Examination of Witnesses (Questions 240
TUESDAY 9 OCTOBER 2007
Q240 Chairman: That was actually
established under charity law and actually owned by a Channel
Island subsidiary of the Law Debenture Corporation. Does that
not seem a totally artificial construction to shift liability
and avoid responsibility? Did the FSA not smell a rat?
Mr Sants: It is possible with
regard to the Granite structure. We would probably have to come
back to you with the detail of that proposition. I am not totally
convinced. We might be talking at cross purposes here, so let
me give you a written reply with regard to the Granite structure.
Q241 Chairman: I would welcome correspondence
on that. Have you spoken to the Northern Rock auditors to find
out why they were content with this and, if you have not, can
you include that in your correspondence to us?
Mr Sants: We would certainly be
happy to do that.
Q242 Mr Love: Can I just be clear
from one of your earlier answers, Sir Callum, that what you said
was that the reason why Northern Rock has got a high quality loan
book is that they have passed on all the bad risk to others?
Sir Callum McCarthy: No, I said
that one part of it is that the sub-prime business that they do,
which is very limited in scale, has actually been passed on to
others. That is true, but that is not the only component that
results in their having a quality set of assets.
Q243 Mr Love: Going back to questions
that were asked earlier on, we know that Northern Rock were taking
up one in every five mortgages; so there was a massive expansion
in the loan book. We know from American experience that because
a lot of these banks like Northern Rock were passing on the risk
through securitisation, the lending practices had become somewhat
suspect. Are you concerned about that in the Northern Rock instance?
Sir Callum McCarthy: We are concerned
about that across the board, which is why, since we took responsibility
for mortgage brokers, we have been consistent in looking at the
standards that have been used and have taken significant enforcement
action across the board.
Q244 Mr Love: If I extend the American
experience, I think almost all commentators say that the high-risk,
if you like, sub-prime mortgage effect grew exponentially in the
last months before the crisis hit. Is that the case? Have you
been able to track the quality of the loans that Northern Rock
were making as they grew to consume one in every five mortgage
and is that a continuing concern for you?
Sir Callum McCarthy: Can I just
deal with the fact that Northern Rock did get a significant increase
in market share in the first half of this year. The first point
I would make is that the mortgage market is a competitive market
which has quite considerable swings in market share from quarter
to quarter, and that is not unusual and it is not something which
in itself we should take action about; this is a competitive market.
What we should be concerned about is the effect of that on the
actual financial ability or capabilities of any firm, and I think
that is something which we looked at the carefully and I think
Hector has got the figures on it.
Mr Sants: Yes, as you rightly
point out, clearly the balance sheet for loans to customers did
grow in the first half of 2007 something of the order of £10.7bn
extra loans net to customers. It is an increase, but I think we
need to put it into perspective. The second half of 2006 was £9.3bn,
so clearly an increase, as you say, growth, but I think we need
to have a context there. But also, critically, back to our earlier
conversation, if I may, we are talking about the vulnerabilities
which resulted from that business expansion to its funding process
and actually where you look there, a degree of that was covered
by increased retail deposits, probably around two billion or so,
and the actual amount of quarterly securitisation which, back
to our earlier conversation, of course, was what they failed to
do when they subsequently encountered the market turbulence, in
terms of volume did not change hugely. In the first half of 2006
that was about £5.8bn, in the first half of 2007 it was £5.6bn.
So their dependence on what we previously identified as being
the issue here, the securitisation volume, did not actually materially
change too much at the time their balance sheet was expanding.
So, yes, absolutely, a period of growth should well be a signal
for regulators to take increased interest (back to my earlier
point there) but I think if you look at the actual impact on the
securitisation programme, that growth has not really been the
point at issue here.
Q245 Mr Love: Before I come to the
securitisation programme I just want to be absolutely clear. Of
course, in general terms, competition is a good thing but there
is also a negative impact of competition in that in the desperation
to sign up mortgages the lending practices will be set aside to
some extent. Was there any concern in the FSA in relation to that?
Mr Sants: I think, as you rightly
point out, you should always be concerned where you see market
share growth and the question always has to be asked, therefore,
around the conduct around that. Of course, being able to tell
at this stage whether or not there were improper practices in
terms of the quality of the mortgages, it is traditional when
you are securitising mortgages to wait for a period of seasoning
to see what happens to the performance. So, in terms of looking
at the financial data, it is difficult to tell at this point.
