House of COMMONS








Tuesday 11 December 2007


Evidence heard in Public Questions 1424 - 1547





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Oral Evidence

Taken before the Treasury Committee

on Tuesday 11 December 2007

Members present

John McFall, Chairman

Nick Ainger

Mr Graham Brady

Mr Colin Breed

Mr Jim Cousins

Mr Philip Dunne

Mr Michael Fallon

Mr Andrew Love

Mr George Mudie

Mr Sin Simon

John Thurso

Mr Mark Todd



Witnesses: Sir Callum McCarthy, Chairman, and Mr Hector Sants, Chief Executive, Financial Services Authority; Ms Loretta Minghella, Chief Executive, Financial Services Compensation Scheme, gave evidence.

Q1424 Chairman: Sir Callum, welcome to you and your colleagues. We have met before. Can I ask why you are pushing ahead with reforms to the FSCS funding ahead of the Government's consultation on the future of the entire deposit protection scheme?

Sir Callum McCarthy: Chairman, because we had for a long time had in train changes, changes designed to make the scheme more resilient and to give it better funding power, and we thought that whatever changes come about from the legislation the Government plans to introduce next year it would be sensible to make those changes in the meantime because we did not think there would be any conflict between improvements we are planning to make and had planned for some time and whatever comes out of that legislation.

Q1425 Mr Todd: In the discussion over the FSCS there has been debate over how to define the boundaries of it and the implications in terms of moral hazard, both for the depositor in not perhaps being fully aware of the products they are purchasing and the method of protecting their deposit, and also the financial institutions that they have placed their deposits with. How do you address those?

Sir Callum McCarthy: The moral hazard question was particularly predominant at the very early stages of the scheme. When the scheme was first introduced in the 1970s it was a 75% deposit insurance, and it only went up to 90% relatively recently, and it is only post Northern Rock that we have increased it to 100% for the first 35,000. The difficulty is forming the right judgment on that because, for example, if you look at the experience in the US during savings and loan problems it was quite clear that that resulted in some distortion of behaviour and some serious moral hazard.

Q1426 Mr Todd: So what advice do you give, because you have said there is a question of balance to be struck here, is there not, in addressing how to design this, both in terms of the concept of co insurance, of the depositors bearing some proportion of the risk and therefore incentivised to understand what they are involved in, and also in terms of the limit of protection on the deposit to encourage the financial institutions to manage its affairs responsibly and not recklessly?

Sir Callum McCarthy: First, I do not think that this is a science. There is no algorithm we can apply to give you the right answer; it has to have elements of judgment in it. We are looking at this very carefully. The present 35,000 probably covers something like 95% of individual depositors; it probably covers something like 50% of deposits, and getting that balance right so you get the right protection for individuals but do not encourage irresponsible behaviour by institutions is what the judgment has to be.

Q1427 Mr Todd: Do you think that the current limit, or the limit as it was, was properly understood by consumers in the first place, because for this to have any value consumers really have to understand the level of protection that is offered, and I think I would not have been alone in not knowing the details of this until Northern Rock filled our screens - and I tend to take the view that I am a reasonably well-informed consumer. There must be many, many who knew nothing about it, and did not know the limits or any co-insurance element within it?

Sir Callum McCarthy: That is true, and I think one of the questions is how to explain the reality and that reality is both a question of the amount of coverage, when this no longer applies when there is co insurance, and also the speed with which an individual can expect to receive a payment under the deposit insurance.

Ms Minghella: It is important that consumers understand the protection that is available to them in the event of a failure, and that is why when a business does fail we take steps to inform every consumer who is affected that they have a right to claim on the scheme. We also do work with a number of stakeholders, Consumer Advice Centres, Money Advice Bureaux, journalists, MPs, to try and bring the scheme to general attention in advance.

Q1428 Mr Todd: Do you not think there should be a clear obligation on a provider of a deposit-taking service to communicate regularly with the person having that deposit the limits of a scheme of this kind? Without wanting to spread alarm about it they can couch it in appropriate terms of "in the unlikely event" and all the other things, but surely there should be an absolutely clear obligation placed on a business to do that, and that has not been done.

Ms Minghella: I would agree with you, Mr Todd, that a firm should have an obligation to communicate with its customers; it does have that obligation at the point of giving any explanatory information about a product, and I think that could be further enforced.

Q1429 Mr Todd: What about the research into institutions which might be safer than others? To what extent do you think humans are able to make reasonable judgments to spot, if you like, the Northern Rock circumstance and say: "Well, I would perhaps rather not place my money there but in an institution which might be regarded as safer"? To what extent does that information exist in a way that consumers can regularly understand and, if it does not, should the Financial Services Authority not be providing that?

Sir Callum McCarthy: First, unlike, say, the FDIC which does have a pre-funding basis and where contribution from the different institutions is adjusted according to the assessment of risk given by the FDIC, we do not do that, partly because we do not have the pre-funded system. One would have to be quite careful about that process because it is not self-evident that one wants all the time to be marking institutions up or down, and there would have to be a considerable degree of care in how any approach was taken to that.

Mr Sants: We might add that in making the decision to go to the 100% of the 35,000 we were reflecting a belief that it is probably unrealistic to expect the consumer to have the necessary information and ability to judge funding risk, so I think possibly that would be asking too much of the consumer. I certainly think in our view it would obviously be something we could discuss and take views on as we go through the next stage of the process, but our current thinking, and it certainly was behind the 100 per cent, is that it is a little too ambitious to expect the consumers to have detailed understanding of funding risk.

Q1430 Mr Todd: You do not think even a rudimentary information provision would be of value?

Mr Sants: I think that is highly debatable, to be honest. We have discussed in this group before, of course, the complexities of the events that overtook Northern Rock, and I think a rudimentary description of funding issues might well cause more issues than be helpful.

Q1431 Mr Todd: I think I can appreciate that. We had a discussion with two academics on the issue of the role that depositor protection might have as a financial stability tool, and their view was essentially that this was a matter of social policy, really, and had no particular role in terms of financial stability. Would you agree with that?

Sir Callum McCarthy: I am not sure if I would completely agree with that because I think if there is greater understanding of the position of individual depositors, if they know they are 100% covered up to a certain amount, if they know they get very rapid repayment, it is much less likely that there will be a retail run, and that has implications again for financial stability. So I think it is not just a question of the social aspects of this, though those are important --

Q1432 Mr Todd: It is consumer confidence --

Sir Callum McCarthy: Yes.

Q1433 Mr Todd: -- which, if it is absent, certainly has an effect on financial stability.

