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Financial Services Authority Annual Report 2008-09 - Treasury Contents

Examination of Witnesses (Question Numbers 60-79)


25 NOVEMBER 2009

  Q60  Sir Peter Viggers: Do you think that mark to market has meant that we have dealt with the problems faster?

  Mr Sants: I think that there is a valid argument that says mark to market has pluses and minuses. It does have some procyclical elements but does equally lead to problems crystallising earlier and therefore solutions having to be found earlier.

  Lord Turner of Ecchinswell: On the other hand, I would stress that. I do not think it would have helped us if, this time last year, we were mark to marketing the whole of the banking books of banks. We would have convinced ourselves that there were problems far greater than actually occurred because there was an overshoot in markets and I think that our overall approach is that there is an appropriate role for mark to market in the things which legitimately exist within the trading books of banks and are liquidly tradable, but the correct and appropriate long-term accounting approach to the banking books of banks is an accrued interest or an economic loss approach, not a mark to market approach. In the past, there have been arguments about extending mark to market to the banking books of banks as well.

  Q61  Ms Keeble: I want to ask you, Lord Turner, about your suggestion of a Tobin tax. This was arising out of the Prospect interview, which has obviously given rise to a huge amount of debate. What is your view now on that?

  Lord Turner of Ecchinswell: My overall view is that when you go through such an extraordinarily big economic crisis which has challenged a whole set of intellectual assumptions about the way the financial system works and the benefits of liquid traded markets and how far they are beneficial and up to what point, when you have been through a crisis of that scale, it is useful to have a debate about issues which involves all of the options, which is why, for instance, I very much welcome that there is a debate about breaking up the banks and making them smaller, even if I do not actually necessarily agree with some of the conclusions, but I am very glad that, for instance, John Kay has put his proposals down. I think it is very important in these environments that we look at all the possible issues. The arguments in favour of a transaction tax rely on the idea that while a significant degree of market liquidity in traded markets, which requires there to be traders making money out of position taking, is beneficial, it is possible for markets to have too much trading activity in them and there is a point beyond which, rather than producing beneficial liquidity, it produces harmful volatility. That is a serious proposition put forward by many serious economists and I think it is one that we should think about. It may well be that a transaction tax is undoable in practice or that there is no possible international agreement, but I think that there are a variety of ideas such as that, such as taxes on the size of banks, such as a levy on banks to deal with the potential costs of bailing them out in future, there are several of these which have been proposed by different people and I think it is appropriate for the world now to hand it to a trusted body to look in detail at all of these options, which is what the IMF has now decided to do.

  Q62  Ms Keeble: So you see that one as being more of starting a debate than putting forward a realistic proposition for a tax to be introduced.

  Lord Turner of Ecchinswell: Let us be clear as to the background of the comments I made in that Prospect interview and I would like to be absolutely clear on that. It was against the background of being asked, what are you going to do about bankers' bonuses? What are you going to do about excessive trading activity? The answer is that what a regulator can do is to have an influence over the structure of incentives so that they do not create unnecessary and unreasonable incentives for risk taking. We can also have a focus on the aggregate level of bonuses, of remuneration, insofar as that is at the expense of building up capital ratios, but where you have a bank which has a reasonable level of capital and if the structure of incentives is reasonable, then, beyond that, no regulator can be responsible for the level of pay. To do that is to ask us to be in charge of a prices and incomes policy even while fiscal and monetary policy is set for inflation. If you are worried in the long-term about the level of traders' pay, what you have to be saying is you think there is some activity going on here which is making a super-normal return, in which case you have to address that either by things in the competitive arena, the competition arena, or by things in the taxation arena and not by regulation. So, the statement was against the background of essentially saying, "Society cannot ask a regulator to regulate the level of pay in a particular sector of the economy". If you think that level of pay is too high, you must be making some statement about super-normal returns and there are other instruments with which you should attack it.

  Q63  Ms Keeble: Given where the debate is now, because it has moved on quite some time since August, what do you think is the most likely way forward given that it needs international consensus as well for dealing either with the problem of excess remuneration, which could be done through windfall tax, or through the underlying factors which are what I think you called socially useless activity by the banks?

