Memorandum from the Building Societies
The Building Societies Association (BSA) represents
all 59 building societies in the United Kingdom. Building societies
have total assets of just under £325 billion and, with their
subsidiaries hold residential mortgages of around £250 billion,
approximately 20% of the total outstanding in the UK. Societies
hold just under £210 billion of retail deposits, accounting
for about 20% of all such deposits in the UK. Building societies
also account for over 37% of all cash ISA balances. Building societies
employ over 50,000 full and part-time staff and operate through
more than 2,100 branches.
The BSA welcomes the opportunity to contribute
written evidence to the Treasury Committee's inquiry. The events
to which the inquiry relates are, of course, still unfolding and
it would be premature of us to seek to draw firm conclusions.
Accordingly, the evidence we offer in this submission is, of necessity,
very much of a preliminary nature.
The reasons for the difficulties faced by Northern
Rock, and the events that led up to the run on the bank
1. The market conditions that led to the
run on the Northern Rock bank have been well documented and have
their roots in the United States market for sub-prime mortgages.
Many US sub-prime mortgages were securitised and it is clear now
that the price of such securities did not fully reflect the risk
of default on the underlying assets. During July 2007 rising default
rates in the US sub-prime market caused the markets to reassess
the risk of holding asset-based securities. By early August the
market in asset backed securities effectively ground to a halt.
This was due to uncertainty among investors about the exposure
of the issuers of such securities to losses in the US sub-prime
market. Such uncertainty was compounded by the inherent structure
of securitisations, which meant that the holders of the asset-backed
securities were not party to the information about loan quality
and default rates to which the institutions which originated the
loans had access.
2. Liquidity was squeezed further as the
commercial banks hoarded cash and restructured vehicles that had
been major purchasers of asset-backed securities, or took them
back onto their own balance sheets. This process employed the
banks' liquidity, thereby restricting further the availability
of credit to other banks.
3. Northern Rock was particularly vulnerable
to the credit squeeze created by the US sub-prime crisis. This
was in part due to its extreme business modelmore than
75% of its funding came from the wholesale markets. It relied
on securitising its mortgages and in the first half of 2007 it
raised more money from the securitisation of its mortgages than
any other UK bank. Northern Rock's securitisations funded very
fast growth of its lending. In the first half of 2007 its lending
was up 31% on the comparable period in 2006. This compares to
growth of 13% in building society lending in the same period.
Northern Rock's share of the market for new mortgage lending grew
to 19%a substantial proportion given that its market share
of outstanding loans at the end of 2006 was only 7%. Concern about
the quality of Northern Rock's loan bookand in particular
the quality of the lending that underpinned its dramatic growth
in early 2007is likely to have contributed to the difficulties
it faced in obtaining wholesale funding in August. In essence,
the liquidity on which Northern Rock relied to carry on its day-to-day
business dried up so that it was unable to meet its commitments
as these fell due.
4. Whilst they are often a more expensive
option for banks and building societiesdue to the higher
acquisition costs associated with a retail banking operationretail
deposits are generally a steadier source of finance than wholesale
funding; reliance on predominantly retail funding tends to promote
steadier growth than is possible using the wholesale markets.
5. Most of the other high street banks and
all building societies have a much lower proportion of wholesale
funding than Northern Rock. Building societies are explicitly
prevented from having as high a proportion of wholesale funding
as Northern Rock. The Building Societies Act 1986 requires all
building societies to derive at least 50% of their funding from
their members, (ie essentially from the retail market). This means
that in theory it would be possible for building societies to
be 50% funded from the wholesale markets. In practice, the proportion
of building society wholesale funding is much lower than this,
typically around 25% to 30%. It is interesting to note that Virgin
Group, in announcing its interest in taking over Northern Rock
last month, said it wants to make the bank "more like a building
society". This indicated recognition of the need for a back-to-basics
approach, a return to the values to which Northern Rock used to
adhere before it demutualised 10 years ago.
6. A note explaining the differences between
banks and building societies is appended; this has been posted
in a prominent position on the home page of the BSA's website
since mid August.
7. Northern Rock's funding model and its
dramatic growth explain how it got into difficulty but they do
not explain the run on the bank. The run can be attributed to
three other factors that combined to exacerbate the impact of
the liquidity problems faced by Northern Rock bank:
Firstly, the publicity surrounding
the Northern Rock's approach to the Bank of England for liquidity,
under lender of last resort arrangements, and the alarmist terms
in which Northern Rock's actions were portrayed in sections of
the media, were instrumental in undermining depositor confidence
in the bank.
Secondly, Northern Rock's falling
share price worried depositors. This was illogical, as it had
no impact on the safety of their savings, but it served to add
to their sense of unease.