Sir Callum McCarthy: Yes.

Q1434 Mr Todd: But the primary aim of this scheme I think was described as widows and orphans. It certainly extends to a lot more than widows and orphans but the principle is of people of relatively modest means having their savings properly protected so they need not worry about them, and providing a scheme which, for example, encompassed the deposits of businesses or relatively wealthy individuals should not be an objective. Is that reasonable?

Sir Callum McCarthy: Broadly I would agree with that. The basis is it is unreasonable to expect ordinary individuals to assess matters.

Q1435 Mr Todd: Fair enough. Lastly, obviously a depositor protection scheme of this kind cannot protect against all possible circumstances of failure, and there is a recognition that if a very major financial institution failed then it would not be adequate to cope with that circumstance. How should that be expressed?

Sir Callum McCarthy: It is important that, even if there were a very large failure, people should know that the guarantee that they had received would be met, but that essentially would have to be met in the last resort by Government.

Q1436 John Thurso: Prior to October this year the scheme would only cover 90% deposits between 2000 and 35,000. I understand the rationale for deciding upon an upper limit figure but I do not understand the rationale for an intermediary band of only 90 per cent. What is the rationale behind that?

Sir Callum McCarthy: The rationale was a view of the moral hazard and the importance of some degree of co-insurance, in a sentence.

Q1437 John Thurso: Do you think it is appropriate that the individual depositor at the under 35,000 level should be obliged to partake in that moral hazard, given clearly the Government have decided since October that is not the case?

Sir Callum McCarthy: In answer to a previous question I explained that the background of the introduction of this scheme started off at 75% then went up to 90 per cent. Originally it did not have any fixed element at all and if you look at the development of it you can see where it started from and where it has moved to.

Q1438 John Thurso: UK banking generally over the last 12-15 years has enjoyed a long run of very strong profits, and it may be not for me to guess where the markets are going but there was reason to suspect they might be going into a cyclical downturn. The compensation scheme appears to lack funds to do its job. Is that correct?

Ms Minghella: The compensation scheme has a very strong levying power, and it has been further improved by the Financial Services Authority's recently announced changes so that from 1 April next year we will be able to levy 4 billion per year according to need. We are not constructed, the Statute does not allow us to be constructed, as a pre-funded scheme, we can only levy on a pay-as-you-go basis, but the 4 billion a year we believe will enable us to deal certainly with a wider range of failures than we can now and will be sufficient to deal with the sort of failures we would normally expect.

Q1439 John Thurso: That levy would normally have a degree of ex ante in it as opposed to ex post funding for the future?

Ms Minghella: It will not be an ex ante levy mechanism because we will just levy each year for the failures we can see ahead on the basis of our forecasts.

Q1440 John Thurso: Can I just have a go at your crystal ball? What failures do you see ahead next year that you are going to be raising money for?

Ms Minghella: We are in the process of preparing our forecasts for next year at present --

Q1441 John Thurso: But you are forecasting that there will be failures and you will raise money?

Ms Minghella: Yes, that is right, based on our past experience and on the information available to us at the time of the levy decision. If a failure were to occur that was not in our forecast we would levy for it at the time, and the industry would be obliged to pay our levy invoices within 30 days.

John Thurso: That is such a wonderful minefield of information that you have given us there that I do not think the Chairman would let me prosecute all of the possibilities -

Chairman: Try your best!

Q1442 John Thurso: One begins by saying was Northern Rock in your forecast?

Ms Minghella: No, it was not.

Q1443 John Thurso: So what confidence can I have in the forecasts you have got?

Ms Minghella: It is not bust; it has not gone bust; and we only levy for firms that we believe are likely to come our way for pay-out.

Q1444 John Thurso: Do you think anything will go bust?

Ms Minghella: Based on our past experience we can anticipate a number of failures. We have since we took our power six years ago declared 1800 firms in default and, based on that pattern, we can foresee --

Q1445 John Thurso: But none of those are major deposit holding banks?

Ms Minghella: Absolutely not, no. In the deposit taking area we have only had 29 credit union failures, and that is it, and they are small.

Q1446 John Thurso: In your forecasts do you forecast that any major deposit taking institutions are up to fail?

Ms Minghella: Not at present, no.

Q1447 John Thurso: So in fact, if you come down to the major banks and the principal secondary banking institutions, you are not forecasting any failures and therefore you are not going to be raising any funds, in fact?

Ms Minghella: Not in advance, that is right, so we levy according to need, and should the need arise mid-year we would levy at that point.

Q1448 John Thurso: Thank you for that. One of the problems with the protection system or the reasons why it has to exist is that if a bank is put into administration the depositors become creditors in line with ordinary law and, as a result, they are unsecured and therefore take their chances following what the receiver or administrator will do, whereas that is a politically unacceptable situation and therefore governments step in and have schemes. Is there any merit in considering changing the legal status of depositors such that they are in a secured creditor position so that it changes the balance of moral hazard?

Sir Callum McCarthy: Clearly the Government could, if it wished, change insolvency law. You would have to be very careful in approaching those changes because it would also change the relative attractiveness of advancing money in other ways for the funding of banks, and before making a particular change it is very important to consider the overall effect on the banking system.

Q1449 John Thurso: The fundamental point here is that the banking system in virtually every country depends on the fact that governments will not allow banks to fail and will therefore have some form of scheme or rescue always in place, so what the banking industry are asking us to do is to publicly underwrite that. If you change the structure of the law you put that cost and that responsibility back on to the banking system earlier in the process. Does that not have some merit?

Sir Callum McCarthy: I would point out that it is not the case that all banks in all circumstances have been saved. I can understand the merit of the argument but I also think it has to be weighed carefully with the continuing need to make banks attractive as institutions to either invest in or to lend to.

Q1450 John Thurso: The Governor of the Bank of England admitted that our system for dealing with insolvency of banks and depositor insurance is markedly inferior to other countries. What changes could we make in particular to the release of depositor funds in the event of a bank failure that we could learn from other countries.

Sir Callum McCarthy: I would not agree with that statement in comparison with "all" other countries; I am not sure if the Governor intended it as such.

Q1451 John Thurso: I think he was selecting his countries.

Sir Callum McCarthy: I think there are certainly things we can learn from the US experience where they have the ability to deal with a failure rapidly and in a way which enables them to take powers to deal with a failing bank.

Q1452 John Thurso: So you would share John Bovenzi's view that, had the UK had a system rather like the US model of depositor protection, the Northern Rock crisis could have been avoided in the UK?

