Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 1480 - 1499)

TUESDAY 11 DECEMBER 2007

SIR CALLUM MCCARTHY, MR HECTOR SANTS AND MS LORETTA MINGHELLA

  Q1480  Nick Ainger: Mr Sants, you have told us of the warnings that the Financial Services Authority gave, and also the Bank of England were warning about the complexity of these packages. Specifically in January you say: "The financial markets have become increasingly complex since the last financial stability crisis, which implies a transmission of mechanism for shocks, have also become more complicated, and possibly more rapid. Market liquidity remains abundant, but it is still important for market participants to consider how they would operate in an environment where liquidity is restricted". Remarkably prescient, if I may say so. Between that warning that you gave in January and the warning which the Bank also gave in its Financial Stability report in April, have you any evidence that the institutions that you regulate did anything to address the problems that you and the Bank had highlighted only months before?

  Mr Sants: We certainly do have evidence that some of the institutions were taking steps to manage their financial affairs on the assumption that market conditions would get more difficult, yes.

  Q1481  Nick Ainger: "Some"? All?

  Mr Sants: Not all. As I mentioned before in the July press conference we re-stated our concerns that we thought that not all institutions had properly anticipated the possibility of an abrupt change in market liquidity and ratings, which I think was a quotation from myself at a press conference at the end of July, so we have been concerned that not all institutions had properly anticipated the possibility or the likelihood of a significant deterioration in credit markets.

  Q1482  Nick Ainger: I asked a question last week of the investment banks that came before us, about whether they felt some of them had been reckless rather than cautious. In the spectrum between reckless and cautious, do you think some of our financial institutions have been on the reckless side of the spectrum?

  Mr Sants: If you define "reckless" as endangering the corporate entity in a way which was identifiable and which could have been seen as probable by the management, then that is not a statement I would be making about the mainstream institutions here in the UK.

  Q1483  Nick Ainger: What has surprised me from the evidence we had last week from the investment banks was their basic admission that they did not know the extent of the risk involved on the CDOs they were trading. Surely that is reckless? If you are going to spend many, many millions, perhaps billions, of pounds on these packages and you do not know what the risk is, is that not reckless?

  Mr Sants: I do not particularly want to get drawn into commenting on individual institutions. In general we have said that the UK large banking community, and as the Chairman has said this a number of times, it is well capitalised and has gone into this downturn in generally good shape. We are talking here about our UK regulated banks.

  Q1484  Nick Ainger: Mr Mudie was asking you questions about lessons that were learnt and so on. Do you think that you will now be regulating differently our financial institutions, particularly in relation to credit risk assessment and also liquidity, bearing in mind what has happened in the past six months?

  Mr Sants: Yes. There are two elements to that, as we have touched on before. There is the question of ensuring at the coalface that our supervisory teams rigorously pursue our current framework, which already includes a requirement for comprehensive and effective stress-testing by institutions, and specifically with regard to Northern Rock we have mentioned here before that we think it is a matter we should properly review and publish the conclusions of in March, but I think it is reasonable to say that a more rigorous on-the-ground supervisory engagement could have been made. Then there is, of course, a wider question. I think you have to take a global perspective, of this unusual set of events in the round. It is right and proper that we should also then be looking at that liquidity regime and seeing how we should modernise and learn from the experience in the last few months. We are committed to publishing a discussion paper shortly on the issue of liquidity framework, both looking at the national element of it and the international element, which will be out before the end of the year, and we will engage in a rigorous debate with the community in terms of improving the framework.

  Q1485  Nick Ainger: That is in relation to liquidity, but what about credit risk assessment? Is that a role you should be playing as a regulator, do you feel? Looking at the particular performance of some of these institutions some have acted quite markedly differently from others in their exposure to these risks.

  Mr Sants: It is already part of our framework that institutions obviously should have a proper controlled framework which includes a proper credit control framework and an analytical approach. We will obviously continue, as I think we already do, to have that as a key focus of our regulatory engagement. I have made the observation already with regard to the large UK banks headquartered here in the UK that they are well capitalised at the current time, but clearly that is an area of supervisory focus and needs to continue to be so. Just to be clear, we do also think we should engage with the credit rating agencies, who are a key part of that mechanism by which people make credit judgments.