  Lord Turner of Ecchinswell: Let me be absolutely clear what the single, most important instrument to address unnecessary volumes or unnecessarily risky trading activity is. It is not any of these taxes, it is capital requirements. The single biggest thing that was wrong with the capital requirements under the existing regime is that they were not just a little bit too low, but they were dramatically too low for trading activities. 80%/90% of what we will do on this is to get those capital requirements right. Anything else is interesting issues that we have to look at but is peripheral to the single most important thing we will do.

  Q64  Ms Keeble: Thank you. That is helpful. I wanted to ask you about women in the City because you will have seen our inquiry on that and also perhaps the comments that the Equality and Human Rights Commission made which was that they thought that you were the people who were supposed to be delivering on this. You, in your letter, have said that whilst you welcome the gender equality duty, you do not consider that you have a particular duty on the gender equality objective, but you have made comments about what you are doing to take it through. Can you say, first of all, in your remuneration policy statements, if you find evidence of gender pay gaps, what action you will take and whether you will make the information public.

  Lord Turner of Ecchinswell: First of all, on the general point, obviously the 2006 Order, I think it was, required public authorities such as ourselves to have due regard for gender equality issues. I think that is different from making it a statutory objective for us. It is not one of our primary statutory objectives. There are other things like equal rights bodies which do have responsibility to pursue it as objectives. I think when Parliament did that, it was because they wanted to make sure that other authorities have due regard for it, they are thinking about it, they are responding to clear problems, but it is not, as it were, a primary focus of our activity. Our activity is focused on conduct of business and prudential soundness. Nevertheless, due regard does mean that whenever we are involved in policies where there is a possibility that there might be a significant gender equality issue, we should have regard for it—we should keep our eye out for it—and that is what we are doing in relation to the remuneration code which we are now involved in and I will ask Hector to comment on that.

  Mr Sants: We have set out the facts that, when we are doing our reviews with the remuneration codes, which we committed ourselves to do, we will be taking a look at firms' compliance with the gender equality issue and we are also currently in discussion with the EHRC to see how we can best take forward over the long-term a partnership to make sure that we are appropriately focused on that issue with regard to our remit. Obviously, if we were to find when we were reviewing compensation practices, which we are doing at the moment as you know, which do not comply with the law, then we would work with the EHRC to make sure that appropriate action was taken.

  Q65  Ms Keeble: Would you report it publicly or would you report it to this Committee?

  Mr Sants: I think we need to discuss that with the EHRC; we are in the process of talking to them about how we can usefully help them. They are obviously the prime mover here. We are delighted to be able to help them. We have to have regard to objective, as the Chairman said, and we are in discussions now as to how we can usefully help them.

  Ms Keeble: One of the key issues with our inquiry is, how do things get progressed? You can either rely on goodwill in the banks either for enlightened self-interest or for whatever reason, which might take quite a long time, or you can say, as you have, Lord Turner, that the Equality and Human Rights Commission that was set up has to deal with it, which would mean a David of an organisation taking on the Goliath of the City of London which I think is a bit unequal, or it means an organisation like yourselves taking a more proactive position than just saying that you have a general duty in this area which you could say about the whole of humanity in a way. Why do you think you should not take a more proactive position?

  Q66  Chairman: Perhaps you could give us a quick answer and we can move on to the next question.

  Mr Sants: We are. That is why we put that element in our remuneration code, it is an important issue, which we take very seriously.

  Lord Turner of Ecchinswell: I think we are taking the degree of proactivity on this which is reasonable given our legal mandate. If Parliament wanted us to be the primary mover rather than the EHRC, then they could change that. I would not necessarily recommend that—I think it makes sense for the EHRC to be the primary agency in this respect—but I do not think it is for us to suddenly start saying the EHRC will never manage to deal with the City so we are going to turn ourselves into an EHRC for the City. It is, basically, for Parliament to make those decisions about which are the responsible authorities for particular aspects of policy.

  Q67  John Thurso: I want to ask about narrow banks, but, first, can I ask one quick question about capital adequacy? I read a report last week that suggested that the appropriate level of capital adequacy in order to achieve the objective for stability would be in the order of 20% at Tier 1, which is two and a half times where we are now. Is that the kind of level you are looking at?