Sir Callum McCarthy: It would have undoubtedly been of real help in preventing the retail run.

Q1453 John Thurso: The final question, if I may, and it really goes back to what I was touching on, is this. If we had had an effective depositor protection scheme and a more suitable insolvency regime in place at the time, would the Tripartite Authorities simply have allowed Northern Rock to fail? And maybe I should not ask the question "would" they have, but "could" they have? Would it have been easier?

Sir Callum McCarthy: I honestly do not know, I am sorry. I understand the question but I am not sure if I can deal with the hypothetical circumstances. The issues that would have been involved would have been serious and I do not know the answer, is the only truthful answer I can give.

Q1454 John Thurso: I am probably asking you to speculate, then, but do you think there are any banks that are simply too big to rescue?

Sir Callum McCarthy: No. If you look at those instances where there have been very big banking failures, the Swedish experience, for example, people have been rescued on a very large scale. Going back to the other question, just thinking about it in terms of the US experience, I do not think the answer is self-evident, that if you had a deposit insurance and the insolvency regime you have in America it necessarily makes it easier to take a decision not to save institutions. I think it is still a difficult decision.

Mr Sants: Indeed you could argue it might have been the converse because, taking your earlier point that the Tripartite would have been more confident that there would not be a run on the Bank then the cost of saving it would probably have been estimated to be less, but it is obviously a finely balanced call.

Q1455 Chairman: What constraints does the Deposit Guarantee Schemes Directive, Sir Callum, impose on the design and operation of the UK scheme? For example, would a US style system be permissible here if so desired?

Sir Callum McCarthy: My understanding is that it represents minimum levels, and does not constrain us.

Q1456 Chairman: Are any changes afoot on the European Commission's Deposit Guarantee Scheme Directive that you are aware of?

Sir Callum McCarthy: Not that I am aware of, no.

Q1457 Chairman: How should the UK deposit insurance system deal with the issues of home versus host regulation?

Ms Minghella: The way it works now is that if a UK deposit institution were to fail it would be for the UK as a home state to look after the depositors, not only the depositors in the UK but the depositors of any EEA branch, and if a EU bank from overseas passports into the UK it is for the home state of that EU bank to look after the depositors and for us only to become involved if the bank has topped up into the UK scheme, which a number of banks have done. That is basically the way it works under the Directive.

Q1458 Chairman: Sir Callum, the Chancellor assured this Committee that the 100% guarantee given by the Government to the depositors of Northern Rock did not extend to any other institution; rather "each case will be assessed on its merits". How credible is that assurance?

Sir Callum McCarthy: I see no reason to doubt it, Chairman. It was a statement made to you seriously by the Chancellor.

Q1459 Chairman: So it is 100% credible?

Sir Callum McCarthy: I absolutely believe that the Chancellor meant what he said.

Q1460 Chairman: What a fine answer, Sir Callum! I am asking you, is it 100% credible? Would those very words have come out of your mouth, if you were in that position, in other words?

Sir Callum McCarthy: I should make clear that the only person who can make that guarantee of 100% of deposits is the Chancellor, and that has always been the case.

Q1461 Chairman: We understand that, but I am asking you, Sir Callum, is it credible?

Sir Callum McCarthy: I think it is.

Q1462 Chairman: One hundred% credible?

Sir Callum McCarthy: Yes.

Q1463 Chairman: What factors might make a financial institution less deserving of a 100% guarantee than the Government assessed Northern Rock to be?

Sir Callum McCarthy: Sorry, Chairman, I am not sure I am qualified to answer the question.

Q1464 Chairman: But you understand the question?

Sir Callum McCarthy: I understand it. If I were the Chancellor I might have addressed my mind to it but since I am not the Chancellor I have never addressed my mind to the question.

Q1465 Chairman: You are a lucky man, you are not the Chancellor. On the issue of financial stability, Sir Callum, what are the financial stability implications of the shift we have seen towards an "originate and distribute" business model, and is that irreversible?

Sir Callum McCarthy: I think they have very substantial implications and they do not all go in the same direction. First of all, the "originate and distribute" model, as the shorthand suggests, it distributes risk much more widely, and that in itself is attractive because it stops risk being concentrated in highly geared banks. The questions that go the other way which we have always been conscious of as other regulators around the world, is it makes it much more difficult to identify where risk lies. There are also two major questions that the "origination and distribute" model has to address more clearly than has been addressed: the first is the standards of underwriting in the originator, where failures in those standards have been one of the fundamental causes of the sub prime problems, and, secondly, it is important that those who invest, those to whom the risk is distributed, understand what they are investing in. It is clear that there has been a degree of complexity of product which has been distributed, and not everybody who has bought those products properly understood them.

Mr Sants: Just to add, if I may, and to develop that theme a bit further, what we are thinking is clearly the structure of the market place will change as reflected in your question, and that those complex structures which were previously part of that distribute model are not going to find favour with investors going forward because of the issues we have seen. So we see a disappearance, or certainly a significant diminution in the use of complex structures, but not necessarily a disappearance altogether of a distribute model. It is more that the banks will have to think about distributing through clearer and simpler processes, so we see the model evolving but not disappearing entirely. But, of course, these are all crystal ball forecasts and it could go in other directions.

Q1466 Chairman: So the idea of dispersing risk which would increase the resilience of the financial system to shocks still holds, but it needs one or two adjustments?

Sir Callum McCarthy: I think it holds but we have always been concerned to make sure that the distribution of risk is real rather than apparent, and one of the things that is difficult is to make sure we can identify the channels by which that distributed risk may become reconcentrated.

Mr Sants: The other aspect that we have talked here about before is that when you are dealing with this distributed risk model, which almost by definition means you will not know where all the risk has gone, the focus of the regulatory community is clearly on the major transmission mechanisms to make sure they are in good health, namely the core banks, and therefore it is important going forward that those core banks are operating a very transparent way. We have, of course, had this slightly opaque proposition in place with regard to the conduits and the sieves which needs to be addressed, so that the core transmission mechanisms have to be working in a transparent way.

Q1467 Chairman: I notice that Josef Ackermann, Chairman of Deutsche Bank, as a member of the Institute of International Finance made the point that a number of structural problems need to be addressed and included in that improved risk management, review of the role of off-balance sheet conduits and special investment vehicles, the valuation of complex products, the examination of credit agencies, and improved transparency. I do not want you to go through every one of them, but is that a reasonably comprehensive list to you?

Sir Callum McCarthy: Those are the major items.

Q1468 Chairman: And you would agree with those?

Sir Callum McCarthy: Yes.

Chairman: Good.

