House of COMMONS









Tuesday 6 May 2008


Evidence heard in Public Questions 1 - 124





This is an uncorrected transcript of evidence taken in public and reported to the House. The transcript has been placed on the internet on the authority of the Committee, and copies have been made available by the Vote Office for the use of Members and others.



Any public use of, or reference to, the contents should make clear that neither witnesses nor Members have had the opportunity to correct the record. The transcript is not yet an approved formal record of these proceedings.



Members who receive this for the purpose of correcting questions addressed by them to witnesses are asked to send corrections to the Committee Assistant.



Prospective witnesses may receive this in preparation for any written or oral evidence they may in due course give to the Committee.


Oral Evidence

Taken before the Treasury Committee

on Tuesday 6 May 2008

Members present

John McFall, in the Chair

Nick Ainger

Mr Graham Brady

Mr Philip Dunne

Mr Michael Fallon

Ms Sally Keeble

John Thurso

Mr Mark Todd

Peter Viggers



Memorandum submitted by Financial Services Authority


Examination of Witnesses

Witnesses: Sir Callum McCarthy, Chairman, Mr Hector Sants, Chief Executive, and Ms Margaret Cole, Director of Enforcement, Financial Services Authority, gave evidence.

Q1 Chairman: Sir Callum, welcome to you and your colleagues to the session this morning on the FSA and financial stability and transparency. Can you introduce yourselves, please, for the shorthand writer?

Sir Callum McCarthy: I am Callum McCarthy, Chairman of the FSA.

Mr Sants: I am Hector Sants, Chief Executive of the FSA.

Ms Cole: Margaret Cole, Director of Enforcement at the FSA.

Q2 Chairman: Sir Callum, in your memorandum, you note the proposal in the Government's consultation paper is for the decision to activate a new special resolution regime to lie with the FSA. Why do you believe it is integral to the supervisory process for only you to be able to make that decision?

Sir Callum McCarthy: Because I think it is a decision that is absolutely integral with the normal supervision of banks and I think that the question of doing so is inextricably linked between the two. It is not simply a decision at the time of pulling the trigger but in order for someone to pull the trigger they have to decide over an extended period whether that trigger should be pulled and be in a position to defend that, so if you have more than one institution involved in that you would have an extended period during which a bank would be subject to interrogation and a degree of supervision by more than one institution, and I think that that would produce ambiguity and a degree of uncertainty, and I am not surprised that the major trade associations, both LIBA and the British Bankers' Association, see great advantage in there being unambiguous responsibility.

Q3 Chairman: But you screwed up the last time, Sir Callum, and the one who is responsible for the fault, that did not find the mistake, could cover it up, so what reassurance could you give this Committee that if you get these powers you are not going to screw up again?

Sir Callum McCarthy: I was making a difference between a decision in any one case and the argument about whether introducing ambiguity into the system will produce better results.

Q4 Chairman: But we did have ambiguity in the system with the Tripartite Authority because every one of you came to this Committee and said you did your job.

Sir Callum McCarthy: I am all in favour of having as much charity and as little overlap as possible.

Q5 Chairman: But I am saying, Sir Callum, there was no clarity previously ---

Sir Callum McCarthy: There are some questions, Chairman, which can be asked about that. Sorry, could I just reply to your question which I think is a very fair question. I think there are questions about what happened in the past but I see no advantage in introducing additional ambiguity into the system in order to deal with past failings.

Q6 Chairman: Okay, Sir Callum, I will put it to you like this then: do you have sympathy with the views of politicians who would be sceptical about giving these powers to the FSA given your track record with Northern Rock?

Sir Callum McCarthy: No, I think that the question of how we exercised our discretion and our responsibilities in relation to Northern Rock is something which we have examined and we have identified a number of things that we believe it is essential that we put right. We have started a programme to put those right and we are busily doing that.

Q7 Chairman: You see, Sir Callum, I took the opportunity when the Governor of the Bank of England was here last week, and no doubt your staff have bought to your attention his comments, when you make the point about the trigger, he is very clear and he is saying that they should have someone other than the supervisor with the ability to pull the trigger and that is because of the concerns about regulatory forbearance, "the natural reluctance of a supervisor to announce publicly that the supervision regime has not been successful and the bank needs to go into a special resolution regime." So there is a difference between you and the Governor on that?

Sir Callum McCarthy: There is a difference between the Governor and myself and indeed between the FSA Board and the Governor. I would point out that there is no evidence at all that we indulged in what was described as "regulatory forbearance" in relation to Northern Rock. The problems in relation to Northern Rock, which we have examined in considerable detail and with a great degree of rather brutal honesty, are different from the questions of regulatory forbearance.

Mr Sants: If I may make a comment on regulatory forbearance.

Q8 Chairman: Hold on a second, the Governor made the point as well about the basic argument about the special resolution regime, and in answer to my question he says: "I think you argue, correctly, in my view, that it should not be with the supervisor but with a different body. I think you can argue plausibly that it should be with an independent body, it could be with the Bank." Given that legislation has to come in in front of us, Mr Sants, and politicians have to feel reassured that the FSA is on the job, then I would take a bit of persuasion that it has to lie with yourselves, and I would suggest to you that if it is going to lie with yourselves that it is not done by you sitting back but by convincing people, particularly the body politick in the House of Commons - all MPs, not just the Government - that you are the correct body to have that power.

Mr Sants: I would absolutely agree with you that we should ensure that we have the confidence of all MPs and indeed of all depositors and savers. I do believe the programme we have set out should generate that confidence. On the point, if I may, of regulatory forbearance I would just like to expand a bit on that. I am afraid I do not really understand that argument. It seems to me that under the new proposed regime, if anything, the incentive for the supervisor is to place the bank early into the special regime, not late, because our objective is to actually protect depositors; that is what we are here for. Your point about appealing to ensuring we have the confidence of Parliament; we are here to protect the depositors and under the new proposals, if anything, the incentive for the regulator is to put it early into the regime to ensure that there are no issues for depositors. A disorderly unwinding of a bank would inconvenience depositors, so I do not agree at all that there is some incentive here for us to delay placing a failing bank into the regime. But, as I say, to your first and most important point, I absolutely believe that we can and are ensuring that we are well-placed to do our job effectively. I would echo one point the Governor made, he talked about the importance of not giving an organisation responsibility without authority. I think the issue of having two separate triggers then creates the possibility that we as a supervisor are not able to do our job and I am sure that Parliament would not want to set the FSA up to place it in a position where it has responsibility without the necessary authority.

Q9 Chairman: Given the different views that have been expressed by the Governor last week and yourselves this week, I think it is incumbent on you to go back and discuss with the Governor so that we as a Committee can feel some reassurance that two legs of the Tripartite Authority agree with each other on a particular issue, otherwise there is no confidence in the future. To date, I do not think that you have given us sufficient evidence to give us any confidence that you are the correct body to have these powers, so I think you have a big job to do on that in the next few months.

Sir Callum McCarthy: Could I make one distinction which may help. We have been answering questions about the use of the trigger. One thing we are in complete agreement with with the Governor is that once a bank goes into the special regime we do not believe it should be the FSA that administers that bank because we believe that it would be an undesirable and incorrect conflict of interest to both regulate an institution and to run it, so on that point there is complete agreement.

Q10 Chairman: I understand that but there is a big gulf between you yet and I think it is important that you get together and if there is a possibility of a joint submission to this Committee with which you agree, only then I think will we as a body start to have some confidence in those two legs of the Tripartite Authority. In terms of conflicts of interest, if you are given the powers for the special resolution regime you would be in charge both of regulating institutions and shutting them down should they fail (potentially because of your poor regulation), so if you were given these powers, how would you deal with those conflicts of interest? Maybe that is for a later time when you are giving us your submission but if you could give us a flavour today it would help, Sir Callum.

Sir Callum McCarthy: I think that the regulation of an institution once it has moved into the special resolution regime is not actually a terribly difficult set of issues provided we are not also running that institution, and it is because of that that we have made it clear that we think it would be inappropriate to do both. Once an institution is in the regime we would be concerned to look at the same aspects that we look at, ie things which determine whether it is breaching threshold conditions.

Mr Sants: I come back to my earlier point that our role is to protect the depositors not to protect the shareholders and I think there seems to be a little bit of a misunderstanding here. There is no question that the purpose of setting up the special regime and the Bank's reformed proposals in front of you, is to better enhance consumer and depositor protection.

Q11 Chairman: Although I would just make one point there, in a sense you could be protecting the shareholders if through your poor supervision you do not want any of your mistakes uncovered or one does not want one's mistakes uncovered, so there is a potential there, that you want to have a clean record in supervising banks.

Mr Sants: Any time you take on responsibilities you have to be accountable for discharging those responsibilities effectively.

Q12 Chairman: I am highlighting the conflict of interest there. Could I go on to one area where we are agreeing and that is market abuse - and we are going to come back to that at a later time - the FSA has successfully prosecuted only two firms and 12 individuals for market abuse since your inception in 1998. Does this mean that the UK has a very clean market or does it demonstrate that the FSA is ineffective in clamping down on market abuse? I am mindful of the comment that Howard Davies made in 1999 when he said: "Perhaps London's markets have been perfectly clean through this period; I beg leave to doubt it."

Sir Callum McCarthy: I absolutely agree with Howard Davies that there is no evidence to suggest that the London market, the British market, is uniquely clean. Indeed, the evidence that we have produced, and which we are determined to keep on producing, shows that this remains a significant problem. I would say that I think that one of the things that successive administrations and successive attempts to deal with this have not been very successful in dealing with insider trading and market abuse, and it is because of that that we have determined to increase our resources to attack this, to change the technology that we have available to enable us to identify this more, and why we are seeking from the Government additional legal powers in relation to plea bargaining which we believe are essential if we are to make a step change which, as your question implies Chairman, we believe is very necessary.

Q13 Chairman: How does your track record compare with, say, the United States' track record in prosecuting?

Mr Sants: It is not very easy to make comparisons because, as the Chairman has already indicated, we do not think we are as well-equipped as we would like to be with respect to achieving prosecutions, but certainly on the key point of criminal prosecutions clearly it is the case that the US has a longer track record than we do since at the moment in terms of completed cases our track record is zero. What we have stated is we find the current level of market abuse, at least as best as we can measure it, unacceptable. We need to address it and we can see that the measures we have taken so far have not addressed it, and going forward we intend to be more determined and more effective, and in particular to pursue criminal prosecutions in this area to significantly increase the deterrent effect. As you rightly point out in respect of the US, that has been a difference which we intend to rectify in the future.

