority should have a well-defined menu of options for taking action. The purpose of such prompt corrective action would not be to prevent banks failing as such, but to prevent them failing in a disorderly manner. (Paragraph 193)

32.  We do not view a bank's recourse to the Bank of England in its capacity as lender of last resort as an ideal trigger for prompt corrective action. This option is a last resort, and the relevant authorities must be able to identify a bank as failing prior to this stage. (Paragraph 194)

33.  Under the current system, where depositors' funds can be tied up for months upon the failure of a financial institution, depositors have a clear and strong incentive to join a bank run and withdraw their deposits. This incentive would remain, even if depositors were guaranteed eventually to receive 100% of all of their deposits, if the inconvenience of being unable to access savings for prolonged periods is not tackled. Because of the potential impact of bank runs on financial stability, we recommend that insured deposits at a failing bank be ring-fenced by the relevant authority, to reassure customers that their insured deposits are safe and accessible. This will require a special resolution regime for financial institutions. We note that the Tripartite authorities currently have no means of quickly resolving a failing bank. The new special resolution regime we propose would grant powers for the relevant authority to establish a "Bridge Bank" which would take over and continue to run the failing institution with the aim of quickly returning it to health, and returning it to the private sector, either as a standalone organisation, or as part of another bank. The relevant authority should also have the power to employ a third-party financial institution to manage a failing bank's deposits, if that would facilitate the smooth administration of the failing bank. In carrying out such an operation, the relevant authority should have an obligation to resolve the situation at least cost to the taxpayer. (Paragraph 201)

34.  We recognise that the ring-fencing of insured deposits, and transfer of them to a third party, would be to the detriment of other creditors of banks, and that this might serve to increase banks' funding costs. However, we believe that this is a cost that the banking industry must bear, because we view a special resolution regime "to be" an essential pillar of an effective system for ensuring financial stability. (Paragraph 202)

35.  We recognise that shareholders will consider themselves to be disadvantaged by the new powers we propose for the relevant authority. At the moment, bank shareholders appear to be protected from the total collapse of their firm by the State's unwillingness to allow a bank to fail. Our proposals would remove this taxpayer-funded prop, equalising the status of bank shareholders with that of non-financial firms' shareholders, who receive no such assistance. Because of the unique nature of banking, bank shareholders cannot be expected to have the sole final say over the direction of their company, if that company has become reliant on State support to continue trading. The relevant authorities should be in a position to undertake a solution in the public interest that may be to the detriment of shareholders. (Paragraph 205)

36.  The Government should also consider whether it will be possible, in the event of a bank failure, to endow the relevant authority with the decision-making powers currently held by the shareholders, whilst protecting those shareholders' financial interest. Any new legislation must clearly set out any changes to the status of shareholders of banks and members of building societies. (Paragraph 206)

37.  The UK is increasingly reliant on transactional banking services and any disruption to salary payments, direct debits, standing orders, ATM availability and other banking services would cause profound problems for the banking system as a whole. If a bank were to fail, a smooth transition to a Bridge Bank or third-party bank would be essential. We recommend that, in bringing forward its proposals on improvements to the system of handling failing banks, the Government address the issue of how essential banking services would be maintained. (Paragraph 210)

38.  We recommend that the Government seek to work with the European Commission, European Central Bank and national central banks within the European Union to establish whether the Market Abuse Directive ought be amended, so as to ensure that covert support operations by a central bank are permitted in specified circumstances. (Paragraph 215)

39.  We further recommend that the Government review the interaction between the terms of the Market Abuse Directive and other aspects of the regulatory regime including the FSA guidelines, to ensure that they do not unnecessarily restrict areas of the discretion otherwise allowed under the Directive. (Paragraph 216)

40.  The presence of an element of co-insurance in a deposit protection scheme adds considerable complexity for customers to understand: Northern Rock pointed to the difficulty of explaining the scheme's intricacies to their customers when the bank run occurred. Not only does co-insurance add complexity, it also does not work. Co-insurance implies that a potential depositor would have the means, time and ability to assess the financial strength of an institution through the examination of publicly-available information about that company. We do not believe this to be a realistic proposition. The main way the ordinary depositor can gauge the financial health of a bank is by considering the strength of the brand and whether the bank has a reputation for financial strength. Tellingly, Northern Rock did well on both of these counts. Rather than contributing to financial stability, co-insurance directly undermines it, by offering an incentive to join a bank run. We consider the co-insurance model to be discredited with regard to depositor protection. The moral hazard argument, that banks would offer excessively high rates to customers, on the back of the full deposit insurance for customers, would be mitigated by our proposals for a system of prompt corrective action and a special resolution regime, together with a modest compensation limit, to discussion of which we now turn. (Paragraph 227)

