Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 1560 - 1579)



  Q1560  Mr Fallon: But it is not true to say that the American scheme simply operates for the very, very small banks. Continental Illinois which failed was £40 billion, about half the size of Northern Rock, and that was 17 years ago, so it is not true to say that it is small banks. Your evidence to us says that you want to stick with this post funding model?

  Ms Knight: Correct.

  Q1561  Mr Fallon: Why not put the money upfront so everybody can see it is there and have a system where they can get their money back within a few days?

  Ms Knight: Putting money upfront is not the only way of making sure that you can get your money back in a few days. If there is a requirement on the industry to pay there is a requirement on the industry to pay. It seems rather difficult to see why one should have some large sum of money just hanging around waiting when actually the issue is not one of is there money to pay out in a difficult circumstance; it is how quickly can a deposition access their money and what rules changes and what legislation changes are required in order for that to come about. If I may say, one of the main concerns which I think comes out from the memorandum which we submitted to the Treasury Select Committee is this: we need to be looking with considerable attention at prevention, and that is where we believe the whole issue lies; on the preventative side. We think that the Deposit Protection Scheme as it is currently formulated—100% to £35,000 with a requirement by the industry to pay quickly—is a workable model. The question that arises is how does it get from the FSCS to the individual deposit takers, and that is an area where, as I say, rules and legislation may be required.

  Q1562  Mr Fallon: But what the Governor said was required was a scheme that did not mean that people had to wait more than a year to get their money out.

  Ms Knight: We would entirely agree.

  Q1563  Mr Fallon: Are you not dragging your feet on this?

  Ms Knight: No, we have put forward some proposals, as you know. We entirely agree that a scheme that requires a year to pay out is not good enough. As Adrian Coles has just said, where the scheme has been used has been with failed credit unions, there the payout is quick, and indeed has been getting quicker. If one is looking at large numbers of individuals, there are systemic issues and there is panic hanging around there as well. I do not think that one should just say that it is the responsibility of an independent or quasi independent scheme to address that situation.

  Q1564  Chairman: Last week, Mr Fallon and I were talking to your equivalent, the American Bankers Association, in Washington and they were very clear that an upfront funded scheme was essential for the confidence in the system in the first place and, secondly, that when a situation arises where payout has to be made, it is probably not the best time economically so you have a fund there that is available. That was their unequivocal view to us.

  Mr Coles: Could I add a point there. I think the crucial difference between the British scheme and the American scheme is not the upfront funding; the crucial difference is that the FDIC is backed by the full faith and credit of the US Government, and I think that is what gives the confidence to depositors in the United States.

  Q1565  Chairman: No, no, no, but they were very clear on this upfront funding.

  Mr Coles: I know that is a difference but this is another important difference.

  Chairman: You are missing the point. They were very, very clear on that and they were saying why not get the money in the fat years so that when the lean years come there is no problem getting money out of people? That was the issue. I just put that as public evidence. Nick?

  Q1566  Nick Ainger: The Financial Services Authority in their Financial Risk Outlook in January and the Bank of England in their Financial Stability Report in April both gave clear warnings of problems of weakened credit risk assessment and impaired market liquidity. Why did the banks not listen to those warnings?

  Ms Knight: The banks did.

  Q1567  Nick Ainger: What action did they take?

  Ms Knight: As far as the banks themselves individually are concerned, they did, as I am informed, take full notice of the points that were made to them and the issues that were raised. Clearly we have one bank that may have taken a different view and I know that you have had a discussion with them. I think also, though, the one thing that neither authority nor indeed the industry, wherever it was in the world, expected was the way in which the housing problems of the US unfolded as rapidly as they did and as widespread as they did. Nevertheless, I think one of the comforts that we can take in the UK is not only do we have a strong banking industry but they do heed the documents, the consultations, and the other communication that are issued from our various authorities.

  Q1568  Nick Ainger: So everything in the garden is rosy, there is no problem? Surely our experience from August onwards is that there have been serious problems and warnings were not heeded?

  Ms Knight: I do not know why you say that. Quite clearly there are some very difficult market situations taking place, but you cannot necessarily cure a market situation that has arisen nor can you do anything other than handle something well as it arises. We have well-capitalised banks, they are handling the situation that has arisen, but what you cannot expect them to do is suddenly manage to rectify a problem that has arisen in America. What can be expected them is to look at their credit assessment and look at how they are handling their own affairs, and I think that is something that we have seen.

  Mr Coles: Can I offer an observation from the building society point of view there. On the day the Financial Risk Outlook was published by the FSA, we sent out a circular to our members strongly advising them to read the FRO. We gave them full details of the relevant pages for building societies, the relevant developments in the mortgage and savings market that would be most important for building societies to read, and our evidence is that building societies read that carefully and were fully expecting a slowdown in the housing market this year. They were not expecting the closedown of markets in August but they were expecting a slowdown and we encouraged them to read the relevant documents.

