House of COMMONS






Banking Crisis - FSA & FSCS



Wednesday 25 February 2009



Evidence heard in Public Questions 2140 - 2319





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Transcribed by the Official Shorthand Writers to the Houses of Parliament:

W B Gurney & Sons LLP, Hope House, 45 Great Peter Street, London, SW1P 3LT

Telephone Number: 020 7233 1935


Oral Evidence

Taken before the Treasury Committee

on Wednesday 25 February 2009

Members present

John McFall, in the Chair

Nick Ainger

Mr Graham Brady

Colin Breed

Jim Cousins

Mr Michael Fallon

Ms Sally Keeble

Mr Andrew Love

John Mann

Mr George Mudie

John Thurso

Mr Mark Todd

Mr Andrew Tyrie

Sir Peter Viggers


Memorandum submitted by Financial Services Authority


Examination of Witnesses

Witnesses: Mr Hector Sants, Chief Executive, Lord Turner of Ecchinswell, Chairman, Financial Services Authority, and Ms Loretta Minghella, Chief Executive, Financial Services Compensation Scheme, gave evidence.

Q2140 Chairman: Welcome to our Banking Crisis inquiry. Loretta, can you introduce yourself for the shorthand writer, please?

Ms Minghella: Thank you, Chairman. Loretta Minghella, the Chief Executive of the Financial Services Compensation Scheme.

Lord Turner of Ecchinswell: Adair Turner, Chairman of the Financial Services Authority.

Mr Sants: Hector Sants, Chief Executive of the Financial Services Authority.

Q2141 Chairman: We have a lot of questions to put to you today, so I am asking my colleagues to have short questions, yourselves to have short answers and given that the financial services industry has a language all of its own could you make your answers simple, so that they are intelligible to both us and to the wider public who have a great interest in this subject. If I cut across you, do not be offended - I want to move on because we have all these questions to ask. One of our witnesses, I think it was Will Hutton, said that bankers were now privately saying that they "badly, badly need some regulation". One wonders how we allowed things to get to a state where even the bankers are calling for more regulation. In answer to a question from myself at the Liaison Committee, the Prime Minister made the point that the FSA should " ... look at the position of capitalisation of banks and on the basis of the risks that they are taking, with short term bonuses for employees, they can be tougher in their regulatory standards." Are you capable of being tough with your regulatory standards, bonuses and other areas for bankers now as a result of this catastrophe?

Lord Turner of Ecchinswell: The answer is yes, we think we have, broadly speaking, the legal powers to do what we need to do, and I think we have to realise that after what has occurred we need a fairly complete change in the structure of banking regulation and the style of bank supervision. I do not think we should at all underestimate that it is not just a change at the margin; it is absolutely fundamental. I will be producing a report on March 18, attached to which will be a number of FSA discussion papers, which will propose fundamental changes to the way that we regulate capital, the way that we regulate liquidity; things to do with published accounts, things to do with the coverage of institutions such as hedge funds, and which will also be setting out proposals relating to remuneration, credit rating agencies, credit default swaps, the organisation at international level and commenting upon the resources and style that we need to do our job. I think we should be just absolutely clear: this is not a small change, it amounts to a revolution.

Q2142 Chairman: In your Economist lecture, which was an excellent lecture, you made the point that the "huge inherent system-wide risks and the cycle of irrational exuberance was close to reaching a crisis point". Do you think the FSA was captured by the markets and captured by the markets in that almost everyone in a senior FSA role comes from a banking background?

Lord Turner of Ecchinswell: I do not think that that is at all fundamental to why there was a failure across the world to see that we were at a point of unsustainable irrational exuberance, because I think that failure also existed among many economists, central bankers and finance ministers, who come from a different background; who do not come from a market practitioner background but come from a theoretical economics background. Indeed, I think it is important to realise that up until 2006 and even into 2007 the world was awash with erudite, authoritative arguments put forward not just by bankers who had a self-interest in it but by theoretical economists who thought that they were looking at this in a disinterested fashion, who were arguing that the world, as a result of the development of structured credit and derivatives, had become less risky. That is there in the IMF global financial stability report; that is there in documents produced by Chicago School economists, etc, etc. So I think there was a very fundamental intellectual failure. I think it encompassed people who had a self-interest because of their role as bankers themselves but I think it was far, far wider than that.

Q2143 Mr Fallon: In your evidence to the Committee you included a stunning sentence that the failure was not inadequate supervision of any specific institution, but a failure to recognise systemic-wide risks. That is a kind of Nuremburg defence, is it not?

Lord Turner of Ecchinswell: No, I do not think I said it was not a failure; I said the most important failure. Let us be absolutely clear: the FSA has accepted entirely and has, I think, been more open than any other institution at apologising for the fact that it made specific failures in the supervision of Northern Rock. That is absolutely clear. We, in no way, attempt to deny that, and that is clear and has been said at this Committee before. However, the point I was making was that the far more important failure was the failure to see the overall systemic risk. So it is a matter of what is the most important failure rather than denying that there was a failure. There was a failure in the supervision of Northern Rock - that is absolutely clear.

Q2144 Mr Fallon: Was there not also a failure in the supervision of the other four banks that collapsed?

Lord Turner of Ecchinswell: In relation to those, the most important failures were the failures to see the systemic things. We have not become aware, we do not believe, that in the way that we were looking at the supervision of those other banks there were the similar categories of failure that there were with Northern Rock. Having said that, and I am very happy to come back to this, we were supervising people like HBOS within a particular philosophy of the way you do regulation which I think, in retrospect, was wrong. I have, you will not be surprised to know, spent the last few weeks reading through, for instance, the HBOS file, all the way through the different things that we reported. I think it is a competent execution of a style of regulation and a philosophy of regulation which was, in retrospect, mistaken.

Q2145 Mr Fallon: But HSBC or Standard Chartered did not make these kinds of mistakes. Why did you allow banks like HBOS, RBS, Bradford & Bingley and Northern Rock to be run by people without any financial qualification; to lend out so much more than they had on deposit; to make acquisitions that were reckless?

Lord Turner of Ecchinswell: On your first point, the degree of financial qualification, I do not think you will find that that is a differentiating feature between the management and top executives of HSBC and Standard Chartered, on the one hand, or HBOS or RBS, on the other. I think, therefore, we have to decide how important formal qualifications are, and that should be based upon the fact that it is a discriminating variable as we look at what occurred. What is the case in relation to HBOS is that we had a philosophy of how we did regulation which focused on organisation structures, processes, systems and whether the reporting lines were correct. It fairly overtly said that it was not the function of the regulator to cast questions over the overall business strategy of the institution. You may find that surprising and I think, with hindsight, I find it surprising, but that is the case, and I think it is also the case that that existed within a political philosophy where all the pressure on the FSA was not to say: "Are you looking more closely at these business models?" but to say: "Why are you being so heavy and intrusive? Can you not make your regulation a bit more light touch?"

Q2146 Mr Fallon: But what is the point of a regulator that has cost us, I think it is, 400 million this year, that employs 2,500 people, is given ten big British banks to supervise and allows five of them to collapse?

Lord Turner of Ecchinswell: We have to get it right for the future. You can say exactly the same about: "What is the point of the US regulatory authorities?" because ---

Q2147 Mr Fallon: You are from the FSA. What we want to know is: is the FSA actually fit for purpose?

Lord Turner of Ecchinswell: It is going to be fit for purpose, given the changes that we are going to make and we are making, and which have been set out in a supervisory enhancement programme and will be set out in more detail in my report on March 18. I said earlier, these are not minor changes; these are a revolution in approach.

Mr Sants: Perhaps I might ----

Q2148 Mr Fallon: No, I want to ask Lord Turner this stuff. Do you actually understand what these banks are doing?

Lord Turner of Ecchinswell: Let me put it this way: I have read over the last two weeks the reports that we produced in HBOS in 2002, 2003 and 2004; I have also read very, very detailed stuff on RBS, which we are producing as background to the stuff which has been talked about in the press and which we are all familiar with, which is the possibility of an asset protection scheme. These are completely different documents which reflect a completely different philosophy from one which is focused on structured systems and procedures to one which is focused on understanding the fundamental economics of the banks we are dealing with. It is a fundamental change; it is a change which was in place already for about six months, led by Hector Sants before I joined last September, but it is one we need to intensify and deepen.

Q2149 Mr Fallon: Have you seen Barclays' trading statement of two weeks ago?

Lord Turner of Ecchinswell: Of course, we have seen Barclays' trading statement.

Q2150 Mr Fallon: Have you seen it?

Lord Turner of Ecchinswell: Well, I have looked at it, yes.

Q2151 Mr Fallon: There is a section entitled: "Unobservable profit". What is "unobservable profit", Lord Turner?

Lord Turner of Ecchinswell: I would have to say I do not know the answer to that specific line item which you have raised with me, but I can assure you that we are crawling through the issues of the profit of the banks that we are regulating.

Q2152 Mr Fallon: If you do not know what "unobservable profit" is, you are the Chairman of the ----

Lord Turner of Ecchinswell: I did not know that that line was there, but I am sure we do understand what is in that line. I have not read that particular line and focused on it.

Q2153 Mr Fallon: It comes just after a paragraph that tells us that, as a result of the most recent stress test, there is potential to increase the fair value of Barclays by up to 2.4 billion or to decrease the fair values by up to 3 billion. So when Barclays tell us they have made 6 billion profit, how can we believe it?

Lord Turner of Ecchinswell: That is a much more straightforward thing to argue. When you do stress tests you are looking at a wide range of scenarios. I think the idea that there is, as it were, a truth as to what losses will be over the next year, and that people are hiding it, is a fundamental intellectual mistake, if I may say, because it fails to realise that what we are trying to do in stress tests is to consider the future, and the future is not determined yet; it depends upon the course of the economy, it depends on the course of financial markets. So, yes, we are deeply involved with running stress tests with Barclays, as they are themselves, and those inevitably have wide degrees of uncertainty. That is inherent, that will always be the case, and that is good supervision, not bad supervision.

Q2154 Chairman: I have given you pages 102 and 103 of Barclays' trading report, and I have highlighted the various sections for you, Lord Turner. The report says that Barclays has assets of almost 45 billion, measured using unobservable inputs almost twice a year before, and they talk about "vanilla" and "exotic" products. This is how they describe vanilla products - it is important for the public record. "Vanilla products are valued using simple models, such as discounted cashflow or Black Scholes models. However, some of the inputs are not observable." They then go on to exotic products and say that they are over-the-counter products that are relatively bespoke, not commonly traded in the markets and their valuation comes from sophisticated, mathematical models though some of the inputs are not observable.

Lord Turner of Ecchinswell: Can I explain what this is? I will explain precisely because I now understand the context of it. Within the valuation of things which are in the trading books of a bank, which are valued on a fair value basis, there is a categorisation of assets which is known as level one, level two and level three, where, at the end of the spectrum which is level one, you are dealing with an instrument - an example might be a traded Treasury bond which is a particular maturity of Treasury bond where there is large and immediate liquidity available every day - where, at five o'clock in the afternoon, you can definitively say: "The value of this is X" because you could, at five o'clock, sell it for X plus or minus a very, very small amount because it is a liquid instrument. There is then a spectrum and there are those called level three. These are assets where there is not, at that point, a liquid market to which you can refer - i.e. it might be a CDO or a CDO squared, or something like that - where if you called up at that point and asked for a quote you would not get a quote. So you then have to try and work out what the value of that is on the basis of a model. Sometimes you try and do that with other observable instruments, i.e. by cross-reference to other markets. I was asked this question and I think I was asked it within the context that this was a trick question which was going to find us out ----

Q2155 Chairman: No, the reason you were asked this question, Lord Turner, is very simple. We had Brendan Nelson of KPMG before us, the Chief Auditor, and I asked him quite simply that if he had HSBC's statement of accounts before him and he looked at them, could he understand it? He said he could not understand it. The fact is you, in the sophisticated language, could maybe understand it, but this is not understandable to the ordinary person. At the end of the day, what we have found in this Committee is that there has been a massive failure of corporate governance. I put it to you that the type of non-executives on these boards, the best and the brightest, cannot understand what is happening. It is not because they are of limited intelligence. That is the issue here. If we cannot put things in simple language, then we have had it. That is the reason why you have been asked it.

Lord Turner of Ecchinswell: I accept that point and I accept entirely - and I think it is the case - that there has been the development within the trading books of banks of instruments so complex that they have become very difficult to understand, that they have required these "unobservable inputs to value", which is deeply unsatisfactory, and I think, given the changes which we, with international agreement, are putting into the capital which is required against trading books, it is unlikely that these things will exist in future on anything like the scale that they existed in the past. I have also said, which I said in my letter earlier, that I am not convinced that these instruments added much to the sum total of human welfare, and their disappearance we should not regret.

Chairman: That is a satisfactory answer for us because if we are talking about 45 billion, which is a heck of a lot of money, we have got to understand where that 45 million is, and the question for me is how you prevent bank staff from making over-optimistic judgments for using the faulty pricing models we have seen when valuing these assets. We are on the same lines here, that things need to change, and I am quite happy with that answer.

Q2156 Mr Tyrie: You have given us a pretty clear statement that you think the framework of regulation was mistaken, in retrospect. Are you criticising your predecessors or are you criticising the system?

Lord Turner of Ecchinswell: I think there was a philosophy of regulation which emerged, not just in this country but in other countries, which was based upon too extreme a form of confidence in markets and confidence in the ideas that markets were self-correcting, which therefore believed that the fundamental role of the supervision of financial institutions, in particular banks, was to make sure that processes and procedures and systems were in place, while leaving it to the judgment of individual management to make fundamentally sensible decisions. As Alan Greenspan said, that is the intellectual framework which has received an extraordinary challenge.

Q2157 Mr Tyrie: What I am trying to get at is whether you think this is the specific fault of your predecessors or whether you think this was the fault of the structure and system of regulation.

Lord Turner of Ecchinswell: I am not convinced it was the fault of the structure, if you mean by that the separation of banking supervision from the central bank, because I think there is very good analysis that suggests that the relative success of different authorities around the world at dealing with the financial problems that we face is pretty much totally independent of the way that you organise the structures.

Q2158 Mr Tyrie: So you are saying it was your predecessors?

Lord Turner of Ecchinswell: No, I think there was a philosophy of how regulation was done.

Q2159 Mr Tyrie: Where did this philosophy come from, Lord Turner?

Lord Turner of Ecchinswell: I think it was rooted in particular political assumptions at the time, where all the focus on people like the FSA ----

Q2160 Mr Tyrie: So it was just a general ----

Lord Turner of Ecchinswell: No, it was expressed in speeches on both sides of the House but which suggested that the key priority in regulation was to keep it light rather than to ask ever more searching questions.

Q2161 Mr Tyrie: While you were listening to those speeches and breathing that air which generated this philosophy, were you also infected? If you had been running the FSA without the advantage of hindsight, would you have made the same mistakes?

Lord Turner of Ecchinswell: I fear I would have, yes. I think hindsight is very valuable and it is a question I have asked myself as to whether I would have. I did have intellectual doubts, which I expressed in a book I wrote in 2001 which has some comments upon the fact that we might have financial market deregulation overdone, but those doubts were not as deep as they should, in retrospect, have been.

