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Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 300 - 319)



  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 it effectively.

  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. If—and I may be misunderstanding and I apologise if that is the case—you 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 agenda.

  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 from this.

  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 instruments.

  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 about it?

  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 do—and I think this is an explanation I offered the Committee when we were talking about financial stability earlier in the year—is 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 national—Indeed, 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 that—and I am happy to go back over the ground if you would like me to—its 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.

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