Examination of Witnesses (Questions 86
- 99)
TUESDAY 12 MAY 2009
MS VERENA
ROSS
Q86 Chairman:
Good morning. Ms Ross, first of all, thank you for agreeing to
come and give evidence today. Obviously as part of our inquiry
some thoughts from the FSA are welcome. You may have seen some
of the previous evidence sessions. We are following a similar
theme of questions. First of all, could better regulation have
avoided the financial crisis, at least in part? What principle
failures of regulation or regulators have come to light in your
investigations since the problems have started?
Ms Ross: Thank you very much,
Chairman. Good morning. I think it is very important to look at
the crisis in quite a broad way. It is clearly a global crisis
which had some of its origins in quite fundamental macro imbalances
in the global economic system and so on, so it is clear that to
my mind there were things which were building up in the broader
macro- economy and through financial innovation and other things
over the last 10-15 years which eventually led to a situation
which then exploded, probably in a way that no-one quite imagined
would ever happen. That does not mean that there are not things
that we can learn from the way the build up of these various different
aspects developed. We are certainly keen to make sure that both
globally and domestically we learn the lessons from that. We are
looking very closely at how we can make sure that we have a proper
understanding of the type of developments and causality of different
parts of the financial system working together, and working very
closely not only domestically with the Bank of England and the
Treasury but also internationally with other regulators, other
central banks and so on, in getting better at looking at the macro
picture and having mechanisms which allow us both to do that analysis
and also to decide what we need to do in terms of actions to try
to prevent such a scenario occurring again.
Q87 Chairman:
The failures on the part of the FSA were that you did not have
the tools in place to measure what was going on.
Ms Ross: No. There were quite
specific issues which we have been very open about in terms of
how we conducted our supervision on the ground, and we have obviously
published the internal audit report on Northern Rock and taken
some action as a result. I was trying to put it into the bigger
picture. Basically there are lessons to be learned for the FSA
specifically about how it conducts supervision; for example, the
kind of capabilities of the staff, the type of way in which we
do supervision, the ability to look not just at the micro, individual
institutions when we supervise but to look at the broader business
model of the individual sectors of the financial services industry,
and then to work with our colleagues, both domestically and internationally,
to put that picture together and make sure that we then have the
right tools, such as better capital requirements, looking more
closely at liquidity and things like that, which all were outlined
in the Turner Report, in terms of our policy responses.
Q88 Chairman:
What risks are there in risk-based regulation? Are risk-based
regulation and principles-based regulation fine in theory but
flawed in practice?
Ms Ross: I do believe that, ultimately,
you have to take a risk-based approach to regulation because in
any regulator your resources are ultimately limited to some degree.
You need to focus the effort on the things that you think present
the most risk. Having said that, clearly the crisis has told us
that maybe we did look at the risks from a slightly narrower angle,
and looked specifically at institution-specific issues and not
enough at the broader picture. I think it has also shown that,
although risk-based regulation to my mind remains an important
tenet of how you do regulation, you need to be sure that your
risk appetite is properly adjusted to what is going on. For example,
clearly the view has changed as to what is an acceptable failure
in financial services and what is not an acceptable failure. Those
are the kinds of things which clearly need to be debated in the
public domain and amongst regulators. We need to decide with the
public in terms of where that risk appetite is. Risk-based regulation
certainly will continue. We also believe that making sure that
we focus the rules very clearly on the outcomes that we want to
achieve—which was part of our principles-based regulation
outcome, focused regulation—is something which remains very,
very important. We have, however, said that some of the assumptions
we have made and other people have made that markets ultimately
adjust themselves—it is going back to a market mean that
senior management of the firms know best how to run their business
and so on—were hardly questioned, and part of what we are
now doing is being much more intrusive in our regulation in terms
of saying that we need to make judgment calls on the types of
judgments firms' senior management take and we need to make sure
there is proper governance in place to take those types of judgments
in the firms concerned.
Q89 Chairman:
In summary, carrying on with a risk-based approach but making
sure that the underlying principles stand up to more rigorous
scrutiny.