Q1469 Mr Mudie: Would you please tell me what the core transmission method means?

Mr Sants: One of the key issues here is, if we are having disruptions in the financial system, is that going to then affect the real economy, your constituents, the man in the street, and from the regulatory perspective one of the key ways of managing and assessing that risk is through making sure that the mainstream banks which, as it were, sit on the interface between the financial system and the consumers are in good health, so the transmission mechanism is another way of describing the large banks.

Q1470 Mr Mudie: I suppose that answer deals with the bigger question of stability, but what about investor protection? What we have are securities that were contaminated. I think some of the bankers did not know what the hell were in them, and they more or less said: "We were selling them, they were buying them, nobody was worried because we were all making money from them". Did you at the Financial Services Authority ever flag up, ever analyse, the various securities with a view to saying whether you should be warning investors about the possible risk? It is one thing to look at the wider stability but I am just thinking why were these allowed to pass through for such a length of time without anybody in the Financial Services Authority - well, perhaps you did. Did you?

Mr Sants: Just to remind ourselves, of course, the buyers of these complex instruments are institutions, not the consumer in the street. The consequences, however, of that development of the financial market has ultimately been to cause disruption to the consumer in the street --

Q1471 Mr Mudie: But, Hector, just stopping you, we had the pension funds in here and it was an interesting session. You could say those words; what you are saying is: "Well, I blame the buyers", but one of the things that I would take comfort from as a buyer is you. After all, the industry is paying a lot of money - not you personally but the Financial Services Authority - to give that regulatory structure and comfort. Now, your answer seems to be: "Well, you should know better".

Mr Sants: It is a two-part answer, actually, and that was the first part. It is the case, nevertheless, I think we should remind ourselves, that institutions are meant to be sophisticated enough to make good judgments, but having said that the Financial Services Authority and the Bank of England as well had repeatedly over the previous few years warned of the risks of the evolution and the development of the credit derivative and related complex securities market, and a variety of our publications have highlighted those risks to the institutional investors --

Q1472 Mr Mudie: Let me take your latest one - we have a later one but it is less relevant - of January this year, a whole paragraph that will cover you in terms of warning, but in the middle of it: "Financial markets have been increasingly complex since the last financial stability crisis". Nothing about the individual securities. If you were regulating in a parallel industry the blood supply I would want you to assure me if I were in hospital facing a transmission that the regulation was working and that blood supply was not contaminated. This is what is happening in terms of these securities. These securities were coming in bundled up to avoid people seeing the real risk and the real original basis of the loan, and you were letting them come into the market, traded, with people making money from them. Now, it is not that we are looking for you to say you made a mistake: it is we are looking for some comfort for the future. Did you think, first of all, you recognised the dangers and, if you did, did you adequately tell the market about the dangers?

Mr Sants: I think this takes us back a bit to the comments I made to the Committee earlier, that we absolutely acknowledged and made clear in our last appearance that we did not foresee, and nor do we think any other market commentators or regulators foresaw, the precise set of circumstances which have arisen since, and that includes the liquidity crisis.

Q1473 Mr Mudie: I understand that, and we can all be wise after the event. I am just asking, as somebody in the street might ask, as a pension fund might ask, and maybe a pension fund with no great resources because we heard last week about how deep the analysis would have to be, how deep you would have to go in to see the make-up of these things, and a lot of purchasers - even if they are not individual and are institutions - are going to have those resources so they are depending on you, amongst others. What comfort can you give us in the future?

Mr Sants: I think we were clear in our advice as to the risks inherent in complex derivative products, and we have made that clear in a variety of our publications, and the complexity and potential liquidity risks that accrues to credit derivatives. What obviously is the case is that on top of that, in addition to the liquidity point I have made, we have seen a failure with regard to the income stream accruing from the US sub-prime marketplace which has then led to those securities falling significantly in value. If you are asking whether we are placing ourselves in a position where we would be looking to make all the commercial judgments that we think mainstream institutional investors should be making, no, we are not seeking to put ourselves into that position, but I do think in terms of a structural observation on the market we were clear on the risks that the increased complexity in the marketplace was creating for institutional investors, but we placed the onus on them then to draw the conclusions from that process, otherwise effectively we would be running the market which I do not think is desirable in terms of the overall process here and the type of marketplace that the community is looking for.

Q1474 Mr Mudie: So, to bring that all together, a pension fund that finds itself losing money and looking to you will find on record the clear warning: "Be careful about these products".

Mr Sants: About the inherent liquidity and complexity that these products, credit derivatives or related products, carry.

Q1475 Mr Mudie: It is all about transparency. Did you feel these products were transparent enough?

Mr Sants: I think I have said before here --

Q1476 Mr Mudie: Yes or no. Did you think these products were transparent enough?

Mr Sants: I think they are transparent enough to those who have the right level of competence and the time and the resource to look at them. I think there is a risk that because they are highly complex not all institutions have devoted the necessary time and resources, and have chosen to make assumptions, sometimes a dependency on the rating agencies, which have proved to be unwarranted and inappropriate and not wise in the circumstances, but in principle, if you choose to and you take the time and you have the expertise, you can unpick these structures.

Q1477 Mr Mudie: Are you intending, are you working on, are you investigating, any fresh approach to these securities? Or are you lying in the sand? Is that your industry? Are the Financial Services Authority doing anything further to give comfort that this sort of thing will not happen again?

Mr Sants: Well, of course, as we mentioned before, the market place will itself adjust as it does in the event of circumstances --

Q1478 Mr Mudie: I am asking about the FSA, though, Hector.

Mr Sants: -- but I think on top of that there are a variety of initiatives that the worldwide regulatory community --

Q1479 Mr Mudie: No, Hector. Again, "worldwide". I would be very interested, because I think it is key, that the Financial Services Authority should be operating worldwide, but what are you doing as the Financial Services Authority? Anything?

Mr Sants: Yes, indeed, and I was telling you that. I was just making the point that as the Financial Services Authority on our own we would not generally be able to solve these problems as a national regulator. Having said that, we will take the lead in and be fully active in looking at a number of the issues which includes the credit rating agency point which has already been mentioned, which is an important aspect of providing the right information and a clear understanding of how those organisations operate; we certainly do have our initiative with our institutional community to get them to give consideration to the lessons they can learn and the actions they should take; and we will also be obviously looking carefully around the transparency, which is a point mentioned earlier by the Chairman, around these special purpose vehicles and related points. All those initiatives are part of the list that was mentioned earlier, and we will pursue those nationally and internationally with vigour.

