Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 200 - 219)

TUESDAY 9 OCTOBER 2007

SIR CALLUM MCCARTHY AND MR HECTOR SANTS

  Q200  Mr Fallon: Why was there a five-day gap from 9 August to 14 August before you alerted the Treasury?

  Sir Callum McCarthy: Because the identification of Northern Rock was a reasonable thing for us to consider. The ninth to the fourteenth does not seem to me of particular materiality in this. You may take a different view.

  Mr Sants: If I can maybe amplify a little bit. Certainly as of the ninth we were in regular discussion with Northern Rock in monitoring their liquidity, but if you look at their liquidity availability in terms of days, which is a way of looking at their liquidity regime, you are not actually looking at a significant deterioration in their profile until well after 14 August. So we properly identified that, because of their dependence on securitisation, which required them in general to do around £5 billion of securitisation in a quarter, with the closure of the markets this was potentially an at-risk firm, but the actual deterioration in the profile does not occur until well into September and, indeed, it was not until 10 September that they reached a conclusion that securitisation was not going to be possible. They were actually in negotiation, as you know from our memo, with a number of banks about the possibility of doing under-written securitised transactions during that period. So, in terms of alerting the Treasury to the fact that we anticipated a significant issue with Northern Rock, which was done by myself on 15 August, I would say that was very early to alert them to specific concerns about a specific firm in the light of the liquidity information we had available and not in the light of our knowledge of the business model. So I think we very quickly identified that that business model was at risk. Also in passing, whether we had told the Treasury on the fifteenth or a few days earlier would not have made any difference to the set of circumstances that transpired.

  Q201  Mr Fallon: Sir Callum, you were quoted on a BBC website in September as describing Northern Rock's heavy reliance on short-term loans to fund its mortgage business as "extreme". When did you first come to the conclusion that Northern Rock's business model was extreme?

  Sir Callum McCarthy: I actually said the business model was extreme but it was in relation to the fact that they had a heavy dependence overall on what I will loosely describe as wholesale funding. Their overall pattern of funding was around more 70% from securitisation, covered bonds, long-term, and in that respect they are an outlier in terms of most British banks, though not necessarily banks in other countries. I would point out that that is not necessarily a source of vulnerability, the long-term funding, because those long-term funds can match the assets that people have.

  Q202  Mr Fallon: What is the answer to my question? When did you first realise that this model was extreme?

  Sir Callum McCarthy: In terms of its reliance on securitisation in terms of the overall balance sheet, that was something that was well-known. I do not know what time in the last two years, three years I became aware of it, but it was well-known that that was a particular feature.

  Q203  Mr Fallon: You were in charge of supervising Northern Rock, you were aware that its business model was extreme, yet over the last two years nothing was done to prevent this particular crisis.

  Sir Callum McCarthy: No, that is not a description of events that I would recognise. I have tried to explain that my comment on "extreme" related to the overall balance sheet of Northern Rock. The particular problem, as Hector has explained, related to the short-term funding, and the short-term funding is a problem which has been acute but has been caused by the fact that they had access to securitisation, to covered bonds, to commercial paper and had high quality assets to repo, and they did that in euros, in dollars, in sterling, and all those markets, including the repo market, closed and that is an exceptional, indeed unprecedented, set of events to have occurred for the duration and severity that has occurred. I absolutely accept, as Hector has said, that we did not identify the probability of that happening. I would also say that very few people and no regulator that I know anywhere round the world have succeeded in identifying that.

  Q204  Chairman: To clear up, Mr Sants, you said you had three supervisors for high impact banks of which Northern Rock was one and there are 160 institutions that are high impact. Is that correct?

  Mr Sants: Yes, I am saying that depending on the high impact institution, the number of supervisors tends to vary between about two and six so three was a fairly standard number within our normal range for high impact banks. Even the biggest UK financial institution would not have more than six or seven supervisors.

  Q205  Chairman: I have spoken to a number of the biggest UK financial institutions in the past week in preparation for this inquiry and one of them in particular told me that FSA have had a line side-team dedicated to them and over a year they could see 1,000 to 1,200 people in the FSA in terms of supervision. The group risk director is almost in intimate contact with the FSA almost on a daily basis and the FSA are coming in for themed visits—for example safety, private equity—so there is intensity there. That was described to me, that intensity. Are you saying the same intensity was provided to Northern Rock?

  Mr Sants: I am saying that certainly in the period in question during the second half of 2006 and early 2007, yes, I was answering the very direct question, possibly not giving a full answer in that respect of the precise number of dedicated supervisors in our supervisory group, but the supervisory model is like that of other investment banks, as I have indicated earlier, namely you have coverage supervisors, you have the relationship with the bank and then you have a series of specialist teams who regularly visit the bank on particular issues. So, the question, for example, of stress testing would be addressed by a specialist team who come and visit to look at the stress test, and that was the visits that were carried out in this case in April and May 2007 and, indeed, we also have teams looking at the securitisation process and so forth during that period. So, if you are asking the question about the total number of people involved in the FSA engaged with Northern Rock, you would have a much higher number.

  Q206  Chairman: The question I am asking, before we go on, was it of the same intensity as your relationship with say the big banks?

  Mr Sants: Yes, for our high-impact institutions we have the same coverage model, which includes all the specialists that you refer to.

