Select Committee on Treasury Written Evidence


Memorandum from the Financial Services Authority

  This memorandum responds to the Committee's requests at the evidence session on 9 October 2007.

1.  Granite (Qq 231-240)

  Decisions on the structure for any securitisation will rest with the originating bank. As part of our overall supervision work, we monitor the range of securitisation programmes used by UK banks, including the Granite securitisation used by Northern Rock. We have extensive discussions with the firms involved and access to all relevant documentation which they hold.

  The structure of the Granite securitisation meets industry norms and there is nothing to suggest that the Granite structure is not functioning as intended. The Committee should note that there is also an extensive body of public literature that explain the details of all types of securitisation activity.

  Securitisation is a well-established management tool and has been used in the UK for 15-20 years. It has been an efficient and low-cost form of funding for the UK and global mortgage markets as the buyers of a mortgage securitisation are able to look for repayment purely from cash generated by the mortgage assets that have been securitised, as opposed to the bank itself For many transactions these buyers will include other banks, insurance companies and pension funds.

  An integral part of securitisation is that the assets must be removed from a potential insolvency of the bank that has made the loans. In the UK, an effective way for this separation to take place is via a trust structure. Each securitisation will include many "special purpose vehicles" (SPVs) that each has a role to play; for example one vehicle will hold the assets while another will issue bonds. The arrangements are overseen by independent trustees who ensure proceedings are undertaken in line with strict documentation during the transaction; overseas, many civil law jurisdictions have set up specific securitisation legislation in order to replicate the features of securitisation that can be achieved via trusts in common law jurisdictions such as the UK. It is not unusual for some of the SPVs to be based in off-shore jurisdictions, such as the Channel Islands, where the laws are well-suited to the purpose. Tax considerations may also be a factor in decisions on where to domicile such entities.

  The SPVs are typically legally owned by a holding company. To reinforce the separation from the bank, the shares in this holding company are held by a third party. In many cases, including Granite, they are held under the terms of a trust for the benefit of charitable institutions. The company used to facilitate this process in Granite is the Law Debenture Corporation. It should be noted that any payments to charity in this sort of structure are unlikely as the trustees ensure that payments are allocated in line with the strict payment schedule.

  In our response to your question we were not clear if it concerned the Northern Rock foundation or the Granite SPV. I would like to make it quite clear that the Granite SPV is entirely separate from the charitable body, Northern Rock Foundation, which was established by Northern Rock and which receives contributions by way of profit share.

2.  The FSA's communications with Northern Rock's auditors (Q 241)

  We met Northern Rock's external auditors as part of the last full ARROW assessment in December 2005. There were no material audit or control issues arising. Aside from formal communication with the external auditors, we checked the firm's external audit status with senior management on an continuing basis, as part of our close and continuous relationship. No material issues have arisen during this period and this has been confirmed by the firm's external auditors.

  As a result of the bank's current difficulties we received a letter from Northern Rock's auditors on 11 September and had a meeting with them on 20 September 2007. In this letter the auditors expressed concern that the firm might cease to be a going concern if a liquidity facility could not be arranged.

3.  The regulatory relationship between the FSA and Northern Rock prior to August 2007 and how that relationship compared with other businesses in the same markets

  Our framework for assessing the risks to our objectives posed by individual firms is called "ARROW". Full ARROW risk assessments are an integral part of this supervisory process; they are intensive stocktakes of individual firms and are supplemented by a number of other monitoring techniques. We have designated Northern Rock and more than a hundred comparable businesses as high- impact firms.

  In addition to these full ARROW risk assessments, we subject firms which we designate as high-impact to "close and continuous" supervision. This is characterised by very regular dialogue with the firm on the full range of supervisory issues, through ad hoc meetings and regular telephone conversations and email traffic. Our workstreams in supervising Northern Rock over the last two years have included: reviewing strategic and business developments through discussions with the firm; attendance at results presentations; monitoring the market; assessing the ongoing validity of our risk assessment; monitoring financial data, supervisory returns and management information; reacting to specific requests from the firm—such as the Capital Requirements Directive (CRD) waiver request which was a major workstream during this period; and undertaking the formal review process which sets the capital requirements of the firm on the basis of the risks identified by the firm and the FSA. We also carry out thematic reviews—projects to review practices in a range of firms in a specific area of their business. Northern Rock was subject to thematic reviews in the same way as other similar firms.

  In implementing our ARROW framework, we form ajudgement on how frequently we should carry out a full risk-assessment of each high-impact firm. In making that decision we take into account a range of factors including impact, probability, complexity, and the potential for the risk profile of the firm to change. Currently the mean period between full risk assessments for high impact firms is 26.4 months; this is longer than usual because of the work we are carrying out reviewing capital requirements under the CRD.

  Our first ARROW assessment of Northern Rock was completed in Q4 2002. Following this, we set the next regulatory period to run from December 2002 to December 2003. Following the assessment in December 2003, taking account of our close and continuous relationship with the firm, we set the next regulatory period to run for 24 months, from December 2003 to December 2005. After completing the most recent ARROW assessment in Q4 2005, we set the third (and current) regulatory period, to run from January 2006 to January 2009.