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

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

Q1481 Nick Ainger: "Some"? All?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Q1491 Chairman: Is Northern Rock still solvent?

Sir Callum McCarthy: Yes. In our judgment.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Q1500 Mr Fallon: Sir Callum, if Northern Rock cannot find the funding it needs to finance its operations without nearly 29 billion worth of support from the taxpayer, how do you still describe it as solvent?

Sir Callum McCarthy: Because we have looked at the assets it has and the demands on those assets and believe that those assets meet those demands. The amount that has come from the taxpayer is secured against the assets of Northern Rock.

Q1501 Mr Fallon: But if it is not able to finance its future liquidity, how can you regard it as solvent?

Sir Callum McCarthy: Because there is a distinction between liquidity and solvency.

Mr Sants: We are clear that it would not meet its thresholds and conditions if it were not for the availability of the finance from the Bank of England.

Q1502 Mr Fallon: But you still think it is solvent?

Mr Sants: Yes. In clear accounting terminology, threshold and conditions is regulatory terminology and we have answered the question.

Q1503 Mr Fallon: Yes. I think you have also explained to us exactly what has been happening. You have said there are regulatory lessons to be learned here and you are going to publish a discussion paper on liquidity. Is that right?

Sir Callum McCarthy: No, there are two quite different things and let me explain what they are. One is a paper on liquidity as a general set of issues and, as Hector said, we plan to publish a discussion paper on that before the year end. The second and quite different aspect is that we have undertaken to do a review of the way in which the FSA discharged its responsibilities in relation to Northern Rock during the period up until August and we have undertaken to do that and publish the results of that in March and that is not a discussion paper, it is a quite forensic investigation.

Q1504 Mr Fallon: Will that include the possibility of somebody else supervising liquidity?

Sir Callum McCarthy: No, this is to do with the question of how the FSA discharged the responsibilities it had up until August 2007.

Q1505 Mr Fallon: I thought we were pretty clear now that you did not discharge your responsibilities. We have had the worst banking crisis for 140 years. Somebody failed.

Sir Callum McCarthy: I repeat, we are looking at the lessons that we are going to learn.

Mr Sants: We have already said quite clearly that we think the supervisory process with regard to Northern Rock in the period prior to July should have addressed the liquidity issues through more aggressive engagement around the question of stress testing and ensuring that the board, whose primary responsibility is ultimately to run the institution, fully understood its business model and its limit to its business model and the risks it was running. We would agree with you that process did not take place, so the purpose of the review will be to ask the questions as to why that did not take place and what lessons should be learned from that. That is about our application of our regulatory regime as it then was. There is then a second question as to whether or not the regulatory regime should be modified which will be looked at through the combination of the liquidity discussion paper and, of course, if there are any issues relating to the tripartite review, that will be handled through the tripartite review. We are in no way not acknowledging the fact that our supervisory engagement with Northern Rock prior to July should have looked into these scenarios and it would appear on the reading of the file to date not to have done so.

Q1506 Mr Fallon: If you were charged with supervising banks, including their liquidity, and you failed, is not one of the answers to return that supervisory duty to where it once was, which is to the bank?

Mr Sants: I think we need to look at a couple of points here and they will come out in the review. There is a question as to whether or not the overall regulatory proposition is in some way flawed as opposed to was the narrow engagement of that group of supervisors with that institution not properly discharged. It would be wrong to prejudge the conclusion of these various reviews, but my preliminary thoughts would suggest that the approach we were taking in terms of emphasising stress testing in principles-based regulation was right. I do not think that events here undermine the basic regulatory philosophy of principles-based regulation, the crux of which is about asking management to take responsibility for the outcomes and consequences of their decisions and you could well argue here that is something the board should have been doing more rigorously than it was. I do not think the philosophy of regulation is undermined here, there may well be questions, I think there are questions, as I have just indicated, about the particular engagement with this particular company. As to the question of whether or not it would have made any difference if administratively those supervisors had reported to the bank rather than to the FSA - Sir Callum may wish to comment - I do not think there is any evidence at all if the reporting line of that supervisory department had been moved that would have made any difference to the set of circumstances which transpired prior to July, nor would it have made any difference to the information being passed over to the relevant part of the bank with regard to monetary operations during the course of August and September.

Sir Callum McCarthy: Could I just add one point, which is I think that the idea of transferring banking supervision separately from insurance and security supervision is an idea that has severe disadvantages.

Q1507 Mr Fallon: It is a pretty severe disadvantage with the background and all the damage we have seen to British banking as a result. You seem to be simply defending your empire. The supervision of liquidity was done perfectly well by the Bank of England until you started it in 1997.

Sir Callum McCarthy: People can have different views on the ability of different supervisory regimes historically. I would point out that if you look at the problems that the events have caused, they have caused severe problems in Germany, where banking supervision is shared between BaFin and the Bundesbank, so the idea that making bank supervision the responsibility of the Central Bank is the answer to these is not necessarily supported by the facts.

Q1508 Mr Fallon: You think you are still the best people to supervise banking liquidity?

Sir Callum McCarthy: I believe that it is impossible to take the question of banking liquidity from overall supervision. There are questions, as Hector has absolutely indicated, about whether we did that sufficiently well, but I do not believe you can take bank liquidity supervision from other aspects.

Mr Sants: Also you have to ask the question, what particular benefit do you think would accrue from aligning a supervisory group with a money markets management group and a central banking liquidity function? There is no particular evidence that the issue with regard to Northern Rock would have in any way been changed by that alignment, so I think you do also have to ask the counter-factual question what is it you think would have been brought to this issue that was not brought to the issue as a result of making that organisational change.

Q1509 Mr Breed: Could I return to your view on the solvency of Northern Rock. I think you said that there is a difference between solvency and liquidity. Of course, one of the tests of solvency is all to do with liquidity and, indeed, the vast majority of businesses that go bust go bust because they have not got cash, not because they have not got assets, so liquidity is a fundamental of solvency. That test is that a business can meet its obligations within the normal course of its business and therefore looking forward, including in Northern Rock's case, of course, the repayment of 25 to 29 billion - whatever it is - of taxpayer's money, and I understand that is in place until February, do you, therefore, believe at this moment in time that Northern Rock is solvent on the basis that it can meet all its obligations within the normal course of its business, including that taxpayer's loan to it?

Sir Callum McCarthy: The answer is yes. We would not deem it solvent unless we believed it could do that. The fact that it is getting liquidity from the Government is undoubtedly the case and without that liquidity the bank would have failed.