Q2162 Mr Tyrie: In which case it sounds as if there was something wrong with the system.

Lord Turner of Ecchinswell: I think there was something wrong with the system but you used the word "structure" and ----

Q2163 Mr Tyrie: So did you, actually. I wrote down what you said as you said it; you also came out with the word "structure".

Lord Turner of Ecchinswell: I think that was a misunderstanding. What I said was that there was a philosophy of regulation which when it went into an organisation like HBOS was asking questions about its internal structures and systems rather than about its strategy.

Q2164 Mr Tyrie: We are going to have a new philosophy on the 18th. You said that the FSA is going to be fit for purpose. Do we take it from that that it is not fit for purpose now?

Lord Turner of Ecchinswell: It is a long way through a set of necessary changes. I think it might be helpful if Hector Sants described the very significant changes that have been driven through the supervisory enhancement programme which was already well in place before I became Chairman.

Mr Sants: I will keep it very short but, just to make the point, I do believe that for the last 12 months we have put in place a significant set of changes to our supervisory processes - i.e. the processes that we as a national regulator can control. As Lord Turner has said, there are many other things in the regulatory architecture structure system that also needed to be changed for that supervision to be effective, not least of which a whole series of the rules which we are not directly responsible for. In terms of changing that supervisory philosophy, so that going forward we look at the business models, we look at the risks, we make judgments about the future, we have the right quality of staff which has a good mix of industry practitioners who understand the sort of issues we have just been talking about but, also, others who take a more dispassionate view with a professional regulatory background, we are well down that track. I believe the FSA is a fundamentally different organisation to that which it was 12 or 18 months ago. We have not quite completed that programme, we are about two-thirds of the way through, but any suggestion the FSA is not currently fit for purpose I would completely reject; we are a fundamentally different business delivering to a different supervisory philosophy to the one that has been described.

Q2165 Chairman: This word "philosophy" has been bandied about, and maybe we can just tie this up, Lord Turner, because is it the philosophy of an independent regulator to roll over under the rubric of political (?) philosophy? If it is, what assurance can you give us in the future that you are going to be independent?

Lord Turner of Ecchinswell: I think that is a good question. All I can say is that I am absolutely determined that as long as I am Chairman it will be independent. I also think that it is the nature of such a huge shock to the world that has occurred that round the world regulators will be able to be more independent. When I talked about philosophy, I think some of the most important points about this are, if you look at the style of the reports that we were doing back in 2003, 2004 and 2005 on the banks that existed at the moment, there is just an assumption that it is not clearly the role of the FSA to cast doubt upon the whole business strategy of the organisation. As I said, that may be surprising, but that was either an implicit or sometimes close to an explicit assumption - and it sometimes was an explicit assumption. You will find in statements, in consultation papers of the FSA, for instance, in 1999, on the way that we do the approval of approved processes, very strong statements that the responsibility for ensuring that people have the right competences is on the business itself rather than for the FSA to do. So it is quite telling, when you read back, how permeating that overall approach is.

Chairman: I am still not clear about how independent you are going to be, but we will move on and you can, maybe, think about it and come back to me.

Q2166 Sir Peter Viggers: I am baffled by this. If it was not the responsibility of the FSA to look at overall strategy - you have said that, perhaps, you were not concentrating enough on the overall business strategy - whose was it?

Lord Turner of Ecchinswell: As I have said earlier, I think there was a (at times implicit and at times absolutely explicit) philosophy, for instance, expressed by people like Alan Greenspan that it was not the role of regulators to interfere with what the market did. If you see the debates going back to the US about the expansion of sub-prime and debates in the US where people said: "You ought to be stopping this sub-prime explosion of lending", you are getting a quite explicit push back from academics and people like Mr Greenspan saying: "No, that's wrong; we should not be preventing financial market innovation. These things are self-correcting. You may think that this is a boom but none of us know whether it is a boom." That was not simply something that the FSA did on its own; that was the absolutely dominant intellectual conventional wisdom of the years running up to 2007.

Q2167 Sir Peter Viggers: Ben Bernanke referred to the "great moderation" with low interest rates, low inflation and easy access to credit, and so on, but did the FSA think this was going to be a permanent state for the economy? Looking at the tripartite arrangements, who did the FSA think was responsible for overall business strategy?

Lord Turner of Ecchinswell: I think Mr Paul Tucker, the new Deputy Governor of the Bank of England, has used a very good phrase in this respect. He said that between the FSA and the Bank of England there was so much desire to avoid overlap that there was an underlap, i.e. that there was a Bank of England focus on monetary policy focused on the pursuit of a specifically defined inflation target; there was, at the FSA, a focus on the supervision of individual institutions according to a philosophy that was based upon structures, systems, processes and things like that, and between the two of us there was not enough focus on what we now call (and I think is a good phrase) macro-prudential analysis on identifying what is the overall big picture of what is going on and identifying what we are going to do about it. I think, in future, and again it is a point that John Gieve made in his valedictory letter at the LSE last week, it is much better to have an overlap than an underlap, and it would be better in future for us to be both involved and intensively involved in those debates about what we think the situation is and what we do about it.

Q2168 Sir Peter Viggers: You were not there in the FSA, but if there was a structural fault was it not the FSA's prime responsibility? Were they not the prime mover responsible for identifying this?

Lord Turner of Ecchinswell: I think, in retrospect, the FSA should have been more involved in sectoral analysis, but that was not what was believed at the time. I have to say that I think if we were to roll back and the FSA had come out in 2004 and had started aggressively challenging the mortgage banks to cut back on lending, I suspect that the predominant reaction of many people, including perhaps many people in this House, would have been to be telling us that we should not be holding back the extension of mortgage credit to ordinary people; that we were preventing the democratisation of home ownership. So in hindsight, yes, it would have been better if we did, but I suspect we would have been pushed back politically if we had.

Mr Sants: We did not have a financial stability-explicit requirement, so people were primarily focused on individual firms, as Lord Turner has said.

Lord Turner of Ecchinswell: I think that is a good point. We feel that both we and the Bank of England should have formal financial stability responsibility; it should be defined that both of us have a significant role in macro-prudential analysis and in thinking about overall financial stability. If you go back, the situation in legal terms was that we did not and nor did the Bank of England.

Q2169 Chairman: For the record, this Committee in its Northern Rock report specifically asked for an overlap between the Bank of England and the FSA. It is not overt enough for us, at the moment, and what we worry about is it is dependent on personalities, as the TPA was at the beginning, and I think there is a bit of work to do there. As you know, we wanted a beefed-up financial stability responsibility.

Lord Turner of Ecchinswell: I accept that entirely, yes.

Q2170 Colin Breed: Mr Sants, according to the FSA's website, individuals must be shown to be fit and proper before they become approved persons eligible to run controlled functions. Can you tell us: what is the process for assessing someone's application for such status?

Mr Sants: This picks up on Lord Turner's earlier comments, so there is a change in our approach here, but looking back historically, which I think probably refers back to some of the earlier questioning, as we have demonstrated in the material if you go back over time, and Lord Turner referred to 1999, the fit-and-proper process was primarily focused on probity. There is a full review done of visible facts in relation to the probity of the individual, and that process goes through a formal review process. There was not, historically, in the philosophy of the FSA, as was mentioned already, formally, publicly set out, a competency remit, a competency review done; the view was taken that it was for the firms to determine whether the person they were putting forward was competent for the role. There was, I believe, although I was not around at the time but my colleagues tell me, a very extensive debate between the industry and the regulators at the time of M2, around this point, I am told, where the industry was very, very clear that competency is a judgmental matter and is a matter for firms as to whether they consider people to be competent, not for the regulator, and they did not want the regulator reaching that view. Going forward, if I may finish, we have already announced a set of measures to change that approach, and we will be seeking and have already begun a process to judge competency which includes for significant, senior appointments (we do not have sufficient resource to do it for everybody who is approved with us) at major banks an interview process which is now established, and going forward directors of major deposit taking institutions, for example, will be, and indeed have been since the procedure was put in place, interviewed, and we will be taking a view on competency. Historically, that was not what we were doing and it was explicit in our regulatory philosophy that that was not what we were doing.

Q2171 Colin Breed: Thank you. So historically, basically, as long as you had not been convicted of fraud or something and you were honest, you were quite happy?

Mr Sants: That appears to have been the approach of the organisation, historically, but it was an explicit one which the industry and the debate at the time reached a collective conclusion on, as I understand.

Q2172 Colin Breed: As you are aware, when we interviewed some of the executives from RBS and Lloyds and such, they indicated to us that there was no, really, great formal process, at least as far as the FSA was concerned, prior to their appointments. You accept that that was probably an oversight or a mistake?

Mr Sants: It is not a regulatory philosophy that either Lord Turner or I would agree with, in the light of circumstance, and going forward it is not the one we are going to be having, and they are right in saying that that was what was pertaining when they were appointed.

Q2173 Colin Breed: So on the basis of going forward then, what, in your view, makes someone a fit and proper person, particularly in respect of, say, a risk director or someone involved in the risk management of a large bank?

Mr Sants: This is a difficult question because, of course, competency is about saying: "Do you think they will make judgments which, when you see the consequences of those judgments, you will be happy with?" So it is a judgment about a judgment. By definition, I have to say we cannot set ourselves up here as infallible if we go down this track; there will be occasions when, no doubt, our judgment will be disputed by the firms and the individuals, but clearly, as we have already said, in setting out this process (and we will be developing this further, by the way, over the coming months) we certainly need to look for technical competence in respect of risk management (the particular question you were asking), the ability to understand the data, the types of accounts we have just been referring to and understand the fundamentals and to apply that practically to the role in question. Whether we can say for certain that will necessarily lead to a better outcome shareholders, of course, is a matter of greater debate.

Q2174 Colin Breed: So experience would be an important factor in determining somebody's ability to be a fit and proper person to do risk management?

Mr Sants: Either experience or a set of relevant formal qualifications, absolutely, for a senior person. Obviously, you have to allow people to develop through the process but if we are talking about a senior person then you need to be able to demonstrate competency. You might be able to do this in the interview process but, yes, you would need to demonstrate competency.

Q2175 Colin Breed: One of the charges levelled against HBOS is that they appointed a group risk director who did not have any risk management experience. In what circumstance can someone be approved to do risk management if they do not have any risk management experience?

Mr Sants: We are back to the answer I have already given you in terms of what I would describe the new approach going forward ----

Q2176 Colin Breed: But in the previous regime you said that that sort of competency ----

Mr Sants: Would be a matter for the company.

Q2177 Colin Breed: ---- was a matter for the company. So in that particular instance, then, it would have been the company's decision, and perhaps a not particularly clever decision, to undertake that the FSA would not have any role. Going forward now, you are saying that if they were preparing to do that you may well say: "No, we are not prepared to accept that person as a fit and proper authorised person".

Mr Sants: Quite so.

Colin Breed: Thank you very much.

Q2178 Chairman: How many people in senior positions have you found not to be fit and proper in the past?

Mr Sants: I would have to give you a written answer on that. I suspect, in all honesty, for the reasons I have described, going through the screen that we have described, not that many.

Q2179 Chairman: It could be zero?

Mr Sants: I do not think it is zero but I think it is a very small number. I can give you a written answer. That is for, precisely, the reasons we have just described, which is given that we would only broadly, in the past, reject people based on observable facts of probity, as we have just discussed, the firms of course know that and they are not going to put forward people who do not meet those criteria. Actually rejecting a form does not necessarily mean that screen did not have some effect, but undoubtedly this approach would mean that the vast majority of people that firms were comfortable with, to the point discussed, would be allowed to take up those jobs. That was the approach prevailing at the time.

Q2180 Ms Keeble: I wanted to ask Lord Turner about the regulation of complex instruments, because there has been discussion of the fact that they were under-standard (?). You said just now that you thought that some of these instruments had not contributed to the sum total of human welfare and would not be missed, which is a very Philistine comment, in some ways, for a regulator. Could you expand on your comments and say which instruments, in particular, would be on your hit list?

Lord Turner of Ecchinswell: I am not sure why you are using the word Philistine there, but let me explain. It is certainly a comment which would be offensive to somebody who believes in an extreme version of efficient market theory, who would believe that if something had been innovated by a private sector, profit-making firm then we could assume by that very fact that it must be beneficial socially and economically. What I clearly set out in my lecture was that I think there are particular features of financial markets why that is not the case, and whereby you can have financial innovations in financial markets which survive for a long period of time, which fundamentally extract what economists call "economic rent" from the rest of society rather than adding value to the rest of society and which create significant risk. That is a complex theoretical argument that is something I believe. What did happen with the more complex forms of securitised credit is that we were doing things where the possible benefits to allocated efficiency, which people argued existed, were pretty trivial and which were creating, through their complexity and the fact that they were so difficult to understand, huge risk. I think that some of the more complex things that existed will not exist in the future. I think they will not exist in the immediate future because nobody will buy them because they have been shown to be in some sense toxic and, at least for a period of time, whatever we do on regulation they will not be bought. However, looking forward longer term, one of the things that we did realise and has been recognised across the world - and the Basel Committee has already got proposals in the public domain to address it - is that we were not demanding enough capital against the proprietary trading books of banks, and we are going to very significantly increase the capital required against that, and that also will lead to the disappearance of that.

Q2181 Ms Keeble: Do you not think that, in fact - I take the point about the capital and the liquidity and so on - with quite a number of these products it was the lack of due diligence and difficulty about assessment and pricing of risk that was the real issue? How would you improve that through tighter regulation?

Lord Turner of Ecchinswell: There are two issues here: the indirect lever is through the capital requirements that we set against the trading books of banks. I think we now realise, and the world realises, that we had that wrong, not by 10 or 20% but by a factor of several times - there just was not enough ----

Q2182 Ms Keeble: By 200 or 300, do you mean?

Lord Turner of Ecchinswell: Yes, 200% or 300%. We will be increasing the capital required against categories of trading books by several times, not by 10 or 20%. That will make a significant difference to the incentives for companies to have very large trading books of complicated activities. I think the issue which we might have to address is whether you could ever imagine a regulator saying: "That product should not exist because it is too complicated." Regulators, so far, have been wary of that degree of ability to step in and simply say: "I am going to product regulate", but I certainly do not exclude it. Indeed, in the "open issues", the final chapter of the report that I will be producing on March 18, it will put, not for definitive conclusion but as an open issue, whether in future there are some categories of financial product where we should simply say we think this is too complicated for anybody to actually deliver in a risk managed fashion.

Q2183 Ms Keeble: You also, in that lecture, identified some of the institutions which have been particularly associated with some of the more complex products which might need tighter regulation, and you mentioned in particular the mutual funds and the hedge funds. I am sure you do not want to pre-empt your March report, but could you just say what your thinking is there and how you are thinking that you might regulate?

