Examination of Witnesses (Questions 1460
TUESDAY 11 DECEMBER 2007
Q1460 Chairman: What a fine answer,
Sir Callum! I am asking you, is it 100% credible? Would those
very words have come out of your mouth, if you were in that position,
in other words?
Sir Callum McCarthy: I should
make clear that the only person who can make that guarantee of
100% of deposits is the Chancellor, and that has always been the
Q1461 Chairman: We understand that,
but I am asking you, Sir Callum, is it credible?
Sir Callum McCarthy: I think it
Q1462 Chairman: 100% credible?
Sir Callum McCarthy: Yes.
Q1463 Chairman: What factors might
make a financial institution less deserving of a 100% guarantee
than the Government assessed Northern Rock to be?
Sir Callum McCarthy: Sorry, Chairman,
I am not sure I am qualified to answer the question.
Q1464 Chairman: But you understand
Sir Callum McCarthy: I understand
it. If I were the Chancellor I might have addressed my mind to
it but since I am not the Chancellor I have never addressed my
mind to the question.
Q1465 Chairman: You are a lucky man,
you are not the Chancellor. On the issue of financial stability,
Sir Callum, what are the financial stability implications of the
shift we have seen towards an "originate and distribute"
business model, and is that irreversible?
Sir Callum McCarthy: I think they
have very substantial implications and they do not all go in the
same direction. First of all, the "originate and distribute"
model, as the shorthand suggests, it distributes risk much more
widely, and that in itself is attractive because it stops risk
being concentrated in highly geared banks. The questions that
go the other way, which we have always been conscious of, as have
other regulators around the world, is it makes it much more difficult
to identify where risk lies. There are also two major questions
that the "origination and distribute" model has to address
more clearly than has been addressed: the first is the standards
of underwriting by the originator, where failures in those standards
have been one of the fundamental causes of the sub prime problems,
and, secondly, it is important that those who invest, those to
whom the risk is distributed, understand what they are investing
in. It is clear that there has been a degree of complexity of
product which has been distributed, and not everybody who has
bought those products properly understood them.
Mr Sants: Just to add, if I may,
and to develop that theme a bit further, what we are thinking
is clearly the structure of the market place will change as reflected
in your question, and that those complex structures which were
previously part of that distribute model are not going to find
favour with investors going forward because of the issues we have
seen. So we see a disappearance, or certainly a significant diminution
in the use of complex structures, but not necessarily a disappearance
altogether of a distribute model. It is more that the banks will
have to think about distributing through clearer and simpler processes,
so we see the model evolving but not disappearing entirely. But,
of course, these are all crystal ball forecasts and it could go
in other directions.
Q1466 Chairman: So the idea of dispersing
risk which would increase the resilience of the financial system
to shocks still holds, but it needs one or two adjustments?
Sir Callum McCarthy: I think it
holds but we have always been concerned to make sure that the
distribution of risk is real rather than apparent, and one of
the things that is difficult is to make sure we can identify the
channels by which that distributed risk may become reconcentrated.
Mr Sants: The other aspect that
we have talked here about before is that when you are dealing
with this distributed risk model: almost by definition you will
not know where all the risk has gone. The focus of the regulatory
community is clearly on the major transmission mechanisms to make
sure they are in good health, namely the core banks, and therefore
it is important going forward that those core banks are operating
in a very transparent way. We have, of course, had this slightly
opaque proposition in place with regard to the conduits and the
SIVs which needs to be addressed, so that the core transmission
mechanisms are able to work in a transparent way.
Q1467 Chairman: I notice that Josef
Ackermann, Chairman of Deutsche Bank, as a member of the Institute
of International Finance made the point that a number of structural
problems need to be addressed and included in that: improved risk
management, review of the role of off-balance sheet conduits and
special investment vehicles, the valuation of complex products,
the examination of credit agencies, and improved transparency.
I do not want you to go through every one of them, but is that
a reasonably comprehensive list to you?
Sir Callum McCarthy: Those are
the major items.
Q1468 Chairman: And you would agree
Sir Callum McCarthy: Yes.
Q1469 Mr Mudie: Would you please
tell me what the core transmission method means?
Mr Sants: One of the key issues
here is, if we are having disruptions in the financial system,
is that going to then affect the real economy, your constituents,
the man in the street. From the regulatory perspective one of
the key ways of managing and assessing that risk is through making
sure that the mainstream banks which, as it were, sit on the interface
between the financial system and the consumers, are in good health.
The transmission mechanism is another way of describing the large
Q1470 Mr Mudie: I suppose that answer
deals with the bigger question of stability, but what about investor
protection? What we have are securities that were contaminated.
I think some of the bankers did not know what the hell were in
them, and they more or less said: "We were selling them,
they were buying them, nobody was worried because we were all
making money from them". Did you at the Financial Services
Authority ever flag up, ever analyse, the various securities with
a view to saying whether you should be warning investors about
the possible risk? It is one thing to look at the wider stability
but I am just thinking why were these allowed to pass through
for such a length of time without anybody in the Financial Services
Authoritywell, perhaps you did. Did you?
Mr Sants: Just to remind ourselves,
of course, the buyers of these complex instruments are institutions,
not the consumer in the street. The consequences, however, of
that development of the financial market has ultimately been to
cause disruption to the consumer in the street
Q1471 Mr Mudie: But, Hector, just
stopping you, we had the pension funds in here and it was an interesting
session. What you are saying is: "Well, I blame the buyers",
but one of the things that I would take comfort from as a buyer
is you. After all, the industry is paying a lot of moneynot
to you personally but to the Financial Services Authorityto
give that regulatory structure and comfort. Now, your answer seems
to be: "Well, you should know better".
