Select Committee on Treasury Written Evidence

Memorandum from the Financial Services Authority


  1.  This memorandum is submitted in advance of the FSA's appearance before the Committee on 9 October.


  2.  The turbulence which has characterised credit markets over recent months originated in the US sub-prime mortgage market but then spread much more widely in the financial system, with the contagion being fuelled by a fear of where the sub-prime risk now ultimately resides and a general loss of confidence in asset-backed securities and how they are rated. The chain of events leading from difficulties in the US to a tightening of credit markets globally and to serious problems in inter-bank lending in the UK is set out clearly in the note which the Governor of the Bank of England sent the Committee on 12 September. We would highlight one particular aspect of market developments in August and September: the disruption to credit markets in the UK and globally was partly due to a loss of confidence by buyers in high-quality commercial paper, leading to an almost complete and unprecedented disappearance of liquidity in the wholesale markets other than in the very short-term money markets.

  3.  In this Memorandum we summarise our regulatory actions over recent months, generally and in relation to Northern Rock. We explain how we worked with the Treasury and the Bank of England, within the Tripartite Framework, to respond to market developments and deal with problems in individual firms. Finally, we outline our plans to learn lessons from recent events.

  4.  To ensure that major banks at the core of the financial system remain sound and liquid, over recent months we have enhanced our monitoring of major market players by increasing the frequency of our monitoring of their liquidity and encouraging banks to take remedial action as appropriate. We have also assessed and dealt with threats to overall liquidity. This has included analysis of the funding and liquidity profile of the firms we regulate, including the obligations and implications of their involvement with Structured Investment Vehicles (SIVs) and Conduits. This also involved an assessment of the maturity and pricing profile of various instruments such as asset-backed commercial paper and other structured products, and their liquidity implications.

  5.  We have also collaborated closely with supervisors in other major financial centres to exchange information on developments in each centre, and to identify issues of common interest. From 9 August a daily, sometimes more frequent, discussion of developments has taken place between the Bank of England, the Treasury and the FSA.


  6.  As the Committee will be aware from previous FSA evidence, our general approach is to regulate in a way which supports competition and innovation in financial markets. We believe that, overall, this approach has served UK financial markets well. We adopt a risk-based approach to our work; that is, we consider the impact on our statutory objectives (including consumer protection and market confidence) if particular problems were to arise in firms, sectors, markets or among consumers. We also consider the probability of such problems actually materialising. Taking these two factors together enables us to make a judgement on what priority to give to particular risks, and to allocate appropriate FSA resource to dealing with them. In competitive markets there will be failures; as we have said in the past, it would be impossible—and, in any event, undesirable—to seek to eliminate all risk from financial markets and to operate a zero-failure regime.

  7.  We had been concerned for some time that the impact of a severe tightening in global credit markets would be very significant. For example, in our "Financial Risk Outlook" published in January 2007 we alerted firms to the need to consider how they would operate in an environment where liquidity was restricted, and we reminded firms of the need to incorporate stress testing and scenario analysis into their business models. On 19 July this year Hector Sants, on assuming his role as FSA Chief Executive, highlighted in a press conference following the FSA's Annual Public Meeting concerns about possible deterioration in credit markets. However, whilst we felt that a market correction was likely, we attached a very low probability to a tightening of the speed, duration and scale which we have just experienced. Our assessment was widely shared at the time by market commentators and analysts and by other banking regulators globally. However, it should be noted that we increased the intensity of our monitoring of credit markets in July.

  8.  Turning to the Northern Rock case, we supervise the firm in line with our overall risk-assessment framework. We carried out our most recent full risk assessment of the firm in the period December 2005 to February 2006. Since this last full assessment, our supervision has included monitoring the firm's compliance with liquidity and other prudential requirements. We have also paid a number of visits to the firm to review particular aspects of its operations, including its arrangements for managing credit and liquidity risk and for stress-testing. In response to the firm's Pre-Close Period Statement on 27 June we increased our supervisory focus. Our reviews included giving feedback to the firm asking it to carry out more work on liquidity risk and the cash-flow implications of stresses on its securitisation programme. However, as noted above, we did not envisage, and the firm did not carry out, stress tests on a liquidity event as sudden and then sustained as the actual stress experienced this summer.

  9.  From early August conditions in credit markets deteriorated and Northern Rock experienced increasing difficulty in securing wholesale market funding other than on an overnight basis. We further intensified our monitoring of credit markets and considered the possible impact on individual firms. Therefore from 9 August onwards FSA senior management held daily meetings to review market conditions and the latest position of firms that were vulnerable to these market conditions. This increased supervisory activity covered all major market players and, since the market turmoil had originated in the US sub-prime mortgage market, from an early stage one area of focus was Northern Rock. We also took part in daily telephone calls with the other Tripartite authorities to discuss the latest market conditions. In the period between 9 August and the end of September we held a variety of meetings with individual institutions, as well as three larger meetings (also attended by the Bank of England) with the CEOs of the major UK banks and UK institutional investors.

