Examination of Witnesses (Questions 300
TUESDAY 9 OCTOBER 2007
Q300 Ms Keeble: The code of practice
is presumably voluntary. Given the issues that have been raised
about people not being aware of the risk and the comments that
you have made this morning about risk assessment, do you think
there is a need for something more substantial and robust than
a code of practice?
Sir Callum McCarthy: I think you
will find since we are dealing with a limited number of credit
ratings agencies that there will be no problem, once we identify
what we want, getting them to accept it. I do not think that is
going to be a problem.
Q301 Ms Keeble: Sorry, that kind
of agreement between a small number of people can have other names
other than a code of practice: it can be a gentlemen's agreement,
a cartel, it can be all kinds of things. If we are talking about
transparency of information and certainty, do you think there
is a need for something that is more robust?
Sir Callum McCarthy: If we get
a robust code of practice I believe that we will be able to implement
Q302 Ms Keeble: Okay. Do you think
that there is a need, and Hector you have hinted at this, for
a look again at the liquidity rules, because Northern Rock was
within the rules and a number of other banks have got similar
profiles to Northern Rock?
Mr Sants: There are two separate
points. On the credit agency point, we completely agree with you,
there is work needed to be done as to what use are the institutional
investors making of credit agency material, how do they engage
with it, and is that properly understood and is there proper transparency
with regard to the purposes and backdrop to the conclusions of
the credit agencies' work. Ifand I may be misunderstanding
and I apologise if that is the caseyou are referring back
to my earlier comment about are we satisfied with the way that
we approached the stress testing work that was done in Northern
Rock, I think I have made clear, no, we are not satisfied with
that, and I think we need to address that, and that will be something
I will place as a priority agenda from my point of view.
Q303 Ms Keeble: It was just that
you referred a bit earlier to the need for a look at the rules
around liquidity requirements to which the Governor also referred?
Mr Sants: Yes.
Sir Callum McCarthy: There is
work going on, led by the Bank of England in the Basle Committee
on trying to establish what should be the basis for a new liquidity
regime. One of the difficulties about doing that on a national
basis, which goes back to Hector's comment about it takes longer
to do things internationally than nationally, if you look at any
of the major institutions which operate internationally they run
their liquidity on a global basis and they are very hostile to
having separate national liquidity regimes. We believe it is a
good thing to try and get an international agreement on it, and
that is what we are working to do, and that is what we will intensify
our efforts to do.
Mr Sants: We should try to use
the regrettable circumstances that have occurred to get fresh
impetus behind that initiative. It is one that we have been supporting,
and indeed the Bank of England co-chairs the key Basle Committee
here, but I think there is clearly an opportunity to use this
regrettable set of circumstances to put fresh impetus behind the
Q304 Ms Keeble: Obviously what everybody
wants to make sure of is that this does not happen again. I wondered
how you see the risk if there is future fall-out from the risks
of the sub-prime market in the US and if you feel that you have
got a proper assessment of where the risks are in the system,
and if you have got a proper way of managing them. I think it
comes back to perhaps some of the points that Siôn Simon
was raising about who is going to take the lead on this and how
are you going to make sure that you have got robust enough systems
in place. So far you have only talked about the stress testing
as being the one real, substantial lesson that you have learned
Sir Callum McCarthy: I think you
raise a lot of very big issues in your question. One is that we
have long recognised that risk is now much more widely distributed
than previously through the origination and distribution model
that many banks adopt. One of the issues that has always concerned
us was what was the mechanism for reconcentration of that risk.
One of the things, for example, that has become clear in relation
to major financial institutions is their use of conduits or special
investment vehicles. One of the things that Basle II will help
with is a better identification of the way in which risk can come
back from that on to the major banks, and that, for example, is
an area where (quite apart from the work on stress testing which
Hector described) that we will want to do a lot more work on.
Mr Sants: We should not underestimate
the specifics of Northern Rock and the implications there for
consumer confidence and the FSCS scheme of administration. The
FSCS scheme is within the remit of the FSA and we have committed
ourselves to re-review that. Those issues to do with the wholesale
market were components of what happened and at the end of the
day I repeat the point that the retail run was the critical element
that placed Northern Rock in the situation it is now in, but absolutely,
we need to look at a number of aspects of the framework of the
wider wholesale market.