Lord Turner of Ecchinswell: The issue relating to mutual funds is not fundamentally a UK situation, because we do not have this category of mutual funds; the issue is mutual funds in which you make an investment but which then give you a close-to-categoric promise that they will not, as it is called, "break the buck" - i.e. they will not allow the value of your investment of 1,000 to go below 1,000 - and who, thus, end up performing a bank-like function - a product which is not legally a bank deposit but has the economic characteristics of a bank deposit. As it happens, we have almost no such institutions. So that issue of extending the regulatory boundary is fundamentally an issue for the US authorities, not for us.

Q2184 Ms Keeble: And hedge funds?

Lord Turner of Ecchinswell: On hedge funds, I think we certainly believe that we need to gather enough information on hedge funds (and this will require more information from them) to assess what risks they are creating at the macro level and an individual institution level, and if at any time we believe they have become sufficiently bank-like in their activities or large in their scale that they are systemically important, then we should extend bank style capital and liquidity to their activities. We need that power.

Mr Sants: We also recognise that we regulate hedge fund managers here whose standard is above the rest of the world. So a good first step, quite frankly, is that the rest of the world catches up with us. In this area we are ahead of the game. We can go further, but the first step, actually, is the rest of the world catches up with us.

Q2185 Ms Keeble: You might have seen, Lord Turner, the suggestion from Dr Danielsson of having the complex and securitised interests traded on exchanges. I wonder if you had considered that and thought that that might increase transparency and confidence.

Lord Turner of Ecchinswell: We are certainly very interested in the credit default swaps market - CDS market - of getting as much as possible of that trading going through clearing systems and central counterparties, so that you net out not only on a bilateral basis but a multilateral basis a lot of the huge, nominal value of these instruments which are outstanding. That is covered in my review and it is something that the FSA is deeply involved in discussions with the Federal Reserve in the US and the EU Commission about how we progress that. It is important to realise that about 75% or so of the CDS market is probably not of a sufficiently standardised form that it would be possible to put into a central counterparty clearing arrangement, because these are bespoke and therefore are, almost by definition, over-the-counter products. However, in that segment where we can make progress there is a clear belief that we should try to do so and we are trying to drive that.

Q2186 Ms Keeble: Can I just read back to you something you said back in July when things were very much calmer and we were interviewing you about your three-day working week, amongst other things? You said, "What is absolutely clear is this is a job where, if a crisis happens, it has to be effectively full time".

Lord Turner of Ecchinswell: Yes.

Q2187 Ms Keeble: Is it full time?

Lord Turner of Ecchinswell: Yes, I would say it is about 80 hours a week.

Mr Sants: I concur with that. It is definitely full time.

Q2188 Mr Todd: You have turned down your bonus, Mr Sants, have you not?

Mr Sants: I have.

Q2189 Mr Todd: Does that reflect a view that that would be a reward for failure?

Mr Sants: No, not at all. I just took a view that in the current climate, the overall economic circumstances, it would not be the right thing for me as the chief executive of the financial regulator not to do. I also, on a topic to which no doubt we will return; we have mentioned it already, felt this was important, namely, the topic of compensation structures. This is an area I personally have always been very interested in. I believe that the regulator should take much greater interest in ensuring we have effective compensation structures within banks and financial institutions which seek to minimise risk, and indeed certainly do not incentivise risk. That is something I said very early on in speeches and have been looking at since I have joined the FSA. I have felt, in terms of my authority to speak on that topic from a personal point of view, that that was not going to be helped in the debate if I had taken a bonus. Obviously, Lord Turner can comment in more detail on our individual incentive plans but I strongly believe, in respect of calendar 2008, that it is right that the relevant FSA employees are able to receive individual performance pay.

Q2190 Mr Todd: I was going to ask how many have followed your example.

Mr Sants: I do not think anybody else in the FSA will be volunteering to forgo their bonus, which is what I have done, unsolicited in any way whatsoever.

Q2191 Mr Todd: So what is the typical payment of a bonus within the FSA?

Mr Sants: To be quite clear, the press have run very speculative articles. We are going through a process which is assessing the individual performance and then allocating a performance pay against those individuals. We have not completed that exercise yet but, relative to the potential pot of some 21 million, not other figures which have been reported in the press, that obviously works out at 7,000 or 8,000 per employee. I should make the point that the FSA works on a total compensation system. That is part of the overall pay of an FSA employee. It is an individual scheme. It is not an FSA bonus that is distributed on the back of some general judgment about the FSA.

Q2192 Mr Todd: You will have noted, I think, a piece in The Spectator about the terms of departure of one of your members of staff who left after Northern Rock. I assume you noted that, did you?

Mr Sants: I think from memory that was a comment about the managing director, who obviously had a board contract, so it is really for Lord Turner to comment on and, to be fair, he was not there at the time. Obviously, the executive board members have specific contracts.

Q2193 Mr Todd: So, just to clarify for the record, was the payment referred to in The Spectator piece accurate, and, secondly, was that the contractual obligation to that particular individual?

Mr Sants: I am at a slight disadvantage here because I had not assumed there would be lots of comments about individuals in the FSA receiving payments. I assume you are referring to the retail managing director.

Q2194 Mr Todd: Yes.

Mr Sants: The numbers for that were published in our accounts for last year, so obviously they are already in the public domain, and I assume the Evening Standard correctly read our accounts. Without looking at the article I cannot tell you off the top of my head. That figure was determined by the remuneration committee, not by myself, and it was deemed to be the right award to pay.

Q2195 Mr Todd: I asked a different question, which was, was that the contractual obligation to that individual, the minimum required on severance of that person's contract?

Mr Sants: There is the issue of the precise contractual amount required in the contract and what was deemed to be the right practice relative to the FSA's severance policy. That was a matter for our remuneration committee to comment on. I believe it was in line with the practice of the FSA.

Q2196 Mr Todd: Does Lord Turner want to comment? I know you are at a disadvantage.

Lord Turner of Ecchinswell: I am at a disadvantage because I was neither chairman nor on the board and certainly not on the remuneration committee.

Q2197 Mr Todd: But you realise the reasons why these questions are asked?

Lord Turner of Ecchinswell: I do understand the reasons why they are asked but I just do not know the answer to those particular questions. That had happened before I joined. I would, however, be very willing to talk about the overall philosophy of the performance related pay if you want me to do that.

Q2198 Mr Todd: Can I suggest, so that we speed the time, that it would be useful to have that set out in a note to us on the future plans for remuneration within the FSA?

Lord Turner of Ecchinswell: On severance or on -----?

Q2199 Mr Todd: On both, because this issue of rewards for failure relates both to bonuses and to severance terms for those who have failed.

Lord Turner of Ecchinswell: Okay.

Q2200 Chairman: Also the bonus as a percentage of the basic salary; I think that aspect is important.

Lord Turner of Ecchinswell: It comes to 15%. That is the maximum that it can be this year. That was agreed in the budget for 2008 and 2009 which was agreed by the board a year ago, at the beginning of it. That was the figure.

Q2201 Chairman: So that is the maximum that anyone can get, 15%?

Lord Turner of Ecchinswell: No. Individuals can get more. The 15% is the total bonus pool. That is the average.

Q2202 Chairman: Perhaps you could give us an indication of what the -----

Lord Turner of Ecchinswell: Okay, we can do that.

Q2203 Mr Mudie: The obscene thing about this is that the low-paid can reach the dizzy heights of 10% but the top brass, with their obscene salaries compared to the lass at the bottom, can have 100%, 200%, 300%, which all piles down to an average of 8% or 9%, we hear. Is this the same with the FSA?

Mr Sants: 35% is the answer to your question.

Lord Turner of Ecchinswell: 35% is the absolute maximum.

Mr Sants: There is a maximum set by the board, which, in respect of this -----

Q2204 Mr Mudie: Yes, but what I am asking is, is the lowest member of staff able to earn 35%, because the banks have this quaint habit where there is a limit on what the low-paid can have but no limit on what the senior staff can have? Are you saying the lowest-paid in the FSA can earn 35%, they have got a scheme which allows them to do it, or are they limited to 10% but you have a scheme that allows you to hit 35%?

Mr Sants: That is the current structure.

Q2205 Mr Mudie: So you do have that?

Mr Sants: 35% is the maximum for everybody taken across the board.

Q2206 Mr Mudie: For everybody?

Lord Turner of Ecchinswell: Yes, for everybody. Let us be clear. The present scheme does have the same potential amounts for everybody and the FSA is an institution which has gone down the road over the years of somewhat moderating base salary in order to have a significant element of performance-related pay which does relate to our secretaries who have been working flat out over the last year on the pressures, et cetera, as well as to the chief executive, though in this case Hector has decided to waive it, and I think he has explained that the reason why he wants to do that is to put himself in a position so that he can engage in this debate without people saying that he has a self-interest in it, and I think that is a very good thing for him to have, entirely voluntarily, done.

Q2207 Chairman: It would be good if we got the salary scale ranges and maybe the maximum bonus that people got because in terms of the culture of bonuses there is a feeling in the public about why it is that the financial services industry is almost unique in that some people need two or three times their basic salary to get them out of bed in the morning while most people go to work for a basic salary.

Lord Turner of Ecchinswell: I do think that is an important point and, if I may just say it, I think it is unfortunate that we have, in the process of this debate about bonuses, confused the very reasonable concerns about people receiving enormous multiples of salary for things which have turned out in retrospect to be harmful to their institutions and now to the taxpayer with the bonuses paid to people of much more modest salaries as performance-related pay, which has been again, whether we agree with it or not, the flavour of the month of human resources' approach in the public sector as well as the private sector over the last ten years.

Q2208 Chairman: That is why as a committee we have always distinguished between the utility aspect of the banks, where they have the branches and people doing a good job, and the casino aspect. It is therefore important that we drive that home.

Mr Sants: Can I say a couple of very quick things and I think they might help with the wider debate? We are proposing to be much more transparent in our next report and accounts around our pay ranges and we hope that sets the example for the approach, at below board level, obviously, that we would like our firms to take. I just would like to make a point, and I am sure you will give me a moment just to make this point, with regard to FSA staff in calendar 2008 in respect of this 15% pool. These people have worked unbelievably hard to mitigate these problems. They have worked all night, they have worked all weekends. The idea that we have not tried with every sinew to address the issues that have come out of the crisis I think is misplaced. We are talking about recognition of a huge effort by our staff in the last 12 months and I just feel I have to say that.

Q2209 Chairman: Just to clear up a point earlier, Lord Turner, there has been a suggestion that the Bank of England should be in charge of the macro potential tool beyond interest rates to temper the excess of credit booms. Could the Bank or yourselves have that instrument or should it be shared?

Lord Turner of Ecchinswell: I think however you define the legal responsibility for it, and I think there is a variety of different ways that you could structure the relationship which go from the Bank spelling out its analysis and us having to publicly say what we are doing about it, or the creating of a joint forum in the middle or the Bank being able to say, "No, we really think you have got to change the capital regime", whichever way we structure that relationship, and I think it is possible to argue the pros and cons of it, de facto it will only work if there is a very deep discussion between us, and I believe that we will end up with a process whereby, on a regular basis, we are having detailed discussions of the macro situation, including the most senior people at the FSA and the most senior people at the Bank, with the technical experts looking at the data developing a point of view of the macro situation and developing a joint point of view as to what we are going to have to do about it. Where there clearly is something which more purely relies on the Bank side is, if you think you are using these tools not only to keep the financial system robust but also as an extra tool of macroeconomic management and inflation targeting - and that is where it gets complicated - there are a lot of ways to organise this. I think they need to be debated, but however it is done we need very intense joint working between us.

Chairman: When we produce our bank inquiry report we will be looking further at international regulation in the macroeconomic aspects as well as the consumer issues, so if you could have those discussions with the Bank of England and come back to us with information at a later date it would be helpful to us.

Q2210 Mr Cousins: Lord Turner, in the year 2006 at the annual general meeting of the Royal Bank of Scotland the then board of directors marched to the rostrum while the bagpipes played the tune from Brave Heart. What we have to ask ourselves is what regulatory system, what system of accounting, or what actual regulator can control that kind of greed, pride and out-of-control locker-room culture?

Lord Turner of Ecchinswell: I think that regulators in the future can do a very much better job than in the past in leaning against the winds of exuberance, and exuberance includes organisations being convinced that they are on a roll which is unstoppable, et cetera. I also think that only regulators or central banks can do it. I think we have a fundamental issue here rooted in human nature and institutional cultures whereby, if we leave the leaning against the wind entirely to boards of directors and management, it will not happen to sufficient extent. I think that human nature and institutional cultures do have a tendency for, as it were, the animal spirits of capitalism to get out of hand and be self-reinforcing, and I think that is our job, in the famous statement of one of the chairmen of the Federal Reserve, to "take away the punchbowl before the party gets out of hand".

Q2211 Mr Cousins: But were the auditors simply not doing their job in those situations, and how could they be made to do their jobs?

Lord Turner of Ecchinswell: Can I just be clear? I think this is a very important point which gets to the role of published accounts in this. At the moment the philosophy of the published accounts of banks as of retailers or manufacturers is quite overtly not forward-looking, both in relation to the trading books that we earlier discussed and in relation to the banking books, the stuff which is not traded but simply a standard mortgage or a loan to a corporate. The overt philosophy is that what auditors should do is reflect information currently then available, so in the trading books you say, "If I were to sell this instantaneously today what could I get for it?". That is the value you have to put down and you are not allowed to put down a lower value for cautious reasons. In relation to the banking books, you are clearly told that you must only work on an incurred loss basis, and an incurred loss basis means that there must already have been an event or a reason believe that an event has occurred such that you know that somehow or other a loan is under threat; somebody has not paid on time. You are not only not encouraged; you are not allowed in January 2005 to say, "At the moment people are all paying my mortgages back on time but I know from history that there is a cycle and therefore I want to put something aside for a rainy day". This is a very major issue. We believe, as many people believe, that there is a value not only in regulatory capital but somewhere in the published accounts, maybe as a movement to reserve or at the bottom end of the P&L, in having something which is what the Spanish call a dynamic provision in reserve and what the Financial Reporting Council have proposed as an economic cycle reserve, some process within the published accounts of more looking forward and saying, "Things look good now but history tells me there are cycles so I have to aim off with some caution for the future". I think it is very important to realise that not only is that not encouraged at the moment; it is not allowed at the moment. The philosophy of accounting is that you reflect the facts which currently exist, not an expectation of the facts that will exist in two or three years' time.

Q2212 Mr Cousins: Your own recent report, and indeed a number of other reports done by the European Central Bank, the SEC, the IMF, throughout 2008 were expressing growing concerns about whether the system of accountancy standards and accountancy performance was adequate to the task in hand, but so far nothing has been done on that front. What is going to be done on that front?

Lord Turner of Ecchinswell: This is under intensive debate within the Financial Stability Forum on which I sit. We were in fact debating this just two days ago at a meeting. We will be debating it again at a major meeting of the Financial Stability Forum which meets in two weeks' time here in London; we are the host of it, and the debate between regulators and accountants about how we meet both the requirements for clear communication of facts to shareholders, which is where the accountants come from in this debate, but also the desire of regulators to have something that recognises systemic risk and economic cycles, is a debate which is intensely going on and we in the FSA attach considerable importance to getting a correct resolution of this debate. Having said that, this is an area where it is very difficult for us to go it alone because we simply cannot run a system, certainly not in Europe and ideally not indeed in the world, where we have different accounting systems in one part of the world from another part of the world. It is an area where are going to have to try to get international agreement on this appropriate balance between these different ways of thinking about the information which is in published accounts.