Q1510 Mr Breed: It is totally dependent upon the Treasury contribution which lasts until February according to the Chancellor. By February, when the taxpayer may expect to have all its money back which would be in the normal course of its current business, you expect that to happen which is an assessment therefore of its solvency today?

Sir Callum McCarthy: No, I do not think we are necessarily saying that we believe the taxpayer will have all the money which has been advanced returned by February because I think if you look at the Chancellor's statement he said February or the time at which other events have been reached. It is clear that the Treasury, in discussions with the bidders, has been prepared to discuss timetables for repayment which go beyond that. All that is in the public domain, I am saying nothing new.

Q1511 Mr Breed: You consider that sufficient to consider that Northern Rock remains solvent?

Sir Callum McCarthy: We do believe that Northern Rock remains solvent.

Q1512 Mr Breed: Could I ask finally then, when is Northern Rock's next trading statement to be published?

Mr Sants: The next trading statement would come with the final results.

Q1513 Mr Breed: Is there not one due in the middle of December?

Mr Sants: That would be its pre-close and then it would have a full statement in the spring in February.

Q1514 Mr Breed: We are now 12 December, so within the next few days you would expect Northern Rock to produce an interim trading statement?

Mr Sants: Coming back to the quotation point you have just made, I think it is clear to investors that without the support provided by the Bank of England at the current time then Northern Rock would not be able to continue in its current form. There has to be a presumption, as Callum has already laid out, that support would remain in place unless an alternative mechanism can be put in place to justify continuing the meeting of the threshold and conditions, and that analysis is correct. In a narrow sense we are clearly dependent on that funding stream to continue to make the assertions we have made and that is absolutely right and any statement by the company will have to reflect that.

Q1515 Mr Breed: Just to repeat, you are expecting the company to make its interim trading figures available by the middle of this month?

Mr Sants: It would make a pre-close statement and then a statement after the end of the year.

Q1516 Mr Breed: You are expecting that to happen?

Mr Sants: In order to fulfil its listing conditions it will have to so do.

Q1517 Mr Breed: If it does not, then its listing might be in jeopardy?

Mr Sants: Its listing could be in jeopardy.

Q1518 Mr Dunne: With hindsight, should the lender of last resort facility have been extended to Lloyds TSB in order to have allowed a private sector solution?

Sir Callum McCarthy: I think it is very difficult to form a judgment on that because, as I think I said last time I was before this Committee, it was not quite as cut and dried as I think it has been suggested that there was a complete proposal on the table. It was the case that it was made clear slightly later than that that the facility which had been offered to Northern Rock would be offered to other bidders, ie they could take advantage of it, but it is a difficult set of circumstances to take a view on even in hindsight.

Q1519 Mr Dunne: You just explained that you do not believe it would be appropriate for liquidity supervision to be separated from regulatory supervision and the regulatory supervision restored to the bank. Do you think there is an alternative scenario in which the liquidity supervision should be brought into the FSA so it is brought under a common roof?

Sir Callum McCarthy: No. There is a question about whether the only route providing finance should be via the Bank of England or whether the Government should have other agencies that it could use. I think that is something which is an impossible route. I should make clear that I am not arguing for the FSA to have a very large balance sheet. That is the last thing I want.

Mr Sants: We obviously have a mandate to facilitate private sector solutions and, as was demonstrated by the retail bank point you just made, you could argue that is a difficult mandate to discharge when the FSA has no locus with regard to providing funding with regard to institutional specific situations. That is a question that could be reasonably considered but, as the Chairman indicates, there are different ways that mechanism could be considered.

Q1520 Mr Dunne: If Northern Rock is nationalised, will Granite have to be nationalised too?

Sir Callum McCarthy: I am sorry, it is a hypothetical question and I do not know the answer at all.

Mr Sants: Granite is, as you know, an on-balance sheet vehicle in that sense. I know the obligations which are carried by Northern Rock to Granite would have to be carried through the nationalisation process, I would imagine.

Q1521 Mr Dunne: That would survive? Events of default would not be triggered or it could be organised so they did not trigger through a nationalisation, do you envisage?

Sir Callum McCarthy: It is a predicament. It would depend on the details of the Granite trust.

Mr Sants: It would depend. I have a view, but I am hesitant to express a definitive view. I could send you a note on it. I am pretty sure that it could be organised in such a way, but I hesitate to be absolutely definitive.

Mr Dunne: If you could send a note, that would be appreciated, Chairman

Q1522 Mr Brady: When we took evidence from Northern Rock it was not readily suggested that the first contact specifically about the liquidity problems between the FSA and Northern Rock was initiated by Northern Rock and not by the FSA. I think, Mr Sants, you were interviewed for the File on Four programme. You gave the opposite answer and said it was the FSA that initiated that contact.

Mr Sants: Sorry, I have got a very bad cold. I actually could not hear the question.

Q1523 Mr Brady: Who first contacted whom regarding the liquidity problems at Northern Rock? Was it the FSA contacting Northern Rock or vice versa?

Mr Sants: My understanding of the events - I think, as always in these things, it is a question of how you perceive them - from our point of view, we contacted them first in the sense that, just to be clear, we always knew the funding model of Northern Rock, as I think I have explained before, so from the moment that market conditions deteriorated and we set up our special process from 10 August and so forth, if you remember the earlier discussion, we were proactively engaging with the firms that we perceived as carrying risk and that includes Northern Rock. Northern Rock may have been answering the question in the sense that clearly, as the company, it would be their judgment as to when they had a serious problem, so in that sense they might have rung us and said, "We now do officially think we have a serious problem", but from our perspective we were contacting and proactive as an at risk firm once market conditions had deteriorated from 9 August. I believe, as I said on the programme, that we were proactively engaging with Northern Rock and that was our proactive engagement.

Q1524 Mr Brady: That dated from 9 August?

Mr Sants: I think from the 10th actually.

Sir Callum McCarthy: Could I make a distinction between after the events crystallised on 9 August I think it would be a misleading impression to suggest that the first time we had ever discussed liquidity, those issues, stress testing, was 9 August.

Mr Sants: Yes, I did not think that was the question. I think I made clear earlier that in July we had already started to point out to the firm, recognising that we could have been doing this before, that we were very unhappy with their stress testing scenarios and asked them to do "further distinct liquidity tests and scenario tests" and give greater consideration to the impact of accelerated cash flows from a trigger event in a liquidity crisis, so that communication was already taking place with them in July and that was proactively initiated by us.

Q1525 Mr Brady: What advice did the FSA give to the Chancellor about the need for an immediate depositor guarantee after the lender of last resort operation was leaked?