Q14 Chairman: This is one area where we agree because in the Budget debate I made the case for you having this plea bargaining, so I am interested in this, and first of all, in terms of the Government's proposals, do they go far enough for you in terms of achieving that objective?

Sir Callum McCarthy: I was very grateful for your remarks in the Budget debate, Chairman, thank you very much.

Q15 Chairman: We can get on sometimes, Callum!

Sir Callum McCarthy: I am genuinely grateful. The Chancellor's statement when he made clear that he thought it would be a positive step to give us the powers of plea bargaining is an admirable statement. We are in the hands of the Government to give us the legal powers and that has not yet happened.

Q16 Chairman: You are in the hands of the Government and that is what worries me because I am told that there could be some seizure in terms of getting the legislation here. The Chancellor has given us the rhetoric but it is still to be implemented and I am told it could be getting held up somewhere. Do you know anything about that? The reason I am asking this today is to ensure that we get a move on with this so that everybody is listening.

Mr Sants: We have no timetable to date so we would obviously very much welcome a timetable being forthcoming.

Q17 Chairman: So it is disappointing that we have not got a timetable yet?

Mr Sants: From our perspective, given the importance we attach to this issue, yes.

Q18 Chairman: I will write to the Chancellor after this meeting today to see if we can get this moved on in terms of legislation.

Sir Callum McCarthy: I am very grateful again, Chairman.

Q19 Mr Fallon: Coming back to the supervision of Northern Rock and the report you have done, it appears to be a catalogue of failure. You identify a lack of sufficient supervisory engagement, a lack of adequate oversight, a lack of specific resources directly supervising the firm, and a lack of intensity by the FSA, Sir Callum, at the point you were supervising Northern Rock last summer you employed 2,600 people; how many have been dismissed?

Sir Callum McCarthy: None has been dismissed. Of the people who were responsible for supervision of Northern Rock at the relevant period, none is now involved in supervision and a number of them have left the FSA.

Q20 Mr Fallon: But the ones you have kept have simply been shuffled sideways have they?

Sir Callum McCarthy: Some of them have been moved.

Q21 Mr Fallon: They have been shuffled sideways?

Sir Callum McCarthy: Some of them have been moved. They have been moved out of direct supervisory responsibility.

Q22 Mr Fallon: So they have failed at supervision but they are still being kept on the books doing something else?

Sir Callum McCarthy: There are people who have been moved to other places where we believe that they should remain as employees of the FSA. If we had not been of that judgment they would have left the FSA.

Q23 Mr Fallon: How many senior managers were paid bonuses in the year 2007-08?

Sir Callum McCarthy: It is a question I would be grateful if the Chief Executive could answer because I am not sure I know the answer. Most managers in the FSA, indeed all staff in the FSA, qualify for bonuses. I do not know how many senior managers in total.

Mr Sants: It would depend on how you chose to define "senior managers" but I assume the question you are asking is about non-Board members of the FSA who were paid bonuses in the period in question, and the answer is yes.

Q24 Mr Fallon: The bonus information for senior manager is not in your annual report, it is only there for the directors.

Mr Sants: Is that the question you are asking, whether or not we list individual bonuses for non-directors in the annual report? That would not be normal practice.

Q25 Mr Fallon: The question is how many senior managers received bonuses in 2007-08 and how does that compare with the previous year?

Mr Sants: I was saying if you would like to define to me how you want me to define senior managers, whether you wish me to define them as directors or heads of department or the total pool, then I will happily answer the question. Perhaps I could put it in witting back to you.

Q26 Mr Fallon: Did you pay more in bonuses in the financial year just concluded than you did in the previous financial year?

Mr Sants: Again, it is a matter for the Board's decision but we paid the same percentage of bonuses to the employees of the FSA for 2007-08 as we did in the previous year.

Q27 Mr Fallon: Percentage of what, total remuneration?

Mr Sants: Of salaries, yes, that is the way we look at it.

Q28 Mr Fallon: Not of people but of total remuneration?

Mr Sants: Yes, the bonus percentage of their salaries across the whole of the FSA was the same for the two years in question. It was a decision that was made by the Board on the recommendation of the executive and was reflective of the excellent work across the entire organisation and the executive thought that was a fair recommendation to make to the Board, which was accepted.

Q29 Mr Fallon: You have shuffled a lot of these people sideways because they have failed and you have hired 100 new supervisors. How can you give us confidence that the 100 new supervisors will be better than the last lot?

Mr Sants: We have not completed the hiring programme. We have indicated our intention to increase significantly the number of supervisors, a number of whom have been hired. In terms of ensuring that the quality is at a level we require going forward, one of the measures we are taking is to further improve and tighten our overall training and competency regime and we will have tighter standards to be achieved for supervisors and a tighter regime to ensure that those competences have been achieved and if they do not achieve those competences they will not continue as supervisors.

Q30 Mr Fallon: Does that mean they are being employed on shorter contracts than previously?

Mr Sants: We do not use contracts in the way I think you are implying. People are employed in the FSA as they are in all normal organisations. What I am saying is if they do not achieve the required level of competency, ie do not achieve the qualifications we require in order to be a supervisor, they will not be allowed to continue in supervision. This is a change from where the FSA was before where we will have a formal competency requirement with testing for supervision.

Q31 Mr Fallon: Sir Callum, do you not think it would have been an acknowledgement of the extent to which you recognise the failure of supervision of Northern Rock and the confidence you want to give everybody in claiming these new powers if at least one person had been dismissed? Out of 2,600 people not one has been sacked.

Sir Callum McCarthy: There have been various people who have left the FSA. Some have left by mutual agreement. There have been a number of people who have been moved and I think that if some people had not earlier left we would also have had more people who would have left by mutual agreement.

Q32 Peter Viggers: The internal audit says that the FSA was operating prior to August 2007 with a presumption that "in the event of a crisis like that experienced in August 2007, general market liquidity provided by the Bank of England would be increased and, in extremis, liquidity would be provided for systemically important institutions." Is that a fair summary of the FSA's attitude at that time?

Sir Callum McCarthy: Yes it is.

Q33 Peter Viggers: Why did such a seemingly dangerous mismatch between the expectations of two of the members of the Tripartite Authorities exist, because that was not the way the Bank of England saw it, was it?

Sir Callum McCarthy: If you look at the provision of liquidity to a solvent institution, which was what happened in relation to Northern Rock, liquidity was provided by the Bank of England, the problem in relation to Northern Rock is that the actual use of a weapon that has always been part of the armoury of central banks and of supervisors, namely the provision of liquidity to an institution that was solvent, instead of having the effect of giving confidence, had exactly the opposite effect. I do not think the problem was the refusal of the Bank of England to provide liquidity, because after all that is what happened; the problem was that when that liquidity was provided, it actually triggered the retail run that undid Northern Rock.

Q34 Peter Viggers: Did the presumption about the provision of liquidity affect the way in which you regulated liquidity?

Sir Callum McCarthy: In one respect yes, because the sterling regime that we have, which is the quantified aspect of our liquidity regime rather than more qualitative aspects, essentially is a regime which presupposes that if there is a catastrophic failure and a problem institutions will have a short buffer of liquidity until the central bank actually takes action, and that is something that is well established and has been there for years. Incidentally, it is a quantitative measure which Northern Rock comfortably exceeded so that was not the problem.

Q35 Peter Viggers: One of your responses to the internal audit is to seek to improve working level relations with the Financial Stability Directorate at the Bank of England. How are you going about implementing such improvements and what are the results that you wish to see?

Sir Callum McCarthy: I think that one of the things that the Governor made clear when he gave evidence to you was that he regarded the involvement of the Bank in relation to Northern Rock as having happened rather late in the day. There is nothing institutional in the arrangements that prevented that happening. The Governor for example saw the then Chairman of Northern Rock on exactly the same day that Hector and I saw the Chairman of Northern Rock, which happened to be 30 August, considerably in advance of the point at which liquidity was actually announced. I think there are some important questions in terms of the detailed working arrangements between the Bank and FSA to make sure that in future if there were ever to be case comparable to Northern Rock the Bank is encouraged to raise all questions that it wants to raise about the actual eligible collateral assets, et cetera, of the institution at an early stage, and those are things which are being worked on as the Governor's evidence made clear.

Mr Sants: I think you are also asking about improvements going forward. We are also putting in place an improved technology platform so effectively in the future our vision would be that the Bank officials would have the same access to data as if they were sitting in the FSA, ie everybody is working off the same database. We would obviously be obtaining the data from the institutions to simplify that data collection process but effectively it will become, in virtual terms, a single department.

Q36 Peter Viggers: I think it is common ground that in the case of extreme difficulty it will be the Bank of England that will step in and deal with the administration of the bank because only the Bank of England has the financial levers available. The point of dispute which I think colleagues would agree is the thrust of our report on the run on the Rock is that the Bank of England should remain sufficiently close to the situation overall so that it can, if it feels appropriate, trigger the special arrangements. I take it from answers to previous questions that you do not accept that and you feel that this must be something entirely within the purview of the FSA?

Sir Callum McCarthy: The difficulty that I see in giving two separate triggers, which is what would actually be involved, is that if I were responsible not in the FSA but in some other institution for deciding whether I was going to pull the trigger, and I knew that for example I would have to quite properly appear before this Committee some time to justify that decision or justify why I had not taken it earlier, it would inevitably push me into a degree of interrogation and quasi supervision of banks over an extended period. It is not just at the moment when you pull the trigger, it is an extended period of duplication, and I see very significant disadvantages in terms of clarity of responsibility, I see disadvantages for the banks involved who would be subject to that, and I do not think it is the sensible way of doing it.

Q37 Mark Todd: Reading the internal audit report on the supervision of Northern Rock, Michael listed some of the failings that were identified and he was not as harsh as one might have expected. I think poor recordkeeping was conceded; a very high turnover of staff without proper monitoring of what happened when that was happening; very few visits and little personal engagement with the particular institution, very poor risk analysis and an acceptance that, in your words, an outlier in this industry was not treated as such; and very poor challenge mechanisms at senior management level of those who were directly involved in the supervision of the bank. If I read that in another institution I would regard that as a description of systemic failure and not a criticism of a particular group of individuals carrying out a function. Would you accept that view?