Q2213 Mr Cousins: The Financial Stability Forum was raising some of these issues in early 2008. Nothing seems to have happened so far and what were the FSA doing in that period of late 2007 and throughout 2008, with the powers they had, the section 166 powers, to look deeper?

Lord Turner of Ecchinswell: Can I be clear? The FSA has no powers to change accounting standards. We have no powers whatsoever. Accounting standards are set by the IASB and the FASB.

Q2214 Mr Cousins: You have the powers to look at how those accounting standards are being used.

Lord Turner of Ecchinswell: Yes, but I think the biggest issue is the accounting standards, not how they are being used. Having said that, you have also identified something which is also an important part in the shift of the philosophy that we will have for the future. I think we will be much more involved in the future, whatever the accounting standards are, in looking at the variability in specific ways of how that is implemented in different banks and saying, "Hang on. Why is this bank using this approach and that bank using that approach?". That is an issue which we have got much closer to over the last four or five months as we have been involved with the Treasury and the Bank of England in understanding things which we need to understand for the purposes of the recapitalisation programmes, and I think going forward we will be much more actively involved in debates with the auditors and with the banks about what is the range of particular ways of implementing whatever the standards are and who the outliers are and should they be coming in line. However, I do stress I think an even more important issue is the standards overall.

Q2215 Mr Cousins: The regulators themselves in 2008 were starting to recognise that there were changes in the American system of accounting which were producing new situations and a growing divergence between the accounting systems in Europe and the accounting systems in the United States which perhaps was making it possible for products that in theory were sold, in fact, to be warehoused. Is this something that the FSA looked at then? Is it something that it is looking at now? This issue of the results of the divergence between the accounting systems in Europe and the United States was on the agenda in 2008.

Lord Turner of Ecchinswell: I think Hector should come in in a minute but I think this issue of the divergence of accounting standards is relatively minor compared with the longer term issue. I think we have to separate two things here. When we entered the downturn and when a lot of assets which were in the trading book became deeply illiquid and therefore, as we discussed earlier, difficult to value, there was an extensive debate about the freedom with which banks should be allowed to move it from the trading book to the banking book and to change the approach. There were debates about whether there was a commonality of approach in the US and in Europe. I do not think these are fundamentally differences at the end of the process but I think it is in some senses a less important issue than getting the whole approach right for the long term.

Mr Sants: I think, again, it is important to emphasise this point. The FSA is not responsible for setting accounting standards. We can influence them. The fact that there is some divergence between the US and the UK on accounting standards historically has no doubt encouraged some business to be done in the European regime - it is a European regime - and not in the US, but I do not think that has been a central cause of the recent sets of events. If you are asking, since the crisis unfolded - I am not sure you are, but there seems to be a bit of an undertone to this point - has the FSA taken a deep-dive interest in ensuring they know what is inside the institutions and that those models, the levels two and three analysis that we were referring to, which it is the responsibility of the auditors to audit, are nevertheless reasonable models to apply, the answer is yes. As Lord Turner said in his opening remarks, we have fundamentally changed our supervisory style so that we now have detailed risk management position information on the banks. We know what is in the banks. Of course, knowing what is in the bank is not the same as being able to forecast what you will be worth in a few months' time but it is not a question of lack of visibility to the regulator of the specific positions or the valuation models which their auditors are using.

Q2216 Mr Cousins: One last point. That is what you are doing after the crisis has unfolded. I would just like to know when you think that was. What was this moment of crisis?

Mr Sants: I have been quite clear that we have changed the supervisory style fundamentally since I took over, which happened to coincide with the crisis, ie, July/August 2007. We have put in place our new programme for the last six or nine months. We have been doing this since the crisis began in varying degrees and now much more intensively, ie, for the last 18 months, for certain.

Q2217 John Mann: Mr Sants, how can you do your job properly when the credit rating agencies are so poorly regulated?

Mr Sants: There is no question: we support extra regulation of credit rating agencies. Again, I have always hesitated to do this because we keep drawing attention to the fact that these things are not necessarily in our direct area of responsibility, and I apologise if I am doing that again but, of course, the major credit rating agencies are located in the US. We are a national regulator. Therefore, initiatives to strengthen -----

Q2218 John Mann: The banks that you oversee, as they told us, use the credit rating agencies.

Mr Sants: Absolutely, and we support further fundamental reform in the regulatory regime that is applied to credit rating agencies. There is no question that the use of ratings has been a major contributor, one of the many, to the crisis, and I have to say that is both in the way that those ratings were produced but also in the way they were used by the investors and used in the selling process by the investment banks. It is not just the credit rating agencies themselves that need to change their practice but also those that use the ratings. There is also an issue that these have become very deeply embedded in the regulatory architecture, so when they change they have knock-on effects across the board in terms of the way companies can fund themselves. We support change in this area and we are taking that forward through the European agenda. My point rather is that we did not have a national remit to take it forward locally because they are not based here.

Q2219 John Mann: That is one significant problem. I come to a second one that may impinge on your ability to do your job as effectively as you might like. Offshoring in UK dependencies, of which many of the offshoring centres are, of course, British dependencies, how much is that a problem in terms of your inability to oversee what is going on in places like Belize, the Cayman Islands, Gibraltar, et cetera?

Mr Sants: There are two different issues here and there is a wider philosophical point the Chairman may want to pull out here, but in terms of practical points, of course, I do not think the offshore problem is a significant contributor per se to the prudential oversight of the major banks because they are not normally domiciled in those types of location, so in terms of the principal discussion to date I think I would not draw attention to that. However, there are two key issues. This shadow banking sector, to use the phrase that has been used, which includes the hedge funds we referred to earlier and various other types of structures that are used to facilitate, if I can use clear language, financing transactions, these types of structure are not, as we reflected, as transparent to the regulators as they should be, so we support ensuring that you cannot use those types of devices to escape the oversight of the regulator. That is an issue, and the other issue, of course, is consumer protection.

Q2220 John Mann: That is two issues. How many individual consumer complaints have you received in the last five years?

Mr Sants: Sorry - in aggregate?

Q2221 John Mann: Yes.

Mr Sants: I would have to come back to you. Many thousands go through our consumer contact centre in a year and we normally have something of the order of 5,000 or so whistleblowing-type alerts to us in a year and so forth. Over five years I am afraid it is not something I have to hand immediately.

Q2222 John Mann: Tell me about the toxic debt of the financial institutions that you regulate. What is it in total? How much of that is unsecured debt of UK consumers and how much of that is the secured mortgages and other debts of UK residents?

Mr Sants: Of course, it depends how you want to define toxic debt. We are back to the point that we cannot say with certainty - nobody can say with certainty - how these assets will perform in the future. If you use the word "toxic" as being something that moves to an almost worthless valuation and is very difficult to value at the current time, that is a prediction about the future. In general, to your consumer point in the UK, as we have discussed here before, UK mortgages have generally performed to date pretty well, though, of course, arrears numbers are rising, as you will know from the public data, and we have not had the degree of problems that we saw in the US market.

Q2223 John Mann: Do you classify them as toxic debts?

Mr Sants: No. We would only classify in that category, on the basis of general terminology, the sub-prime group, which is 5% to 7%. I think there are considerable potential risks around some areas of self-certification but even if you added in self-certification you would only come to about 20%. The vast majority of mortgages in the UK we would not in any way see as toxic debt.

Q2224 John Mann: Is that 20% of UK mortgages?

Mr Sants: I am saying there are 5% to 7% of UK mortgages in the classic sub-prime category, which is a lot less than in the US, and the other category where you would raise some questions as to how they would perform in the future would be pure self-certification where the consumer has indicated what their income was, and in many cases that may not be facts and therefore that debt will have to be challenged about being serviced when the consumer gets into difficulties.

Q2225 John Mann: So there are problems identifying the toxic debt, there are problems in regulating UK dependencies, problems of the credit rating agencies and regulating them, and none of them is specifically your responsibility. My final question is to you, Lord Turner, and that is on your philosophy. Your regulatory philosophy, and we have here your current business plan for the next year, changes from the principles-based regulation to the outcomes-focused regulation but nowhere in it is the anticipation-based regulation. At the same time you have produced this macroeconomic financial outlook, in other words, you are overlapping the Bank of England's role and the Treasury's role entirely by suggesting, "Here is the macroeconomic outlook". Do we not need a regulator in this country, and is not the weakness and your weakness in your philosophy that you are passing the buck on regulation, that we do not have a regulator, that we need a regulator, and that what you are doing is dressing up vagueness in terms of moving into the overlapping rather than the underpinning of actual regulation?

Lord Turner of Ecchinswell: No, I think that is completely wrong. I cannot recognise what you have said at all. We need, along with the Bank of England, to have a point of view as to what the macro situation is, which as best as possible has a point of view about how the future develops. On the basis of that, that is one input to the way that we regulate. We require capital to be put against businesses. We have a very strong liquidity regime. We are going to be increasingly involved in the accounting side. We are regulating and we are looking very carefully at debt. I do not understand at all how you took from what Hector said the idea that toxic debt is outside our regulation. It is absolutely what we are focused on. I am afraid I simply cannot understand your point at all.

Mr Sants: And I think you misunderstand the term "outcome". The whole point of outcome, as I sought to explain earlier, is that we want the supervisors to supervise, ie, to give consideration to whether the actions which companies are taking are leading to consequences which work in the best interests of society, consumer and the markets. We want them to think ahead, anticipate, think what is going to happen next, think whether what is going to happen next is going to work for society. That is what we mean by outcomes-based regulation. It is always difficult to capture that in one word but the point is clear. They need to be forward-thinking, braver, intrusive and get involved.

Q2226 John Mann: Finally, if a consumer comes to you with a complaint, such as they have been lent far too much credit or they have been lent far too much secured and unsecured loans, you have not acted on that in the past repeatedly as the FSA. Any of the complaints I have ever seen you have never acted upon, not one, even when challenged on this Committee on them. Do you intend to act on those complaints and intervene in the markets, in other words, using consumer complaints as an indicator of a culture within financial institutions that means they are cavalier in their attitude?

Mr Sants: In terms of the narrow point, and Lord Turner will want to comment on the philosophy, I completely agree with you, which is that consumer complaints are a tool which the regulator should take into account when making judgments about whether firms are managed themselves properly in compliance with our regulations, and I come back to the point that as part of the reforms we have introduced over the last 12 months consumer complaints are now a key factor in our assessment of the performance of firms and whether they are delivering what consumers want them to deliver. To your narrow, narrow point, if a consumer has been sold an unsuitable product we will take action, we do take action. If you have any constituents where you feel we have not properly followed through please feel free to contact me. Suitability is critical to the current regime. There is a philosophical question we have already touched on as to whether we should do more and that takes you back into the product-rate basis.

Q2227 Chairman: Lord Turner, give us a quick answer.

Lord Turner of Ecchinswell: The quick point is that again I am a little bit surprised at your questions because, on the issue of the conduct of how people sell things, that is what we have been very intensively involved in over the last ten years, and indeed some people have criticised us for being more focused on conduct than on prudential issues. That has been very much the focus. We have looked at consumer complaints. We have fined companies for mis-selling. The involvement in that has been central. In the past the focus has entirely been on the selling style. It has not been on saying a 100% mortgage is by definition wrong. We are going to raise the issue as to whether we need to get more directly involved in product regulation by saying a mortgage of a particular type is definitionally wrong whoever you are selling it to. There are pros and cons to that which I think we need to debate and it is not straightforward, but in the past we have been absolutely centrally involved in the process, so monitoring and regulating the conduct of business and fining firms who are wrong in the conduct of business, and on the whole most people have criticised us for being too focused on that and less focused on whether the banks were going to go bankrupt.

Q2228 John Thurso: I want to ask you some questions about corporate governance and remuneration at board level, the top end. It seems to me that both of those things come back to a kind of core philosophy question which is around what has been called the narrow bank or the Glass-Steagall question or whatever. In order not to have a lengthy question and answer, can I put something to you and take this forward a bit? Broadly, investment merchant banking came out of the tradition of the partnership - their own money, trading, dealing, making large profits and topping up the profits amongst themselves at the end of a particular time period. Broadly, the clearing traditional banks came out of stock companies with shareholders and a much more prudential approach. A number of witnesses - Sir Tom McKillop was one of them - made the point that actually these are so different as philosophies that you cannot put them together and if you wish to have the full regulation of the money utility you have to disaggregate the gambling side which the Chairman referred to at the beginning - Jon Moulton, Will Hutton; there is a whole list of people. Recently, for a completely different reason, I happen to have been talking to quite a lot of institutional investors and I would say 80% of them, who are quite big investors in RBS, or were in these banks, have the same view. Lord Turner, you have expressed the opposite view, or you have expressed doubt as to that view, and said you remain unconvinced. Can you say why you are not convinced when there seem to be so many intelligent commentators in the City and elsewhere who feel that a return to Glass-Steagall is something few should aim for?

Lord Turner of Ecchinswell: I am well aware that there are many intelligent commentators, including very close friends, who are arguing exactly that point and I think they have good arguments. Let me just express again what I put in my lecture on this debate. I think there are very major issues about how we make sure that proprietary trading activity does not contaminate the ability of banks to perform their fundamental functions in commercial and retail banking, and clearly there have been instances where that has occurred. If you look at the management report which the board of UBS developed and then published on what happened in UBS, it was clearly a case of profits and funding made in the retail and commercial bank being used to fund a blow-up of a proprietary trading activity, so it is a very major issue. What I am just a little bit cautious about is that we cannot, as it were, go all the way back to a clearing bank of the 1950s and, as it were, the merchant banks of the 1950s, because I think we have to live with the reality that that extreme separation existed in a world of fixed exchange rates, capital control, very limited global cross-border operation of corporates who needed to be serviced by banks, much smaller international trade and capital flows, and I think that that account of, "I want them to be a narrow bank and an investment bank" really does not deal with banks which, to take the point that was mentioned earlier - I think reference was made to banks like HSBC or Standard Chartered, are inherently global banks which have done better than most at avoiding some of the problems, they are deeply involved in this process of lubricating a global economy in a world of floating exchange rates and which, in order to do that, cannot be entirely away from things that happen in trading rooms, markets that need to be made, derivative products that are legitimately offered.

Q2229 John Thurso: If I can just ask you on that, those two banks are the exception. If you look at all our banks that native and not work-based in the Far East, if you look at all the big American banks, you are talking of eight out of ten going down and two surviving. Should we not be building a model on the eight that went down, not the two that survived?

Lord Turner of Ecchinswell: I think we have to build a model that deals with the reality of a global economy. What I will say is that I think we will put through changes - more capital for trading books, different approaches to credit rating agencies, tighter control of risk, which, while it will not produce the extreme version of, "There are narrow banks and investment banks", I think it probably will produce a significant number of banks which de facto look like the narrow banks that these people will want. I think several of our British banks may say, "We are not going to get into that proprietary trading", I think there will be less of that proprietary trading being done in total than there was before, and I think we will look very carefully at those banks which are still involved in both activities to make sure we are asking searching questions about how funding and support are transferred from one institution to the other. That is, I would say, the approach which to my mind one of the best reports which has been produced, that is, Paul Volcker's report for the Group of Thirty, has put forward. I think Paul Volcker has thought more deeply about this than many people. He has not come out in favour of a radical unwinding of Glass-Steagall, but he has talked about a philosophy which is very much in line with what I have just suggested.