Thirdly, the bank's regulators failed
to communicate effectively to reassure depositors. In essence,
they failed to speak plain English: assurances from the FSA that
Northern Rock was, for example, "solvent" cut no ice
with the bank's retail customers because it is not a term that
is widely understood by non-technicians. (Whilst it is questionable
whether better communications could have avoided a run on Northern
Rock, given the impact of other factors, the poor quality of communications
seems likely to have contributed to depositor unease).
The functioning of the Tripartite system, including
the memorandum of understanding, and the actions undertaken by
the Tripartite authorities during the crisis, both in relation
to the overall market, and the situation regarding Northern Rock
8. It is difficult for those not closely
involved in the Northern Rock crisis to assess the extent to which
the problems that occurred and the mistakes that were made were
due to the tripartite systemand the degree to which these
could have been avoided under a different approach. But, what
is clear is that:
Northern Rock pursued a risky business
model, notwithstanding regulatory scrutiny from the FSA.
The publicity surrounding the Bank
of England's lender of last resort arrangements meant it could
not operate effectively and it is questionable whether future
support for individual institutions is possible under the MoU
as it is currently constructed.
Communication from the parties to
the tripartite agreement appeared disjointed particularly in the
early days of the crisis, and added to the sense of confusion.
This was perhaps reflective of a lack of emphasis, in the tripartite
Memorandum of Understanding, on the importance of effective communication.
One of the MoU's four guiding principles is transparency, but
under this principle the document refers to the public's understanding
of each authority's responsibilities, rather than to how communication
takes place in a crisis.
The apparent change in the Bank of
England's policy of not offering three month liquidity to banks
that encountered difficulty as a result of the credit crunch created
uncertainty and contributed to the panic among Northern Rock savers.
Changes that may be required to the regulatory
requirements regarding liquidity
9. The main high level requirements for
banks and building societies on liquidity risk systems and controls
are in chapters SYSC 4, 5, 6, 7 and 11 of the Senior Management
Arrangements, Systems and Controls part of the FSA Handbook. The
current, separate, detailed liquidity requirements for banks and
building societies have been in place for a number of years, pre-dating
the establishment of the Financial Services Authority.
10. It is essential that any changes to
the liquidity regime arising from the current crisis are not designed
solely to address the funding model of Northern Rock, but are
tailored to take account of the funding models of building societies
11. Earlier this year both the Basel Committee
on Banking Supervision and the Committee of European Banking Supervisors
started looking at international requirements for bank liquidity.
There are a number of different liquidity regimes for deposit-takers
around the world (and within Europe), and it would be appropriate
for any changes that may be thought useful in light of the Northern
Rock experience to be viewed in the context of the regimes applying
elsewhere. We understand the FSA is preparing a discussion paper
for issue later this year on possible changes to current UK liquidity
Lessons for Lender of Last Resort operations conducted
by the Bank of England
12. The main lesson to be drawn from the
Northern Rock experience is the need for the Bank's lender of
last resort operationsand other liquidity operationsto
be carried out with the maximum possible discretion. If the industry
is to have confidence in the process in the future, it is essential
that all contact between the Bank and individual banks and building
societies is conducted as confidentially as possible, and with
due regard to the public's possible reaction if and when the news
breaks. Ultimately, it was public perception of Northern Rock's
appeal to the Bank of England for an injection of liquiditycompounded
by widespread and possibly alarmist media coveragethat
led to the run on the bank. This must be avoided in the future.
Any other regulatory changes that may be required
in the light of recent experience within the financial system
13. The overriding principle governing any
regulatory response to the current financial crisis is that it
should be proportionate and well-thought through. There are real
dangers in any regulatory overreaction.
14. One lesson of the US sub-prime crisis
is that there is a need for greater transparency in relation to
asset-backed securities. This is necessary so as to provide better
information to the holders of ABSs about the performance of the
underlying assets, in order to ensure more accurate pricing of
risk and help prevent major jolts to the market and stasis, such
as that created over the past few months by uncertainty about
the extent of institutions' exposures to the risks represented
by ABS holdings.
15. In light of uncertainty surrounding
the respective responsibilities of the parties to the tripartite
MoU, there is speculation that HM Treasury will assume a more
controlling role. This is unlikely to be an optimal outcome. Whilst
the Treasury has access to taxpayers' funds necessary to effect
any bailing out, those best placed in a crisis are likely to be
those with detailed hands-on knowledge of the financial institutions
involved, ie FSA, and those charged with safeguarding financial
stability, ie the Bank of England. The answer may lie not in a
shift of responsibility to HM Treasury, but in greater clarity
in the respective roles of all three parties.
The current position regarding Northern Rock's
depositor guarantees, and the Government's balance sheet
16. A distinction should be drawn between
the Government's guarantee of those Northern Rock deposits that
were extant at the time of the run on the bank and the guarantee
on all subsequent deposits.
17. The Government's guarantee of Northern
Rock deposits extant at that timewhich it announced on
17 September (and clarified on 20 September)was probably
unavoidable in order to stop the run on Northern Rock and minimise
the potential for wider contagion. It also provided necessary
confidence to Northern Rock's market counterparties to roll-over
pre-existing lines of credit to the bank.