  Q1486  Mr Dunne: That leads very nicely to my question. We had the credit rating agencies in front of us last month and you have just made the point you would need to engage with them. Could you give us your views on the Bank of England's five proposals which they think should be considered in relation to the credit rating agencies, and I can remind you what they are if you have not got them at your fingertips. The first was that they should publish expected loss distributions of structured products to illustrate the tail risks surrounding them; secondly, that they should provide a summary of information provided to them by the originators of structured products; third, that they should provide probability ranges for scores on probability of default; fourth, that they should adopt the same scoring definitions between them; and, finally, that they should consider scoring other aspects of the products such as liquidity, stability and so on.

  Mr Sants: The first four are eminently sensible and are all around the point that the principal purpose of the credit rating agencies, as you will know from their appearance, is to measure credit risk as opposed to liquidity risk, and it is important that is done in as comprehensive and transparent way as possible and ideally in a way which is easily understood by investors and allows people to have confidence in similar methodologies being used by all agencies, so I think the first group of points talk to that aspect and we fully support that. We are part of IOSCO, as you know, which has recently introduced a code of conduct for credit rating agencies and we are very active in encouraging IOSCO, which I am sure they will do, to revisit that code to look at exactly those sorts of issues. The fifth point is an interesting point in that clearly an element of the problem that has occurred here has been institutional investors choosing to use a rating agency's process as a shorthand way of potentially evaluating liquidity as well as credit, and that has not been helpful and is not, indeed, what the agencies were intending their measurements to be addressing, so it does open the question, given liquidity is clearly as important an issue as credit, and in the current circumstances more important though it can depend on the set of circumstances, should they not also be bringing forward liquidity measurements. We know from our conversations with them that they are considering it; it is quite complicated; so I think what I would say about that fifth point is, if it could be done in a way that was credible and robust and simple to understand, then that would be a good idea, but I think we have to leave it to the agencies to see whether that is really something they can deliver, and to be fair to them they are commercial organisations and they have to also decide whether that is commercially worthwhile offering to make. But it is vitally important going forward that people understand the limitations of the service that a credit rating agency delivers, and do not use it as a shorthand way of avoiding their obligations to look properly at the structures and the risk they are taking on.

  Q1487  Mr Dunne: You also identified the conflict of interest that the issuer pays the agency who provides the rating. Do those proposals help to address that problem?

  Sir Callum McCarthy: Just before we deal with conflicts of interest, could I reinforce what Hector said? One of the comments I think made correctly is that people have relied too much on the rating agencies rather than doing their real analysis of whether "This investment is something that I understand". It is somewhat ironical that one of the responses is to try and seek from the rating agencies even more work and even more assessment not just of credit but of liquidity, and I, like Hector, think that is an idea that has to be subjected to a lot of thought before simply signing up to it.

  Mr Sants: On the matter of conflicts, obviously it is a conflict and that is an uncomfortable position for those organisations to be in and, as regulators, when we see a conflict we rightfully are concerned as to what consequences might flow from such a conflict. The conclusion that has been reached in the past, and at the moment there is no reason to go away from that, is that it is not obvious that without that model the credit rating agencies would be able to continue to thrive commercially and exist, so we are in a position where that conflict has to be managed rather than removed because if it was removed the service probably would not exist as well and we do need to be pragmatic. But I think we need to revisit again, and that is part of the IOSCO initiative that we just referred to, whether or not we are addressing conflict management as rigorously as we should.

  Q1488  Mr Dunne: Briefly, you touched on the international ramifications of this global crisis and increasingly internationally sophisticated organisations. The EU Commissioner was here last week—not before this Committee—and said there are 45 banks with cross-border activities engaged in Europe, and the challenge for the regulators is determining who takes responsibility if one of these major cross-border organisations fails. What role is there for a supranational regulator, or the IMF or some other such body, to help with bank supervision?