  Lord Turner of Ecchinswell: First of all, I think it is very important that we realise that when we change the level of capital requirement, we change it through three mechanisms. We sometimes change the definition of the numerator of what is capital; we often change the definition of the denominator of what is weighted risk assets; and we also change the ratio. I make that point because, actually, in the area of the trading book, where have already made very major changes increasing capital requirements against some categories of the trading book by three or four times and where there is now a fundamental review of trading book capital adequacy going on within the Basel Committee which could produce similar increases across a wider range of the trading book, that will not change the declared ratio at all, it will change what you multiply the ratio by, and we do have to be careful of that, because otherwise there is a danger that we change various definitions of the numerator, of the denominator and the ratio and we do not quite spot what we have done in total. So any discussion of ratio has to have regard for that. There are changes coming forward in the numerator and the denominator which of themselves would be equivalent to at least 2-3% changes in what the ratio is. In relation to the 20% figure I am not sure I can immediately recognise which report you are working on.

  Q68  John Thurso: It was actually 18.8, I think.

  Lord Turner of Ecchinswell: From?

  Q69  John Thurso: It was from either the OECD or the European Central Bank.

  Lord Turner of Ecchinswell: I think what we have all realised, and what we spelt out in a document we produced at the tail end of October, is that there is no absolute science to this.

  Q70  John Thurso: I want to deal with narrow banking, so what I am after is this. Is the scale of increase from around about 7-8%, which is where we are now, to around about 18-20% what you have in mind?

  Lord Turner of Ecchinswell: I would not like to say that at the moment, because it is a process that we are going through internationally. We certainly are already well advanced in very significant increases in capital requirement. Let me give you one particular factor. If you take Core Tier 1, common equity, if you take the absolute minimum limit of the previous rule, it was actually 2%, because it was a half of 4% and half of 8%. We now have a regime which requires that to be above 6% and above 4% on a forward-looking stress basis. So we have already, in some aspects of capital, very significantly increased it already.

  Q71  John Thurso: Can I turn to narrow banking. Judging from the comments that you made to Sally Keeble, your thinking is evolving. When we last discussed this you were pretty well against the concept of narrow banking. You have just said that you appreciate the work that John Kay has done. Are you edging towards a rapprochement of some of kind with the Governor?

  Lord Turner of Ecchinswell: No rapprochement is required with the Governor, since we agree on so many things. Let me be clear on this debate. It is one that we addressed, again, in the document which we set out at the end of October, and on which we had a conference devoted in early November, because it relates to the "too big to fail" debate. I would say I think it would be something which I would hugely welcome if this Committee had a detailed focus on (if it has enough time before we get into election, et cetera), because I fear that we will have a brief discussion on this, as we have had a brief discussion before, and do no more than skim the surface of an immensely important debate, and I would urge you to have a proper inquiry on this where you bring people in and have a session entirely devoted to it. I think the crucial thing to understand in narrow banking is that there are a range of different ideas being put out there and, in particular, there are two completely different ideas. John Kay's idea is not about separating commercial banking from investment banking. It is about separating retail deposit-taking from commercial banking. I disagree with John. I think it is very useful that he has put his debate forward, but he knows I disagree with him. He gave me a copy of his pamphlet two months before he produced it. I wrote him a lengthy response over the summer saying, "John, here is why I disagree with you", and I actually think that John's proposal would make the banking system significantly more risky than it is at the moment. I think there is a different debate to be had as to the distinction between commercial banking and investment banking—a new Glass-Steagall divide. There I think the issues are not those of principle. I think, in principle, there is an attractive concept there. I think it is simply very difficult, in practice, to distinguish between that element of involvement in treasury and trading activities, which is a natural and legitimate element of providing a commercial banking service, and when that becomes unnecessary proprietary trading on its own sake, just to give you an example. You cannot create two. Therefore, that is why in that area we have focused on the capital requirements and things like the living wills and resolution approach to have an internal division within banks.