  10.  In order to mitigate the risk in Northern Rock's position we carried out work under three main headings:

    —  First, on 16 August we set up a Northern Rock project team working on: continuing supervision; liquidity support; a possible sale of the firm; and consideration of what would happen if the firm failed.

    —  Second, we actively discharged our mandate to seek private sector solutions. Clearly this is primarily the responsibility of the board of a listed company and its advisors. However, we contacted a number of potential purchasers during this period. The FSA had a number of discussions with one potential purchaser, but no acceptable structure was identified in the circumstances.

    —  Third, the company was continuing to investigate a variety of alternative funding strategies, notably the possibility of an underwritten securitised transaction.

  By 11 September it became clear that private sector solutions, including securitisation, were not an option. During this period the Tripartite Authorities were also looking at public sector funding options.

  11.  As the relevant markets remained effectively closed, and the implications for Northern Rock became increasingly serious, we raised the position of the firm in the Tripartite Standing Committee. Following discussion in the Committee on 14 August, we formally directly notified the Treasury on 15 August of the position of Northern Rock. On 22 August the Tripartite Committee's Joint Crisis Coordination Team set up a working group, which included workstreams on the practical aspects of enabling the firm to borrow against a wider range of collateral, and triggers for the recommendation of such support. On 29 August the FSA Chairman wrote formally to the Chancellor, copying his letter to the Governor of the Bank of England. Our judgement was that the firm was systemically significant in the market conditions prevalent at the time. We discussed with our Tripartite partners, in particular the Bank, operational aspects and the potential provision of a lender of last resort facility at some future date. During this period we also monitored closely other institutions to identify any funding problems arising from the tightening in credit markets.

  12.  When it became apparent that a private sector solution was not available and alternative funding options were not materialising, discussions intensified within the Tripartite on the timing and terms of a facility. At the same time it became increasingly apparent that the company would need to consider updating its trading statement in the light of its deteriorating financial condition. The Chancellor, on the advice of the Governor and the FSA Chairman, authorised the Bank to provide a liquidity support facility and the company's proposed trading statement made reference to the provision of the facility. However, before any formal announcement from the company there was during the evening of 13 September media coverage of the prospect of such a facility being provided. On 14 September as part of a combined Tripartite announcement we confirmed our judgement that Northern Rock remained solvent, continued to meet its capital requirements, and had a good quality loan book. On 17 September the Chancellor announced that the Government, with the Bank, would put in place arrangements that would guarantee deposits held with Northern Rock. The Treasury subsequently issued statements on the terms of that guarantee.

  13.  In the period from 14 September onwards we supported Northern Rock's communications with its customers by providing information, through our website and our Consumer Contact Centre, on the latest position and on steps which consumers could take.

  14.  It should be recognised that the key dependency for Northern Rock was not its use of wholesale funding per se. In terms of its net short-term wholesale funding to balance sheet asset ratio it was not a significant outlier in relation to other UK banks. Rather, its key dependency was its use of securitisation; its securitisation product was a simple one, based on high-quality assets. The market disruption did not affect Northern Rock's existing securitisations, but the market for new securitisations had largely closed. Neither did the market disruption lead to a cessation of Northern Rock's wholesale funding, but rather to a shortening of its duration and an increase in its price. The combination of these factors led the Northern Rock Board to seek assurance that contingency funding from the Bank of England would be available. The large retail outflows in mid-September led to a significant and sudden deterioration in Northern Rock's liquidity and required it to draw on the Bank of England facility. So it is clear that a combination of circumstances led to the position which Northern Rock is now in, rather than any single event.

  15.  Responsibility for Northern Rock's business lies primarily with its Board and management. But we recognise the great inconvenience and anxiety which Northern Rock's problems have caused for its customers, and the wide public concern and loss of consumer confidence occasioned by the unprecedented events of recent months. Despite the Government's safeguards for depositors, we are clear that what has occurred has been damaging. This is despite the fact that all depositors who have reclaimed deposits have been paid in full. As the regulator with a statutory duty to maintain market confidence and provide appropriate protection to consumers, the FSA needs to identify what lessons to learn, and what improvements to make.

  16.  As we note above, it is generally agreed that the disruption to credit markets we have experienced in recent months has been unprecedented. Yet it is already clear from our review of our supervision of Northern Rock before August 2007 that, whilst we understood the firm's business model and the attendant risks, our assessment of the probability of market conditions deteriorating as they did has proved incorrect.