  Sir Callum McCarthy: I do not believe that is the right solution. There is a major task to identify the responsibilities and rights of home and host supervisors for these major institutions, and we have set out our views on and we are working closely with other regulators and central banks to try and find practical solutions. I do not believe the right answer is to move towards some form of supranational supervision.

  Q1489  Chairman: Sir Callum, I believe there is an individual designated as a grey panther at the Financial Services Authority for banking asset management insurance and markets, and that individual is on the Challenge Panel preparing supervisors for Arrow visits. Is that correct?

  Sir Callum McCarthy: There are a number of grey panthers who do the things you describe.

  Q1490  Chairman: And they ask questions like: "Are you supervising the right area? Are you asking the right questions?" Given what happened to the Northern Rock share price earlier in the year, should that have flashed a red alert with the Financial Services Authority and taken Northern Rock out of the normal procedure of Arrow visits?

  Sir Callum McCarthy: One of the matters we are looking at in terms of the examination that is being done of how we supervise Northern Rock up to the time when these risks crystallised, is to answer questions exactly like that, but overall I do not think that we paid enough attention to various signs.

  Q1491  Chairman: Is Northern Rock still solvent?

  Sir Callum McCarthy: Yes. In our judgment.

  Q1492  Chairman: What risks are there to the continued solvency of Northern Rock?

  Sir Callum McCarthy: I suppose the risks would be the same risks that would apply to many institutions: an abrupt decline in the asset values or—yes, I think that is probably the biggest risk.

  Q1493  Chairman: When did you last look over the books of Northern Rock, or are you doing that right now?

  Sir Callum McCarthy: I am not quite sure what you mean by "look over the books". We are not auditing Northern Rock but we have detailed certainly weekly, if not daily, discussions with Northern Rock.

  Q1494  Chairman: What role is the Financial Services Authority playing, if at all, in facilitating a takeover of Northern Rock?

  Sir Callum McCarthy: Our principal responsibility, when there are particular bidders for Northern Rock, is to make sure we subject them to the normal regulatory challenges and we are doing that—that is the question of change of control as far as a change of control is concerned, authorisation of individuals, and a view of any proposal and whether it meets our threshold conditions.

  Q1495  Chairman: How would you respond to the suggestion that a false market has developed in the shares for Northern Rock?

  Sir Callum McCarthy: We do not believe that a false market has developed. We believe there are considerable uncertainties which account for the sometimes very considerable variation in the UK, both in the volume of trading and in the share price, but we do not believe that any of the conditions that are necessary to be met for us to suspend trading have been met.

  Mr Sants: Volatility is, in itself, not a reason for suspension.

  Q1496  Chairman: Some suggest that there is a case for a new team to run Northern Rock as soon as possible, and that changes need to be made with speed. Mention has been made regarding nationalisation. Do you see any merit in nationalisation being used to break the log jam? In other words, to stop any parties being a legal impediment and have legislation in the House of Commons, and indeed the House of Lords, over the period of a couple of days with a new team already identified, so they can get on with the business of reviving this institution?

  Sir Callum McCarthy: We have at the moment, Chairman, two proposals which do not depend on that, and it is important that those two proposals are investigated and pushed through to find out whether they will work or not before intervention through legislation.

  Q1497  Chairman: I understand but if speed is not of the essence here then we could find ourselves with further problems, so would you say you have any sympathy with the notion of having nationalisation to ensure over the period of a day or two that we get everything up and running quickly?

  Sir Callum McCarthy: I agree that speed is highly desirable. That is why we would like to be in a position so that the board and the Government can, as quickly as possible, come to a view on one of the two proposals that are on the table, and it would be better to see whether those can be advanced before discussing nationalisation, or any legislation.

  Q1498  Chairman: It is not off the table, perhaps?

  Sir Callum McCarthy: I think the Chancellor made clear that everything remains.

  Q1499  Chairman: Within the public sector, where are the resources needed to manage a nationalised bank in the interests of taxpayers and consumers?

  Sir Callum McCarthy: If that eventuality occurred it would be necessary to find a team to do so.


 
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