Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 240 - 259)

TUESDAY 9 OCTOBER 2007

SIR CALLUM MCCARTHY AND MR HECTOR SANTS

  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.[3]

  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.[4]

  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 was informed.

  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 information—I believe that information exchange has worked well—we 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 framework.

  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 successful?

  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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