Q2230 John Thurso: I want to move on because time is limited, but can I just put this one point to you? The real problem is that we have discovered that the money utilities are too important to the system to be allowed to go down. What we have ended up having, because we have got the casino attached to the money utility, is the taxpayer saving the casino. What we need is a system that allows the casinos to fail so that the utilities can be saved.

Lord Turner of Ecchinswell: I think it is possible to imagine that you would create banks narrow enough that they were not in the casino. I think the idea that we can with certainty create casino banking such that we could definitely say it would fail and we would never rescue it is a delusion. I think that would take us down the path in precisely the opposite way that Sally Keeble suggested of saying it does not matter what the hedge funds do or the investment banks do because they are non-systemic. I think whatever we do to these structures we have to have everybody in the regulatory environment because what we realised on the evening of Bear Stearns in February - which was not a commercial bank but when it went down it was systemically important - is that although I could have some sympathy with the idea that there are narrow banks the idea that we will ever define the casino sufficiently tightly that it is not systemically important I think is a delusion.

Q2231 John Thurso: Can I move on to the next point because it is about corporate governance? It has been put to me that these things are so big that they are not only unmanageable; they are ungovernable, and certainly the evidence we have had from those who are no longer running the banks did not give any confidence. The Chairman in his opening remarks referred to "the great and the good, none of whom could see it coming", and you indeed have talked about leaning against the wind and the fact that will never happen by corporate governance. Is not the weak point in this that the risk assessment side is not covered as a major point within the non-management side? Could you not envisage a model, for example, where the senior independent or somebody other than the chairman and the chief executive, not a part-timer who was also running another company somewhere else but actually had to be there two days a week, had a fully resourced staff and actually had to have a specific responsibility, and had the line management for the risk assessment department so that he or she could lean against the wind effectively? I see you nodding, Hector, would you like to have a crack at it?

Mr Sants: The answer is yes, that is certainly something we have done.

Lord Turner of Ecchinswell: We agree with you.

Mr Sants: Fundamental reform is needed here.

Q2232 John Thurso: We have got a yes we will move on. Remuneration. You have talked earlier on about the remuneration practices, I have mentioned the two philosophies. What is your view, in a few short words, of the practices that have been prevalent in financial services that have been most disruptive, or bad if you like, and what are you looking to see emerge as being good practice?

Lord Turner of Ecchinswell: We think that poor practice has played a role, it is difficult to know how big a role in what has occurred. I think the most extreme forms of poor practice are where you have bonuses which are very large multiples of base salary so that somebody is incredibly focused on what they are going to get for their bonuses, where that bonus is based on one year's profit or even in some circumstances one year's revenue, and without taking account of risk, and where it is paid either wholly or primarily in cash and immediately. I think if you have such structures, and there have been such structures, they will create incentives to the bank and we need to change it.

Q2233 John Thurso: Short-term bonus out, eltive (?) good, pay in shares more than cash.

Lord Turner of Ecchinswell: Just be careful of not over-stating what we will achieve by that. The head of Lehman Brothers owned a hell of a lot of the stock of Lehman's so when people are convinced by irrational exuberance, the fact that they own a lot of the stock of the company, they are still taken in with their own rhetoric.

Q2234 John Thurso: Last question, and I hope this is relatively yes or no. We had evidence from Mr Moore in regard to allegations, if you like, with regard to HBOS. Can I ask you, are you satisfied with the report that was done by KPMG?

Lord Turner of Ecchinswell: I have read the report by KPMG. I think it dealt effectively with the issues which were specifically raised. They concluded that the processes had been reasonable and that the person who was appointed to replace Mr Moore was appropriate. I think that was an appropriate way to proceed. We have talked earlier about the whole philosophy of how we approach some of these risk things is different from what it was at the time but on the narrow issue of things to do with the dismissal of Paul Moore, I think that was an appropriate process.

Q2235 Chairman: Can I just add, Paul Volcker yesterday at Columbia University made a speech and he stressed the importance of preventing financial institutions large enough to pose a threat to the entire system from engaging in risky behaviour such as running hedge funds or trading on its own accounts. Are you in favour of allowing institutions to be complex only if they are not systematically important?

Lord Turner of Ecchinswell: I am very much in favour of Paul Volcker's statement on this. I think we have to accept that there will be some large complex financial institutions which will be doing some things which we associate with investment banks like making markets in government bonds, providing forward FX cover, FX swaps, et cetera, but will not be doing nearly as much proprietary trading as they have done in the past.

Q2236 Chairman: The core of my question is how do we ensure the safe banks whilst letting the exotic element go its own way that does not pose a systemic threat? That is the issue for us here.

Lord Turner of Ecchinswell: I think the crucial thing is we have to look at the totality.

Mr Sants: I was going to draw out another point in the debate, just very quickly. Surely, to a degree, what it is about is ensuring that risk in the institution can be well managed. Part of managing that risk is diversity so we do need to be careful, when we are in this narrow banking debate, that we do not suddenly create a new risk which is lack of diversity. When you look at the funding issue it is not as simple as saying retail good, wholesale bad, it is more complicated than that.

Q2237 Chairman: We know that.

Mr Sants: The answer to your question, what we need is institutions where the risk can be well managed. If the risk becomes too complex to be well managed then the regulator should narrow that.

Chairman: We have had unsung witnesses here who came after the press, namely the Building Societies Association, who did not get themselves into trouble and that has made quite an impression on us.

Q2238 John Thurso: The point is that the level of risk that is acceptable if you are running an arbitrage operation is wholly different from the level of risk that is acceptable if you are running a clearing bank. If you put the two in the same organisation you get the worst of both worlds. That is the point.

Lord Turner of Ecchinswell: If we have some elements of more risky businesses the aggregate risk for an institution which has deposit taking institutions cannot be allowed to rise to a level of a pure wholesale one I think is where we are coming from. We are just trying to be careful about taking the argument to the next level and saying, let us just have none of those activities in these institutions. There are potential other debates to be had around that point.

Q2239 Nick Ainger: Mr Sants, you wrote a letter dated 13 October to all chief executives in those banks that you regulate. If I could just quote one part of the letter. You said, "It would appear that in many cases the remuneration structures of firms may have been inconsistent with sound risk management. It is possible that they frequently gave incentives to staff to pursue risky policies undermining the impact of systems designed to control risk and to the detriment of shareholders and other stakeholders, including depositors, creditors and ultimately taxpayers". I am sure you remember the letter. Why did it take you until 13 October to write that letter?

Mr Sants: I think, back to the earlier point, we are taking a more intrusive approach to regulation since the late summer of 2007. We have been developing those themes. You do not rush out and just write a letter upfront. What is the traditional FSA approach I think is right which is you engage in rhetoric first, you visit the firms, you see what is going on, you do so to make certain that the nature of this has been made there, you need to be sure that is true. Prior to that letter we made a series of thematic visits to the firms to address the issue. We are back to the debate, to be frank, we have had here a number of times. There was a fundamental change/shift in the regulatory philosophy in the FSA which kicked in from the second half of 2007. That does not get delivered in weeks, that takes a number of years to deliver and public letters, which then rightly are where people consider every word in them, need to be properly researched in the market place. I think a matter of months to deliver that is not unreasonable.

Q2240 Nick Ainger: The bonus culture which we have had lots of evidence about and the chief executive and chairmen of banks that you regulate have said it exists, they agree with you in your summary that it has had a major impact on the major cause of the credit crisis but it is not new ---

Mr Sants: I am agreeing with you, I think that takes us back to the earlier argument.

Q2241 Nick Ainger: You as a regulator must have been aware, from the regular headlines that appeared both on the front and in the financial pages of newspapers, that there were massive - and I mean massive - amounts of money being paid out to individual bankers, to traders and to dealers which clearly must have had an impact on the level of risk that those individuals were taking and yet it was not until October 2008, more than a year after Northern Rock had got into the situation it is, that you wrote to the chief executives and said, "We think there is a problem here". You have been asleep on the job, have you not?

Mr Sants: I think that is a rather over-used phrase and in this case is wholly inappropriate.

Q2242 Nick Ainger: How many letters ---

Mr Sants: Because we talk to firms without writing to them. We actually talk to them all the time. We have been on this case throughout 2008 but to write a public letter with clear assertions of substance about the industry as a whole, that needs to be properly researched which requires engagements with the firms. We regulate the firms. That is a public document which needs to be properly researched beforehand. Personally I have been very, very focused on this agenda from taking over in the summer of 2007. I can assure you the firms know our views but, of course, the amount of payments is a matter for the firms rather than the structure and as we have discussed before, historically in the context described in the prevailing market climate, regulators did not historically engage with those issues anywhere in the world.

Q2243 Nick Ainger: Did you have any discussions with RBS about what they were proposing to pay out in this round of bonuses because the information that was being quoted in the press a few weeks ago was that they were considering paying 1 billion in bonuses at a time when they were going to be losing 8 billion in trading losses and they were going to write down 20 billion of assets. Did you have any discussions with Stephen Hester, the chief executive of RBS, about the level of bonus that he was intending to pay?

Mr Sants: I had discussions, we had discussions, I had discussions with Stephen Hester about the mechanisms and compensation structures which they are using in respect of the 2008 pay round to ensure that they are consistent with our views on the subject which are set out in the letter you have. As has been said before, the quantum as opposed to the mechanism is not an area of our direct remit. There is a wider question here which I think the Chairman might like to add to.

Lord Turner of Ecchinswell: I think it is important to realise two separate responsibilities here. The focus of the FSA, and indeed of the international discussions of this issue, because it is something where the Financial Stability Forum is close to having an agreement for a code of conduct which we hope to be able to apply equally across all financial centres, that focus is not on the level of pay, it is on the way that the structure of remuneration can create incentives either for excessive risk taking or risk management. There is a completely separate issue as to institutions which have received large amounts of public money, what should be their appropriate response in the period while they are receiving public money to the bonuses that they pay or indeed to their total remuneration but that issue is really for the Government as a very large or in one case the majority shareholder of these banks, that is not for us. Our focus is on the long-term issue and then there is this separate issue. The core issue in relation to appropriate bonuses within the firms that receive public money is with Government, which is also the way that it has been approached in the US where there is a clear distinction between a set of long-term standards in which regulators have an interest and short-term things which are legitimately somewhat political because large amounts of public money have been provided.

Q2244 Nick Ainger: Is not the truth of the matter that if there had not been a drive in the media, in this Committee, raising the profile of the bonus culture, that perhaps nothing would have been done? Your actions have not come from your regulatory role, it is a reaction to the anger and disbelief of many people out there when they see the credit crunch happening and still banks were driving the bonus culture.

Mr Sants: We went on the record on this many months before.

Q2245 Nick Ainger: It was not until October 2008 that you apparently did anything about this?

Mr Sants: Not true. That is completely untrue and not a reflection of the facts.

Lord Turner of Ecchinswell: Yes. The Financial Stability Forum, for instance, in its April 2008 debate, into which the FSA have put in input, defined this as a key area to look at. There has been a Financial Stability Forum working group looking at this under the leadership of Philip Hildebrand, the deputy governor of the Swiss National Bank, since April last year. By the time I joined in September there were already lots of papers for me to read on this issue. It is just not factually correct that there was nothing going on either in the FSA or internationally before the more recent public focus on the issue.

Mr Sants: I gave a speech and the previous chairman gave a speech on this matter earlier in 2008. If you check your records you will see we are on the record many months before then.

Q2246 Nick Ainger: The bonus culture did not start in 2007, it was many, many years before that.

Lord Turner of Ecchinswell: What I entirely accept, and this is very clear in the document which the Financial Stability Forum will be producing, is that both regulators across the world and management until this crisis really failed to focus on the fact that remuneration structures, the structure of compensation, could play a crucial role in the incentives to take risk. Now again you may say, "Well surely they should have noticed it" but within the document which the FSF will produce it makes that point absolutely explicitly that we need to integrate incentive structures into risk management in a way which really was not done in the past.

Chairman: Do you want one question on that before we move on, Sally?

Q2247 Ms Keeble: Just a brief one. When you came before us previously you accepted that there was, in fact, a relationship and it was perceived wisdom that there was relationship between the remunerations in particular the bonuses and the risk taking. You said, "The responsibility to look at the structure of how the bonuses are paid, what they are paid for, and in what they are paid and how they affect risk taking, that is our responsibility". You are suggesting that it was well-known but it was not dealt with, which is a slightly different point from the one you are making now.

Lord Turner of Ecchinswell: Are you referring to what I said when I came before this Committee before I was appointed?

Q2248 Ms Keeble: No, I think it was the next evidence session after tha, which was when you came with the Governor.

Lord Turner of Ecchinswell: Then I would say we had by then accepted it was our responsibility. I think if you roll back to 2005/06, it was not believed to be the responsibility and if we had suggested it was the responsibility then we would have been met with a wildfire of criticism from the industry which I think would have received some significant support from politicians as well.

Ms Keeble: It must have been known about.

Q2249 Mr Breed: Two quick questions. Firstly, to what extent do you think potential hedge fund failures present a threat to their prime brokers?

Lord Turner of Ecchinswell: I think our best judgment would be to only a relatively limited extent at the moment. It is an area which, as we said, we want to gather more information on but I think it is important to realise that contrary to the belief that hedge funds are all incredibly highly leveraged, some of them in particular strategies are reasonably highly leveraged but quite a lot of them are not terribly highly leveraged, they are leveraged 2:1 or something like that rather than 10:1 or so in a bank and indeed that leverage has already come down quite significantly over the last year. Because there is not enough international gathering of data we cannot be precise on this but it is quite possible that average levels of leverage in the vast majority of hedge funds have come down from a bit above 2 to not much above 1 in the course of the last year. We cannot exclude the possibility that there are particular hedge funds in particular strategies which are a risk but I think it is not an area where we believe there are huge risks at the moment. Hector, would you like to comment.

Mr Sants: The key point is the point you made. The hedge fund standard board itself has said they believe leverage has come down to around 11/2 and of course the prime brokerage industry has seen significant change, that having been a major factor in the demise of Bear Stearns and Lehman's so they have adjusted their systems in the light of those events. There is a risk, there is always a risk but I think it is a diminished one.

Q2250 Mr Breed: You are not looking at any increased regulation on hedge funds at the present time?

Mr Sants: Back to our earlier point, I think, we do regulate the fund managers in the UK. We would certainly like global standards of regulations to come up to ours and we would like to go further; as Lord Turner said earlier, we would like to increase our ability to properly assess the very point you are bringing up which is the financial stability impact of hedge fund failures. We see them essentially as wholesale vehicles so it is not so much concerned about individual failures, hedge funds have failed in the past, they will fail in the future but the overall global regulatory architect would benefit from greater visibility of systemic risk. We need to work with the US in particular to achieve that. We have been at the forefront of pushing that argument and we will continue to do so.