  Q72  John Thurso: Thank you for your suggestion about looking into this in detail—one I hope that the Chairman might well think about because I think it is a very important issue—but one of the core points in all of this is that you have what has been described as utility banking, which is the utility that is required to make the world of commerce and industry go round and for individuals to be able to deposit money and receive interest, and so on. At the other end of the scale you have what some people have called "casino banking". I am not sure I like the term. I prefer to call it the area where risk is quite properly taken. At the first end, the utility end, you need a culture that is based on prudence, on prudential management, as all utilities should be. At the other end you have people whose job it is to measure and take risk because they are in investment merchant banking. In the old days they were largely partnerships and, as the Governor told us yesterday, because they were partnerships, there was a culture of awareness of risk because it was all their own money. What you now have is a conflation of the two cultures, so you have lots of people in limited companies who have the protection of the utility but still take the risk and, therefore, they are not actually paying sufficient attention to it. The argument really is about how you get people who are in the risk-taking business to take proper account of it and not use the utility as a way of funding those activities without taking proper account.

  Lord Turner of Ecchinswell: I agree that that is an argument. I would, however, point out that Northern Rock was clearly, by that definition, a utility bank involved in basic functions and not significantly involved in fancy trading activities, and Lehman Brothers was a trading bank not significantly involved in basic utility activities and, basically, both of them had problems.

  Q73  John Thurso: You and the Prime Minister have a flaw in that argument, and the flaw is this. Northern Rock was allowed to go bust, and we were perfectly happy about that. It went bust; end of story. It was nationalised, taken over, broken up. Lehman Brothers was deemed to be allowed to go bust. So the argument is actually not quite that straightforward.

  Lord Turner of Ecchinswell: No, Northern Rock was not allowed to go bust in the normal fashion. The crucial definition of "too big to fail" is too big to fail in a fashion which involves losses to people other than equity holders. The distinction between what happened to RBS and what happened to Northern Rock actually is quite minor. One was a 90% dilution of existing equity holders; the other was a 100% dilution through nationalisation. Certainly we should have the possibility of doing nationalisation options in future, but that is a quite straightforward thing to do. The crucial issue in "too big to fail" is what is the treatment of debt providers? When we say "too big to fail", we mean too big to fail in a fashion which meets the normal characteristics of an insolvency or a wind-down, where losses are imposed on debt providers, and in that respect Northern Rock did not fail, it was rescued.

  Q74  John Thurso: Can I put one last area to you. We have heard evidence and we have observed that a number of countries in Asia are requiring operations of other countries' banks to become subsidiaries so that they are regulated. Is there merit in looking at the concept of ensuring that different parts of an operation are wholly separate subsidiaries so that you can look at separate levels of capital, et cetera, so that actually you end up with a kind of bank core at the top but all its actual operations are in differently licensed and differently capitalised subsidiaries that are discrete and can, therefore, die without bringing the whole thing down?

  Lord Turner of Ecchinswell: Yes, I think there is great merit in looking at that. That is an idea that I have actually referred to at length in various speeches, and I am personally, I guess, associated in the world with being somewhat of a spokesman for that approach. It is a controversial approach, which is sometimes opposed by people across the world who say that it will get in the way of the useful flow of capital across the world. I am not convinced by that—and the Standing Committee of the Financial Stability Board, which I chair, is focusing specifically on the pros and cons of that argument with a requirement to come back to the G20 by August next year—but my overall sentiment is to be very sympathetic to what you have just suggested.

  Q75  John Thurso: So in looking at the concept of narrow banking, that is a further element that we should take into account?

  Lord Turner of Ecchinswell: I think, crucially, in looking at narrow banking one should not simply look at the idea of how you separate groups between each other, but also the internal organisation of groups and the extent to which, either by national location or by categories of activity, you can create legal structures where it is possible to rescue one part of the group while allowing another to go bankrupt. That is certainly something that we should look at and are looking at.

  Chairman: Your views on narrow banking for us looking at that are very welcome, and we will certainly take that seriously.

  Q76  Nick Ainger: Lord Turner, the Financial Services Bill, which will be before the House very shortly, gives the FSA new powers to regulate remuneration, including bonuses. Sir George Mathewson has commented on this. He says, "Interfering with contracts that have been reached between willing participants is a somewhat dangerous route to go down. I also think the FSA has enough tools already in order to ensure bonus systems which could be said to threaten the overall financial system should not exist." Do you agree with Sir George?

