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Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 180 - 199)



  Q180  Chairman: Were the non-executives in both the FSA and the Court of the Bank of England kept fully informed at all times on this issue?

  Sir Callum McCarthy: Can I explain what we did in terms of the FSA? After the liquidity problems developed in August I wrote to all Board members explaining what we were doing. I wrote to them again in September and gave them a warning that we had a particular problem with an unnamed institution. We briefed them on 13 September and there have been, since then, a series of board meetings in which aspects of Northern Rock have been discussed.

  Q181  Chairman: Back to the initial question: do you believe that the non-executives in both the FSA and the Court of the Bank of England were fully informed at all stages?

  Sir Callum McCarthy: I believe, if I can speak for the FSA—

  Q182  Chairman: You can speak for the Court of the Bank of England because you are on that.

  Sir Callum McCarthy: Yes, but I do have some specific responsibilities as Chairman of the FSA which are different from my responsibilities as a member of the Court; but if I speak as the Chairman of the FSA in relation to the FSA Board, I believe that they were appropriately involved at all stages.

  Q183  Chairman: Appropriately?

  Sir Callum McCarthy: Yes.

  Q184  Chairman: The Court of the Bank England, giving you a non-executive role there, were they kept informed at all stages.

  Sir Callum McCarthy: They were informed and took a particular decision, which was an important decision of the Court, at a Court meeting on the evening of 13 September.

  Q185  Chairman: One final question from me. On the day we had the Governor of Bank of England in (20 September), the Financial Times did a front-page story where it was talking about property: "Hector Sants urged the banks to lend to each other, but Mr King did not respond fully." Why did your spinners in the FSA feel it was necessary to go to the Financial Times that morning before the Bank of England came along?

  Sir Callum McCarthy: I am sorry, it is not a reporting of events that I understand. I believe that that refers—

  Q186  Chairman: John must have been telling me the FSA's risk people and spinners were out fully just before they came to our Committee. That just seems to undermine the Tripartite agreement with the Bank of England that the FSA are supposed to work in tandem?

  Sir Callum McCarthy: All I can say, Chairman, is you are making statements which I do not recognise.

  Q187  Chairman: You should read the Financial Times of 20 September. If you read those statements, you would see yourself that it was the FSA getting their oar in first.

  Sir Callum McCarthy: I repeat, these are allegations which I do not know.

  Chairman: I do not think you can react as simply as that, Sir Callum, when you read that report. Michael.

  Q188  Mr Fallon: Could we turn now to the events leading up to this fiasco. In your letter you admit that you had not carried out a full risk-assessment of Northern Rock since February 2006.[1] That is 18 months ago. Why was that?

  Sir Callum McCarthy: Because it is—. I think I would draw a distinction between the formal examination that we do under something called an "Arrow process" which, as you say, was carried out on a particular date, and the interim work that was done. If I may, I will ask Hector to describe that interim work.

  Q189  Mr Fallon: I just want to know why a full assessment was not done in the 18-month period between the last one and the problems that Northern Rock ran into?

  Mr Sants: I will be happy to answer that. There are two points to make, first of all. The full arrow assessment, even for high impact firms under close and continuous supervision, of which Northern Rock is one, is not done at a frequency greater than every 12 months or so in terms of normal practice.

  Q190  Mr Fallon: Every 12 months?

  Mr Sants: Between 12 and 18 months. The most frequent assessment we would do would be 12 to 18 months. What we do, however, is engage very closely with specific thematic issues of concern, and Northern Rock were regularly visited by supervisors, roughly speaking (and I do have a full list here), on two to three months or so intervals. If I may finish, I would like to say something about our supervisory practices.

  Q191  Mr Fallon: Can you just answer the questions that we put to you. I want to know when was the next full assessment due?

  Mr Sants: The next full assessment due would have been three years after the one in question, and, in my opinion, that is inadequate.

  Q192  Mr Fallon: You are dealing with a bank which is lending quadrupled from 25 billion to 100 billion, that was taking one in five of the mortgage market, and you only did a full assessment every three years.

  Mr Sants: As we lay out in the statement we put before you, I completely agree with you. I think there are lessons to be learnt here with regard to our supervisory practice and I think we do need to look back over our engagement with this particular company and do a lessons-learned exercise, particularly with regard to particular areas. I think we need to look into our assessment of probability with regard to the set of scenarios that actually did develop. We did have this organisation as a high-impact organisation, but in terms of the probability of it getting into difficulty we had it as low-probability, and there was no question, of course, looking at the way events transpired, that that probability analysis has been proved to be incorrect, so we had some serious lessons to be learned in terms of the way we went about measuring our probability, and linked into that, which I think links into your point about the Arrow risk assessment, which I completely agree with, is that we need to look more carefully at the stress testing issues in relation to this company. I think the question is not: did we understand the Northern Rock business model? I think we did completely understand the Northern Rock business model and I would not, by the way, agree with your analysis of how the Northern Rock business model worked, but what I would agree with absolutely is that we did not engage in our supervised process in a way to my satisfaction with regard to the stress testing scenarios, because the stress testing scenarios which they were operating with did not envisage the set of circumstances that transpired in August, which was complete closure to them of all reasonable funding mechanisms, including the repo market. I have to say, I do not think any reasonable professional would have anticipated that set of circumstances, but I think as a regulator we should have engaged with that in an extreme stress test. Indeed, we had been saying over the previous period, in anticipation of market conditions declining, that we wanted firms to take a more extreme view of their stress testing; and we had that engagement with Northern Rock in July when we went to visit them with regard to their stress test and pointed out that we were not comfortable with their scenarios, but, regrettably, as is apparent to us all, that was rather late in the day. So, we take the view that we should look at our supervisory practices and we agree with you to that point.