Q305 Mr Dunne: I would like to probe
a little bit further the comment you just made, Hector, because,
as you explained, the Northern Rock crisis was essentially a liquidity
problem, not a problem with the asset base, and the problem stemmed
internationally from the drying up of wholesale markets due to
the extreme uncertainty over liquidity, security and value of
AAA-rated off balance sheet paper. Do you agree that the wider
collateralised debt obligation market was the primary trigger
to the drying up of the wholesale market?
Mr Sants: Yes, and I think your
point identifies the other aspect of this which was singular and
unusual which is what actually happened as a result of the problems
you have graphically described was the mainstream institutional
investors, who traditionally purchase commercial paper, which
is a fairly vanilla sort of product, lost confidence in the system,
so it is a curious combination not just of structural elements
of actual credit failure but then we had a confidence failure
in mainstream investors which then led to a liquidity problem.
Of course your analysis of the origins of this confidence failure
is absolutely right, and I think that takes me back a little bit
to the credit point that when they lost their confidence, because
these are very complex instruments (which I think takes us back
to where we were a minute ago) they were very nervous to go out
and buy the related revenue flows dependent on those complicated
Q306 Mr Dunne: So when was the FSA
first concerned about price and risk within the CDO market?
Sir Callum McCarthy: I think you
will find that the FSA has been concerned for some time about
the pricing of risk generally, because one of the problems that
we have encountered over the last two years is, because of the
extent of liquidity in the world, there has been a mispricing
of risk, and that has been repeatedly a point we have made. It
applies to CDOs but it applies more generally than that. The work
that we did for example on leveraged buyouts was concerned about
that and other pieces of work were also concerned.
Mr Sants: And, as you know, we
have done a huge amount of work with regard to operational risk
in relation to the credit derivative market, reflecting our understanding
that where you had a credit issue one potential knock-on effect
was operational concerns. This aspect of the crisis was not the
unexpected part; it was the confidence
Q307 Mr Dunne: In that case, you
did not answer the question as to when you identified this problem?
Mr Sants: We were clear in our
February Financial Risk Outlook, which is one of our more
recent publications. I was clear, I believe, in the press conference
in July. I believe my predecessors have been clear in various
other publications prior to that really for the last couple of
years that there was a significant build-up of risk in this area
and a gradual mispricing of that risk that needed to be corrected.
Q308 Mr Dunne: Had you discussed
these concerns with the SEC and other international regulators?
Mr Sants: Absolutely.
Q309 Mr Dunne: Throughout this period?
Mr Sants: Yes.
Q310 Mr Dunne: So why was nothing
more done by yourselves and other international regulators to
slow the growth of this market if you had such fundamental concerns
Sir Callum McCarthy: I am not
sure what mechanisms you believe are available to us to actually
constrain global markets.
Q311 Mr Dunne: Possibly Basle considerations.
Mr Sants: I have made the point
that under Basle II the treatment of off balance sheet capital
in SIVs and conduits will be brought back and more accurately
reflected, so that will be done.
Q312 Mr Dunne: Are you saying that
the regulators have no powers to control the spread of derivative
instruments, which are not well understood either by the market
or by the regulators, there are no tools in your toolbox?
Mr Sants: As a national agency
there are clear limitations on our ability to address those risks.
What we seek to doand I think this is an explanation I
offered the Committee when we were talking about financial stability
earlier in the yearis to control and regulate the central
transmission mechanisms within the UK economy, which are the large
banks and, as Sir Callum himself said, recently the large banks
have gone into this period of market turbulence well capitalised
and well set up to withstand these market shocks. We also place
increased emphasis on our banking sector having effective stress
tests, which takes us back to where we were earlier in the discussion,
but our ability to actually curtail the growth in OTC credit derivatives
markets are clearly limited by our nationalIndeed, you
have to argue it is debatable whether that is necessarily desirable
given the wider arguments about risk dispersion. I think we need
to be clear here that what has happened was a collapse in confidence,
particularly of CP purchasing, and we need to be careful that
we do not undermine some of the beneficial aspects of the growth
in the derivative market as a result of looking at the lessons
learned from this particular period.
Q313 Mr Dunne: Within your risk management
specialist teams do you have individuals who have direct experience
of trading in these derivative markets and understand the nature
of security and risk?
Mr Sants: Yes.