Sir Callum McCarthy: The announcement was made on the Friday and, as you say, it was leaked on the Thursday night. Over the weekend there was a series of conversations with various Treasury officials and the Chancellor in which the need to give an explicit government guarantee was discussed and the decision was taken on the Monday afternoon.

Q1526 Mr Brady: What advice did you give?

Sir Callum McCarthy: The advice was that if the run that was taking place continued, the only way of stopping it was an explicit government guarantee.

Q1527 Mr Brady: Could I also then ask about the advice that was given prior to the leak or the announcement being made. The Governor has pointed out there was no easy way to predict the response of the customer, but is it not really common sense that in those circumstances without 100% guarantee there would be a state of panic created?

Sir Callum McCarthy: No, I do not think it was obvious. I think that a whole series of things conspired. It was extremely unfortunate that the information leaked because it meant that instead of this being put in place as, "This is a solvent institution which has a cash flow problem and the Government is stepping in to make sure that it is saved", it became a panic measure or a response to something that was already in the making. Panic was how it was seen. I think that it was unfortunate that the administrative arrangements within Northern Rock were not better developed, both in terms of the Internet access which was inadequate and something which very little could be done about at all, which was the physical layout of the branches. One of the problems in these circumstances is because of anti-money laundering requirements, if somebody comes in and says, "I wish to withdraw 20,000", it takes something like a quarter of an hour to go through all the necessary steps. If you have a small branch with two counters, you only need ten people and you have a queue. There was a whole series of things that were difficult, some of which with more favourable timing we could have overcome; some of which we could not. Also, I think in retrospect it would have been better to have emphasised the positive aspects rather than the negative aspects of lender of last resort.

Q1528 Mr Brady: Did the FSA advise the Chancellor that there should be the guarantee put in place at the same time as the lender of last resort?

Sir Callum McCarthy: No, we did not, nor did anybody else, nor would I have wished to have given that advice because it would clearly have been better if the lender of last resort facility had been put in place and had worked without a general guarantee.

Q1529 Mr Brady: Again, I think I am quoting correctly from the File on Four programme, Mr Sants, on this subject you said - I think this refers to the FSA and the Chancellor collectively - "We obviously had made the judgment that it wasn't an announcement we wanted to make at the same time as the facility". That implies this was at least discussed.

Mr Sants: To be fair, I think this particular programme is an edited programme, not a live programme, so I am not sure I can particularly recall the question to which I was responding or, indeed, can be sure from the transcript what the question was I was responding to. I was not involved in everyday conversation with the Chancellor but I concur with the analysis the Chairman has given. I do not think we specifically gave any advice with regard to the 100% guarantee prior to the news breaking.

Q1530 Mr Brady: As you say, the programme is edited but the transcript I have got in front of me, your actual words in response to this point were: "We certainly discussed the possibility, but we obviously made the judgment that it wasn't an announcement we wanted to make at the same time as the facility", so it was the possibility of it.

Mr Sants: My recollection of the discussions, I have to say these were not specifically with the Chancellor, and I will come back to the point we had alerted the FSCS and others is that we were talking about the way in which this announcement would interact with the compensation scheme. We were, of course, aware of the limitations of the scheme and, indeed, as we said before in our consultation paper, which was a precursor to the changes we have announced and the Chairman mentioned at the beginning, we made clear the scheme was not structured to address a large scale failure in the banking system. This is the point we had already made in public. What I was seeking to reflect in that comment, I believe, from memory was the fact that we had been talking about those issues, but we had not given specific advice as to whether the matter should be addressed prior to the announcement.

Q1531 Mr Brady: You did not give advice one way or the other?

Mr Sants: Not personally to my recollection, none of us did.

Sir Callum McCarthy: My recollection is that the question of the guarantee only arose after the queues began to develop.

Q1532 Mr Brady: Yet it was discussed before that?

Sir Callum McCarthy: Hector has explained the context in which he made that remark.

Mr Sants: The compensation scheme was discussed beforehand. The issue of 100% guarantee was certainly not discussed at the principals' level. I think I may have some vague recollection of it being mentioned by some working group discussion, but that is the extent of it.

Q1533 Mr Brady: Do the Tripartite Authorities have a communication strategy for coping with a bankrupt?

Sir Callum McCarthy: I would say a better one now than we did some time ago.

Mr Sants: That was the point we made when we were here before. We absolutely do think that there are significant lessons to be learned in terms of the way the Tripartite Authorities communicate around these types of issues, both the terminology and the way we handle the release of the news, and we have already started to learn from those lessons and continue to so do.

Q1534 Mr Brady: One final point. If I could come back to Ms Minghella. How involved were you at the time all of this was going on and how confident, in particular, were you that the FSCS could cope with the failure of Northern Rock had that happened?

Ms Minghella: We were not involved in August with the discussions with the Tripartite Authorities when they were going on. We became aware of the problems of Northern Rock in particular in September. I think a point that has been made earlier with Mr Todd was we were not designed to deal with a failure of this size, so it was not a surprise to us that these discussions had been going on in advance of our being informed by the time we found out the lender of last resort facilities were already in mind and that seemed to us to be appropriate in the circumstances.

Q1535 Jim Cousins: Sir Callum, if a bank were to be nationalised, how would that affect the workings of the tripartite committee?

Sir Callum McCarthy: I think that it would be depend on who was the owner of any nationalised bank because we do not have responsibility for supervising the Bank of England or any subsidiary of the Bank of England, so if an institution became a subsidiary of the Bank of England, we would not supervise it. If it were a freestanding, if I can use that expression, nationalised bank, we would supervise it.

Q1536 Jim Cousins: Is this something that has been discussed by the tripartite committee, how its own workings would be affected in the event of the nationalisation of a bank?

Sir Callum McCarthy: I am not aware of any discussions. I have not taken part in any discussions. I am not sure if there have been any.

Mr Sants: I am not aware of it in the way I think you are asking in the way the Chairman has already answered in terms of understanding the supervisory framework, but in terms of the specific tripartite question, I am not aware of any discussions.

Q1537 Jim Cousins: You are obviously aware, Sir Callum, that there is a campaign to downgrade the value of the assets in Northern Rock and force it into nationalisation, that campaign has been in front of the Committee this morning. What regulatory consequences do you think there would be if one of the members of the tripartite committee itself became the owner of a bank?

Sir Callum McCarthy: Sorry, I should make clear that I do not understand the reference to downgrading the assets.

Q1538 Jim Cousins: I am not suggesting you have done that.

