Examination of Witnesses (Questions 1480
TUESDAY 11 DECEMBER 2007
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"?
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
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
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
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
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 weeknot before this Committeeand 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
Sir Callum McCarthy: Yes. In our
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 oryes, 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
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 thatthat 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
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.