41.  The setting of an appropriate compensation limit should balance the objective of enhancing consumer confidence through adequate coverage against the implications for moral hazard and the problems of increasing the cost of the scheme. The current limit of £35,000 is easy to remember and covers the vast majority of depositors. The case has not yet been made for any extension above the current limit of £35,000. We do, however, recommend that whatever limit is adopted, it should be indexed to a measure of inflation, but such that the guaranteed limit is always an easily memorable sum. (Paragraph 233)

42.  We do not believe that very large deposits held for short periods of time, perhaps in the course of residential property transactions, should be covered by the deposit protection scheme. However, we do think that the concerns raised by the Financial Services Consumer Panel are important, particularly where customers are placing deposits for purely transactional reasons, rather than seeking to earn interest. We recommend that the Government, in its response to this Report, set out what arrangements are available, or might become available, for depositors in such circumstances. One possible solution would be for depositors to invest in a risk-free National Savings & Investment product, and the Government should consider introducing a product targeted at those selling and then buying property, to raise awareness of this option. (Paragraph 234)

43.  The current arrangements, under which the Financial Services Compensation Scheme could take months, maybe years, to reimburse the depositors of a large failed institution, are completely inadequate. The speed of release of funds is of critical importance. However generous a compensation scheme may be, and however much confidence consumers may have in eventually getting back their deposits, it would still be rational for a depositor to withdraw their funds from a failing bank if there were a prospect of them losing access for more than a few days. There should be a requirement in law that all insured deposits should have to be paid within a few days of a bank failing and calling on the deposit protection scheme. The relevant authority must ensure that banks' information systems and procedures are capable of such a speedy release of funds. (Paragraph 240)

44.  Depositors' understanding of the intricacies of the Financial Services Compensation Scheme, prior to the post-Northern Rock changes, was inadequate. We favour as simple and as transparent a scheme as possible. Alongside the removal of co-insurance and the adoption of a simple compensation limit, depositors need to understand that they can maximise their protection by dividing their savings between different institutions. In addition, there needs to be am emphasis on the fact that the compensation limit is per customer, rather than per account. For the scheme to have the maximum impact in protecting financial stability, the details of the scheme must be well-advertised, both in national and regional media, and through the display of posters in individual bank branches. (Paragraph 243)

45.  It is important for the relevant authority operating a deposit protection scheme to understand the size and profile of the depositors it is insuring, not least so that that authority can calculate an appropriate funding requirement. Furthermore, an essential prerequisite of the speedy reimbursement of funds to the depositors of a failed institution is that insured depositors can be quickly identified. At present, we doubt that all financial institutions would be able to produce such data at short notice. We recommend that each financial institution (or, each FSA-registered group, where several institutions share one FSA registration) maintain a register of each depositor's insured deposits under the scheme. The existence of a register would greatly simplify the task faced by the relevant authority if a failed bank's depositors were to be ring-fenced or placed under the control of a Bridge Bank. This register must take into consideration individual shares of joint accounts in calculating the extent of coverage. The relevant authority should confirm that every bank and building society is able to produce such a register at a day's notice, so that the authority can be assured that, in the event of a bank failing, the speedy release of funds would not be jeopardised by an inability to identify insured depositors. (Paragraph 248)

46.  Not only is it important for firms and the deposit insurance scheme to know which depositors are insured, but the depositors themselves must be aware of the extent to which their deposits are insured. We recommend that depositors should be alerted, via a letter from the financial institution, if a portion of their deposits is, or becomes, uninsured. Again, this notification should take into consideration whether the depositor has savings at other organisations within the FSA-registered group which is writing to the depositor, and where a depositor has invested in a joint account. (Paragraph 249)