Sir Callum McCarthy: I regard what has happened as having two deeply worrying aspects. One is there was a misjudgment of the risk involved in the Northern Rock business model and the second thing, which is of a different dimension, is that there was a failure by the management within the FSA to actually control a group of people who were not doing their job properly.

Q38 Mark Todd: Most of whom you have retained in employment.

Sir Callum McCarthy: No, I actually think most of whom, for one reason or another, are no longer with the FSA. What does concern me however, and what concerns the Board and what we have spent a lot of time looking at, was to try and establish whether this deeply worrying set of events that you have described was characteristic of the way in which the FSA supervises institutions overall or whether it was an outlier, and it is clear from the work done by internal audit and it is clear from the work that has been done elsewhere - and Hector can comment on this - that the Northern Rock experience was an outlier, a deeply worrying outlier, but it was not characteristic of the whole.

Mr Sants: I would just make two points. Could I pick up on this "most of whom" of the management" and could we just take that off the table. I have done the calculation in my head, and there are five managers in the chain involved here, and four of them are no longer with the FSA, and in my book one out of five is not "most", so I would be grateful if we do not use that terminology going forward.

Q39 Mark Todd: I am glad you have quantified it.

Mr Sants: If we just make that point. On to the second point, we could dance around a pin a bit as to what we think "systemic" means, but I think we should be absolutely clear, and I think I have been absolutely clear about that, that the way the Northern Rock was supervised was unacceptable and to ensure that that does not happen in the future requires us not just to make changes with regard to the people who were specifically and directly involved in that set of events but also to make a number of changes across the whole organisation, both with regard to culture and system, and I do believe we do need to make some general changes to ensure we can deliver going forward. I am confident we can but I am absolutely open about the fact that some general changes are required.

Q40 Mark Todd: I take that as an answer saying, yes, systemic failure is a reasonable criticism. To give an example, the poor recordkeeping which was revealed, which I think to an outsider was startling, where rather important meetings were not minuted in any way so you could not get a proper picture of what had actually happened; was that unique to the Northern Rock team?

Mr Sants: I think a degree of failure to keep records on the basis of the analysis that we had done was unique. Certainly there is a key aspect in respect of Northern Rock, without getting too much into the technical details, concerning the fact that the team did not keep up-to-date a necessary risk database where the key issues should have been recorded. As the data shows there with regard to the high impact firms, that was a unique failure and that was a major contributor to the problem here, so I think you can say based on that analysis that, yes, there was a high degree of specificity here.

Q41 Mark Todd: And the revelation of rather poor challenge mechanisms so that those at a more senior level actually discussed issues raised within an individual firm and challenged the team directly - because I think we all recognise that those closely engaged may not necessarily have the most objective perspective and require challenge - is the picture that you are presenting to us that management discipline was in place elsewhere in the FSA but was not in place in this particular instance?

Mr Sants: Yes, correct. I am confident, as you would expect, that that is not to be found across the whole of the FSA and that was not found in some of the other divisions.

Q42 Mark Todd: Some of the other divisions?

Mr Sants: To be specific to your question, that was not found in the wholesale business unit but it would have been found to a degree elsewhere in the retail area. Given there was more than one firm in that retail area responsible to the senior managers, clearly if they were not challenged with regard to Northern Rock it would be a reasonable deduction to assume that the challenge was also not necessarily found across the board.

Q43 Mark Todd: That has been rectified since?

Mr Sants: That has absolutely been rectified already.

Q44 Mark Todd: It really follows through on the Chairman's line of questioning that a reading of this report, which I think you described Sir Callum as "painfully candid" or something like that ---

Sir Callum McCarthy: I think the words I used were "brutally honest".

Q45 Mark Todd: Okay, pretty similar, but people reading this would certainly have considerable doubts about the functionality of the FSA and its ability to perform its duties. I must admit I am mildly surprised that I have not had correspondence from little IFAs saying, "They are all over us like a rash and look at what happens when they are looking at much higher risk institutions." I think I have only had one of those. Can you see the damage that has been done to your organisation in a corporate sense?

Sir Callum McCarthy: I absolutely recognise that what has happened has been damaging both to financial services and to the FSA. Could I just make one point however that throughout the world in relation to the present problems there have been regulatory failures, but the only institution which has set out in detail what went wrong and has set out a programme very determinedly to change those and to put them right is the FSA.

Q46 Mark Todd: It is an unusual document, I agree. It has been mentioned how infrequent the visits were to Northern Rock. Has that anything to do with the fact that they are way out of London up in the North East? It is a startling statistic, the relatively low frequency of visits to the company. Has anyone asked why it seemed to be so infrequently visited?

Sir Callum McCarthy: We look after a range of institutions and it includes for example HBOS which is headquartered out of London and it includes people who are headquartered around the world. This was not because it involved people getting on a train or an aeroplane; it was because we did not do the job properly, full stop.

Q47 Chairman: Sir Callum, we are looking to the future here and you mentioned about regulatory failure but we are the only country where there has been a retail run on a bank. To add to Mark's point here, in terms of your table - and I agree it is a very honest appraisal but we are looking for reassurance for the future - the average number of visits to the major retail banks in the period 1 January to 9 August was 22 and the average number of visits of the FSA to the five largest retail banks was 43; yet for Northern Rock there were seven visits and of those seven visits five were held in the one day, two were by telephone, and none of which had minutes. I suggest to you that if you were the secretary of your local community sports chub you would be thrown out on your neck for that. Here we have a high impact firm, one of the 37, with five meetings in one day and no minutes. Can we get reassurance that there is a fundamental culture change taking place in the FSA to ensure that that never happens again?

Sir Callum McCarthy: Chairman, we have repeatedly made ---

Q48 Chairman: In terms of minutes and visits, give us an idea of what is going to happen now?

Mr Sants: The answer is, yes, there is a fundamental change. The staff are abundantly clear to the fact that if these standards were repeated those employees would not remain with the FSA. I do not believe that they will be repeated. I am confident they have the message loud and clear. We completely agree with you.

Q49 Chairman: Just to assure us that it is not going to be repeated, can you give us a flavour of what you are going to do in the future to effect that change in senior management?

Mr Sants: Most certainly, yes, we have a significant programme but at the end of the day I think personally you can have as many programmes as you like; the most important thing is to deliver a message loud and clear. The message is the one that you have just articulated and we have already delivered it. I have delivered it personally, I shall be repeating it, and I shall be holding managers to account and you can hold me to account.

Q50 Chairman: There will never be a visit undertaken in the future without minutes?

Mr Sants: It would be a rash person who says that there will never be human infallibility of an organisation but what we can say is if we discover such things there will be resolute management action taken.

Chairman: You reassure us. Graham?

Q51 Mr Brady: One of the other issues that was highlighted in the internal audit was the excessive reliance on junior members of staff in regulating Northern Rock. What measures do you propose to deal with that?

Mr Sants: From our point of view, as I say, I believe we have set out a comprehensive programme. We do recognise that we need to make changes across the organisation and not just with regard to specific issues identified in Northern Rock. We will be addressing it through improved training, with clear standards and competency levels which will be assessed; through having extra resource; through having far greater focus applied by the senior management with regard to the supervisory process; by clearer accountability to those senior managers to delivering and then, critically, going forward, we are going to set up a unit which will in addition to our internal audit organisation review constantly that process and ensure that our procedures, as we have just touched on, are being adhered to, and that will be a regular, rolling programme with experienced supervisory resource, constantly reviewing the effectiveness of our supervisory regime and we would apply that to all the high impact firms over - and we will work through the details - something of the order of about an 18-month time period, so in addition to internal audit and in addition to increased and determined focus by senior management, there will be a quality assurance group providing regular review as well as regular help and assistance when tricky situations are encountered.

Q52 Mr Brady: There is general acceptance that you had a difficulty because of the sector you are regulating that it is difficult to recruit and to retain good people. To what extent, in your view, does that lie behind the problem?

Mr Sants: As we said before, it is a challenge obviously to recruit good people, particularly from industry, given the compensation differentials, and that is an established fact that everybody recognises. I would note however two points: (i) industry conditions of late have moved somewhat in our favour; and (ii) I do believe that with thoughtful and imaginative packaging and description of our employment propositions that we can hire. We have demonstrated of late in particular that you can hire senior people particularly if you offer them a mix of advisory roles, maybe part-time roles, and you can bring in senior people with a lot of experience, and we have demonstrated that of late by bringing in five or so very experienced and senior individuals to help us in a variety of different roles on the advisory side, so hiring at the top end to bring market experience into the organisation is absolutely doable and I would say in the last six months we have proved and demonstrated that so that we now have a strong team at the senior level. We have a strong and effective graduate programme where we are able to offer an overview of financial services. This is an excellent starting opportunity to market to bright, young graduates. There is an issue in the middle around retention, reflected primarily in the compensation proposition and that will always be a challenge for us. The expectation that this is an organisation where people come and stay for 20 or 30 years would be the wrong model to be pursuing. What we want to pursue is a model which has fluidity in the interchange between us and the industry and overall gives us a good blend of experience at all times. I think that is achievable and I would say over the last six months there is good evidence that we are on the right track and we have made significant progress already.

Q53 Mr Brady: Would you be able to give me any kind of sense of what proportion of the fees that you charge to Northern Rock would actually have been spent on regulating Northern Rock or perhaps more generally for the big, major institutions?

Mr Sants: It is an interesting question as to what you mean by "regulating". What you can say is, including the specialists who support the supervisory process, something of the order of 60% or 65% of the FSA's people are involved in the supervisory process. Lots of other bits of the FSA are involved in other things such as financial capability and so on and we are not a regulator that only does supervision of individual institutions and, as you rightly point out, we do seek through the fee block mechanism to relate the fees to the amount of supervisory engagement and that is particularly important of course for the smaller firms. However, if you are asking what was the exact cost of regulation for the large firms, or for Northern Rock, over the last 12 months, I would have to do that analysis and come back to you.