Q314 Mr Dunne: Good. You have touched
on the low probability of Northern Rock getting into difficulty
given the quality of its loan book. Given the role that you have
as banking supervisors, what emphasis do you place on looking
at a bank's share price as a determinant of concerns in the market
about its performance? Would you like to comment on the fact that
the Northern Rock share price declined some 40% in the period
from April to the middle of August in a pretty straight line,
against the bank sector indices, as an early warning sign that
something was going seriously wrong?
Mr Sants: Yes, I think that share
prices are indicators of a variety of different potential issues
and should be scrutinised by regulators. Share prices also, may
I say just in passing, impact retail confidence as well, so there
is a variety of the reasons why we should be properly focused
on the share price. Clearly we saw acceleration of that trend
with the profits warning, to use a colloquial term, and we significantly
intensified our regulatory engagement with Northern Rock at that
point. I completely agree with you that share prices should be
closely monitored by regulators, and they are.
Q315 Mr Dunne: The business model
of Northern Rock was heavily reliant, as we know, on the wholesale
markets and you have just touched on commercial paper. The commercial
paper market is of a one to three-month duration typically. For
a bank as significant as this with long-term obligations stretching
out many years in the mortgage market, do you think it is wise
for funding sources to be so reliant on the short end, and is
this not one of the fundamental tenets of bank practice that you
do not borrow short to lend long?
Mr Sants: To some degree of course,
that maturity transformation does have its uses but actually in
the context of Northern Rock the figures do not suggest that it
was an outlier in respect of its dependency on very short-term
funding. We have discussed previously the fact thatand
I am happy to go back over the ground if you would like me toits
bigger risk factor was its dependence on the use of the securitisation
products which was the market that froze. The actual percentage
of its funding which was dependent on three months or under was
not a particular outlier, and also just to remind us again, I
think it is important to remember that it did not actually fail
to fund itself is this period. What happened was its maturity
shortened back into the overnight period to the point at which
the Board thought it prudent to seek the lender of last resort
facility, and we are all aware of the regrettable consequences
of that in terms of consumer confidence, but it was not actually
an outlier in respect of short-term funding ratios, it was an
outlier in respect of overall wholesale funding, as Sir Callum
indicated earlier, which included the securitisation component.
Q316 Mr Dunne: If it is not an outlier,
does that not suggest that there are many other banks that are
overly dependent on short-term sources of funding and if these
dry up there could be contagion across the sector?
Mr Sants: I tread very carefully
in this space, but of course, as I have mentioned before, it was
specifically the short-term funding failure which was the problem
here, it was the absence of the securitisation market, which is
a widespread phenomenon, and we need to remind ourselves they
were offering good-quality paper, this was not a Northern Rock-specific
problem, and it is because they are an outlier in that respect
that they put themselves in a position where they became concerned.
As a general point, you are right, and now we are back to our
stress testing point, it has to be right that our banking sector
gives proper consideration to having a diversified set of funding
sources across the whole spectrum of maturity which it properly
gives consideration to even in extreme circumstances so that they
can remain funded for a reasonable duration of time. I am mindful
of the other point earlier, that we are not a regime that guarantees
there are no failures and we need innovation in financial markets.
To say that we should not have had securitisation would not be
a good conclusion to draw from this.
Q317 Mr Dunne: Just changing tack
a little bit and picking up a point that Siôn Simon made,
obviously confidence in regulators is critical during a financial
crisis. Has the FSA or other members of the Tripartite group leaked
information to the press during the course of the last month specifically
in relation to Northern Rock?
Sir Callum McCarthy: I do not
believe that any member of the FSA has leaked any information
to the press in relation to Northern Rock.
Q318 Mr Dunne: So are you suggesting
then that either the Bank of England or the Treasury leaked information
about Northern Rock to journalists?
Sir Callum McCarthy: I am being
rather careful about taking the responsibilities which I have,
which are for the FSA, and you should not infer from my statement
that I am making any comment at all about either the Treasury
or the Bank of England.
Q319 Mr Dunne: So if the BBC website
was able to report, for example, a decision by the Northern Rock
Board as to their dividend announcement recently before the board
meeting had even started, you would be prepared to investigate
whether that had come through the FSA?
Mr Sants: In that particular case,
I am fully aware of the extremely small number of people in the
FSA who had the information that it was possible the Board might
reach that conclusion, and I have already personally satisfied
myself that they did not make any communication with the press
in that period.