Examination of Witnesses (Questions 180
TUESDAY 9 OCTOBER 2007
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
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
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
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
Sir Callum McCarthy: I am sorry,
it is not a reporting of events that I understand. I believe that
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
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.
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 supervisionone
of our top 160 high impact close supervision organisationsso
it was treated at the same level as the other major UK banks in
terms of its supervisory engagement.
Q195 Mr Fallon: Why do you think
now its exposure to a freeze in new securitisations was not picked
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 assetsthere is no
suggestion here this is an organisation taking on poor quality
assetsand 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
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
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