Q2251 Mr Breed: How concerned are you at the moment about the levels of fraud which seem to be appearing within a number of financial institutions?

Lord Turner of Ecchinswell: It is obviously the case that at the end of the boom period, as people have often commented, that a set of frauds which had been covered up have been revealed. We are continually trying to make sure that we are tracking the possibility for this stuff as closely as possible. It has not been so far, in the UK, a major part of the story but it is an area that we do focus on.

Mr Sants: We should also just make clear here, in terms of the focus of this debate, that certainly we primarily focus on market-related issues in terms of our criminal prosecutions and related perimeter issues. Conventional financial fraud we see to be taken forward by the lead agency in that respect which is the SFO but obviously we do require firms to have adequate systems and controls but we are not the lead agency on the conventional financial fraud of the type you have just referred to in those US hedge funds.

Q2252 Chairman: But you will have noted, possibly, an article in The Times yesterday by Ken Macdonald, a former Director of Public Prosecutions, where he says both the SFO and FSA have failed. He is coruscating everyone, including the politicians. He says, "Our system for regulating markets and for prosecuting market crime is completely broken. If you mug someone in the street and you are caught, the chances are that you will go to prison. In recent years mugging someone out of their savings or their pension would probably earn you a yacht." He said that financial deregulation has caused a growing distance between wealthy and powerful individuals and the agencies designed to police the behaviour. This has led to a corrosive loss of trust and no-one in Britain has any confidence that fraud in the banks will be prosecuted. Now he is asking for a new financial regulatory law enforcement authority that inspires respect and fear when it is needed. We are not going to get that but what can you give us today from the FSA that you really seize about the issue of fraud and what do others need to do? I know you are interested in the issue of plea bargaining. Is the Government still dragging its heels on that?

Mr Sants: I hope you do believe from the earlier conversation that I personally am very focused on the issue of taking forward the FSA to achieving real credible deterrence which means real effective sanctioning in the areas where we have lead responsibility. We have been at the forefront obviously in the last 18 months, bringing forward criminal prosecutions in the areas that we focus on. I readily agree with you entirely, and the comments, that historically I do not think the FSA was tough enough, sanctions were not strong enough to achieve credible deterrence in the areas we are responsible for. I think our actions in the last 12 months demonstrate we are addressing that and we have a good track record beginning to build. It takes a while to achieve credible deterrence. On the general fraud point, the point raised about the tolerance here of society of white collar crime, the approaches taken towards a level of sanctioning, is a good point to raise for public debate. I think it should be seen as a far more serious crime than sometimes when you look at the outcome of the legal process it appears to be taken as. We welcome that debate opening up and we work closely with our colleagues in the SFO to help them identify and I hope vigorously prosecute, going forward, these areas. On plea bargaining, we believe it is coming in to the next session of Parliament. We hope it is. There are some other powers we would like and we are going to continue to develop the theme of Parliament needs to equip us if we are going to deliver.

Q2253 Chairman: I heard it was jammed in the Ministry of Justice.

Mr Sants: I fear that it is maybe not getting the prominence that we would like and we would welcome any help you can give us to continue to make the point. There is no question that criminal prosecutions require a different set of powers and the FSA needs to be set up as an effective criminal prosecutor if it is going to do that.

Chairman: As a result of this I will write today from the Committee's point.

Q2254 Mr Mudie: Can I clear up one point very quickly. When Andrew Tyrie opened up he asked you whether the FSA was fit for purpose. Your answer, Lord Turner, was, "It is going to be fit for purpose". Then a few minutes later Hector said "it is fit for purpose". We cannot leave the room with this dubiety. Who was correct? Is it fit for purpose or is it going to be fit for purpose?

Lord Turner of Ecchinswell: I think we are in the process of putting in place changes which are making it fit for purpose.

Q2255 Mr Mudie: It is not fit for purpose as we sit?

Lord Turner of Ecchinswell: Do you know ---

Q2256 Mr Mudie: No, no, I am not being funny. If you were a politician, you are a politician.

Lord Turner of Ecchinswell: I think people before these committees have come and made grandstanding remarks about how the institution they have taken over is not fit for purpose and it has not made much difference ---

Q2257 Mr Fallon: Surely not.

Lord Turner of Ecchinswell: --- so I am a little bit wary of this stuff. I think these are easy words.

Q2258 Mr Mudie: Can I just get an answer. Is it fit for purpose or is it going to be?

Lord Turner of Ecchinswell: We are in the process of putting in place a whole load of changes. For instance, within the supervisory enhancement programme which Hector is putting in place ---

Q2259 Mr Mudie: No, I have read the papers. I am just a simple man asking a simple question and you are saying to me, "It will be" but you have to live with the implication of that, that at the moment it is not fit for purpose.

Lord Turner of Ecchinswell: We are driving change. For instance, we are in the process of hiring about 280 people and we are two-thirds of the way through it. If you want to call that two-thirds fit for purpose and one-third not quite then you can do that.

Q2260 Mr Mudie: No. I did not use the words it is going to be fit for purpose.

Mr Sants: We need ---

Q2261 Mr Mudie: Hector, you are not going to overrule your Chairman are you?

Mr Sants: No, I was going to give you an explanation of what I meant which is to say there are two things we have highlighted here. There is a regulatory architecture. We are talking in plain language that everybody out there can understand and at the moment people associate with the FSA the whole of the regulatory process. They do not, of course, want to hear the distinctions of responsibility within that, I quite understand. The regulatory architecture is not fit for purpose. The supervisory changes that are required to deliver effective supervision to the earlier point are two-thirds to 80% done and in the core areas are currently delivering.

Q2262 Mr Mudie: Lord Turner, three of my colleagues have raised, and you certainly had an interesting dialogue with the Chairman about macro-economic management. You said you were going to be revolutionary about the changes that you are pushing forward. When I saw your evidence you raised everything bar what of the structure was right between the tripartite authorities. Does that mean you think it is a done deal?

Lord Turner of Ecchinswell: I will tell you exactly what I think. I do not think it is a crucial issue. Looking at the different ways around the world in which you organise where conduct of business is done, where prudential regulation of banks is done, where you put prudential regulation of insurance companies and whether you combine it with the central bank, whether you call it what some people call a twin peak system, I have become convinced looking around the world that this is one of the least important issues. However you organise it there will be problems with that form of organisation that you then have to guard against and therefore it is more important to get other things right rather than to shift the boxes around.

Q2263 Mr Mudie: Except, Lord Turner, I would come back to you and say one of the things that worried us after Northern Rock was the apparent things being left to one another but also the inability of someone to say, "I take the decision". I have now seen you, heard you, a very intelligent, articulate man. I can see you having a good philosophical decision with your opposite number, right, the Governor. At some stage somebody is going to say, "I have heard your arguments but I am going to take this decision" Now with your overlapping I am not sure I am alone on the Committee in saying I am not sure who is going to say "I am going to take the decision on this".

Lord Turner of Ecchinswell: I think it is recognised that at the time of Northern Rock, I think it was John Gieve who said the dancing was more John Sargeant than Fred Astaire in his recent lecture.

Q2264 Mr Mudie: He actually raised the question of shifting some things back into the bank.

Lord Turner of Ecchinswell: He did raise that but he also said that he did not think that was at all the priority or necessarily a good idea.

Q2265 Mr Mudie: No, he said it would be costly.

Lord Turner of Ecchinswell: I have extensively discussed it with John.

Q2266 Mr Mudie: 80 million and new staff in 12 months.

Lord Turner of Ecchinswell: Let me go back to the point. I think it is the case that since Northern Rock in what have been a series of areas which have required quick decisions and crisis management decisions both in relation to individual institutions and in relation to things like the overall recapitalisation of the banks, the October things, there have been decision making processes within the tripartite which have been successful. I think the system has worked and shown it can work even in crisis.

Q2267 Mr Mudie: Two other matters. I was listening to you with some pleasure when you were asking for sanctions et cetera but I was disappointed - and we will see what happens when all the facts are on the table - about your dismissal of the whistleblower, this KPMG was right. That is not the question. The Chairman and myself and I do not know how many others have received a letter from another individual who raises allegations about this Italian litigation that is going on 35 billion local authorities and a British based company. This was drawn to the attention of the FSA and his letters were not even answered. I am going to send it to you. Do you take whistleblowers seriously? Pushing a point, if you put yourself out on a limb in America, they will even change your identity and look after you. It seems in this country whistleblowers take the decision, often for mixed motives but often a large part of it is in the public interest and they are hung out to dry. Since the hearing we had I have had three or four letters from people who have had very bad experiences because they said the wrong things to people in charge of the institutions. Do you take them seriously and are you looking seriously at not giving them identities or anything like that, but giving them more protection than they apparently have not enjoyed in the past?

Mr Sants: On the first point, we take them extremely seriously. To my general point earlier, which was about getting ability to encourage people to come forward in respect of insider dealing, we have been very clear that really without those type of people it is very difficult to bring prosecutions. The reality is in order to get insight on what is going on inside an institution or inside what has been going on between a group of people who are committing some type of offence you do need a whistle-blower. We take the whistle-blowing very seriously. I have to say, and I can go into the detail if you want to, I can assure you that with regard to all the recent ones that have had publicity on the matter, Lord Turner and I have reviewed the files on their cases and all of them were extensively interviewed by FSA staff, there are copious notes of those discussions which we have both read and which show that they were listened to extremely carefully.

Q2268 Mr Mudie: We will see.

Mr Sants: You can be assured that we do take them very seriously. I do take them very seriously. They are central to your point of achieving successful prosecutions and I quite agree with you that they need to be encouraged.

Q2269 Mr Mudie: Can I change the subject for my last points? The building societies when they were before us were understandably upset about the compensation scheme and the funding of it. To them, almost universally well behaved in the current climate, they seemed to be paying an unfair share of it. They raised this with you. Do you accept that there is any fairness in the building societies' argument that the effect on their profits is greater than the effect on the profits of those organisations that have caused the problem? Do you think there is any fairness and are you looking at it? Secondly, and probably more importantly, can you do anything about it? If the answer is yes, you have it in your gift, are you looking positively at their complaints?

Lord Turner of Ecchinswell: The overall issue is we are aware of their concerns and it is something which we intend to review, whether the precise balance of the different fee pools in relation to the FSCS is correct for the future. You will appreciate it is difficult to change the rules from where they were in the past, and there is a value in having pools quite wide. I do not know whether Loretta Minghella would like to comment on this issue, which is on the Financial Services Compensation Scheme.

Ms Minghella: Thank you very much, Lord Turner. Just to add to that, I think we are all very conscious of the fact that the compensation scheme has to be funded by the live industry and that does mean that good firms pay for bad firms that have gone, so there is always an element of unfairness about any of the bills that we produce for people. We do recognise that these bills are going to come at a difficult time, which was precisely why we agreed with the Government that we would take the loans for all these compensation bills that we have paid on an interest-only basis for the first three years and that we would only start to repay the principal ---

Q2270 Mr Mudie: I am sorry for cutting you off but, again, the Chairman is trying to catch my eye to shut me up. That is all stuff I have read. The basic point is do you accept there is unfairness in the manner in which the scheme is now working towards building societies who have a different method of raising their brass so they have more deposits and, therefore, as it is based on deposits, they are paying more? Your Chairman handed it over to you and I thought he was doing well because he seemed to be very sympathetic in indicating that as soon as the opportunity arose you were going to look at this with the complaints in mind. Was that what you were going to say?

Lord Turner of Ecchinswell: We are going to look at this.

Q2271 Mr Mudie: I am happy for you to let Loretta continue.

Ms Minghella: Mr Mudie, actually Lord Turner is not my Chairman.

Q2272 Mr Mudie: Is he not?

Ms Minghella: No. The FSCS is an independent organisation and the rules are, indeed, a matter for Lord Turner and not for the FSCS. It is worth bringing out that at the moment the tariff base for building societies and banks is what share do they have of the retail deposit base in the UK and what share do they have therefore of people who are protected by the scheme. They pay in proportion, I think, in part for the benefit that they have of being able to say to their retail protected depositors, "You are protected by the FSCS", which is an important protection which they will need to contribute to. Having said that, I do think it is time to look again at the way the scheme is funded. One of the things that has come out over the past few months is that of course we have had the money that we have needed to pay the claims as they have fallen due, but the bills are coming at a difficult time and this does raise the question again of whether or not there should be an element of pre-funding for the scheme which I think will now come back onto the agenda.

Lord Turner of Ecchinswell: I wanted to add that we feel that this issue does need to be looked at within the wider context of the whole way that we run the scheme and the pre-funding, and also issues relating to the European dimension of this and how we should deal in future with situations like the Icelandic banks and whether we should have pre-funding with some element of European organisation of pre-funding because otherwise if we ever had a situation like a small country with very large banks, as we did for Iceland, we are ultimately dependent on the deposit insurance or the backstop fiscal resources of a country which cannot do it. There are some very wide and complicated issues both in relation to the UK and also in relation to how the European Single Market operates.

Q2273 Mr Mudie: You are like a minister who just speaks and takes every piece of information and it fills a space. I have heard all this, I have read all this, I understand all this. I am specifically asking -----

Lord Turner of Ecchinswell: We will look at that specific issue, I can assure you.

Q2274 Mr Mudie: I am not being rude; I am making the point that you are faced with a lot of complicated problems and you have extended it to add to the complexity, but the building societies are facing a very tough time and the decision on helping them will not be held up because of the complexity of the EC and international situations.

Lord Turner of Ecchinswell: I accept that point, that we could make progress and we need to look at the UK thing. We do need to look at these wider issues as well but I accept the point that that should not hold up us looking at that particular issue.

Mr Sants: We will be able to retrospectively revisit that which has already been done.

Mr Mudie: No, but an earlier decision was taken.

Q2275 Chairman: Loretta, we have not asked you too many questions. Maybe it is because you are the success amongst the witnesses here today. Five banks have gone down since September 2008. How has your organisation coped with that increasing workload and are you adequately resourced for that?

Ms Minghella: Chairman, thank you. I think on the whole the FSCS has managed very well in really very challenging circumstances. If you think back, we were an organisation that in the last financial year paid 16,000 claims and in the whole of our existence in the first seven years we have paid 1 billion of compensation. We were faced not with one bank failure in September but in the space of two months we had five bank failures, four of them in a fortnight. I think you might have feared that we would not have coped with that but, in fact, we have been coping with that. We have paid over 20 billion in compensation. We have been doing our own job, we have been acting on behalf of the Government which has been offering amounts above our limits, we have been acting in place of the Icelandic scheme for the time being that should have paid the first portion of each Icesave claim. We have been protecting people in the end who have had nearly three million accounts between them. We have operated three different ways of paying during that time, one of which we have always used, which is the manual process; that has been in place for four of the five failures, but we have also been using two new ways of compensating. In Bradford & Bingley we made a one-off payment of 14 million on 29 September and that meant that people went to bed on Sunday night banking with Bradford & Bingley and woke up on Monday banking with the Abbey. Also, in Icesave, we took an electronic Icesave banking platform and turned it in a matter of days, in fact, into an on-line compensation platform. Through that platform we paid 190,000 people in a number of weeks.