Q54 Mr Brady: I would be interested to see that, thank you, in particular as a percentage of what the fees coming in from that institution were. If I can just move on to the question of capital requirements, it is also noted that you were aware that Northern Rock was in breach of its capital requirements and yet there was no risk mitigation programme. Why not?

Mr Sants: There should have been a risk mitigation programme in my opinion and, back to the analysis shown in the report, I think the failure to fill out the necessary risk data and have a risk mitigation programme were probably two of the most important reasons why we did not do a good job in this case. I do not think the particular issue of the breach of the regulatory capital requirement has at the end of the day had any impact on the events that transpired in the summer because it was a breach of only some 0.2% and it was rectified by the time the summer was reached, so I do not think that particular breach has influenced the events that transpired from the end of July onwards. Should there have been a risk mitigation programme? In my opinion, yes, and that was one of the readings that led to an unacceptable performance in supervision.

Q55 Mr Brady: On average, how often do firms breach their capital requirements?

Mr Sants: If I were to give you a precise answer I would have to come back to you in writing and I am not sure whether we would necessarily want to say that. We might be able to give you the aggregate data but we do need to be aware of the confidentiality of individual firms' data. I think I would have to take an opinion as to whether we could release that information. However it does happen and it is not that unusual an occurrence. The question is how you respond to that and what happens next.

Sir Callum McCarthy: Could I make one supplementary point to what Hector has said. A breach should not be thought of as a necessarily irrevocable event. The important thing is if there is a breach what is the action that the bank or insurance company or whatever it may be is going to take to put it right. If you take the instance of Northern Rock there was a programme that put that right, so I am not even sure if the number of breaches quite gives you a flavour of the reality of the situation.

Mr Sants: You do not want to confuse breaching a regulatory capital requirement with failing thresholds and conditions so some idea that just because you breach the regulatory capital requirement you cannot continue as a viable institution would be a serious misunderstanding; they are not the same.

Q56 Mr Brady: Why did Northern Rock not have to disclose it to the market then?

Mr Sants: In certain circumstances it can be a disclosable event. It depends on the circumstances surrounding the breach. If it was of material importance to shareholders and likely to remain so it would therefore then be a disclosable event.

Q57 Mr Brady: So is it your view that this particular breach was too small and insignificant to be disclosable?

Mr Sants: It is not necessarily just the quantum, it is also back to the issue around disclosure. If you are likely to be rectifying it within a short period of time then you do not necessarily have to disclose, so it is also around the specifics of a set of mitigating actions. In this particular case, as you know, Northern Rock was able to swiftly mitigate the problem through the disposal of the loan book.

Q58 Mr Brady: So there was no need for disclosure in this instance?

Mr Sants: I do not believe so but if you would like a more detailed explanation on this I would have to come back to you. These are matters in the past prior to my taking on the Chief Executive role, so if you want a detailed explanation I will come back to you.

Q59 Ms Keeble: I wanted to ask a bit more about the overall banking regulation. First of all, do you think that it would be possible for the FSA or the Bank of England to encourage a contra-cyclical break of some sort - this was Charles Goodhart's approach - so that during the good times if patterns end it did not trigger the next crisis?

Sir Callum McCarthy: I think this is one of the questions that we and other regulators around the world absolutely have to develop over the next 12 to 18 months because what one does not want to do is to find that you tighten requirements at the wrong time in the cycle and relax them at the wrong time in the cycle. In some respects, Basle II will help in this. There are other aspects of Basel II where we need to improve aspects of the capital requirements and that is going to be worked on. It is one of the things that the Financial Stability Forum report identified but the wider question that Charles Goodhart was raising is something that we will have to come back to and follow up on.

Q60 Ms Keeble: I wanted to ask specifically about some of the issues around liquidity of financial institutions. What have you learned out of the last crisis, the Northern Rock crisis, and will that need international action or do you think there are measures you can take to improve the situation?

Sir Callum McCarthy: You know that we have already started the process of taking action on a UK basis. The history of international agreement on liquidity is not a good history. When the Governor gave evidence to you last week, he was pointing out that when the Basle II process began, there was an attempt by the Bank of England to try and make sure that liquidity came higher up the agenda and that attempt failed. One of the things that concerns us is that because it is likely that there will be slow process in the Basle Committee in relation to liquidity, it is essential that we take action in the UK and we have already started that with the discussion paper that we published at the end of last year and I think we will be coming forward, indeed we will be coming forward this year with other proposals on liquidity. It would be ideal if we could get agreement internationally but I am sceptical about the practicality.

Q61 Ms Keeble: In the memo you sent to us you said that in your new programme there would be more focus on liquidity particularly in the supervision of high impact firms. Are those some of the changes that you are proposing? One of the key issues here was that Northern Rock did not actually breach the rules so how are you going to improve and sharpen the focus, particularly on the risks factors, and how are you going to assess them given that the rules are quite lax?

Mr Sants: We come back here to the point we have made a number of times before. The primary focus, in our view, with regard to liquidity management should be on scenario planning, on stress testing. We do believe that you need to have some prescriptive and detailed rules. As we said before, we do not believe that liquidity regimes should be solely principles-based and, yes, there should be some rules and we will reassess where those rules are pitched and also, critically, the definitions in terms of eligible collateral and definitions of securities which are relevant to those specific rules, but the main focus has to be on ensuring that boards and executives and non-executives are properly focused on giving clear consideration to the various stress-test scenarios, stress scenarios that could develop and that they properly satisfy themselves that they have adequate liquidity to deal with those types of eventualities. As we said before, that is not what happened here with regard to Northern Rock. It had not properly considered all eventualities with regard to the various scenarios that might develop, it had not made a judgment as to whether it thought those risks were adequate for its board to bear. We as supervisors, however, had equally not properly engaged with them to ensure that that was happening.

Q62 Ms Keeble: Mr Sants, I wondered if I saw some sort of changing of the position around principles-based regulation, because you mention in your memo that you are an outcomes-based regulator. I know we can all sort of dance on a pinhead when it comes to words, but it would seem that outcomes-based regulation, and it is quite specific in your memo, where you look at the results of actions, is different from the principles-based which would look more at the processes that are put in hand, and I wonder if this is a shift. What do you mean by this what seems to be a difference of approach?

Mr Sants: I think we have always stated, and certainly when we re-launched our regulatory proposition with our document back June of last year, that we were a more principles-based regulator rather than solely a principles-based regulator, a point I think I have covered with the committee before. We are not in any way suggesting we could operate solely on 11 principles, there are undoubtedly occasions when rules are necessary, but in that document we also talked about outcomes - judging firms on the outcomes of their actions. I think you are right in saying, however, that in trying to communicate our message in a way that firms and, critically, of course, the management of firms can understand, I do myself find it more helpful to focus on the word "outcome" rather than necessarily that we are more principles-based. More principles-based, if you will, is a framework that we are using and focusing on outcomes is what we want the management of firms to do. I think it is more helpful in the communication process and in the messaging process to stress the point that people have to think about the consequences of what they do. That, surely, is the most important point here. Are people giving proper consideration as to the consequences of what they do? The framework under which we judge whether they are giving proper consideration sits behind that, but I think the main message should be about you, the management of the firms, are the people responsible for running firms, not the regulator, we do not run firms, and you need to think about the consequences of your actions.

Q63 Ms Keeble: There has been a lot of critical questioning from colleagues here about the management structures and the reliance on junior staff and the messaging sent out, and so on, and it would seem to me that, if the regulation is to be improved, there has to be clarity of focus, and it would seem (and again I do not want to dance on a pinhead) that there is a difference in approach between rules-based, principles-based and outcomes-based, and if people are asked to do all three things at once it is a muddle. What is the focus of your regulation, moving forward, given that you need real clarity to deal with financial institutions in a difficult climate?

Mr Sants: I would make the point that we would hope that sophisticated banking staff can focus on three things at one, but notwithstanding that, I take the point and, just to be clear, we are asking people to focus on the consequences, the outcomes of what they do. The other comments are about describing the framework that we will use to judge whether those outcomes are reasonable. What we are asking management to do, what we are asking people to do to protect depositors and savers is to focus on outcomes, and I think the message is straightforward and simple and should be easily understandable, is actually a lot more understandable than, say, adhering to an 8,000-page rule book.

Q64 Ms Keeble: What more do you think that financial institutions could have done to overcome the current difficulties?

Sir Callum McCarthy: I think that there are a wide range of things that have gone wrong in the risk management within banks and other financial institutions - that is undoubtedly the case - and that is one of the fundamental things. If you look at the origin of the present problems, there have been problems in the origination of mortgages in the US which represent a series of failures, including what I think the US regulatory authorities would recognise as things that they have not appropriately controlled. There are a wide range of things. If you ask what can now be done, I think the particularly important question is to ensure that financial institutions improve their disclosure so that counter parties can make a proper, informed assessment of the position of those institutions, and that is something that we are pursuing.

Q65 Ms Keeble: Do you agree with Governor that the incentive structures in the City of London presently are partly to blame for market turmoil?

Sir Callum McCarthy: I think there are some very difficult questions about incentive structures. I think it is a very complex area. I am very mindful of the fact, for example, that if you take Bear Stearns, about a third of the stock of Bear Stearns was actually owned by the employees, but that did not prevent Bear Stearns materialising as an acute problem. I think there are some very interesting and important questions about incentives which are very difficult to deal with.

Q66 Ms Keeble: I want to ask one further question, which is about the Special Liquidity Regime. I wondered if you had been consulted on it as one of the tripartite authorities. Given that you think that there should be credible deterrents for financial institutions who do not adopt sound lending policies, as is also set out in your memo, do you think that the prospect, as the public would see it, of a 50,000 bail-out is a credible deterrent?

Sir Callum McCarthy: Yes, indeed. We were involved extensively involved in the discussions of the development of the Special Liquidity Regime. Second, I do believe that the existence of this is going to impede credible deterrents because the essential---

Q67 Ms Keeble: It is going to impede it?

Sir Callum McCarthy: It is not going to impede it, and the reason why is that the credit risk lies with the banks and remains with the banks, and that is essential to the scheme.

Q68 Mr Fallon: The medium-sized and smaller building societies were excluded from the scheme, presumably because they could access funding indirectly. Has that worked? Are you aware that capital liquidity pressures on the smaller building societies have been eased or not?

