Memorandum from the Financial Services
RECENT TURBULENCE IN GLOBAL FINANCIAL MARKETS
AND NORTHERN ROCK'S LIQUIDITY CRISIS
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 impossibleand,
in any event, undesirableto 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
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;
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
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 £31,700100% 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 depositsa 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.
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