  Q1569  Nick Ainger: Can I follow on from that and ask you if Northern Rock had still been a building society, would it have experienced what it experienced this summer?

  Mr Coles: If Northern Rock had still been a building society it would not have been able, by law, to fund itself 75% from the wholesale markets. A building society can fund itself to a maximum of 50% in the wholesale markets under the Building Societies Act 1986 and, typically, building societies fund themselves 70% retail and 30% wholesale. Had Northern Rock stayed a building society, it may or may not have been a successful institution but it would not have come to the sticky end that it appears to have come to in the way that it has.

  Q1570  Nick Ainger: Ms Knight, do you think perhaps there is a lesson here to be learnt for the banks in that if they adopted the same requirements that the building societies have, that would actually give greater protection and security and stability?

  Ms Knight: The Northern Rock had a particular business model, as you know. If you are looking at the banking industry generally of course, it is much broader based in what it does in terms of its operation, how it funds itself and its various activities. If you have any institution of any sort which has a very narrow focus, in terms of both its business model in what it does and indeed how it funds itself, then clearly it is far more hostage to fortune than would otherwise be the case. I think one of the issues as well in all this, though, comes back to your earlier point about the FSA's communications on risk, and that is that the challenge process that the regulators undertake with various institutions in respect of risk and exposure. This is something that certainly we believe warrants looking at further. Clearly the FSA did have an engagement earlier this year with the Northern Rock in terms of stress-testing and risk and so forth, and this highlights an area that is something, as far as the industry is concerned, requires clarification. We want to see proper stability in the market and proper stability within the industry.

  Q1571  Nick Ainger: Have you got any idea when these warnings are issued by the Bank and by the FSA if they are taken note of? You have just told the Committee that they were and yet we ended up with the mess that the banking industry got itself into in August. What measures or what further action do you think particularly the FSA could be taking to ensure that when they do issue warnings that action is taken by the banks?

  Ms Knight: If I may say, you are talking about one bank, not banks in general. There may well be an institution in any walk of life that does not necessarily take the appropriate action at the appropriate time, but in terms of the industry and banks in general, do they act on warnings, the answer is yes. Are they considered? We see that consideration around the various committees that we operate within the BBA, so we are well aware of the sorts of actions and the sorts of issues that are addressed and how the industry in general addresses them. I think also, though, the question is this: what is the nature of the follow-up by the various authorities themselves? Because I agree with you it is one thing to issue some sort of communication and quite another to say that they have also put in place the right tools and the right monitoring process to see whether those actions have taken place. We do wonder whether that is another area which warrants further review.

  Q1572  Mr Love: In the press release that you put out on behalf of the BBA on 5 December you are quoted as saying: "The operation of the Tripartite was found wanting when the Northern Rock problem arose." What changes would you like to see to make it work better in the future?

  Ms Knight: First of all, we do support the Tripartite; we think that the problem is more in execution than in structure. The piece of work that we want to see done and, as far as I am aware, has not been done, and it certainly is not yet in the public domain even if somebody has looked at it, is this: if the various authorities had taken action earlier, both regulatory and in respect of the Bank of England, with the Northern Rock, would we have had a more orderly outcome? Certainly the perception is that whilst issues were raised at certain points in the timetable, actions by the authorities were far more `wait and see'. For example, no changes took place within the money market structure, there was no alternative or Plan B despite many approaches, it appears, put it in place in respect of Northern Rock. Before we know exactly what sort of changes need to be made to the Tripartite, we need to have that piece of work undertaken by our authorities; what would have happened if they had taken action rather than wait and see. Clearly there is a question of leadership within the Tripartite. There is also a question of getting the right information reported at the right time. There is also something about the individuals involved as to whether it is at the right sort of seniority. Lastly, I think that there is a lot of work being undertaken on financial stability within the FSA but there are not all that many people on that side within the Bank of England, and as far as financial services and the Treasury is concerned, we would like to see that side strengthened as well.

  Mr Coles: Could I add one point to that?

  Q1573  Mr Love: Just before you do that, Mr Coles, let me press Ms Knight a second. Is there an implied criticism in what you have just said about the Governor's decision in relation to the provision of liquidity at the very early stages of this problem?

  Ms Knight: Certainly as far as the industry were concerned, they were looking for changes to the money market in July in some degree of urgency and the question about wider collateral and the penal rate had been on-going with the industry for around 12 months. This is not an implied criticism—I am just stating the facts—and I do not want to have that terminology used. But there were certainly differences of view of how the money market should operate and particularly when there were what were referred to as `stress conditions'.

  Q1574  Mr Love: Mr Coles, what was your Association's attitude?