Sir Callum McCarthy: I think the answer is the capital and liquidity pressures on the smaller building societies have eased for a number of reasons. I think it is not principally, at the moment, because of the very early stages of the Special Liquidity Regime. I am confident that there will be a transmission mechanism from those who can access the scheme, which include about half the building societies, to the residual half who cannot.

Q69 Mr Fallon: So there are not any smaller societies at risk?

Sir Callum McCarthy: Could I just make clear that I do not comment on any institution, but I am very confident that the scheme will work in a way that the smaller building societies will actually get access to it, not directly but indirectly.

Q70 Chairman: In fact, there was a radio report last evening as I was coming down talking about Nationwide, which services a number of very small building societies, but that facility had been withdrawn. I am suggesting it is just a radio report, but it highlights the issue of the very small societies having access. Is it something that you can look at and come back to?

Sir Callum McCarthy: Chairman, I would simply say that we have been very conscious, as the Bank, of this issue from the very beginning of the scheme, and I remain confident that there will be a transmission mechanism to ensure that the small building societies indirectly get access to it.

Q71 Chairman: Mr Sants, in regard to the Special Resolution Regime, you said to me that the role the FSA was to protect consumers and not shareholders?

Mr Sants: As a general point, yes.

Q72 Chairman: If you believe so, why do you regard yourselves as the best qualified to close a bank when the best way to protect consumers would be to keep a bank open?

Mr Sants: Basically the special regime would not necessarily involve closure. It depends on the circumstances. It depends on the option, the resolution option, then selected as to whether or not that would lead to an orderly wind down or not. Reaching a determination that the current framework under which a given bank was operating was not a sustainable one, or likely not to be a sustainable one, does not also require reaching a determination as to what the resolution option would be which could then be selected. Just in passing, however, it would be clearly ill-advisable to reach that determination if you had not already worked out with the person or the organisation who would be responsible for running the regime as to what the likely option was to be selected. That would clearly not be a good idea and that is why a high level of co-ordination is absolutely required between the organisation that runs the special regime and the regulator. There is no suggestion that this should not be a wholly co-ordinated process. I think some of this discussion somehow suggests that we would not be talking to each other. We obviously have to have a wholly co-ordinated approach, but determining that the current business model runs at risk of failure does not also require you to determine what would happen next.

Q73 Chairman: But you do not see any conflict of interest between your duty to protect the consumer and the protection of financial institutions?

Mr Sants: Undoubtedly, if you give an organisation a task - in our case, as the regulator, our task is to determine whether or not the institutions we supervise meet thresholds and conditions and we set a set of criteria for so doing - if people stop meeting those thresholds and conditions, people will hold us accountable to that fact along with the fact that we, of course, would be holding the bank management accountable, but that is the case in all cases. If you give people authority and responsibility, you make people accountable for the event. I do not in itself see it as a conflict, I see it as a natural fact of giving us a job which we would have to do well.

Q74 Chairman: Given that fact that the FSA's meeting was not minuted, you can imagine someone like ourselves saying, "Wait a minute, there could be a situation here whereby the potential regulation requirement on the supervisor means that they could hush up what is happening there." That information is not put back to the senior management of the FSA. Indeed, there are no minutes of that. So, at the end of the day, the interests of the consumer are not protected 100% here.

Mr Sants: If we do not do a good job, then the interests of the consumer are at risk. There is an obligation on us to do a good job, and Parliament has to believe that we will do our job well, and the purpose of setting out the programme we have set out and all the comments we have been making today and in our earlier appearances is to persuade you what I truly believe that going forward we will do.

Q75 Chairman: So you have got to persuade us that we have absolute trust in you?

Mr Sants: You always have to believe that the institution you give the responsibility for and the authority is going to do a good job; otherwise, obviously, you should not do that. We have set out what we believe we have to do, we believe we can do it and we make the point that I think the Chairman has already made that we have gone through a very painful learning process. We will be a better institution for having been brave enough and courageous enough to go through a learning process, lay out what we have to do and acknowledge our mistakes. That is the basis for a really strong institution in the future. Acknowledging your mistakes and learning is, I believe, a key component of a successful organisation.

Sir Callum McCarthy: Could I say, Chairman, I have no doubt that this committee would be properly critical of the FSA, and I mean that, and I also think that that is good for us, but you should be in no doubt about the determination of the Board, the executive team, to actually learn from what has gone wrong and put it right.

Q76 Chairman: Sir Callum, but we do not want to be critical of the FSA after the event. We want to make sure that this legislation is fit for purpose, and that is the issue here.

Sir Callum McCarthy: Absolutely.

Q77 Chairman: I have met quite a number of brave people who just hit their head against the wall. We want bravery combined with intelligence and judgment.

Mr Sants: I would ask you not to set it up in a way that we cannot do our job. I am saying I truly believe, if it becomes a complex overlapping process with double supervision, that neither of those supervisors will do a good job and we will be back here with same type of conversation.

Q78 Chairman: I do not want to take too much time up, but the report of the committee in terms of the deputy governor role was made because we need to inject creative tension and grit into the system, and that creative tension, I am suggesting, Sir Callum, was not there. That is why all of you, with equanimity, could some along to the committee and tell us you did your job.

Sir Callum McCarthy: Chairman, I simply repeat what the Governor said. I am all in favour of creative tension so long as it is creative; and the points that Hector has made are ones which seriously worry us in terms of duplication, lack of clarity and lack of responsibility.

Mr Sants: We are all in favour of the Bank having a clear mandate with regard to financial stability and the Bank fully involving itself in discharging that mandate, and fully involving itself in discharging that mandate includes being involved in supervision of firms particularly when there is a risk that they will need to turn to the Bank for liquidity assistance, but being involved in the supervision is not being a parallel supervisor causing confusion.

Chairman: I do not think the Governor was suggesting that.

Q79 John Thurso: Regarding the legislation, the Government have proposed that it should be enacted during this session. In the consultation document the Government also said it would be consulting with the FSA and other parties. What progress has been made?

Sir Callum McCarthy: The initial period for consultation has just closed. There have been very extensive comments, I am glad to say, because I regard this as probably the most important initiative affecting British banking for a decade and is going to shape British banking for decades in terms of the suitability and attractiveness of the UK to do banking business. It is essential that we now digest properly the comments that have been made.

Q80 John Thurso: What is the process going to be? I have the same goal that you have, which is that everybody who has been involved in this needs to put what they think they have learned and we need to work through so we get the best outcome for everybody. What I am worried about is that actually, as sometimes happens with legislation, it disappears into the departmental black hole and what comes out is what we are stuck with. What is going to be the process by which you and the other institutions will ensure that best endeavours are made to get the best legislation?

Sir Callum McCarthy: There are extensive and intensive discussions going on between the Treasury, who are in the lead of this because it is legislation, the Bank and the FSA on all aspects of the proposed legislation. I think the proposal is that there should be a further consultation paper that will come out some time during the summer and then legislation later in the year.

Q81 John Thurso: Would it be worthwhile publishing the legislation in draft or possibly even having pre-legislative scrutiny?

Sir Callum McCarthy: It is not my decision. I think these issues are complex and important, and I am all in favour for giving as much clarity as early as possible so that discussion can take place on the detail as well.

Q82 John Thurso: So you favour legislation?

Sir Callum McCarthy: I favour trying to put out into the public domain the legislative approach. If that is through draft clauses, I think that would be an admirable way of doing that.

Q83 John Thurso: That would be something for this committee to have a good look at, would it not? Let us move on. The Governor of the Bank of England when he was with us suggested that there was not much merit in the fact that he sits on your board and you sit on his and that, indeed, it had distracted us from really understanding the proper relationship that took place at a different level. How useful have you found your membership of the Court?

Sir Callum McCarthy: I think that there are benefits in having---. Actually it is the Deputy Governor who sits on the FSA Board. I see very significant advantages in improving the understanding of the FSA's Board about the approach of the Bank and also, I think, if you talk to most of the non-executive members of the Court you would find that they find there is advantage in having a representative of the FSA on the Court.

Q84 John Thurso: So you disagree with the Governor on that point?

Sir Callum McCarthy: It is possible for reasonable people to have different views.

Q85 John Thurso: That is nice to know. If the Bank of England is given a statutory responsibility for financial stability, as opposed to the more generic responsibility that it has at present, how would that interface and where would be the possible points of friction in regard to your responsibilities in this area?. Maybe, Hector, you want to have a go at that?

Sir Callum McCarthy: Can I make one point before Hector replies. I would not want it thought that at the moment the Bank is, as it were, indifferent to a wide range of issues affecting financial stability. The Bank sits on the Basel Committee and has played a major part in drafting and forming the proposals on capital that are Basel II. The Bank, as the Governor made clear, actually the Financial Executives and Executive Director of the Bank, chairs the present Basel I committee on liquidity, so in all sorts of ways there is an existing interaction which should not be underestimated.

Mr Sants: As I mentioned earlier, I think that being clear about the importance of the Bank focusing on financial stability matters is the way into resolving the question you posed earlier in terms of achieving a degree of four-eyes creative tension, a positive engagement with this important topic from two institutions, and so we support the importance of the Bank having a statutory role with regard to financial stability. As Callum says, I cannot underestimate the point, I think it is important to reiterate the point that we do work well at the working level. We worked well at a working level in the summer of last year, and the Bank was involved right from the beginning, as you are aware from the chronology, in terms of being properly informed of the issues in the market place, including the specifics of Northern Rock. So we do work well together and we should intensify that relationship and a clearer mandate, I think, would help encourage the Bank to be more pro-active in that area, and we would welcome that.

Q86 John Thurso: Let me put to you what worries me in this. It is the difference between the duty and responsibility towards the system as a whole as opposed to the specific regulation of an institution. We talked earlier on about the trigger, for example, that might be used with regard to a special resolution system for a bank. It is possible to imagine a situation where the Bank of England, with its overall new statutory duty with regard to financial stability, took one view with regard to a potentially failing institution, whereas the FSA, as the regulator of the particular institution with, as you have said, high regard for the consumer, might take a different view as to whether or not the trigger should be pulled. Is it possible therefore, if you are the single figure on the trigger, that you might not wish to pull it at a time when the Bank would want to see it pulled and how would that situation be dealt with?