47.  The implication of the statement on the Financial Services Compensation Scheme website is startling: a customer of a bank or building society who had savings, but also a larger mortgage, with the same institution, might receive no compensation through the deposit insurance scheme, but would instead have a smaller balance on their mortgage. We consider that such off-setting of a highly liquid asset (deposits) against a more illiquid liability (mortgage) to be in conflict with the entire purpose of a deposit protection scheme. A deposit scheme's two purposes—to protect depositor's liquid assets, and reduce the incentive for joining bank runs—are both fundamentally weakened by off-setting. It could be argued that off-setting an overdraft might be legitimate, but as a general rule, the widespread off-setting of savings and loans should not be permitted. We expect the Government to re-design the deposit protection scheme so that off-setting of deposits against illiquid liabilities is not permitted. (Paragraph 251)

48.  We regret the FSA's decision to press ahead in November 2007 with changes to the funding of the Financial Services Compensation Scheme, in view of the FSA's knowledge that substantial changes to the Scheme were highly likely in 2008. The FSA's decision to do so pre-empts the Tripartite review of funding issues in relation to deposit protection in which the FSA itself is involved. (Paragraph 256)

49.  We believe that the 'pay as you go' approach to funding depositor protection, as currently used by the Financial Services Compensation Scheme, has two fundamental disadvantages. First, it does not create the requisite depositor confidence in the availability of a source of prompt funding, so fails to contribute towards financial stability. Second, a 'pay as you go' approach could cause significant pro-cyclicality problems. Such an approach could mean obtaining funding from banks at the worst possible time, whereas a pre-funded model could obtain most of its funding at times of plenty. We have noted the arguments of the British Bankers' Association that ex-ante funding is not appropriate in the United Kingdom due to the concentrated nature of the United Kingdom's banking sector. We do not believe that the nature of the banking sector is itself a barrier to the adoption of such a funding arrangement. Objections to an ex-ante scheme appear to be based on the notion that certain United Kingdom banks are 'too big to fail'. We reject this notion. The principle that must underpin a future scheme is that it should be capable of coping with any foreseeable bank failure. We recommend accordingly the establishment of a Deposit Protection Fund, with ex-ante funding. The Fund would receive contributions from banks and building societies on a regular basis, and be of sufficient size to obviate the need for the Government to step in to rescue a major bank. The establishment of a pre-funded scheme would be a significant cost to the institutions involved, but it seems only right to us that the costs of bank failure should be borne by the industry rather than the taxpayer, as would currently be the case. To ensure that the Fund is adequately resourced from the outset, we recommend that it be financed initially by a Government loan, which would then be repaid over time as banks' contributions accumulated. (Paragraph 263)

50.  In the previous section we recommended the establishment of a Deposit Protection Fund, and suggested how the cost of building up this Fund should be spread over several years. During this initial phase, we recommend that banks' contributions be based solely on the size of their insured deposit base, in order to minimise complexity. Once the Fund is established, however, there may be a case for the introduction of a system of risk-based premia, whereby each bank contributes according to the Fund's assessment of the likelihood of needing to compensate depositors. We recommend that the Government, in bringing forward legislation on the establishment of a Deposit Protection Fund, grant powers to that Fund to consult on and introduce risk-based premia once the Fund has been established. (Paragraph 266)

51.   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. (Paragraph 268)

52.  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. (Paragraph 276)

53.  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. (Paragraph 277)

54.  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. (Paragraph 280)

55.  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. (Paragraph 284)

56.  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. (Paragraph 289)

57.  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. (Paragraph 292)

58.  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. (Paragraph 294)

59.  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. (Paragraph 299)

60.  The Financial Services Compensation Scheme model works well for all institutions other than large deposit-taking institutions, where systemic risk is more prevalent. We therefore recommend that the Financial Services Compensation Scheme continue to operate under its current regime for all institutions other than large deposit-taking institutions. We also recommend that the authority in charge of the Deposit Protection Fund decide on how such large institutions should be selected. However, in order to prevent discrepancy in the market, we recommend that the insured deposit limit for individuals under the continuing Financial Services Compensation Scheme be equal to that under the Deposit Protection Fund. (Paragraph 302)

61.  We therefore recommend that the new regulatory powers relating to banks set out in Chapter 5 of this Report reside with the institution that also controls the Deposit Protection Fund. (Paragraph 304)

62.  We have already concluded that we do not wish to dismantle the current structure of the Tripartite system. We therefore do not support the creation of a new institution similar to the US Federal Deposit Insurance Corporation. (Paragraph 305)

