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Select Committee on Treasury Written Evidence

Memorandum from the Building Societies Association


  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 model—more 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 book—and in particular the quality of the lending that underpinned its dramatic growth in early 2007—is 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 societies—due to the higher acquisition costs associated with a retail banking operation—retail 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 system—and 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 and others.

  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 requirements.

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 operations—and other liquidity operations—to 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 liquidity—compounded by widespread and possibly alarmist media coverage—that 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 time—which 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 acknowledged—in its press release of 20 September—that 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 removed—for existing Northern Rock customers—without 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 reform—protecting 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.


Lessons learnt from the effect of US sub-prime mortgage lending defaults on financial institutions and financial stability

  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 regulated.

    —  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 markets—and, in particular, the close alignment of the UK and US wholesale markets—means 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 indirect—but swift—impact on the ability of Northern Rock to conduct business. Such interconnectivity has brought into sharp relief the need for all interested parties—and in particular all UK-authorised financial institutions—and their principal regulator, the FSA—to take full and proportionate account of all relevant risk.

November 2007

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