Mr Sants: It seems to me difficult to envisage the scenario you are suggesting, I have to say. It is easier when one talks about concrete examples, and I am not sure if I can specifically envisage that. I would go back here to maybe looking at it from a slightly different perspective which may help eliminate this key question, which is that the basic role of a supervisor with regard to institutions - there are other things the FSA does, of course - is already to determine whether or not it meets thresholds and conditions. That is our job, and I am back to my earlier point. Either we are doing our job or we are not. It is obviously up to this committee and Parliament to determine whether we are not.

Q87 John Thurso: May ask you to address this distinction? Banks can fail without having an affect on the system overall. Johnson Matthey, Barings, a variety of institutions have in the past gone bust and it has been judged that the overall system was not at risk. A judgment was made with regard to Northern Rock that the system overall was at risk. So you have a duty to regulate an institution. It is perfectly possible for you either not to or to pull the trigger looking at one institution. The Bank of England have a specific duty to the overall financial system. What I am saying is the two are not always matched. How does that get dealt with?

Mr Sants: That would be addressed in a different way. I think that is different question. There is an interesting question as to whether or not all banks and building societies should be eligible for going into a special regime or not, and if it was chosen that not all banks would be able to enter a special regime but only those who are deemed to be systemically important, then that judgment as to whether or not they were systematically important could well be one reached jointly or in different ways and is a separate determination from the decision as to whether or not they have met thresholds and conditions. The point, we are saying, is it should be an initial criterion that you have not met our trigger with regard to the deliberation of whether you go into a special regime. There may well be other criteria for going into the special regime which are separate and apart from the determination of whether or not the FSA's trigger has been breached. By the way, in passing, we would take the view that one of the key lessons to be learnt from Northern Rock is the importance of having a reflective depositor protection scheme that does protect all depositors. So we certainly would like to see a regime which covers all depositors and does not discriminate between those depositors in smaller institutions and larger institutions, but that is a separate question and that determination would be addressed separately from the specific of have you met your regulatory threshold and conditions? What we are not wanting to see is somebody who can pre-empt that initial judgment. The initial judgment should be: have you met your thresholds and conditions? Subsequently other determinations could be made.

Sir Callum McCarthy: Can I make one point. I absolutely follow the line of questioning in terms of institutions versus the system, but to some extent it neglects the fact that there are important things that we do which are aimed at the system. If I can give one example: there has been a rather successful principle between the New York Fed and the FSA designed to ensure that a backlog of credit risk derivative execution was dealt with, and it was something which no individual broker, dealer, bank had an incentive to deal with and it was a collective action problem, and that is something which, by action between the FSA and the New York Fed, we substantially improved; and that was not about any one institution, it was something which was designed to improve the system as a whole.

Q88 John Thurso: My concern is to ensure that going forward the lesson we have learnt is that there is clarity of responsibility?

Mr Sants: We would like our clause to be the necessary but the sufficient does not have to be the sole clause.

Q89 Chairman: To take up John's point about draft legislation and pre-legislative scrutiny, that is one of the points that I will be including in my letter to the Chancellor as well as market abuse, because this committee has produced a report, Sir Callum, which was unanimous, which reflects the feeling across the whole House, and it is important that this committee is to be assured that we have confidence in this future legislation as the House has, because if we do not, then we are off to a bad start on that issue. So pre-legislative scrutiny is extremely important on a bill which you are saying, with which I agree, is one of the most complex bills that we will have before us in the coming months. Do you agree on that?

Sir Callum McCarthy: I think I agree with every word you have said, Chairman.

Q90 Chairman: Good. Mr Sants, you mentioned that all depositors should be protected. Do you include wholesale?

Mr Sants: No. Thank you, Chairman, for making that point? I just observe that on balance we would favour a regime that did look after all retail depositors.

Q91 Nick Ainger: Sir Callum, the Governor told us last week that this crisis, meaning the credit crunch, came right out of the design of instruments traded among the most sophisticated financial institutions where they did not spend enough time thinking deeply enough about the incentive structure of those instruments. Before Northern Rock were you looking at the risks that all financial institutions were exposing themselves to because of their involvement in the trading of these instruments?

Sir Callum McCarthy: Yes. Before Northern Rock, we, the Bank of England and other comparable institutions around the world, had been drawing people's attention to a fundamental mis-pricing of risk which had many aspects associated with it, and one aspect of it, and something which I think has had less attention than it should have had, most of the attention at the moment is on the sale side, i.e. those who originate or distribute products. I think that one of the central questions arises on the buy side: why did people buy instruments that they did not understand on the basis of a simple rating?

Q92 Nick Ainger: Bearing that in mind, if you were giving warnings, as the Bank was as well, about the risks that some of the institutions were exposing themselves to, those warnings were not heeded, and we have now got a situation where banks are still not lending each other money, we have got the credit crunch, people's mortgages are being directly affected and possibly the wider economy. Is it now time to consider a regulatory regime of those financial instruments so it is brought home very clearly and starkly to these financial institutions that they should not expose themselves recklessly, as they clearly have done, to these risks?

Sir Callum McCarthy: I very strongly believe that people should not expose themselves recklessly; and one of the points I think I made earlier is that one of the things that absolutely is required is improvement in the risk management practices within firms. I am not in favour of a regulatory regime which actually attempts to regulate individual products - to say you cannot produce this sort of product, you cannot invest in that sort of product - because I think that that has disadvantages which would outweigh the advantages.

Q93 Nick Ainger: But if we are all agreed that these financial institutions have, despite warnings, exposed themselves recklessly in the last few years and this has resulted in the first major global banking crisis for many years, and we all accept that, but you are saying that we would carry on with this light touch, while the Governor says that he feels that in the next five or ten years hopefully those managers within the financial institutions will have learnt this particular lesson, but do we not run the risk that new instruments not yet dreamt up by financial whiz-kids will end up doing exactly the same thing that the CDOs, and so on, have done this time? Is there not a risk of that and should we not really be trying to define the exposure of these institutions to the risks that they run rather than leaving it to them to make those decisions, because clearly we left it to them before and this is the mess that we have got ourselves into?

Sir Callum McCarthy: I should make clear that I do not believe that either present and certainly not the future should be described as light touch. I do believe that there is a need for a series of changes affecting capital, affecting liquidity, affecting valuation, affecting aspects of credit rating agencies, affecting aspects of origination where we need specific actions, absolutely, and I think that that complete programme is something that we very badly need and which there is determination not only in the UK but in other major capital market centres to implement that.

Mr Sants: Also could I make the observation, one of the lessons which we would learn from the last year or so is that market behaviour is not just a function of numbers, it is not amenable solely to arithmetical modelling; one of the key issues here has been a loss in confidence which then affected liquidity. So I think to set ourselves a goal that somehow or other we can create this model which we, the regulator, could then set parameters within which banks would have to operate, I am afraid, whilst it may sound attractive, it just is not possible. Markets are a function of both human behaviour as well as maths, and it is not possible for us to design a model that will anticipate everything that will happen in financial markets.

Q94 Nick Ainger: But one of the failings that you have identified in your report on Northern Rock was a lack of intensity by the FSA in ensuring that all available risk information was properly utilised to inform its supervisory actions. Given you have admitted that is a failing, the failure to assess the risk that the institution was under because of its business model, how does that fit in with what you have just said?

Mr Sants: Northern Rock's business model, as I have reflected a number of times, was not that complicated, and we do believe in this particular case it was reasonable for the Board, as non-executives, and the supervisor to have better anticipated the risks it was potentially running and to have put in place a better risk mitigation programme than they had. The comment I was making was a reflection of your wider consideration of the wider issues that have occurred in financial markets over the last 12 months. Northern Rock was, as it were, a victim, in the sense of liquidity disappeared in its main financing instrument, of these wider issues. What I was pointing out was that modelling the entirety of the financial system and all the risks that any individual financial institution is therefore running is not a realistic proposition.

Q95 Nick Ainger: So we are back to the position that we were in pre Northern Rock, in that we hope from the culture within these financial institutions that their risk management committees will start performing properly. Would you look at the performance of risk-management committees, for example, within these financial institutions, and what is the difference between what you were doing pre Northern Rock and post Northern Rock?

Sir Callum McCarthy: If I may say so, the answer to that is yes and yes. One of the things that we have done, for example, alongside other supervisors, through something called the Senior Supervisors Group, to look at the experience of the last nine months in relation to those firms which have succeeded in managing these problems and those firms which have exacerbated the problems to pull out exactly what is the difference in behaviour, to make sure that we ourselves in our supervision, the American supervisors and the German supervisors, and so on, go back to all these firms and say, "Are you actually doing the things that the best firms have done or are you simply doing the things which have led to these problems?" Absolutely, we will do that, and that is the line that we think is going to produce the best results.

Mr Sants: We are just trying to tread a balance here between saying, "We can do more" and, "We can do a better job", but also making the point that we are not infallible, we are not a regulator that just comes along and checks, "Are the necessary safety barriers in place", we are a regulator who is trying to make a judgment about the consequences of people's actions, the outcomes of what they are doing. Outcomes occur in the future. It is not possible to predict the future. If we could predict the future, we would not be sitting in these jobs. I am just trying to draw the distinction between what we can do and what we cannot do and encourage the committee to recognise the complexity and challenges in the task, but that should not in any way deflect from the fact that we can do a better job.

Q96 Mr Dunne: Just a couple of questions picking up on lessons to be learnt from Northern Rock before I follow up some of the Chairman's questions on market abuse. Now that we have the benefit of not only the hindsight of the way the Northern Rock crisis was handled but also the way the US authorities handled the Bear Stearns crisis, what lessons do you think the authorities here can learn from the way the Bear Stearns crisis was handled in the US?

Sir Callum McCarthy: I think that it is clear that Bear Stearns, which I think was a very important set of actions by the US authorities, has had a significant effect on improving confidence. It is clear that the rescue of Bear Stearns would not have occurred without involvement from the US authorities and from the Federal Reserve Board in relation to the 29 billion that they underwrote, and I think that one of the things that one has to recognise is that there are circumstances in which that sort of involvement is necessary.

Q97 Mr Dunne: Was there not a very close parallel with the situation with Northern Rock where there was a potential offer, or there was a major domestic bank seeking a central bank funded facility in precisely the same way as JP Morgan were, as you have just acknowledged was required for Bear Stearns? Were those circumstances not parallel to what was potentially available in the UK had the authorities, including yourselves, injected enough energy and speed of activity to encourage a similar situation similar situation to that which happened in the space of a weekend in September last year?