Ms Ross: That is right.
Q90 Chairman:
Are there any particular actions that you are thinking of in that
respect?
Ms Ross: We are, for example,
spending and have been spending a lot of time looking at the position
of certainly our highest impact banks. Not surprisingly, a lot
of our focus has been on that recently, but we have also at the
same time, for example, said that we would focus more on testing
some of the outcomes in the consumer protection area. We are generally
trying to make sure that where we are clear about what the outcomes
are we want to achieve -first we need to articulate those, obviously—we
then are able to test that and check whether that is happening
on the ground.
Q91 Gordon Banks:
Principles-based regulation never got the chance to prove itself
properly. I am interested, following on from the Chairman's questions
and your answers, in how outcomes-based regulations differ. Where
you have talked about risk-based regulation and principles-based
regulation, you have joined them together.
Ms Ross: Yes.
Q92 Gordon Banks:
How do we do that practically? How do we take the risk and the
principles, merge them together and deliver a system that not
only prevents what happened recently from happening but also may
well deliver improved standards and an improved ability to regulate
and to monitor. I am a little bit confused as to how they can
be merged together.
Ms Ross: It is quite subtle that
you have different types of aspects of how you can describe regulation.
As part of our statutory responsibilities we have principles of
good regulation which we have to follow when we do regulation
and supervision. Those also talk about proportionality and about
being conscious of impact on innovation, competition and things
like that. Already in the statutory framework it is recognised
that when you take decisions about what to intervene in, where
to focus, you have a whole range of different objectives to meet,
and it is always a fine judgment call of where you focus your
attention. I think that will be a continuing challenge for any
regulator, whether that is financial services or anywhere else.
To my mind what is particularly important in financial services
is that we do revise, given the lessons we have learned, exactly
what are the outcomes we want to achieve. We want to achieve a
more stable banking system. How do we do that? We try to make
sure that our capital regime works better than it did, we focus
more on liquidity supervision, we focus more on our day-to-day
supervisory attention at the high impact firms (for example, we
strengthen our supervisory resource vis-a"-vis that), so
it does all come together ultimately. That might make it a bit
confusing, I appreciate, but it is very hard to pull it entirely
apart.
Q93 Gordon Banks:
Do you think outcomes-based regulation can be restrictive? Do
you think the industry might think that is restrictive?
Ms Ross: I think industry does
in a way like the fact that we describe what we want to achieve
and then we leave a bit of flexibility around how to get there,
because that is what outcomes-based regulation and ultimately
principles-based regulation is about. On the other hand, that
clearly means that there is an issue of how do we then judge whether
the right outcome has been achieved, and there have been debates
about that, and in terms of how far a regulator then second-guesses
what is happening. One of our purposes is to be very clear about
describing the outcome and then, also, through, for example, putting
out examples of good and bad practice, putting out descriptions
of what we are expecting to see, talking to firms in road shows
and so on, what the expectations are, trying to be as clear as
possible so that it does not feel like 20:20 hindsight when we
then go in and say, "No, that hasn't quite worked right."
Q94 Lorely Burt:
In the future, how are you going to identify major risk areas?
How do you think your enforcement approach is going to change
to ensure that these areas are properly overseen? Also you talk
in your memorandum about the "intensive supervisory model"
and "credible deterrence" strategies. Do you have the
resources to implement them? And more importantly for me personally,
what are they?
Ms Ross: There are a lot of different
aspects to that question. Obviously when I talk about taking risk-based
approach to regulation, we have a whole different range of different
tools that we can deploy in terms of how we regulate. We can make
policies, we can then do individual supervision of firms, we can
use enforcement tools. In all contexts, we need to choose quite
carefully how we deploy those and how we can be most effective
and efficient about employing those different tools. As you rightly
say, as part of the lessons learned out of the crisis, we have
been very clear that we feel we need to up our supervisory game.
