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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