  17.  We will conduct a review of the lessons which the FSA should draw from the Northern Rock events, and what changes these suggest for the FSA's risk-assessment and risk mitigation practices in general. We will publish the conclusions. We will wish to do this in a comprehensive manner, but it is already clear that the areas we will wish to examine (some of which were being worked on before the events of Northern Rock) include:

    —  the extent to which the FSA's framework for assessing risk within firms should place further importance on liquidity issues;

    —  whether changes should be made to the FSA's liquidity regime, and the interrelationship between the UK's and other countries' liquidity regimes;

    —  the strengthening of stress-testing within firms, and the challenge to this from FSA supervisors; and

    —  the continuing strengthening of the FSA's supervisory resources.

  18.  Recent events have also raised questions about the adequacy of current deposit protection arrangements and their interplay with the lender of last resort function. The current system for deposit protection is operated within the framework established in 2001 under the Financial Services and Markets Act 2000. The Financial Services Compensation Scheme (FSCS) covers customers of all authorised financial services firms, including banks and building societies. The FSA is responsible for setting the rules within which the FSCS operates, including on eligibility of claims and compensation limits. Since 2001 it has dealt with a wide variety of firm failures and has paid out more than £950m in compensation to consumers. The FSCS is funded through levies on the industry and is free to consumers at the point of use.

  19.  The FSCS's main function is consumer protection: it provides consumers with a measure of compensation in the event of failure of an institution in the financial sector. The existence of a compensation scheme helps to reduce the systemic risk that a single failure of a financial firm may trigger a wider loss of confidence. But while it contributes to encouraging consumer confidence in the markets, the FSCS was not designed, on its own, to be able to deal with all potential failures of financial firms, nor to be a crisis management tool in the event of a large-scale failure.

  20.  However, in the light of recent events we decided it was necessary to act to reassure depositors and so, as a first step, we announced on 1 October, with immediate effect, that we have increased the FSCS limit for deposits to cover 100% of each depositor's claim up to a limit of £35,000. The previous maximum payout was £31,700—100% of the first £2,000 and 90% of the next £33,000 of depositors' eligible claims. The EU Deposit Guarantee Schemes Directive provides a minimum compensation for depositors in member states of €20,000 (around £14,000). Member states can limit compensation to a percentage of deposits but can not limit it to less than 90% until €20,000 has been paid.

  21.  Meanwhile, we have been considering the underlying funding arrangements for the FSCS. In 2006 we decided to hold a review in order to rectify a number of problems that had been identified. One clear deficiency was the overall capacity of the scheme; in our judgement it was necessary to increase the range of events where we could ensure that consumers would be paid when valid compensation claims were made. Currently the amount available to the deposit taking sub-scheme is a perpetual limit of 0.3% of protected deposits—a total of around £2.6 billion. Our proposals, on which we consulted earlier this year, will substantially increase the funding available to around £4 billion per year across all sectors.[1] While limited, this would significantly increase the funding available to the FSCS. We said in our Consultation Paper that we were not intending to establish a funding model capable of providing total cover in all instances, and we still believe this to be the correct approach. As we noted in our Consultation Paper, we would expect a large-scale failure to trigger the crisis management arrangements set out in the Tripartite Memorandum of Understanding.

  22.  Nearly all the industry strongly opposed our proposals, arguing that there was no need to change the current arrangements, which they believed were fit for purpose, and that introducing greater cross-subsidy between different classes of firms was inappropriate. We are currently finalising our formal policy on the future funding model. The new funding model, with its increased capacity, would be introduced from 1 April 2008.

  23.  Working with the Treasury, the Bank of England and the FSCS, we will build on work that we began in 2006, in order to consider the broader framework within which the FSCS operates. We will focus on how best to deliver an appropriate level of assurance to consumers, including looking at both the monetary limits and improving the speed with which compensation payments can be made to consumers in the event of a large default. In this context it will be important to find a solution for deposit protection which takes account of appropriate changes to compensation arrangements more broadly, including in other financial sectors, and to avoid unintended consequences and possible knock-on effects. As the Chancellor announced on 1 October, the Government intends to legislate to implement a more fundamental reform of the framework for depositor protection. We will consult jointly with Treasury as appropriate on further changes to the regime.

5 October 2007

1   The existing scheme's funding is restricted to each contribution group: deposit-taking £2.6 billion (0.3% of protected deposits in total over the lifetime of claims received); general insurance providers £267 million annually (0.8% of relevant net premium income); general insurance intermediaries £82 million annually (0.8% of annual eligible income); life and pensions providers £544 million annually (0.8% of relevant net premium income); investment firms £400 million annually; and mortgage intermediaries £14 million annually (0.8% of annual eligible income). The amounts available would not be available to other groups as the current scheme does not allow for any cross-subsidy. Back

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