63.  We consider the need for 'creative tension' within the regulatory system as of sufficient importance to justify overlooking any possible synergies of co-locating the new powers recommended in this Report alongside the existing powers of the Financial Services Authority. We have concluded it would be inappropriate for the Financial Service Authority to receive the Deposit Protection Fund, or the associated additional powers. (Paragraph 308)

64.  It is right that where taxpayers' money is being used in a support operation, there should be political responsibility, and that the Chancellor of the Exchequer should make the final decision on whether such operations should be conducted. However, in most instances, regulatory action should and will be taken before such "last resort" support is required. This would be the benefit of a "prompt corrective action" approach. As such, we see no reason for the Chancellor of the Exchequer to be primarily responsible in the decisions that do not require taxpayer support. We have therefore concluded that it would be inappropriate for that the Treasury be the location for the Deposit Protection Fund. (Paragraph 310)

65.  We do not consider that it would be appropriate for the Governor of the Bank of England to assume direct responsibility for the exercise of the new powers that we have proposed in chapters 5 and 6 relating to handling failing banks and the new Deposit Protection Fund. We envisage that the exercise of the new powers should rest first and foremost with a person who should have full-time responsibility for that exercise. We are also not convinced that direct responsibility for the new powers by the Governor of the Bank of England is appropriate in view of the Governor of the Bank of England's duties as Chairman of the Monetary Policy Committee. (Paragraph 314)

66.  We recommend the establishment of a new post of "Deputy Governor of the Bank of England and Head of Financial Stability". He or she will have direct responsibility for the exercise of the new powers we have proposed in Chapter 5 and for the Deposit Protection Fund. The holder of the new post should have full authority within the Financial Services Authority to meet the requirements of his or her post. We recommend that paragraph 1(2) of Schedule 1 to the Bank of England Act 1998 be amended so that the Deputy Governor and Head of Financial Stability would not be required to work exclusively for the Bank of England. The holder of this new post will have a key role in ensuring that a Chancellor of the Exchequer receives authoritative and co-ordinated advice in any future case where financial stability is threatened by difficulties in the banking sector, and that post-holder would be one of the principal channels of advice to the Chancellor of the Exchequer. (Paragraph 315)

67.  An extension of the responsibilities of the Bank of England in the manner we have recommended and the creation of the post of Deputy Governor and Head of Financial Stability must be accompanied by a review of the management structure and lines of responsibility within the Bank of England to ensure that:

  • the Governor of the Bank of England's authority and leadership within the new structure of the Bank of England remains clear; and
  • there is an appropriate division of management and other responsibilities between the holder of the new post and the other Deputy Governor of the Bank of England.

We recommend that, as part of this review, consideration be given as to whether it would be appropriate for the holder of the post of Deputy Governor and Head of Financial Stability to be a member of the Monetary Policy Committee or whether that position should be assumed by a senior member of Bank of England staff specifically charged with responsibility for the interface between financial stability and monetary policy. We recommend that the Deputy Governor and Head of Financial Stability have an important role in the Bank of England's money market operations, but work will be needed to clarify the distinction between that role, and the role needed to ensure money market operations to enact monetary policy. (Paragraph 316)

68.  We recommend that an Office of the Deputy Governor and Head of Financial Stability be created within the Bank of England, including staff seconded from the Financial Services Authority, HM Treasury and other organisations. (Paragraph 317)

69.  The Office must develop a forward-looking analysis, attempting to identify trends and potential risks to the financial system, and provide a regular update on those risks for the financial community. This role would also include adapting and improving stress-testing techniques, both at the system and individual institution level. (Paragraph 318)

70.  One aspect of the recent crisis is the apparent lack of attention paid by financial institutions to the warnings of the Financial Services Authority and the Bank of England. The Office of the Deputy Governor and Head of Financial Stability should be charged with ensuring a feedback system is incorporated between financial institutions and the regulatory authorities for issues relating to financial stability. This feedback system will not just be limited to the financial institutions that have absorbed the message, but also whether the Financial Services Authority has taken these messages onboard. This would of course be linked to the horizon scanning function we outline above. We will discuss this further in our Report on Financial Stability and Transparency. (Paragraph 319)