Sir Callum McCarthy: I think there are not exact parallels, but I do believe there are comparisons between the two, yes.

Q98 Mr Dunne: Would you have done it differently in the light of Bear Stearns. Would Bear Stearns provide the excuse or would Northern Rock provide the excuse to engineer a rescue within a weekend today which was not available last autumn?

Sir Callum McCarthy: I think one of the things that people were very conscious about in relation to Bear Stearns was how much further through the developing crisis were Bear Stearns versus Northern Rock, and I think that you have to recognise the effect of that, which undoubtedly concentrated minds in the US.

Q99 Mr Dunne: Turning to the accounting principles that apply to banks at present, given the difficulties in the securitisation markets of marking books to market, has that exacerbated the problems that there are at present in providing confidence to banks where risks and losses are likely to occur?

Sir Callum McCarthy: I think there are very significant problems in valuation of complex instruments in illiquid market. It is because of that that we have been encouraging UK banks and UK institutions to increase their disclosure to enable counter-parties to form an informed view.

Mr Sants: It is certainly very important that banks lay out fully all the necessary information that investors would need to reach their own views about the valuations of those positions, and that is something we are very much encouraging banks to do, but I would say, I think the main issue for the market place is not so much the issue of whether they are currently marked to market but rather investors' concerns and lack of knowledge as to what will happen in the future. So the bigger issue for investors has not been knowing what the next mark will be, not necessarily their concern as to whether the last mark was marked to the then market.

Q100 Mr Dunne: Do you think there should be greater transparency in identifying bank positions throughout the course of the year rather than simply on balance sheet dates?

Sir Callum McCarthy: I find that quite a difficult judgment to make, because I think that the problem in a way is making sure that there is information that is comprehensible and actually usable, and I have some doubts, as it were, a daily marking of positions and publication of those positions, whether the amount of data would simply flood the market and be unusable. One of the real problems at the moment is, if you look at the length of annual reports of the major institutions, you get a huge amount of data. It is not clear how much information you manage to extract from all that data, and I think the proposal you make might have that problem.

Q101 Mr Dunne: Similarly, do you take the same view over reports by banks of breaches of their capital adequacy positions?

Sir Callum McCarthy: I think that it depends very much on the circumstances of any breach, for the reasons that Hector began to discuss in answer to an earlier question.

Mr Sants: It would not necessarily be right to say that all such breaches were important. I think you need to give proper consideration to the facts involved and the type of remedial action which would be taken.

Q102 Mr Dunne: Because it only transpired that Northern Rock was in breach of its capital adequacy when they published their accounts some nine months later, and it was apparent from your report into your own investigations that the flurry of meetings which suddenly took place with Northern Rock happened about ten days after they had reported that breach to you; so you reacted, obviously, with relatively the appropriate speed at that point; but I note from your report that you did not regard it as sufficiently serious for it to change any of the status of the monitoring of the bank, despite the fact that they were in breach of their capital adequacy regime. Is this a fairly common thing to happen with major banks that they breach capital adequacy, or is it very unusual?

Mr Sants: As I mentioned before, I am reluctant to give you precise data. I will give consideration to what we can say to the point. I come back to my earlier remarks, that whatever we do has to be in the best interests of the stability of that institution and if we judge that appropriate remedial action is in place, then it seems to me that that is a reasonable framework under which to operate, but we will come back to it a bit more with whatever we feel appropriate to reveal with regard to how often this occurs.

Chairman: I think Margaret Coles, it should be, to go on to market abuse questions, Philip.

Q103 Mr Dunne: Thank you, Chairman. The Chairman touched on this in his remarks at the beginning. Ms Cole, you have helpfully provided us with a schedule setting out the apparent reduction in informed price movements from regular announcements over recent years of apparently a failure of the systems proportion of informed price movement on the back of takeover activity. Could you elaborate a little bit more on that and, in particular, set that in the context of how that compares with other countries?

Ms Cole: Yes. As to the latter question, I think we are the only regulator that publishes a survey of this nature. Indeed, we believe that demonstrates our commitment to transparency and trying to assess the scale of the problem. So I do not think I can give you a direct comparison with other countries. Certainly it is the case that we regard what is shown by these figures as a serious problem.

Q104 Mr Dunne: Could you tell us what you are going to do about it?

Ms Cole: Yes, I can. We recognise that we need to do more to address the issue of market abuse and insider dealing. We certainly need to bring more cases - that is why we are in the process of preparing cases and why we have carried out a major upgrade to the skills of the staff in the enforcement division. Clearly, what I cannot tell you about is the detail of cases which are going through the system, but we do have a number of cases which are in the course of being prepared either for criminal prosecutions or for the civil process. We would expect those cases to flow through the system during the course of this year and next year.

Q105 Mr Dunne: You have said in your memorandum to us that it is difficult to extrapolate from these figures the idea that all of the price movements reflect insider illegal activity, insider trading, because there are lots of other reasons why movements might have occurred. I think the public perception, however, is that this suggests that roughly 30% of takeovers involve insider dealing and that is the way it has been characterised in some of the media. If that is not the case, I think that is a very unfortunate consequence of this transparency. Are you able to provide any complication? You have said you are taking action in a number of cases. Can you try and elaborate a little bit more on what proportion of the 28.7% of cases you regard as being suspicious?

Ms Cole: I agree with you. I think we have sought to explain why these figures are not necessarily indicative of insider dealing cases because there are many reasons why the price of shares might move ahead of an announcement. We have provided you with some information, I believe, that suggests that we would certainly expect 10% movement without there being any misuse of inside information. That clearly brings the overall figure down to below 20%. We still think that figure is too high.

Mr Sants: You should also add into that that the statistic is probably not accurate to more than about 5%, so, effectively, something of the order of magnitude of 15% would be taken out of the equation. You are right, it is unfortunate that despite our best efforts to explain this, the media continue to report it in many cases, not in all cases, in a way which sometimes gives the wrong impression of what this data is designed to do, but we remain of the opinion that it is important to try to have some sort of objective measure here and it is important to enable us to focus on our basic objective, which is improving market quality. It is not the number of cases that matters here, it is improving the quality of the market. It is logically true that if there were no insider dealing you would not have any cases: so you obviously cannot have a case target, you need a target improving market quality.

Q106 Mr Dunne: Even if there was no insider dealing, it would be quite possible for a significant price movement in many takeover target companies to occur?

Mr Sants: More than possible, it is highly likely probable.

Q107 Mr Dunne: Which is why I think some of the comments you have just made about the quantification, perhaps it would be helpful if you could elaborate in future public announcements, make that point clearer than you have to date, because otherwise it does give potentially quite a misleading impression.

Ms Cole: I think we have tried to make that clear in the latest Market Watch publication. I will certainly have a look again on that subject.

Q108 Mr Love: Sir Callum, does the City of London take market abuse seriously enough?

Sir Callum McCarthy: I would say, no, I do not think it does. One of our ambitions is to get it to take it more seriously, and that is why we are determined both to put in the resources within the FDA and to get the additional powers that we believe are going to be necessarily to really establish what we are after, which is credible deterrents.

Q109 Mr Love: Mr Sants, is the FSA independent enough from its contributing member firms to be able to deal with this problem adequately?

Mr Sants: Yes.

Q110 Mr Love: Let me go on to talk about the recent controversy over telephone taping, where it would appear, according to The FT, which most people consider to be the in-house magazine of the City, they called it "a climb down" that you had moved from three years to six months in terms of telephone tapping and that you did not include mobile phones. Does that show the sort of independence and robust action that we need at the present time?

Mr Sants: I think that newspaper report was a misrepresentation of the facts with regard to what had happened with regard to our consultation process. Let us just take a look at the facts here. First of all, telephone taping is already common practice in the City, the motivation here being, particularly for the large firms, to deal with trading errors and other related matters. Something in the order of about 80% of all the dealing telephones in the City are already taped. Reflective of our determination to deliver a clearer message with regard to market abuse, we thought it reasonable to take advantage of the introduction of MiFID, though this is not a specific MiFID requirement, to take a look at making a clear rule with regard to telephone taping because of the benefits we believe that brings to our fight against market abuse. As is appropriate, given our regulatory framework, that introducing a rule requires a discussion process and requires a cost-benefit analysis to be done. It is a very difficult issue, doing a cost-benefit analysis with regard to telephone taping, partially because technology is changing all the time and partially because of the difficulty, in fact, of getting accurate information from the firms. We had in our initial process quite a lot of contradictory views as to how expensive this process was. So we put out a proposal to try and flush through that debate and get a clear understanding of the cost of introducing taping. We have now done that and come up with a sensible proposition. Six months is more than adequate for our purposes and we are very happy with where the proposals have ended up. With regard to mobile telephones, it is clearly the case people use mobile telephones and, as technology improves and, therefore, the cost, potentially, of addressing the taping of mobile telephones comes down, we will return to the point, but at the moment, under our statutory obligations, it was not possible for us to push through that measure and, indeed, technically I think may well have been very difficult in any case.

Q111 Mr Love: It was reported to the newspapers that this was a matter of cost, and the institutions have said this was not as expensive as you say on a cost-benefit analysis. Sir Callum, does that send the right message to the City: "Yes, of course we will step down, we are completely independent, we want to send signals to the City of serious market abuse is"? Did that send the right signal?

Sir Callum McCarthy: Given the legal requirements that we have to demonstrate that what we are doing is cost-effective, there was no other course of action that we could properly take. I think there is nobody who doubts the determination that we have to actually tackle the problem that has been a long-standing problem over decades, and I think that we are tackling it with greater resolution and greater resources than has ever happened before.

Mr Sants: To deal with the particular, if we choose to, we can ask people to retain the tapes for longer periods. So as long as we act decisively within the six-month period, this will have no effect. The obligation this places on us is to act quickly and decisively. If we act quickly and decisively, the change in the time period will have no material affect on our ability to deliver in this area. So it is not that important a point, with due respect. What is important is that the tapes are there for at least a four to six-month period.