Q2276 Chairman: I have heard informally that you have done well. I am looking for answers on the public record. We have heard from the banks in the past seven days that the seven-day deadline for compensation payouts is unworkable and robust in their approach, but you are pressing ahead with this tight deadline, and quite right. Have the banks accepted your position yet?

Ms Minghella: The FSA's proposals on seven-day payout are out for consultation at present. I am absolutely convinced that we will not be able to deliver seven-day payout without all the changes that the FSA is putting forward. You have already made important changes in Parliament by enacting the Banking Act. That gave us four of the key ingredients we need for speedy payout. The FSA has some very important ingredients to deliver. The banks must put in place systems which deliver up-to-date accessible data which the FSCS can rely on at the point of failure. One of the difficulties we have had in the failures that we have dealt with, particularly in relation to one of them, is the lack of immediate availability of the data we need to get the right money to the right people. Whatever the banks feel about it, I am firmly behind the FSA's proposal.

Q2277 Chairman: There is also the issue of single customer view of accounts on their data. The only bank that came before us that said they had that was Santander; no other bank has that. As a Committee we feel that is important and maybe the banks are not doing enough on that at the moment. Are there still challenges there for you?

Ms Minghella: I think if the FSA goes ahead and imposes rules then the banks will have no choice but to put in place single customer view.

Q2278 Chairman: Will you do that, Lord Turner?

Lord Turner of Ecchinswell: We are going through the consultation at the moment, but certainly we are consulting with the intention that that is the direction in which we are going.

Q2279 Mr Love: First of all I want to come back to the issue of building societies. I want to ask Lord Turner very directly about the issue of fairness relating to the building societies. They are, I think, by common consent the lowest risk financial services organisation in the marketplace. Indeed, not one building society has gone bust without the cost being picked up by the rest of the movement in its history. In the pension protection fund there is a remit that risk has to be taken into account in the charge that is made to those pension funds. Does it not seem reasonable and fair that that should be taken into account in relation to the building societies, which are much lower risk than any of the other organisations that are levied for this purpose?

Lord Turner of Ecchinswell: As Loretta has said already, the previous approach which was used was to make the levies when something goes wrong proportional to the scale of the benefit being delivered, ie, relative to the retail deposit base. That has been the rule in the past and I do not think we can change it now. You are quite right to say that one has to raise the issue of whether that is the best way to do it or whether one should look on something which is related to some other basis of it.

Q2280 Mr Love: It is patently unfair that when there is little likelihood of a building society actually getting to make use of this fund that they should be charged on exactly the same basis as those who are very high risk organisations.

Lord Turner of Ecchinswell: I am not yet ready to say it is patently obvious what the answer is. All that I am signalling is that this is clearly an issue which we will look at and we will certainly take that argument very seriously.

Q2281 Mr Love: We will come back to this, no doubt, in future sessions. At the weekend, the Prime Minister in an article in The Observer magazine said that he was asking the Financial Services Authority to look at how in the future we should "control" new mortgages for more than 100% of house value. You said earlier on in response to Mr Mann that you are looking to have more involvement in product regulation. Can you tell us which direction you are moving in as far as 100% and over 100% mortgages are concerned?

Lord Turner of Ecchinswell: In the review that we produce in three weeks' time we will be signalling not a definitive answer to our proposals on this but signalling that we can certainly see a strong argument for us getting more involved in product regulation than we have in the past. We will be committing that by the third quarter of this year we will be producing a review of the mortgage market which by then will have our proposals. The issue of whether you should regulate maximum loan-to-value or loan-to-income, because actually loan-to-income is a slightly better predictor of whether people get into trouble than loan-to-value, so if we are going to go down that route we have got to decide what is the appropriate one, is clearly something which is on the table. In the past it has not been the overall philosophy of the FSA and it has not been encouraged by the political system that we should get involved in this; we have regulated conduct and sales. Some authorities around the world are involved in the process of regulating either loan-to-value or loan-to-income ratios, many do, but many do not, and we will look at that international experience. On loan-to-value ratios, there can be some arguments against it. Some people will say is it not better for somebody to have a 100% loan-to-value mortgage than for them to get a 90% loan-to-value mortgage and then get the other 10% off an unsecured debt, a credit card, et cetera? Whatever we do we need to make sure that we do not have unintended consequences. I think we can see considerable merit both in relation to the defence of consumer interests and in relation to the macroprudential issue about guarding against excessive booms and busts in looking at the issue of mortgage regulation either through the loan-to-value or the loan-to-income route, or some alternative. Just one point in relation to that: if we do that, I do not think we can simply narrow it to the 100% issue. Actually, only about 0.5% of mortgages were ever over 100%. I think the bigger issues might be should we be into 85% or 90% and what do you think about those issues, and those are important issues, they require some thought. We can see a prima facie case for a quite significant shift in the previous philosophy of British regulation in this area.

Q2282 Mr Love: I would suggest it is a revolution in the thinking of the FSA to move down the route of product regulation, but in the circumstances that is probably the appropriate response. I note what you say about the different levels, but have you as yet, and I am not asking you to say because it will be published in a few weeks' time, thought on a level of loan-to-value or loan-to-income that you think would not be acceptable for the future?

Lord Turner of Ecchinswell: We were not intending in the review that we publish in three weeks' time to be that specific. We are intending by the third quarter of this year to complete the detailed research work on the pros and cons of this, how this works in other international environments, which I think we need to go through in order to make appropriate decisions on the way forward. That is when we will be specific about this.

Q2283 Mr Love: Can I bring you back to this very interesting discussion that we had earlier on about the separation, or proposed separation, of commercial and investment banking? Can I put to you that round this table I suspect we would wish to reflect consumer concerns in this matter? Of course, when you look at investment in commercial banking, there are millions of people where their incomes and resource is tied up in commercial banking and in investment banking a much smaller number generally of high worth individuals are involved. I read your speech on this matter and, indeed, comments, including from the Prime Minister, in relation to this matter. Do you think we are taking fully into account the consumer interest in this area?

Lord Turner of Ecchinswell: I agree that the consumer interest is very important in this area and I agree it is a very important debate and it is a debate that we have got to get right. I am sympathetic to many of the points made about avoiding detriment to retail and commercial customers arising from proprietary trading investment bank activities. However, to make the correct decisions on this we do need to really think it through. Hector made the point earlier that narrow banks can get into trouble as well. I would point out that although this is the worst global banking crisis that there has ever been, the worst domestic banking crisis that there has ever been was the US banking crisis of 1929-33 and large numbers of narrow banks went bankrupt at that time and part of them went bankrupt because they had highly regionally concentrated portfolios of assets. The original concept of securitisation, which then ended up in investment banks, was that we were going to get round that problem and we were not going to have the problem of banks excessively dependent on their regions so that if the bank went down the region went down. I simply say let us not leap to immediately iconising an old-fashioned regional bank. There are benefits in diversification. In answer to your point, yes, indeed, in this issue of how having gone through this crisis we think about the shape of banks for the future, we need to have regulations in relation to capital and in relation to risk management which clearly defend the customers of classic retail and commercial banking from harm that might occur from risky proprietary trading. That is absolutely clearly an objective and we have really got to think through how that is effected.

Q2284 Mr Love: In doing that, and I understand why you and everyone would want to take into consideration some of the real complexities that exist in this area, you also said in your speech that you want to insulate the commercial banks from adverse impacts.

Lord Turner of Ecchinswell: Yes.

Chairman: Before you answer that, I am extending this session to quarter past five. We have a number of people to come in and I have got questions for the public record, so let us get on with it. Give us a quick answer and then we can move on. Is that your last question, Andy?

Q2285 Mr Love: It is now my last question. All I really wanted to get your opinion on was that you are confident that in the complexity of the modern world you can construct a system that will be as best as is possible for a regulator to protect the consumer interest into the future.

Lord Turner of Ecchinswell: Protect the consumer interest but also, of course, the taxpayer interest because let us realise that when things are too big to fail ultimately it is not the depositors that suffer, it is the taxpayer that suffers. I think it is very important to realise that in getting the balance of regulation right we are often focusing on minimising the potential cost to the taxpayer because ultimately there is a size of bank beyond which we effectively guarantee the depositors.

Q2286 Sir Peter Viggers: Looking at the heart of a financial problem at toxic assets and the Asset Protection Scheme, the Government announced the Asset Protection Scheme on 19 January and it is clearly unresolved and controversial. You may even be going from today's meeting straight to another meeting on that subject. Can you reassure me that you have taken full account in your discussions with Government or its manifestations of the analogy of Lloyd's of London which had a spiral where there were uncertain assets which needed to be parked for a while. It was difficult to value them and, therefore, a vehicle was created called Equitas where these toxic assets could be managed off separately. Have you taken full account of that parallel?

Lord Turner of Ecchinswell: I do not think it is something where we have explicitly looked at the Lloyd's of London/Equitas parallel, but now that you mention it we are well familiar with it. I think the one thing I would stress about the particular challenge of an asset protection scheme at the moment is that the discussions are often presented as if there is within the books of the banks, if we only looked closely enough, an absolutely definable set of "toxic assets" which are bad and other assets which are good. I think up until the middle of last year, or even the third quarter of last year, that was not a bad characterisation. There were things that had come out of sub-prime in the US, there were these fancy structured debts which were bad and the broad mass of corporate and mortgage lending seemed to be good. The challenge we have at the moment, and it is the huge challenge in working out how much capital banks need or how much asset protection they need, is that we are now in an environment where the financial crisis itself has produced an economic downturn and that economic downturn is now producing bad assets among what were previously perfectly good creditworthy customers. The big challenge, and this is the challenge which regulators and authorities, and as much as anything this is as much a problem which treasuries and central banks as for us throughout the world are facing, is the more that this occurs the less easy it is to actually say, "I walk into the books of the bank, that is the bad asset, carve it off and here is the separate stuff". Within the work that we have been doing, extensive work on the Asset Protection Scheme, in order to work out how large a scale that should be and what assets are within it, we are not just involved in an exercise of looking at what the assets are today; we are involved in an exercise of various scenarios of what might happen in future. We do believe that we are progressing towards proposals that make sense in this area.

Q2287 Sir Peter Viggers: Is the Asset Protection Scheme an alternative to the establishment of a so-called "bad bank" or a precursor to the creation of a "bad bank"?

Lord Turner of Ecchinswell: I think in itself it could be either, let us be clear. The other thing I will say is nobody in this crisis who has been in it for more than two months excludes anything as to what might happen in six months' time. We have all learnt that there are unpredictable developments and that the development of the macro-economy is not certain. I am sure that the Chancellor would say and has said to this Committee the same thing: we cannot exclude any options. At the moment the way that the Asset Protection Scheme is being thought about is as an alternative to a straight bad bank approach because in formal terms it is thought of as a form of insurance and loss sharing if losses exceed a certain level rather than an outright purchase. Clearly one could consider a bad bank as well. Having said that, bad banks work best when there is a very clearly definable set of assets. If you go back to the Swedish bad bank experience of the 1990s, the Swedish banks had made some very bad lending in particularly commercial real estate, but a lot of their lending to the broad Swedish economy and caucus was perfectly okay. There was an environment where you could with quite a high degree of certainty say, "This is bad and this is good". I think we are in a more complicated situation at the moment. As we got into a recession we are likely to see, unfortunately, bad assets spread throughout the broad mass of SME lending. That is always what happens in a recession and that makes it more complicated.

Q2288 Sir Peter Viggers: Is there a danger for banks to pay the insurance fees which require them to participate in the scheme that this will either further worsen their capital provision or lead to their creeping nationalisation?

Lord Turner of Ecchinswell: I think I had better leave that for the statements which the Chancellor may make over the next few days.

Q2289 Mr Tyrie: You mentioned that you have developed a set of scenarios to try to work out what the best course might be. Would you be prepared to publish those?

Lord Turner of Ecchinswell: I think we have generically talked about what the scenarios are in terms of the depth of the recession. Hector, have we done that?

Mr Sants: No, we have not to date. It is something we could give consideration to. Having said that, you need to understand ---

Q2290 Mr Tyrie: It sounds a pretty cautious reply to me.

Mr Sants: We need to think it through. I will expand a little bit to say, of course, we are not applying a set scenario to the banks which is uniformly the same for each one.

Q2291 Mr Tyrie: Of course.

Mr Sants: For each single one, going back to the earlier discussions, we look at each individual position.

Lord Turner of Ecchinswell: The answer is we could not possibly do it in that detail. We need to give consideration to it.

Q2292 Chairman: Take it away and write to us on it.

Lord Turner of Ecchinswell: The general macro-environment, okay, there are arguments for and against.

Q2293 Nick Ainger: Can I start with the takeover of the Singer & Friedlander bank by Kaupthing and the evidence that we have had from Tony Shearer, the former Chief Executive of Singer & Friedlander. He has told us, and he has put in further submissions as well, that he was expressing real concerns to FSA staff that he felt that Kaupthing were not fit and proper people to be running a British bank. A meeting was arranged on 14 April 2005 with three members of staff of the FSA: Jonathan Fiscal, Kevin Halpern and James Dresser. That meeting was attended by Mr Shearer, who was then the CEO of the bank, Paul Selwyn-Swift, who was the Finance Director, and Jonathan Spence, who was the head of the bank. At that meeting we are told that they raised real concerns about Kaupthing. I wonder whether you want to review the statement that was issued by the FSA after Mr Shearer's evidence to this Committee in which the statement from the FSA said that the FSA had made a full assessment, consulted the Icelandic regulator and, as the home regulator confirmed, there was no reason why the transaction could not go ahead, then the transaction went ahead. The FSA, presumably following that evidence to us, have conducted some inquiry or whatever. Can you tell us anything more because it does seem that here we have not only an individual but three other directors of a bank saying that they did not think that these individuals who were proposing to take over the bank were fit and proper people?

Mr Sants: I have indeed, as you would expect, as indeed has Lord Turner, reviewed the files and I am looking at the very minute of the meeting in front of me now on 14 April and I can confirm the individuals concerned had the meeting with the FSA officials. This goes back to our earlier point of us taking whistle-blowers and other people bringing information to our attention very seriously. It was obviously an exhaustive meeting and it looks to me - obviously I was not present at the time - to be an extensive note of the meeting. I have to say that our note, and I recognise that this is our note and I can only comment on what is on our files, does not make any comments about the fitness and propriety of senior management. I just say that as a matter of fact in relation to the note; I cannot obviously comment on what was said. What is the case and is absolutely true, as was reflected in the background to the statement we issued, is that a number of issues were brought up, such as cross-holdings and organisational structures and so forth, all of which, and I understand Mr Shearer has acknowledged that, were in publicly available information. I think he acknowledges that he was not whistle-blowing in the sense of bringing us information which was not in the public domain. He and his colleagues were highlighting a number of issues which were in the public domain which absolutely are appropriate issues to highlight in the context of a change of control, certainly very appropriate in the context of the way that we would be looking at these issues going forward. Having said that, even at that time in 2005 each one of these issues was then brought up with the lead regulator. I have to say the reality of the situation here, to be quite clear, is the lead regulator in this case was the FME, it is the Icelandic bank, and we are obliged to take their word as to what is the situation; it is not for us to question another EEA regulator. They addressed those points and, indeed, brought attention to the fact that cross-selling had made a capital assessment mitigation for it. The issues were addressed and we had proper responses from the lead regulator, which we are obliged to take at face value. Whether that throws open the question of quality of regulation in Europe is a wider philosophical point, but I have to say the issues were addressed properly.