  Q193  Mr Fallon: That is quite a long answer. Could you answer the questions as briefly as you can? You have a budget of 300 million; you employ 2,659 staff. How many were supervising Northern Rock?

  Mr Sants: In terms of direct supervision it, it would be three, which is standard practice for high impact firms, and, of course, they are drawing on groups of specialist individual in the area such as stress testing and risk-management and these areas would also contribute to the visit programme.

  Q194  Mr Fallon: Was Northern Rock treated as a small bank?

  Mr Sants: No, it was treated as a high impact bank under close and continuous supervision—one of our top 160 high impact close supervision organisations—so it was treated at the same level as the other major UK banks in terms of its supervisory engagement.[2]

  Q195  Mr Fallon: Why do you think now its exposure to a freeze in new securitisations was not picked up earlier?

  Mr Sants: As I said before, I think that the set of circumstances that transpired in the market were highly unusual and was not, I think, in fairness, anticipated by any regulators around the world; nor, indeed, if you look at the individual commentators. Some, of course, or a number, may have been pointing out the share price was too high; there was nobody really anticipating that set of circumstances. It is not just a question of the securitisation market being closed to them for a prolonged period, it is also a question of other mechanisms of wholesale funding, in particular the repo market being closed. As we indicated, they had high quality assets—there is no suggestion here this is an organisation taking on poor quality assets—and it really is an extraordinary set of circumstances which lead to them being unable to repo those assets for a period of six weeks or so as well as the combined closure of the securitisation. One final point, if I may, because I think it is important to understand, they did not actually have a complete closure of the wholesale funding market here. As we pointed out in our note, what happened was the duration of that funding shortage shortened to the point that they were funding over night. They were not not funding this themselves. What happened, however, was that with the duration shortening the Board very properly (and I think quite rightly, and we would agree with that) took the view that they needed the insurance of opening up a facility with the Bank of England. They would not have had to use that facility, or it may well have been that they would not have had to use that facility unless there had been a retail run. So, to focus solely on the securitisation issue and the fact that market was closed as the sole driver in the set of circumstances that have taken Northern Rock to where it is now would be incorrect. We need to look at it as a combination of circumstances which included the retail run as a major driver of their problem. They were not using the Bank of England facility until the retail run.

  Q196  Mr Fallon: Why were they allowed a waiver under the Basle II Directive? Why were they allowed a waiver in June?

  Mr Sants: The Basle II waiver is standard procedure of the implementation of the CRD and was the standard procedure we were going through with any bank who wished to apply for one at that stage. The actual change in their regulatory Basle II surplus at that point as a result of that waiver was only some 30 million, which I do not think in the context of the problem that we are talking about is significant. It was basically a standard process. It should not be seen as a one-off special exercise on their behalf.

  Q197  Mr Fallon: But in their interim report it says, "This means that the benefits of Basle II enable us to increase our 2007 interim dividend by 30%. You allowed them to weaken the balance sheet and, as a result, they increased their dividend?

  Mr Sants: It clearly is the case, as the statement makes clear, that it gave the Board confidence in relation to their dividend increase, or at least that is how the statement describes it, but I will be clear, under their Pillar 1 capital, even under Basle I, they could have paid that dividend. As I say, this was a standard procedure that we were going through at that time in terms of implementation of the CRD.

  Q198  Mr Fallon: Paul Tucker from the Bank sent you a memo in early July warning of the potential dangers of a liquidity freeze. Why was nothing done until early August when the retail market dried up?

  Mr Sants: It was actually 1 August, the memo in question, and I completely agree with the contents of the memo. Indeed, as we pointed out when I took over the chief executive role at the end of July, I made a great point in the press conference that I thought market conditions were deteriorating. I do not think that the content of the Paul Tucker memo is materially different from the general sentiment that I was expressing in that press conference. I completely agree with him. I think, once we saw the beginnings of the problems in the US sub-prime market beginning to develop, it was reasonable to assume that we were moving into a more difficult period here in the UK and, as I have mentioned earlier, we did already step up our engagement with the market place, convening more regular meetings around the current issues, and as I mentioned earlier as well, we were actually in dialogue with Northern Rock over their stress testing scenario during the course of July. Paul Tucker's memo I say is actually the first week of August.

  Q199  Mr Fallon: But there was already a profits warning from Northern Rock; you had the memo on 1 August; why did it take until 14 August for you to alert the tripartite and Treasury ministers as to the problems that Northern Rock had? Why was there a gap?

  Sir Callum McCarthy: I was simply saying that it was the events around 9 August which resulted in the fundamental drying up of so many markets, both in terms of securitisation and asset-backed, commercial paper, asset-backed, and in so many geographical markets and currencies, and I think the speed with which we have responded to that is perfectly reasonable.

1   Ev 220 Back

2   Note from witness: I commented on the number of the FSA's high-impact supervision organisations which were similar to Northern Rock. The number I provided was actually the number of high-impact assessments (ie the same as Northern Rock) that the FSA was carrying out at that time; this is not the same as the number of high impact firms. The number I provided-160-was not current. The correct figure should have been 131. Back

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