4.  The discussions that took place between the FSA and Northern Rock in August and September 2007 and who conducted them

  Throughout August and September FSA management (Chairman, CEO, relevant Directors and Heads of Department) had frequent discussions with the Northern Rock senior management team. In addition, there were many conversations with the Chairman and Non-Executives of Northern Rock. and Hector Sants and I met the Chairman and Company Secretary on 30 August. Discussions with external parties on private sector solutions were primarily conducted by Hector Sants.

  In addition, a strengthened supervision team had almost daily conversations with Northern Rock from Monday 13 August, which increased after 21 August to twice daily conversations.

In addition, they have visited Northern Rock three times since the beginning of August. During this period we also analysed the whole range of management and financial information submitted by Northern Rock.

5.  Briefing of journalists

  You also asked us to provide further information relating to "the suggestion that the FSA briefed against the Bank of England in the media in September". We understand that in making this suggestion the Committee had in mind two particular newspaper articles. We have reviewed these in detail.

  The FT story headlined "U-turn raises heat on King" (p1: 20 September) purports to be, inter alia, an account of a meeting between the major commercial banks, the FSA and the Bank of England on 19 September. It accurately reports that Hector Sants urged the banks (not the Bank of England) to lend to each other in the interbank market. This approach had been preagreed with the Tripartite Authorities, I do not believe that this supports an inference that that article represents the FSA briefing against the Bank of England. I would also observe that this meeting was attended by numerous parties, any of whom could have provided details to the press. For the record, on that day, the FSA confirmed that the meeting had taken place but declined to provide any information about the content. Indeed at the beginning of the meeting Hector Sants asked all parties to maintain confidentiality about the discussions. It should be clear that from the point of adverse market impact the FSA considered that the contents of this meeting should remain confidential and we were subsequently concerned when reports of it appeared in the press.

  The Daily Telegraph article from 20 September headlined "Government forces King U-turn" contains comments from various parties, about the Bank of England's announcement of its new money market auctions. Its principal argument appears to be that HMT applied pressure on the Bank to change its policy and it quotes unnamed "political sources" to that effect. None of that supports the allegation of FSA briefing. Towards the end of that article there is the following paragraph:

    "The Financial Services Authority was more open to the idea of relaxing rules, though informed sources deny reports the FSA took a strong stand. Relations between the FSA and the Bank have now become poisonous".

  As I made clear in my oral evidence, I entirely reject this characterisation of relations between the two Authorities. Insofar as the article is concerned, it could hardly be said to represent the FSA in a good light in contradistinction to the Bank. It is not evidence of what has been claimed to be FSA briefing.

  I would suggest therefore that neither of the two articles you have brought to our attention supports the contention that FSA staff briefed against the Bank. Nonetheless, as you requested, I have made inquiries and am happy to assure your Committee that no FSA employees who are authorised to brief journalists on these matters carried out any briefing of the kind suggested.

6.  The FSA's Risk Committee

  The Risk Committee is a committee of the Board, made up of a number of non-executive directors. It is responsible for the following, on which it reports to the Board:

    —  review and oversight of the risks to the FSA's statutory objectives;

    —  the executive's appetite for such risks; and

    —  the risk management and mitigation strategies and systems used to control such risks.

  The Committee met on the following dates in 2006-07: 23 February 2006, 25 May 2006, 26 July 2006, 25 October 2006 and 13 February 2007, 17 April 2007 and 17 July 2007. Sir John Gieve sent his apologies for the meetings on 25 May 2006 and 13 February 2007.

7.  Information from regulated firms on liquidity

  In our supervision we rely to a significant extent on analysing information which firms report to us, on prescribed topics and with prescribed frequency. In this context, retail firms report on their liquidity position regularly; for example, building societies report monthly, mortgage lenders report quarterly, and banks report at least quarterly, with large retail banks reporting monthly.

  In the light of the market turbulence, from 9 August we intensified our monitoring of financial markets generally and engaged more closely with those firms likely to be most affected by market developments. From 10 August this involved individual discussions with the large retail banks, which in some cases included daily contact, asking for updates on their funding and liquidity positions. We contacted smaller banks and building societies on 13 August asking for detailed information on their current liquidity.

  From 9 August we also asked for more detail in the data collected, and sought information on a prescribed stress scenario from some banks and building societies. The frequency with which we asked the larger firms to provide data using this framework varied from daily to weekly reporting, depending on their exposure to current market conditions. As part of this enhanced monitoring programme, on 18 September we sent a questionnaire to some smaller wholesale funded mortgage lenders and a further questionnaire to building societies. This questionnaire was referred to in the Financial Times on 27 September. This article suggested that this questionnaire had been sent to the largest banks. This was not the case—as noted above, work commenced with those firms on 10 August.

  As we have said to the Committee in our written and oral evidence, we believe that there are lessons to be learned from our supervision of Northern Rock in the period to August 2007, and we have begun a review, We will publish our conclusions.

  I hope that this information will be helpful to the Committee, including in the context of your hearing with Northern Rock on 16 October.

October 2007





 
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