Q2294 Mr Love: So the meeting took place and you are satisfied that sensible decisions were taken as a result of the information received from the Icelandic regulator. However, in the autumn of 2005 the finance director left, in January 2006 the head of the bank left, and in February and March the head of risk and the head of compliance were asked to leave. Given those circumstances and what you were told back in April 2005, did the alarm bells not start to ring that there was something seriously wrong with this bank?

Mr Sants: Two points. First, the general point. In fairness to the then FSA staff, even when the change of control was allowed to go through they did put in place a number of mitigating actions against concerns that we, the FSA, had which we had identified independently of Mr Shearer's representations, which included asking for two independent UK non-executives, some additional controls around liquidity and other additional actions with regard to governors. To the particular point on the individuals, I have to say I am looking at the withdrawal forms for the two who claimed they were dismissed. They are required to be honest in a withdrawal form, and it is a criminal offence not to be so, and these withdrawal forms do not say they were dismissed. According to my records, they do not tell the FSA they were dismissed. These are forms that they signed and are required to fill out.

Q2295 Nick Ainger: The point about the non-execs was taken immediately after the takeover.

Mr Sants: In response to the change.

Q2296 Nick Ainger: It was not in relation to the fact that the key people, the senior executives, were leaving the bank over a space of six months. Can I move on?

Mr Sants: Other actions were taken during this period, but I think I am being asked not to give you a comprehensive description. There is mitigation that took place during the period. There were other actions.

Q2297 Nick Ainger: Can we move on then to the KSF Isle of Man and the evidence we received from Mr John Aspden of the Financial Services Commission in the Isle of Man to this Committee. We asked if he could provide supplementary evidence about the exchange of correspondence between the FSC in the Isle of Man and the FSA here in London. He has provided us with an exchange of correspondence. I will not quote the whole thing, but the important thing is he wrote, or someone wrote - it has been redacted - on 21 May 2008, to someone in the FSA asking four questions. I will only put to you one of the questions. It is item four in that letter. I do not know if you have got it?

Lord Turner of Ecchinswell: Yes, we have it in front of us.

Q2298 Nick Ainger: It says: "Possible interbank placing by Kaupthing Singer & Friedlander Isle of Man Limited with KS&FL. If Kaupthing Singer & Friedlander (Isle of Man) was to make a large interbank placing with KS&FL maturing at site in less than the eight days maturity band, would the UK FSA be in a position to confirm that adequate liquidity is maintained by KS&FL to repay that interbank deposit should it be requested to do so by Kaupthing Singer & Friedlander (Isle of Man) Limited?" The reply, which is the same date, states in relation to that particular question: "Item C. The FSA applies cumulative mismatch limits to KSF of 0% at site to eight days and of -5% at site to a month. These limits apply to the whole of KSF's book and thus would cover any deposits received from KSF Isle of Man - your question four." Was the purpose of that letter of 21 May to give reassurance to the FSC in the Isle of Man that any large deposit that would be placed in the London bank would be secure and covered?

Lord Turner of Ecchinswell: The purpose of the letter was to confirm, as we did do, to the Isle of Man regulator what the liquidity regime was that was in place. That was the liquidity regime that was in place, which I have to say was more onerous than our normal liquidity regime that we put in place in 2005 in response to some of our concerns earlier. We confirmed that regime was in place. Whether that provided sufficient assurance to the regulator on the Isle of Man was for them to decide. We are another, as it were, host regulator and our job under our MoU with them is to provide them with information; it is not for us to make judgments on that information. We accurately answered their question and that regime was indeed in place with the bank.

Q2299 Nick Ainger: Can I just come back because this is important. The FSA has been accused of instigating this transfer.

Mr Sants: Yes, which there is no evidence of at all, as you can see.

Q2300 Nick Ainger: Can you clarify that, that you never made any approaches to the London branch of this bank to say, "You need to get further assets into your bank". Was any attempt ever made by the FSA to influence a bank so that this transfer from the Isle of Man to London took place?

Mr Sants: No.

Q2301 Mr Todd: So the correspondence we have is the sum of the relationship on this matter between the FSC and the FSA?

Mr Sants: To the absolute best of my knowledge, and I have made a comprehensive investigation of the files and talked to those employees of the FSA who were involved in the incident and are still employed. I did actually meet the Isle of Man regulator personally and he made no suggestion to me that we had in any way encouraged them to make this transfer. I am completely mystified as to where this idea has come from.

Q2302 Mr Todd: I asked a simple question and initially you gave a very simple answer, which was absolutely great. Can I ask you about your "Know Your Customer" rules as they apply to those seeking to make investments in banks in the UK. You will have heard that the justification maybe for not choosing offshore accounts is the difficulty of their establishing their residency and proving their identity. Could you set out whether you feel the position that they have expressed is true or not?

Mr Sants: No, I think it is not true as expressed. Our rules, and more generally because it is a wider framework, the "Know Your Customer" rules do not preclude UK banks offering accounts to offshore UK citizens. What does appear to be the case, and has been the case, is that only a very limited number of banks have chosen so to do. I would recognise perhaps the point, to come back to the point about recognising consumer issues, that they might well have found it difficult because the banks chose not to offer them. There are banks that do it and we did some research with the BBA to assure ourselves to that effect. It is not to do with our rules.

Q2303 Mr Todd: Could you share that with us, not here but separately?

Mr Sants: Happy to.

Q2304 Mr Todd: It would be helpful if you could add to that note a clarification of how you think your rules apply to someone in those circumstances so that we understand them clearly.

Mr Sants: Yes.

Q2305 Mr Todd: Lastly, on the Derbyshire relationship, Lord Turner will recall our brief exchange at an earlier hearing in which you used the words "it is a sorry situation". Have you reflected further on what we have learnt from this sorry situation and whether there is anything that we need to be sorry to some of the customers about?

Lord Turner of Ecchinswell: If I could ask Hector to just tell you the facts on it and then I would like to make a general comment.

Mr Sants: I think Lord Turner broadly covered the principal points with you last time. A transfer of ownership to a company in the Isle of Man which is owned by an Icelandic company is obviously a matter for those regulators to approve those transfers. I repeat again, we have no oversight arrangements on companies and the regulatory structure in respect of this issue. At the time the transfers were made the consumers were properly informed. We have looked at the letters and reviewed them personally, as Lord Turner referred to last time. What is a reasonable observation, and I think this is a point that prompted Lord Turner's earlier comment, is even if you were a customer and you received a letter saying you are being transferred to the jurisdiction of the Isle of Man, the letter is clear about that, clear you are being transferred out of the FSA's jurisdiction, if you are a term depositor you do not have the opportunity to say, "I don't like that and I will terminate my term earlier". If you are a demand depositor in receipt of clear information, which they were, they can make a decision.

Q2306 Mr Todd: Should the FSA have been more active in protecting the interests of the customer in those circumstances?

Mr Sants: I think it comes back to the European framework.

Q2307 Mr Todd: As I made absolutely clear before, the parental guarantee of a British building society is significantly different from the parental guarantee of an Icelandic bank.

Mr Sants: Lord Turner may want to elaborate in a moment on what takes us back to what we would see as some significant issues about the current European home/host regime which we absolutely believe there are. There is no basis for us overruling a judgment by the Icelandic regulator within the framework that we are currently operating.

Lord Turner of Ecchinswell: This is the general point. As you look at the whole of this story it occurs within the context of a particular way of running the single market at the moment and the idea that one has to respect the judgment of the ultimate home supervisor irrespective of which country they come from or whether there would be fiscal resources to support that judgment in extremis. We think there are huge issues here about the way that we need to organise this and major changes are required.

Q2308 Mr Todd: Just so that I can sharpen this further, even if their main focus is not taking deposits in their own country but actually deposits from our citizens and ---

Lord Turner of Ecchinswell: Yes, that is the way that it has worked in the past.

Q2309 Mr Todd: One has to say is that reasonable. I think the Chancellor has already made that remark.

Lord Turner of Ecchinswell: We have tried to run a European single market in retail banking services as if retail banking is the same as retail or manufacturing, and that you can run a European single market without some category of European supervision of supervision or co-ordination of supervision which goes beyond what we do for retailers and manufacturers, but I do not think we can. I do not think we can run a European single market in retail banking without significant changes in the regime.

Q2310 Mr Fallon: Can I just come back to your failure to supervise these banks properly. Is it still true, Mr Sants, that the appraisals of your staff are partly based on feedback from the very firms that they are supervising?

Mr Sants: Within the supervisory structure we have an individual who is responsible for handling the interface between a regulated organisation and the FSA. There are a number of services which those institutions take from us which are separate from supervision, such as prospectus approval, listing requirements, processing of registration forms and so forth, and as you would expect, which I think is wholly reasonable, as part of assessing those individuals' roles we do indeed ask questions as to whether they act as a reflective point person for directing the bank to the various parts of the FSA and handling the interaction with the FSA which is separate from the direct supervisory process. As a large independent regulator providing a number of different services, I think that is absolutely right, people are very keen that the prospectuses are processed quickly and efficiently, that is part of delivering an effective capital market.

Q2311 Mr Fallon: So the answer is yes?

Mr Sants: For a certain group of individuals in respect of non-supervisory functions. Is that a problem?

Q2312 Mr Fallon: It would certainly be a problem if they were supervising those institutions, would it not, because it would mean that they would have a strong disincentive to challenge firms if their appraisals, their pay, their bonuses, even their promotion prospects were adversely affected by negative feedback?

Mr Sants: This is one question in a vast array of performance measurements that we use specifically around directing the provision of other FSA services. We ask that question in a relationship management conversation which senior executives conduct with the firm. It is a de minimis part of any conversation with any individual. It is designed to assist primarily our listing authority responsibilities which are a critical part of looking after the City of London and seems wholly reasonable to me, I am afraid.

Q2313 Mr Fallon: How can you be sure that it is not a disincentive for those staff to challenge firms vigorously?

Mr Sants: Because it is a de minimis part of the process. It is a question that is asked once a year only by a very small number of responsible senior executives who are well capable of using their judgment and discretion.

Q2314 Chairman: I have a couple of questions for the record. Once this crisis is over how different will the financial services landscape be from what consumers could have expected in 2006/07? Should you be managing expectations of what will be available in terms of credit availability and consumer choice in this post-crisis world?

Lord Turner of Ecchinswell: Some of the biggest changes will not necessarily be immediately obvious to retail customers. Some of the biggest changes are going to be a very significant downsizing of the scale of proprietary trading in structured credit and derivatives and those sorts of activities which developed in the particularly complex form of securitised credit. Across the world, there are going to be less people involved earning very significant salaries in fixed income trading, that is clearly going to occur and, by the way, that has some significant consequences for the UK economy because we happened to do quite a lot of that in the past. In relation to ordinary consumers, I think what we have got to try and distinguish is the landscape as it will eventually be and also the landscape over the next few years. The landscape as it eventually will be we hope will be as good, if not better, for consumers as it was in the past, as good in the sense of there will still be the range of products which have been available in the past. To go back to the conversation about loan to value ratios, I think that may well involve not some of the excessive lending that there was in the past. The particular challenge we have over the next year or so is to make sure that there is adequate lending and that is very much something not solely for us but us as part of the tripartite discussions.

Q2315 Chairman: As I mentioned earlier, we are interested in the consumer angle, so that is helpful to us. Should capital provision be dynamic? Is there anything at the moment stopping you from introducing counter-cyclical requirements for the UK banks now?

Lord Turner of Ecchinswell: We could go it alone, it would be much better to get a global agreement. I do not think it makes a difference if we spend another year to get a global agreement, for this reason: the capital regime of the British banks right now and for the next year is so intricately wrapped up with the macro-economy and the debates amongst the tripartite about the asset protection scheme, recapitalisation, et cetera, that we are as it were not proceeding on a classic rule basis for the next year in any case. It is a very managed process. So in that sense it is not fundamental we have the new rules. We are clear that we want the new rules to include a significant element of counter-cyclicality and we are driving with our international colleagues to get an agreement on that.

Q2316 Chairman: This could provoke a long answer but we do not have time for it. What is your view of the Basel 2 capital rules? Need tweaking or ripping up? One or the other.

Lord Turner of Ecchinswell: Significant adjustment but not ripping up.

Q2317 Chairman: Okay. A technical question: should off-balance sheet items attract a capital charge and, if so, how would you enforce this?

Lord Turner of Ecchinswell: Yes, and I think we have the powers already to do that. We simply say, if this off-balance sheet item has the economic substance that you are taking a liquidity or a capital risk, a solvency risk, we have the right to demand capital against it, or a liquidity rating for it, as if it was on balance sheet. We have those powers, we are largely doing it and we can get that right for the future.

Q2318 Chairman: Lastly, Willem Buiter warned against requiring banks to hold sufficient liquidity to cope with the worst case scenario, claming that liquidity was, in his words, "a public good", so should be available from the public sector for events outside, what he calls, "ordinary market conditions". How will you balance this consideration with the moral hazard arguments made by the Governor in drawing up your liquidity proposals?

Lord Turner of Ecchinswell: The desire for a short answer for that really is a bit much! Willem Buiter is absolutely right, if you designed a private liquidity regime without the lender of last resort support which was sufficiently tight to make sure that banks did not go bankrupt, you would essentially do serious harm to the real economy because you would not have a banking system which was able to do maturity transformation on behalf of the real economy. Therefore, liquidity is always a balance of central bank, lender of last resort, support plus appropriate regulation, and we simply have to get that balance right. It is very difficult to say anything other than it is an inherent balance and there is a balance to be struck there.

Q2319 Chairman: That is helpful. We started off the session talking about philosophy and we will end up talking about regulatory philosophy. There has been much talk about that, which the FSA shared with politicians and markets. It seems to us what you are saying is that a hands-off approach has been taken by the FSA on that but today both you and Hector have said that you will change. It is easy now to threaten tougher keeper supervision because the regulatory philosophy has changed, would you not accept that we need a regulator which is not dependent on public and market opinion and it is your job to be unpopular at times and in fact take the punches when the party is going wildly? Can you give any assurance you are going to do that?

Lord Turner of Ecchinswell: I agree that entirely, we have to try and create a culture where it makes it likely that will occur. I have to say that is probably a bigger challenge for our successors because the likely date of the next party is ten to 15 years' time, but the crucial challenge, both in the FSA but also on things like macro-prudential analysis at IMF and international level, is to try at least to take the opportunity of this crisis to reinforce institutional mechanisms so that we do not, in ten to 15 years' time, do it all over again.

Chairman: Okay, I was 100 per cent certain I would keep us to time, I have not, but it has been a fascinating session and I thank all of you, Lord Turner particularly, your answers have been very helpful.