We need to make sure that we do have the right people, we do have
the people who have the knowledge and expertise to stand up to
senior management in big firms, first of all to fully understand
what that firm is doing and then to be able to put it into a broader
context of the broader sector, so you can see whether there is
an outlier or anything like that, but also so we are able properly
to challenge and have discussions at that senior level. That is
all about making sure we are as focused and clear about what we
expect and have the right people to deliver that. But obviously
there will always be people who, despite our best efforts, will
not follow the rules, will decide to do things which are clearly
against the regulatory principles and outcomes that we have described.
In those cases, we do need to have that enforcement tool at our
hand. We are very keen and have over the recent past taken great
effort in making sure we take that very seriously, so we have
taken, for example, more criminal prosecutions than we have ever
taken before, we are generally making sure that we use our enforcement
tools as effectively as we can.
Q95 Lorely Burt:
These two wonderful terms, the "intensive supervisory model"
and the "credible deterrence" presumably you have covered
that, have you?
Ms Ross: In what I was just saying,
yes. The intensive supervisory model is the fact that we will
have more supervisors on the ground focusing particularly on our
highest risk institutions and that we have more specialist resource
flowing into it. We have put in place a training and competence
scheme for the regulators to make sure that we have the best people
and a consistency in how we go about it.
Q96 Chairman:
In simple terms during the recent past, you have not had the right
number of high quality people on the ground capable of challenging
the perceived wisdom inside some of the bigger institutions.
Ms Ross: The fact is, to my mind,
that that is an ongoing challenge and always has been a challenge.
Even if you go back three years or something, you will hear us
talking in similar terms about the need to have the right people
who can make the right judgments. Certainly one of the lessons
learned out of the Northern Rock report was that in relation to
the biggest institution, the highest impact institutions, we did
not have enough people on the ground dealing with those institutions
on a day-to-day basis, yes.
Q97 Lorely Burt:
Is not the best way of ensuring good behaviour maximising the
certainty of being caught? If you have the people there, then
they are able to see just what is going on.
Ms Ross: Absolutely. The likelihood
of detection is a big part in any deterrence strategy. Having
said that, we do supervise 30,000 firms, and there is a limit
as to how many people you can have on the ground constantly checking
to a degree where you will be able to detect every single shortfall.
It will have to have a risk-based approach and we try to do that
through data collection as well as on-site supervision and the
supervisory approach.
Q98 Judy Mallaber:
You have mentioned 30,000 institutions and also wanting to be
concerned about the riskiest. In what proportion of those institutions
would you seek to use this intensive supervisory model? How do
you choose? Do you choose the biggest? How do you assess which
is the riskiest if you have not been supervising them enough to
know which are the ones which have the risk?
Ms Ross: That is a very fair question.
The way we try to make this judgment is we look at impact and
probability. Impact is basically how important is the firm in
the context of the wider market. For example, for a bank, how
many deposits does it have? For an asset manager, how many assets
are under management? That is how we measure the impact. Then
we also look at the probability. Is there a particular risky sector?
Is this firm very close to its capital requirements or not? We
try to gather that data for all 30,000 firms as far as we can,
but we then concentrate our supervisory resource on the "relationship-managed"
firm population. I might have to come back to you on the exact
figure. I think it is about 800 or so, 71 of which are what we
call high impact firms, so on 71 firms is really where the recommendations
of the Northern Rock report have focused, as saying that for the
top 71 firms we do need to have at least two supervisors wholly
responsible for that firm at all times.
Q99 Judy Mallaber:
Should you have been able to spot which institutions were going
to get into trouble or were the circumstances so out of the control
and expectation that you would never have spotted them even with
this system?
Ms Ross: We have been very open
in our report on the Northern Rock incident. We think we could
have been done more to spot the issue. The question is whether,
even if we had spotted it, we could have done much to prevent
the ultimate outcome, because what happened was such a liquidity
crisis which was globally generated that, even if we had tried
to shift that one institution which maybe we should have spotted
as a bit of an outlier earlier, it would have been very hard probably
to get it into a position within the timeframe that was there
to prevent the crisis completely. There are some mistakes but
it fits into the global picture. Whether we could have fundamentally
changed the course of the crisis is very unlikely. It is a global
crisis. Ultimately it has hit not just UK banks but banks around
the world.
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