  Mr Coles: For me, looking at the Memorandum of Understanding, one of the key issues that is missing from that is "which of the Tripartite authorities is responsible for communication once a crisis has begun?" If you look at the final paragraphs of the MOU, which is talking about crisis management, neither the Bank, the Treasury or the FSA is responsible for communicating with depositors, and I think that was one of the key weaknesses on 13/14 September. Firstly, it was not clear who was actually in charge of making that communication and, secondly, as Hector Sants has said in his evidence to you, some of the terminology that was used was inappropriate for the ordinary man in the street. Who is in charge of communication when you have got a crisis problem and where there is a crisis of confidence, which is essentially a communication issue, is a very important improvement that needs to be made to the MOU.

  Ms Knight: That is right.

  Q1575  Mr Dunne: Can I turn to the issue of off balance sheet structures and transparency and disclosure. Hector Sants, when he was here last week, said that we needed to consider the use of off balance sheet financing. Could you comment on whether you think there are mechanisms to bring particular types of structures onto banks' balance sheet? Would that be welcomed by the industry or would that be a problem for the industry?

  Ms Knight: Of course, some are already being brought back onto balance sheet, as you know.

  Q1576  Mr Dunne: But by default.

  Ms Knight: I think the wider question is we are where we are, but should one be looking at other changes in the future? Some of the points that we believe warrant further investigation surround transparency and they surround some of the way in which ratings agencies should operate. I do not want to cast them as the devil in all this, but there are some issues there. Also some of the accounting standards help as well. There are some accounting standard changes which take place in effect from this year and, which again give greater clarity in that area. What we want to do is to see how these operate not park the issue, but see how those accounting standards operate and take forward with some degree of rapidity the whole question of transparency and whether and what that provides in terms of furnishing the right sort of information to the market. There is, dare I say though, a proper role for confidentiality in everything; it is getting that balance right.

  Q1577  Mr Dunne: Do you think Basle I is the culprit here in large part by allowing banks to provide liquidity facilities to off balance sheet vehicles without having to provide any capital adequacy?

  Ms Knight: I think it is certainly arguable now that Basle I is not the right tool for the job, but we are up and running with Basle II. The market does move on and standards do have to be reviewed frequently to ensure that they keep up with the market. The whole question of looking at liquidity is part of Basle II and that is the part that is underway at the moment. One of the issues though is that you cannot look at these things from just one jurisdiction. It is not possible to say, "The UK is going to do this," because we operate in a global market. Therefore I think that this area has come rapidly up the agenda of Basle II and the discussions which have been stuck for some time are now likely to be unstuck. I say again liquidity has got to be looked at internationally and not just in one jurisdiction.

  Mr Coles: I think Basle II is going to be particularly important because pillar three of Basle II is all about market transparency. It is about institutions giving much more information to the market about the nature and structure of the balance sheet and the liabilities that they have under particular circumstances, and that should aid the transparency issue that you are talking about.

  Ms Knight: Yes.

  Q1578  Mr Dunne: Do you think the FSA is equipped to regulate banks properly?

  Ms Knight: Yes I do. I do think they are equipped to do that. I certainly think that they need to review how they do it. It seems to us in the industry that there has been very considerable attention paid to capital and very considerable attention paid to, the conduct of business rules, but the gap in between has not had the focus that it should have had. I appreciate that it almost seems year-by-year additional requirements are placed upon the FSA to regulate more or regulate differently, and I think we all understand the difficulty of addressing that scenario. There is the very real problem now as to how the FSA should be regulating banks and whether they do necessarily have the right tools and the right people in place. That is where they need to look. We think there is some strengthening that is required and we would rather strengthen the existing system than put a new system in place.

  Q1579  Mr Dunne: Could I just press you on the people aspect. Do you think the people within the FSA have enough knowledge of the financial instruments currently being used by banks and is there a retention problem at the FSA of people with those skills?

  Ms Knight: The answer to the first question is clearly no, because if you are a practitioner in the market, you see how quickly it is developing; if you are not a practitioner in the market, you do not. Healthy regulation is about interchange of people from the market into the regulator and from the regulator back into the market. I know the FSA is aware of this and they have been assuring the industry and the wider public that they are paying attention to the quality and calibre of people that they have. I think the industry does want that to take place as well but I suppose we are sometimes guilty of buying out good regulators at the same time. A flow between regulator and industry and industry and regulator is important in this, as it is in other areas as well.

  Mr Coles: I think there is an issue about consistency of regulation. I know of one large building society, for example, that has had its relationship with the FSA headed by five different people in four years. That does not give the relevant people very much time to understand the nature of the institution which they are supervising. I would like to see someone doing a minimum of two or three years so that they properly understand the nature of the business without being subject possibly to regulatory capture.

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