In terms of mortgage practise, from our point of view we have
no evidence of this at this stage to say that their practices
were out of line with quality market delivery. Do bear in mind
on this sub-prime point that we are only talking here in the UK
around 8% of the UK market being sub-prime relative to around
25% in the US. We do not have any particular signs of the sub-prime
market growing, and, indeed, probably as a result of recent market
events it will contract a bit, and there is a genuine social purpose
in the sub-prime market, which is to deliver affordable housing
to some. It is a question of whether the practices that go alongside
with that are reasonable.
Q246 Mr Love: Let me ask you: looking
at it now should the FSA have reigned in the aggressive growth
strategy that Northern Rock has been pursuing?
Mr Sants: I think relative to
the funding issue which was the cause of the problem that they
have put themselves into, it does not seem to me that the particular
market share increase in those few months was a trigger that we
should have been particularly concerned about. I do think we should
have been concerned around the stress testing issues that I referred
to earlier. So, I am more than happy to indicate, I think there
are some significant lessons to be learned, but I am not sure
that the market share point is particularly the critical point
in terms of identifying the driver that led to their problems
and the scenario that we should have envisaged.
Q247 Mr Love: I am not absolutely
clear. At any stage in your discussions with Northern Rock did
you highlight the strategy they were pursuing? Did you say there
might be significant risks involved in it? Did you try in any
way to discourage them from being as aggressive as they turned
out to be? What role did you play? Obviously you were monitoring
them. Were you advising them and did that advice include: "Hey
guys, this could be very risky for you"?
Mr Sants: Yes, but as I have said
earlier, I think the intensity of that dialogue, at the time of
the original arrow visit and subsequently, should have been more
forceful. I think those points were being identified by July when
we were engaging in the discussion around their stress test, but
obviously at that point in time events overtook the firm. I want
to be clear here, and I know you are questioning the FSA, but
let us remind ourselves, it is the Board's responsibility to run
a company prudently and the stress test scenarios are designed
by the Board, not by us. We do not give prescriptive stress tests
to firms; we think it is the job of firms to identify the right
set of stress for themselves, but I agree with you, yes, we should
have been in more intensive dialogue with the company earlier.
Q248 Mr Love: Is there any evidence
to suggest that they changed any of their practices, any of their
aggressive growth strategy as a result of the discussions they
had with you, because we cannot see any. Is it the case that they
ignored entirely what you were saying to them?
Mr Sants: As I have said before,
I think the stress test that they were operating with and their
funding policy statement set out in 2006 did not anticipate the
severity of the market downturn, and when we get to July 2007
that was still the case, which is why we were intensifying our
dialogue with them.
Q249 Mr Love: There have been suggestions
that actually you should not have treated Northern Rock as a bank
but more as a finance company. They took in mortgages for mortgage
brokers and they securitised them. That is effectively the direction
in which they were going very aggressively. Do you have any sympathy
with that argument and should you have dealt with them slightly
differently from the way you would deal with ordinary retail banks?
Mr Sants: As we have mentioned
before, the use of wholesale funding is not in any way an unreasonable
tool in the funding proposition for a bank and, indeed, securitisation
programmes per se which create long-term secure funding are in
fact a very good source of funds. May I remind you here that the
ultimate problem here is a retail run which reminds us that we
should not necessarily equate retail deposits with having greater
stability than long-term securitisation products. I think in terms
of the way we address this supervisory issue, I realise I am repeating
myself and I do agree with you, I think the stress test should
have been looked at.
Q250 Mr Love: Let me ask you finally,
Victoria Mortgages has gone into administration now. We all accept
that was a very small bank, that it was completely in securitisation,
but are there any other problems out there of a larger nature
that you are aware of and are concerned about?
Mr Sants: I think in terms of
the wider public interest you can reasonably expect me to say
that would not be a question I would ever want to answer in terms
of particular companies. I am sure you appreciate that.
Q251 Mr Love: Are there any other
continuing problems in the market place?
Sir Callum McCarthy: Could I make
clear that that is an answer which Hector or I would give in good
times or bad times. It is, as a question of principle, a question
that should not be answered and I do not believe would be answered.
Chairman: That is okay. I anticipated
that would come from your lips. Do not worry about that. You mentioned
about Northern Rock. We are having the company before us next
week, so I will be sending you a letter after this hearing in
terms of your relationship with the Northern Rock Company so we
can be ready for that. We then go to Peter.