Mr Sants: It is a two-part answer,
actually, and that was the first part. It is the case, nevertheless,
I think we should remind ourselves, that institutions are meant
to be sophisticated enough to make good judgments, but having
said that the Financial Services Authority and the Bank of England
as well, have repeatedly over the previous few years warned of
the risks of the evolution and the development of the credit derivative
and related complex securities market, and a variety of our publications
have highlighted those risks to the institutional investors
Q1472 Mr Mudie: Let me take your
latest onewe have a later one but it is less relevantof
January this year, a whole paragraph that will cover you in terms
of warning, but in the middle of it: "Financial markets have
been increasingly complex since the last financial stability crisis".
Nothing about the individual securities. If you were regulating
in a parallel industry: say supplying blood, I would want you
to assure me if I were in hospital facing a transfusion, that
the regulation was working and that the blood supply was not contaminated.
This is what is happening in terms of these securities. These
securities were coming in bundled up to avoid people seeing the
real risk and the real original basis of the loan, and you were
letting them come into the market, traded, with people making
money from them. Now, it is not that we are looking for you to
say you made a mistake: we are looking for some comfort for the
future. Did you think, first of all, you recognised the dangers
and, if you did, did you adequately tell the market about the
Mr Sants: I think this takes us
back a bit to the comments I made to the Committee earlier, that
we absolutely acknowledged and made clear in our last appearance
that we did not foresee, and nor do we think any other market
commentators or regulators foresaw, the precise set of circumstances
which have arisen since, and that includes the liquidity crisis.
Q1473 Mr Mudie: I understand that,
and we can all be wise after the event. I am just asking, as somebody
in the street might ask, as a pension fund might ask, and maybe
a pension fund with no great resources because we heard last week
about how deep the analysis would have to be, how deep you would
have to go in to see the make-up of these things, and a lot of
purchaserseven if they are not individual and are institutionsare
not going to have those resources so they are depending on you,
amongst others. What comfort can you give us in the future?
Mr Sants: I think we were clear
in our advice as to the risks inherent in complex derivative products,
and we have made clear in a variety of our publications, the complexity
and potential liquidity risks that accrue to credit derivatives.
What obviously is the case is that on top of that, in addition
to the liquidity point I have made, we have seen a failure with
regard to the income stream accruing from the US sub-prime marketplace
which has then led to those securities falling significantly in
value. If you are asking whether we are placing ourselves in a
position where we would be looking to make all the commercial
judgments that we think mainstream institutional investors should
be making, no, we are not seeking to put ourselves into that position,
but I do think in terms of a structural observation on the market
we were clear on the risks that the increased complexity in the
marketplace was creating for institutional investors, but we placed
the onus on them then to draw the conclusions from that process,
otherwise effectively we would be running the market which I do
not think is desirable in terms of the overall process here and
the type of marketplace that the community is looking for.
Q1474 Mr Mudie: So, to bring that
all together, a pension fund that finds itself losing money and
looking to you will find on record the clear warning: "Be
careful about these products".
Mr Sants: About the inherent liquidity
and complexity that these productscredit derivatives or
Q1475 Mr Mudie: It is all about transparency.
Did you feel these products were transparent enough?
Mr Sants: I think I have said
Q1476 Mr Mudie: Yes or no. Did you
think these products were transparent enough?
Mr Sants: I think they are transparent
enough to those who have the right level of competence and the
time and the resource to look at them. I think there is a risk
that because they are highly complex not all institutions have
devoted the necessary time and resources, and have chosen to make
assumptions, be over dependent on the rating agencies, which has
proved to be unwarranted and inappropriate and not wise in the
circumstances, but in principle, if you choose to and you take
the time and you have the expertise, you can unpick these structures.
Q1477 Mr Mudie: Are you intending,
are you working on, are you investigating, any fresh approach
to these securities? Or are you lying in the sand? Is that your
industry? Are the Financial Services Authority doing anything
further to give comfort that this sort of thing will not happen
Mr Sants: Well, of course, as
we mentioned before, the market place will itself adjust as it
does in the event of circumstances
Q1478 Mr Mudie: I am asking about
the FSA, though, Hector.
Mr Sants: but I think on
top of that there are a variety of initiatives that the worldwide
Q1479 Mr Mudie: No, Hector. Again,
"worldwide". I would be very interested, because I think
it is key, that the Financial Services Authority should be operating
worldwide, but what are you doing as the Financial Services Authority?
Mr Sants: Yes, indeed, and I was
telling you that. I was just making the point that as the Financial
Services Authority on our own we would not generally be able to
solve these problems as a national regulator. Having said that,
we will take the lead in and be fully active in looking at a number
of the issues which includes the credit rating agency point which
has already been mentioned, which is an important aspect of providing
the right information and a clear understanding of how those organisations
operate; we certainly do have our initiative with our institutional
community to encourage them to give consideration to the lessons
they can learn and the actions they should take; and we will also
be obviously looking carefully around the issue of transparency,
which is a point mentioned earlier by the Chairman, around these
special purpose vehicles and related points. All those initiatives
are part of the list that was mentioned earlier, and we will pursue
those nationally and internationally with vigour.