  Lord Turner of Ecchinswell: I think we have most of the powers that we need, and the rule that we have made already will achieve our ends. I think it is useful, if Parliament wishes to give us that slight extra power and clarify that we have that capability, but we have already, in the rule which we passed in July, put in place a regime which, broadly speaking, we believe we have the power to make stick, because we have the ability to demand that firms explain to us their overall structures of remuneration, we have the ability to look at individual contracts and we have the ability, if we are unhappy with those contracts, either to prevent firms doing particular business—if we were unhappy about the category of contracts in a particular trading area, we have the power to say, "We think that is creating risk; so you cannot do that activity"—we can do a variation of permission or we can impose capital requirements. So we have significant mechanisms other than those legal powers, but I think they are useful additional fall-back positions. Hector, do you want to comment on that?

  Mr Sants: One additional comment might be helpful. We would not envisage that we would be using these powers with regard to contracts retrospectively. So the idea that, somehow or other, we would be unwinding contracts that had been entered into in the past, I think, would not be how we would envisage operating. What we would be doing, of course, which we have already said we would do is that, if a contract could not be reasonably unwound, we would expect the bank to put in mitigating measures to deal with that extra risk. That is the way we would be tackling retrospective issues.

  Q77  Nick Ainger: But the provisions of the Bill actually state that you, the Authority, may prohibit persons from being remunerated in a specified way. Does that not imply that, if there is a contract already in place but which you believe is in breach of the general rules which you set in relation to remuneration for that institution, you actually would have to somehow break that contract? Is there not a retrospective element? It is not that I am opposed to that if that is the effect that the contract has.

  Mr Sants: Obviously there is a Bill process being carried through at the moment. It is not our understanding that it is retrospective in nature. It would apply, as we would understand it, to contracts entered into after the Bill becomes law. As you say however, it is our job to carry out the will of Parliament. If Parliament tells us that it is meant to be interpreted in a different way, obviously we would act accordingly.

  Lord Turner of Ecchinswell: Perhaps we ought to just distinguish the two uses of the word "retrospective". There is retrospective as it relates to a contract which has already been written (and I think that is a very tricky issue in general in relation to Parliament) but there is a separate issue as to whether it be retrospective in October next year to a contract written in July next year after Parliament has made an opinion. That, you might imagine, might be more acceptable. I suspect part of the confusion in this debate is between those two different uses of the word "retrospection", and some of the comments, in particular the comments that Lord Woolf was making, I think, really relate to the first category of retrospection.

  Q78  Nick Ainger: Thank you. You say you have got powers anyway. How often have you used them? There is real concern out there that it is business as usual with the bonus culture.

  Lord Turner of Ecchinswell: We have never been involved, until the last few months, in the regulation of remuneration. That has not been something that we have done before, that is something which we have done through a rule which was passed by the Board in July this year and which will apply to bonuses being paid from early next year onwards. So we are now involved, but this is for the first time ever, in the review of remuneration practices and in relation to looking in some cases at individual contracts, and I think that is a major shift. I would also say that in the past I do not think that remuneration committees in banks have seen it as a major part of their function to focus on the risk implications, rather than the labour market competition implications, of the contracts that they have been agreeing, and the first point of the principles of our rule is that they have to do that in future. Let us be clear, this is completely new stuff to it. It is not something our supervisors have been at all involved in until the last month or so and we had no rule on it until July.

  Mr Sants: Also, just to pick up your point about current practices, of course, as I am sure you understand, banks distribute bonuses generally on an annual basis, on a calendar year basis, so we have yet to have a bonus distribution take place for the major banks since we put in place our new rules. We have made clear, and indeed the banks have made clear, their intention to comply with our Code. Of course, we would make them comply with that practice. That will be applying to the 2009 bonuses that are distributed in the early part of 2010, but the banks themselves will not be making decisions on the size of those bonus pools until after their books are closed. So we have yet to have a bonus round when we have had our rules in place, but in terms of individual contracts, where we have seen individual contracts where the terms are not complying with our new framework, yes, we have intervened and there have been a number of cases already where we have required banks to alter individual contracts. We are intervening on an individual level as we talk, but aggregate bonuses distributions, have yet to occur.

  Q79  Jim Cousins: Could I switch topics, but before I do, Mr Sants, you recently made clear that you had encouraged the restructuring of an insurance company earlier in the year?

  Mr Sants: You are referring to Pearl, I assume. It was in the public speech of 9 November.

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