Sir Callum McCarthy: I am not sure in terms of the tripartite arrangements if there were a nationalised bank whether that would have very great effects on the tripartite arrangements overall.

Q1539 Jim Cousins: If a nationalised bank were to seek to wind up its operation rapidly by selling its assets in the market in a short time frame, would that be something that would come before the tripartite committee?

Sir Callum McCarthy: Were there a nationalised bank, whoever was running that nationalised bank would have responsibilities, it would have responsibilities presumably under the Act of Parliament that had led to the nationalisation. In terms of the FSA's regulatory responsibilities we would be concerned, as with any institution, about systems and controls, adequate management, all those things, but it would not be for us because we would not be the shareholder - the shareholder would be the Government or some form or other - to decide on the commercial strategy of that institution.

Q1540 Jim Cousins: But in your discussions at the tripartite committee if you did have concerns, you would be expressing them in front of other parties who might themselves be the owners of the institution whose management you have some question about.

Sir Callum McCarthy: I should make clear that all of these are hypothetical circumstances, but you should assume that we would discharge our responsibilities with the same independence that we adopt towards any institution for which we have responsibilities.

Q1541 Jim Cousins: One of the issues, looking back over the Northern Rock affair, is the failure to anticipate things. Now I am not myself going over that ground, the Committee has gone over that ground. The issue of nationalisation is not now a theoretical one, it is something that is being actively advocated by a large number of influential people. Are you really telling me that, yet again, we have a failure to anticipate consequences and that there has been no discussion either at the FSA or at the tripartite committee as to how the regulatory system we have for banks would be affected in the event of a bank nationalisation? I find that extraordinary.

Sir Callum McCarthy: I would say that I do not find it extraordinary. I do not find it extraordinary because at the moment we have got two proposals on the table for private sector solutions and we are concentrating very hard on discharging our responsibilities in relation to that. I am yet to be convinced that were there a nationalised bank what are the real problems that this would present for the tripartite arrangements. If there were significant ones we would deal with them, but I do not think that I am convinced there would be difficult problems.

Mr Sants: To your point, we are clear - the Chairman has answered the question - what our regulatory responsibilities as the FSA would be for that entity and it would be our role to discharge those in our capacity as an independent agency, so I think we are clear about our regulatory responsibilities, there should not be a misunderstanding about that.

Q1542 Jim Cousins: The Governor and you, Sir Callum, would look the Chancellor in the eye, if he were to find himself the owner of a bank, and raise criticisms about it?

Sir Callum McCarthy: If there were a question, for example, of inadequate systems and controls within a nationalised bank over which we had supervisory responsibilities, I would have absolutely no difficulty in doing what you suggest.

Q1543 Chairman: Sir Callum, a couple of final questions. In 2006 Northern Rock appointed Rosemary Radcliffe, a former partner of PwC, to their audit committee and their auditors last week mentioned that they raised concerns about this but withdrew them following the receipt of what they called an "explicit clearance" from a regulator. Were you the regulator involved and, if not, did you express any views on the matter?

Sir Callum McCarthy: I think no views were expressed on the matter.

Mr Sants: I think we were the regulator involved, but I know of no views being expressed on that.

Sir Callum McCarthy: Could we come back?

Q1544 Chairman: Definitely. Karin Forseke, a non-executive member of the FSA board, was a CEO of the Swedish investment bank Carnegie until March 2006. The Swedish regulators found that Carnegie's 2005 and 2006 annual reports presented incomplete information and punished the company with the maximum financial penalty, also insisting on multiple board changes. In these circumstances, have you considered whether it is appropriate for her to remain a non-executive member of the FSA board?

Sir Callum McCarthy: Yes, Chairman, I have considered it very carefully. I discussed the matter extensively with the Swedish financial regulator and took advice on the report and at rather considerable expense had the report, which is only in Swedish, translated into English so we could look at the evidence in detail and formed a view, which I formed after consulting the past and future Deputy Chairman of the FSA, that it was appropriate for Karin Forseke to remain a member.

Q1545 Chairman: As a Committee, we visited Sweden in the last couple of weeks and we read the regulatory report in English, so it was no problem for us, but it was quite a censure that the regulator gave. In the light of your answers, I think for the public record I would like you to write to us on this the issue in detail as to why you have confidence in her as a non-executive director and the reasons for that.

Sir Callum McCarthy: I would be delighted to, yes.

Q1546 Chairman: Last question. Do you think that either you as the regulator or the market have a proper understanding of the size of the tail risk in money or credit markets? I say this in light of the evidence that we have looked at from Paul Ormorod and Bridget Rosewell.

Sir Callum McCarthy: I think the analysis of tail risks is an extraordinarily difficult issue. By definition you are saying that you expect events which happen very infrequently, that is what you are examining, and anybody who claimed they had a full understanding of the risks associated with tail risks would be open to misleading.

Mr Sants: I do not think it is possible to have a full understanding of tail risks.

Q1547 Chairman: We understand that, but what they are saying is a gap between the Bank of England's base rate and the three-month Libor is an indication of unusual conditions in the market and really their conclusion was it should not be assumed that the historical data on this gap follows a normal statistical distribution as many have done. Are you alert to that and, for instance, is there some justification in suggesting that the tails of the distribution of spread between the three-month Libor and the base rate may be fatter than conventional analysis might suggest?

Sir Callum McCarthy: It is certainly the case that there has been a very substantial divergence between the three-month Libor and the bank rate, that is manifest in the UK, the Eurozone and the United States. It is exacerbated at the moment by the year end pressures, so that is undoubtedly the case.

Mr Sants: It is also undoubtedly the case with regard to financial markets, as others have said to you, that relying solely on historical statistical analysis as a method of predicting the future via modelling is not a sufficient way to discharge your responsibilities as a board of directors. You do need to take into account the likelihood that the future will not reflect the past and circumstances will not repeat themselves in the way they have in the past. That is why we continue to reiterate the statements we made in the earlier part of the year which are even more appropriate now than they were, that firms need to seek to run full scenario tests, understand the circumstances under which their business models have come under pressure regardless of whether or not that type of modelling looks particularly probable from a tail risk analysis. They should run their businesses to take into account those risks and, as we said earlier, we do not feel that it was the case that all institutions were taking that approach to risk management in the early part of the year. We believe that recent events and supervisory engagement mean that they are much more focused on this point, but it is still a key factor that they need to properly focus on.

Chairman: On that technical point, could I thank you, Sir Callum and colleagues, and wish you a merry Christmas and a peaceful new year, starting with your reappearance at this Committee shortly thereafter.