Q112 Mr Love: Let us talk about quick and decisive. It is accepted, I think, across the City that there is widespread abuse. Whether that is supported in the newspapers, a quarter of all takeovers, or a fifth, or even a lesser figure, it is still very widespread. You have admitted earlier on that there are few prosecutions, even those in the pipeline. Sir Callum has just said this is a system that has been going on, market abuse has been going on, since time immemorial. Why did it take you so long to come back to the Government and say, "We need legislation to improve this situation"? Sir Callum, if you are quick and decisive, why has it taken so long?

Sir Callum McCarthy: All I would say is this is something that we have decided to push up our list of priorities. We started doing that, I would say, about three years ago. I think since then we have, as Margaret has said, changed the enforcement team, we have reinforced it, we have spent money heavily on the technology and we are now very clearly asking the Government for further powers, and I think that it shows our determination.

Mr Sants: Mr Love, you have got a point with regard to the tariffs effect here. What we have learnt in the last year is that civil action alone is not providing sufficient deterrents, which is why we wish and intend to take more criminal prosecutions in the future. So we have learnt something here. We have learnt that our sanctioning needs to be greater to achieve the required deterrent effect.

Q113 Mr Love: I will come back to the criminal issue in a second. Can I ask Ms Cole, you were part of a team who went to see how the SEC do it. You indicated earlier on that they do not publish any figures, but did you get any idea from your visit there about the nature of the way they go about dealing with market abuse and are they, in your view, more successful and why are they more successful?

Ms Cole: I think there is no doubt that they have had more cases and they have more successful cases. I think one of the major reasons that came across to me from that meeting is that they have more tools with which to build the evidence to bring the cases, and the most significant tool that they have is the ability to enter into plea bargaining arrangements and immunity arrangements with co-operating witnesses, and that is not just a tool, they have a long history of that being accepted within their legal system and it is, as I am sure you know, very commonly the practice that witnesses will come forward when they are aware of an SEC investigation and will offer tangible evidence against other participants in a crime. That is not a power that we have historically had. You mentioned earlier: why has it taken so long for us to ask for it? It is not right that we have only just asked for it. We have been asking for this power for a period now of more than two years.

Q114 Mr Love: I accept the issue about the legal powers, but would you accept that there is a difference, a very distinct difference of perception about the robust - I use that word advisedly - and rather tough way that the SEC goes about investigating market abuse in the United States than the more consensual way in which we do it in this country? Is that a contributory factor to whistle-blowing and plea bargaining that they achieve in the United States?

Ms Cole: I would accept there is a difference in perception and I would accept that that makes a difference to people coming forward, as well as I have explained a long history, a longer history than we have had, in prosecuting cases. I think it is important to note that we have said that we accept that we need to do more in this area and that we publicly said that we need to present a tougher face all round.

Q115 Mr Love: What action are you taking? We have heard about the action on resources strengthening the team. We know that you are going to be seeking the legal powers necessary. How do we change the culture in the FSA and, if I may say so, change the culture in the City of London to accept more that this is a criminal offence?

Ms Cole: We are certainly taking more steps that we think are bolder investigate steps. We have started a process of early telephone interviews so that we can get on to a case of suspicious movements at a very early stage. We will use all the powers we have available to us. That is both down the criminal and the civil route. We will use and we have used our ability to obtain civil injunctions to restrain the use of the proceeds of potential market abuse, so we have looked into the various powers that we have and also into the various powers that we need and we do intent to be bolder and more resolute, if I dare use those words, about proceeding with market abuse cases and insider dealing cases.

Q116 Mr Love: We will no doubt look at that in the future when you come back. Can I move on to this issue of criminal versus civil, because it is recognised, certainly I think it is recognised by our committee, how difficult it is to achieve prosecutions in this particular area. The test required for a civil prosecution is significantly lower than that required for a criminal prosecution; so at the time when you are saying to us we are having real difficulty in getting prosecutions in this area but we want to move to a situation where we are doing more criminal cases requiring a higher standard of evidence that we simply cannot get, how do we match those two things?

Ms Cole: I think the first point here is that we think that we need to do criminal cases because we think they have a significantly greater deterrent effect on the industry than the civil cases. Of course, in civil cases we can impose unlimited penalties and we can prohibit unregulated from the industry, but in the criminal context, obviously, what people are looking at is, the threat there is of a custodial sentence, and we think that has a significantly greater deterrent effect. So we think we need to move into the space of criminal prosecutions. That is not to say that we will not use our civil powers as well. You are right in saying that, at least theoretically, the burden of proof in a civil action is lower than for a criminal action. I would just say, however, that when we proceed with civil actions, and the process of reviewing our decision there is for the Financial Services and Markets Tribunal, the tribunal have held that there is no meaningful distinction between the burden of proof in a criminal case and the burden of proof in a civil case. That is something which I would say is very different for the SEC, who operate on a true civil burden in civil cases.

Q117 Mr Love: Can I ask you, and perhaps others would like to comment, is not the greatest deterrent effect actually achieving prosecutions and should not your first priority be, by whatever means, to prosecute?

Ms Cole: We do have a priority to prosecute. Where we can collect the evidence that will justify the bringing of a criminal prosecution in a suitable case, we will bring that prosecution. We have to have evidence that leads to us believe there is a reasonable prospect of conviction and we have to satisfy the public interest test. The important challenge for us is collecting the evidence which will substantiate our cases. We clearly cannot bring cases without the evidence. Insider dealing cases, as you pointed out, are uniquely difficult to bring, largely because the evidence is circumstantial. That is why it is so important to be able to get people to come forward as co-operating witnesses and give us actual direct evidence of the elements of the offence in question.

Mr Sants: As you yourself said, some of this is about messaging. You rightly observe that historically people have questioned whether the FSA is taking this issue seriously enough. We are determined to remove that misconception, we are determined to remove the conception that somehow or other we are light touch, and, therefore, one of the key points about bringing criminal cases, where the circumstances and evidence warrant it, is to deliver the right message here that we are determined to address this issue, and any suggestion that the culture of the FSA is not determined I would reject. I have acknowledged in the earlier point on Northern Rock there is more work to do. On market abuse the issue is not the culture of the FSA. I do, however, agree with the observations made by my Chairman and by you. I think there is still a cultural problem in the City in the round, albeit not in the senior management in the larger firms.

Q118 Mr Love: One final question if I can, Chairman. Mr Sants, you said earlier on, and I agree very strongly with it, that your role is to look after the consumer. Is it the success of the SEC in the United States that there is a perception there that the authorities look after the little guy against what is happening in some of our city institutions, and should not the FSA be concentrating more on looking after the little guy in order that we achieve more success in this area?

Mr Sants: It is absolutely the case that we need to look after everybody. At the end of the day everybody is a beneficiary of fair markets and quality markets, and you are absolutely right, as we said in our Market Watch, insider dealing is cheating and cheating is at the expense of everybody. Everybody who has access to the stock market and every consumer should be worried about this, and we are determined to deal with it.

Q119 Chairman: As you are aware, we will be continuing to look at that in our financial stability and transparency inquiry which has unfolded over the past few months. Could I finish on the issue of short selling and its regulation given the controversy there has been in the past? Going long on 3% or over of the total stock in a company must be disclosed to the market. Should there be a requirement for a declaration of interest from going short similar to applying and going long?

Mr Sants: Are you specifically referring here to our discussion around CFDs or are you talking about the wider issue of going short in---

Q120 Chairman: The wider issue, because I will move on to CFDs in a minute.

Mr Sants: I think, to open up on this point, we have in the past looked in some detail about the validity of shorting and I think it remains the case that thoughtful and considered shorting for justifiable investment purposes is a legitimate investment technique, and I do not think we would want to suggest that it is not. Indeed, we think it contributes to the liquidity of markets and, therefore, probably reduces rather than increases volatility. In general, we do support having a properly transparent market place to enable investors to make informed decisions. The questions around an increase in transparency, both with regard to derivatives and shorts, really focus around whether we can justify that against cost-benefit analyses and the technical difficulties of collecting and delivering data, but the general principle we would agree with; we are always looking for markets to be as transparent as possible without interfering with the reasonable liquidity.

Q121 Chairman: But you have seen the havoc that that has caused in the past. We are not arguing here for banning it, but the same level of transparency and disclosure for going short as going long seems a reasonable proposition.

Mr Sants: It is a reasonable proposition.

Sir Callum McCarthy: Could I just say, if you go back, say 20 years, there was a famous comment once made that insider dealing was a victimless crime. It is absolutely not a view that we have, and one of the things that we are particularly concerned about is drawing the present very fragile market conditions when something could cause real economic harm if it is allowed to flourish, and we are really determined to try and do all we can on this and we will strain all our powers to deal with it because we absolutely reject any implication at all that this is something that should be an acceptable part of practice.

Q122 Chairman: On contracts for difference, on equities, should they be subject to greater trade reporting transparency. The trade reporting disciplines of the cash equity market do not apply to it. Should that discrepancy not be addressed?

Mr Sants: On CFDs, we collect data with regard to market abuse, so we are already collecting that data. The issue around CFDs is transparency and visibility with regard to people making informed decisions. It is not hampering our efforts with regard to market abuse because we already have the data input into it. But to my earlier point, in general, the presumption of the FSA is as long as it is not impeding liquidity, and there is an interaction here between transparency and liquidity, we believe full transparency is the right way forward, and that is the backdrop to our current consultation paper with regard to CFDs, but we do need to balance up that presumption of the benefits of transparency against a full understanding of the costs and practicality of delivering it, and, as you will probably know with regard to CFDs, an element of the industry, particularly the investment banks, have raised issues around the practicality of the cost of delivering a more transparent regime, but our presumption is that the regime should be more transparent and we will coming forward with our proposals for this in due course.

Q123 Chairman: Sir Callum, I saw you nodding enthusiastically there. Is your impending liberation making you agree with me even more on that?

Sir Callum McCarthy: Chairman, I am very conscious that the last time I appeared before you, you very handsomely thanked me for giving evidence before you. I am rather worried how many final farewell performances I am going to have!

Q124 Chairman: Okay. On the short-selling issue, if you take that up and keep in contact, we will be happy. Sir Callum, the remarks I did make the last time I endorse heartily and I think we are quite sure this time will be your last performance. There is no Frank Sinatra here, is there? Can I thank you for your co-operation with the committee and wish you well in your endeavours in the future, and thanks for everything you have done for the committee and the FSA.

Sir Callum McCarthy: Thank you very much. I am grateful.