Q252 Peter Viggers: When the so-called
Tripartite system of regulation was set up in 1997 by the former
Chancellor of the Exchequer some commentators said the system
would prove inadequate in a crisis, and, of course, so it is proving.
Of the three authorities you are quite specifically made responsible
for the prudential supervision of banks and building societies,
so if something goes wrong it is your fault. I assume you would
not wish to disagree with that.
Sir Callum McCarthy: I absolutely
accept, and I think Hector has made clear, that we believe that
there are lessons to be learned which we are busy identifying
and will apply in respect of the supervision of Northern Rock.
In that respect I agree. In one respect, I think it is important
to recognise that we cannot run and do not run what is called
a zero-value regime, because if we were to do that we would insist
upon a degree of avoidance of risk across financial services which
would be deeply damaging to the economy.
Q253 Peter Viggers: If I probe the
chronology, it is simply so that we can understand the manner
in which this works. The crisis emerged on 9 August and in the
memorandum to us you say that from 9 August onwards senior management
held daily meetings, increased supervisory activity, passing daily
telephone calls. It does not sound to me like very much co-ordinated
action at that point until 14 August when the Bank of England
Sir Callum McCarthy: No. If I
may say so, from 9 August we set up a daily, and sometimes more
frequently than daily, meeting, which was a telephonic meeting,
of the Bank, the Treasury and the FSA. We exchanged informationI
believe that information exchange has worked wellwe identified
problems and we have agreed actions.
Q254 Peter Viggers: I put it to you
that, whilst you have the duty of supervision, many of the actions
that need to be taken by government lie elsewhere and that real
action in seeking to find a solution only emerged after 16 August
when you set up a project team with the other two regulatory bodies?
Sir Callum McCarthy: No, I think
it was appropriate. I think Hector gave an account of the developing
liquidity problems. I do not believe that it was a mistake not
have to set up those project teams before 16 August and I think
that there was no indication that the date of 16 August was too
late a date.
Q255 Peter Viggers: So who was negotiating
with Northern Rock? Who was discussing actively on a personal
basis the solutions that might emerge? Was it you or was it the
other members of three regulatory authorities, the Treasury and
the Bank of England?
Sir Callum McCarthy: It was principally
the FSA, and we can give you details of the various discussions
and who conducted them if you would like.
Q256 Peter Viggers: What was your
position as to whether Northern Rock should be taken over?
Sir Callum McCarthy: I am sorry?
Q257 Peter Viggers: What was your
position as to whether Northern Rock should be taken over?
Sir Callum McCarthy: One of the
responsibilities that we have under the Tripartite arrangements
are to identify whether there is a possibility of a private sector
solution. We did that and encouraged and closely monitored discussions
that took place between Northern Rock and potential acquirers.
Q258 Peter Viggers: The Governor
of the Bank of England has spelled out to us a number of statutory
and regulatory matters which prevented a takeover of Northern
Rock or an orderly solution to the problems of Northern Rock.
Were you inhibited by those statutory and regulatory matters?
Sir Callum McCarthy: In relation
to the acquisition of Northern Rock by a potential acquirer, I
do not believe that those legal problems were particularly significant
in relation to that possible outcome and my recollection of the
Governor's evidence to this Committee is that he was commenting
on those legal obstacles in relation to the lender of last resort.
Mr Sants: We were quite properly
identifying potential private sector solutions prior to the need
to apply to the Bank of England for a facility. In that prior
period I do not believe that there were any barriers to those
takeovers taking place in relation to takeover rules. It would
have been done in the conventional fashion through the normal
Q259 Peter Viggers: You said in your
memorandum to us that no acceptable structure for a takeover was
identified. What were the main barriers to such an operation being
Sir Callum McCarthy: I think there
were two issues which were significant in terms of the most serious
indication of support. One was the question initially whether
the bidding bank would receive support from the Bank of England,
the second was the terms on which any support would be given and,
as I think the Governor has made clear and has elucidated in a
letter to the Chairman of this Committee, there was a decision
that it would be improper to give support to a bidding bank. There
was subsequently clarity that after the lender of last resort
facilities had been announced for Northern Rock those would be
available on the same terms if Northern Rock were acquired by
a new bidder.
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