  Q207  Mr Todd: Can I get some procedural stuff straight. In your annual report you refer to stress testing: "We reviewed the stress testing practices in ten large firms in the banking, building society and investment bank sectors. Was Northern Rock one of those ten?

  Mr Sants: No, it was reviewed in May.

  Q208  Mr Todd: So it was reviewed after this report was concluded?

  Mr Sants: Yes.

  Q209  Mr Todd: So you did have a stress test under this model that is referred to in your annual report in May?

  Mr Sants: We reviewed their stress test in the context of their Basle application, and it was that review which led to the conclusion being reached in July, which I referred to earlier, that their stress testing could take into account more extreme scenarios than they were and, as I have already acknowledged in the earlier statement, I think, in terms of our lessons-learnt exercise, we do need to return to our supervisory engagement with the stress test.

  Q210  Mr Todd: You have said what is later said in your annual report in the same paragraph in which you say (and this was after seeing the ten firms which did not include Northern Rock, and so presumably you had already worked out some of the inadequacies in your stress testing then) that further improvements were needed, particularly where firms were not fully taking into account severe but plausible scenarios when making strategic all-risk management decisions. So you already had some intelligence from the stress testing models that you had applied elsewhere than Northern Rock on the perhaps limited compass of that exercise. Did that not give you any hints as to the insight you ought to apply to a business model which I think Sir Callum was not alone in regarding as an outlier in this market place?

  Mr Sants: I agree with you. As I said before, if you look at the type of stress test Northern Rock was using, they were not anticipating closure of the securitisation market and the repo market. The only set of circumstances actually which they had in which those type of closures occurred were operational failures rather than market failure and, as I said earlier, I think that type of scenario should be in a stress test; and we would like to see more extreme stress tests and we were making those points, as you kindly point out, in the document in question, and it is incumbent on us to make sure that we carry that through with all the major firms that we regulate, and I think that lessons learnt point, as I have said before, needs to be picked up in our supervisory practices and we will be returning to—

  Q211  Mr Todd: My point was a slightly different one, which was that from what one can understand from your annual report, which refers to a period before this, you were already learning some of those points about the lack of testing of severe but plausible scenarios. Presumably this particular scenario did not fit into your category of severe but plausible. You regarded it as wholly implausible, did you?

  Sir Callum McCarthy: I think it was unprecedented, and I would say that we have for some time been emphasising the importance of severe but plausible. I would also point out that that is a matter of judgment, it is particular to any institution and it is quite difficult to decide what level of stress to test against.

  Q212  Mr Todd: Can I follow this line of argument a little further? We have got again in your Annual Report, if you turn to 66, 67, the role of the Risk Committee of the FSA—and you have already referred to one of the august members we met earlier. In the list of risks that the Committee does consider one can see some resemblances to some of the issues that have occurred in this particular case. Is it perhaps the case that this Risk Committee treated this as a rather academic exercise of running through risks in a routine way or did not actually consider this in the depth that one might expect? What was this risk committee actually up to?

  Sir Callum McCarthy: Perhaps I could describe the Risk Committee of the Board. It is chaired by Hugh Stevenson; its members are Deidre Hutton, Peter Fisher, who is ex New York-fed, New York based, both an ex-central banker and an investment banker nowadays, David Miles, whose proper title, I think, is the European economist for Morgan Stanley, and John Gieve.

  Q213  Mr Todd: They are not lightweights.

  Sir Callum McCarthy: They are absolutely not lightweights and were carefully chosen for that reason.

  Q214  Mr Todd: They have big reputations anyway!

  Sir Callum McCarthy: If I may say so, the idea that they were looking just at what I think you described as academic points is absolutely not the case. They looked at a variety of issues and those included the credit risk, derivative risk, the sub-prime risk in the US; so they were examining those—

  Q215  Mr Todd: I have got that. We are tight for time. I just want to explore the linkage between your Risk Committee and the stress testing models that you have used. Is there some linkage? You have just touched on one issue, sub-prime markets and its possible implications. Is there any linkage in which the risk committee communicates to those who deliver this process on the ground?

  Sir Callum McCarthy: Yes, indeed. One of the responsibilities of the Risk Committee is to examine the way in which the FSA mitigates against the risks that have been identified.

  Q216  Mr Todd: You prepare fact books. Was there a fact book on Northern Rock?

  Mr Sants: A fact book is a very particular statement about a particular set of data which we are preparing for the Tripartite, and that is an electronic set of data which is held on a particular IT system and is not yet completed for any institution currently in terms of a central IT depository. We carry data of the same nature on all major high-impact institutions. So the answer in that sense is yes.

  Q217  Mr Todd: I am sorry, the answer is yes but you sound as if you are at an early stage. It sounds as if the answer is no actually.

  Mr Sants: I am slightly confused by your question. If you are asking me is the FSA holding the same set of data on Northern Rock as it does on the other major UK institutions, the answer is yes. If you are asking a very particular question about an IT system, the answer is no because it is not generally ready, it is in development.

  Q218  Mr Todd: Even though actually this was referred to as to something that was needed back in October 2005?

  Mr Sants: Yes, I agree. It would be a useful tool for speedy decision-making.

  Q219  Mr Todd: It is one of these projects which is rolling away gently in the background.

  Mr Sants: Yes. It would be a useful tool for speedy decision-making, but in the context of this issue, which arose over a long period of time, I do not think it is a relevant gauge of our handling of it.


 
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