71.  To protect the Deposit Protection Fund for which it would be responsible, the Office of the Deputy Governor and Head of Financial Stability would identify outlying, weakened or potentially systemic financial institutions, and ensure that 'prompt corrective action', if needed, is undertaken. In more extreme circumstances, the Office would have the power to place an institution in the special resolution regime. Such a role would, of course, see this Office working closely with the Financial Services Authority, and we would expect full information disclosure between the Office and the Financial Services Authority. The expectation would be that, while the Office of the Deputy Governor and Head of Financial Stability would have the power to send inspectors into financial institutions covered by the Deposit Protection Fund and to those to which it is considering extending its protection, it would in the main rely on information provided by the Financial Services Authority, marrying this information with the information the Bank of England also receives via its operations in money markets, and liaison work conducted by the Office. (Paragraph 320)

72.  We have already concluded that the communications strategy for handling the September 2007 crisis was weak. We therefore recommend that the Office of the Deputy Governor and Head of Financial Stability be given lead responsibility within the Tripartite authorities on ways to ensure that there is clear, coherent and effective communications with the public and the markets in any future financial stability crisis. (Paragraph 321)

73.  We recommend, given the potential for a conflict of interest between different functions of the Financial Services Authority, that the Deputy Governor and Office of the Head of Financial Stability be given the role of leading for the Tripartite authorities in relation to the identification of third-party buyers for stricken firms. (Paragraph 322)

74.  We recommend that the Office of the Deputy Governor and Head of Financial Stability be given the role of identifying and managing the relationship of the Tripartite authorities with third-party private sector assistance. (Paragraph 323)

75.  One of the lessons learnt from this crisis is that legislation had been in preparation before the crisis hit; but that preparation process was not well-advanced. We recommend that the Office be responsible for identifying weaknesses in the legislative framework for financial stability and crisis management and liaising with the Treasury on the formulation of appropriate legislative responses. (Paragraph 324)

76.  To prevent an overburdening of the Deputy Governor and Head of Financial Stability, we recommend consideration be given to the case for each of the tasks outlined above to be assigned to a separate Director within the Office of the Deputy Governor and Head of Financial Stability to be charged with overseeing each task. (Paragraph 325)

77.  We recommend that, in addition to being responsible for the Bank of England's Financial Stability Report, the Office of the Deputy Governor and Head of Financial Stability produce an annual report on its activities and the work of the Tripartite Standing Committee. (Paragraph 326)

78.  We recommend that there should be at least one meeting of the Tripartite standing committee at the Principal level every six months. We would expect a Chancellor of the Exchequer to ensure that, in any case where financial stability is threatened, he or she would be able to draw directly upon the experience and advice of the Deputy Governor and Head of Financial Stability as well upon that of the Governor of the Bank of England and the Chairman of the FSA. (Paragraph 328)

79.  We recommend that formal advice given to the Chancellor of the Exchequer by the other Tripartite authorities in any future circumstances where financial stability is threatened be published as soon as reasonable after the immediate threat has passed, excluding any commercially sensitive information. (Paragraph 329)

80.  We recommend that the Government clarify as a matter of urgency whether, in the event of the retail deposit guarantee for Northern Rock being invoked, any payments due to depositors would be off-set against depositors' mortgages with Northern Rock. (Paragraph 338)

81.  The guarantee on Northern Rock's retail deposits was necessary to stop the run on those deposits. The guarantees issued in September and October to categories of wholesale deposits with Northern Rock assisted with the stability of the company during that period and since. One effect of the various Government guarantees issued in September and October has been to reinforce the incentive for the Government to help to ensure that Northern Rock remains a going concern that honours its commitments to depositors. (Paragraph 340)

82.  State support for Northern Rock has involved the Government entering into contingent liabilities on a very large scale. It is important that the Treasury discharges its obligations to the House of Commons—and through the House of Commons to the taxpayer—promptly and fully to report on the extent of such liabilities. The actual level of Bank of England support underwritten by the taxpayer is not specified within the Bank of England return. The Government itself should not have relied upon either the Bank of England or the Northern Rock to be the sole sources on the scale of the State commitment. The House of Commons should be updated about the scale of the commitment on a quarterly basis. (Paragraph 362)

83.  We expect to explore the implications for fiscal policy of the Government's decisions relating to Northern Rock in due course. (Paragraph 380)

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