18. The case for the extension of the Government's
guarantee to all subsequent deposits, announced on 9 October,
is far less clear-cut. The BSA is concerned about the impact this
may have on the market for retail savings, in which building societies
are direct competitors of Northern Rock. The Government itself
acknowledgedin its press release of 20 Septemberthat
to extend the guarantee arrangements to future deposits would
"be unfair to other banks and building societies".
19. Although the extension of the Government's
guarantee to future deposits was accompanied by assurances of
safeguards to ensure that Northern Rock would not be able to exploit
the guarantee to its advantage, the pricing of some of the bank's
products suggests this may not have been as effective in suppressing
the pricing of Northern Rock products as might have been hoped.
This is a matter the BSA continues to monitor.
20. It is not in the interests of the wider
market for the Government guarantee to remain in place longer
than is necessary. Equally, it is clear that the Government guarantee
cannot be removedfor existing Northern Rock customerswithout
risking a further run on the bank. Accordingly, it is essential
that Northern Rock is taken over as soon as possible by a company
that is able to meet all its liabilities and restore customer,
and market, confidence in the bank. Any prospective new owner
of Northern Rock is likely to need reassurance that Government
guarantees will remain in place for a period after any transfer
of ownership. The Government needs an exit strategy but, currently,
it is hard to imagine what this might be.
Possible modifications to the Financial Services
Compensation Scheme, including, but not limited to, limits of
deposit protection, funding of the scheme and payout times, in
the light of the publication by the Tripartite Authorities on
11 October of a document entitled Banking reformprotecting
depositors: a discussion paper
21. The BSA is currently considering the
discussion paper on depositor protection and we plan to respond
to the Tripartite Authorities by their December deadline. We recognise,
of course, that the Northern Rock problem may well have damaged
consumer confidence in other banks and, possibly, in the wider
deposit-taking sector. However, it is essential that all issues
surrounding the Financial Services Compensation Scheme are considered
thoroughly. For example, in considering whether to increase the
limit of deposit protection beyond £35,000, certain important
factors should be judged carefully; namely
The £35,000 limit gives 100%
cover to a very high proportion of depositors. BSA analysis
of the distribution of savings within the building society sector
shows that approximately 95% of individuals saving with a building
society have balances of £35,000 or less.
The FSCS is not a substitute for
good regulation. The Financial Services Compensation Scheme
is part of a wider jigsaw of investor protection and financial
stability. Other elements include robust but flexible insolvency
laws, the need for the great majority of firms to be prudently
managed, and good regulation. The FSCS is no substitute for the
regulator taking reasonable steps to seek to ensure that firms
have the crucial building blocks of prudential regulation in place,
including prudent levels of liquidity and capital.
Market distortions and "moral
hazard". There is a risk of market distortion if the
compensation levels for customers of one class of financial services
provider are disproportionately high. It is also the case, as
was illustrated by savings and loans organisations in the US during
the 1980s, that an excessively high compensation limit can cause
moral hazard for both firms and customers alike.
The Funding Review changes.
We await a policy statement from the FSA and revised rules, following
the recent FSCS Funding review. However, the proposed general
retail pool, if implemented, is designed to further strengthen
the FSCS and should reduce the need for other fundamental changes
to the structure of the Scheme.
3. OVERALL FUNCTIONING
Lessons learnt from the effect of US sub-prime
mortgage lending defaults on financial institutions and financial
22. The lessons to be learnt from the US
sub-prime experience have two main components. First, lessons
for the UK lending market arising from the US sub-prime experience.
Second, and perhaps more importantly, lessons arising from the
globalisation of financial markets.
23. There are fundamental differences between
the UK sub-prime lending market and the US market, which support
a conclusion that a crisis, on the lines of that encountered in
the US sub-prime market, is much less likely to be suffered in
the UK. These include:
Significant differences in the products
available in the two markets. In particular, products with heavily
discounted initial interest rates that are prevalent in the US
sub-prime market are much less common in the UK.
The conduct of business of the whole
of the UK sub-prime mortgage market is regulated by the FSA. In
the United States less than half of sub-prime lending is federally
Compared to the US, the UK housing
market continues to be relatively robust and the continuing shortage
of housing is likely to sustain this.
24. The globalisation of financial marketsand,
in particular, the close alignment of the UK and US wholesale
marketsmeans that the institutions that comprise the main
market for the asset backed securities sold by US sub-prime mortgage
lenders are likely to be the same institutions upon which Northern
Rock depended to buy its mortgage-backed securities. The erosion
in confidence in the quality of ABSs issued by US sub-prime lenders
had an indirectbut swiftimpact on the ability of
Northern Rock to conduct business. Such interconnectivity has
brought into sharp relief the need for all interested partiesand
in particular all UK-authorised financial institutionsand
their principal regulator, the FSAto take full and proportionate
account of all relevant risk.