Session 2010-11
Publications on the internet

To be published as HC 785-i

House of COMMONS



Committee of public ACCOUNTS

HM TreasUry Asset Protection SCHEME

Wednesday 2 February 2011

Sir Nicholas Macpherson KCB and Tom Scholar

Evidence heard in Public Questions 1 - 104


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

2. The transcript is an approved formal record of these proceedings. It will be printed in due course.

Oral Evidence

Taken before the Committee of Public Accounts

on Wednesday 2 February 2011

Members present:

Rt Hon Margaret Hodge (Chair)

Mr Richard Bacon

Stephen Barclay

Jackie Doyle-Price

Matthew Hancock

Chris Heaton-Harris

Joseph Johnson

Mrs Anne McGuire

Austin Mitchell

Nick Smith


Amyas Morse, Comptroller and Auditor General, Gabrielle Cohen, Assistant Auditor General, Peter Gray, Director, and Paula Diggle, Treasury Officer of Accounts, National Audit Office, were in attendance.


The Asset Protection Scheme (HC 567)

Examination of Witnesses

Witnesses: Sir Nicholas Macpherson KCB, Permanent Secretary, and Tom Scholar, Second Permanent Secretary, HM Treasury, gave evidence.

Q1 Chair: Welcome again. I think this will become a regular occurrence. And welcome to Tom Scholar. As you know, this is the first of three hearings on these issues that we are to hold over the coming weeks. I want to start off with a very general question. You took these decisions in a tough environment. In January 2009 you took the decision to set up an Asset Protection Scheme, which went live at the end of that year. If you look back on it, what have you learned? Would you do the same thing again in the same circumstances? Is there anything that you would think of doing differently from what you did at that time?

Sir Nicholas Macpherson: I think we have learned quite a lot. Many of the interventions that took place in 2008 and 2009 were done for the first time; in terms of both scale and nature, this was cutting-edge activity. Clearly, the interventions have succeeded in the number one priority, which was to create financial stability. With the benefit of hindsight, interventions like the Asset Protection Agency compare quite well with alternative interventions pursued by countries such as Ireland, but inevitably from Northern Rock onwards it has been a learning experience. I think the National Audit Office and this Committee have played a constructive role in drawing attention to areas in which we could do better. For example, with Northern Rock, we clocked up quite large professional fees, but I think it is fair to say that by the time we got to later interventions, we had accumulated in-house expertise and perhaps we got rather better at procuring professional advice. It is striking that that is an area in which we have improved.

Q2 Chair: But looking very narrowly at the Asset Protection Scheme, do you think that was the right route to go down at that point?

Sir Nicholas Macpherson: Yes, very much so, and I think this report bears that out. There were other options. We could have nationalised RBS; we could have set up an Irish-style NAMA-type scheme where effectively we took over the assets. I think the success of the Asset Protection Scheme rests on the fact that we did not have to go into the markets and raise lots of money effectively to buy these assets, but it did put a floor under RBS at that time. I would not say that RBS is totally out of the woods; it has some way to go.

Chair: We will come back to that.

Sir Nicholas Macpherson: But its share price suggests that this is an organisation with a future. I remain confident, as I told the Committee the last time I appeared before it, that when the dust settles in several years’ time, the taxpayer will make a profit out of all these interventions. I recognise that there has been a huge cost in terms of the effect on the economy, but we all have an interest in the taxpayer making a return.

Q3 Chair: We will come to that. If it was the best of the options that faced you in relation to creating financial stability and confidence, why did you issue a letter of direction?

Sir Nicholas Macpherson: The letter of direction was at the more technical end of the spectrum when it comes to directions. There were special issues that came out of Managing Public Money

DN: official HMT publication – mark in Italics

. If we were to underwrite assets, I felt we needed a better understanding of those assets. Inevitably, not least because of the state of RBS’s systems, we could not know whether some of those assets might be tainted in terms of their underpinning legality. There are directions which are about really big value-for-money issues, some of which we discussed the other week, but I think this was a technical one. I felt that I needed it, given the guidance in Managing Public Money. Alistair Darling was very happy to give me one, and as directions go, it was quite an agreeable exchange of letters.

Q4 Chair: Was it a letter of direction which simply put into the public domain that it was a risk but you thought it was a good idea, or was it one where you and the officials felt-this is why I questioned you a little earlier about whether you thought it was the best option-it was a very risky way in which to secure greater stability of the banking system and RBS in particular?

Sir Nicholas Macpherson: No. I thought it was the right approach. It was a technical issue that I felt we had to cover off, not least for the benefit of this Committee.

Q5 Joseph Johnson: Before we go into the details of the Asset Protection Scheme itself, could we go back to the moment when you faced the choice of which solution to go for: the bad bank; the injection of more capital, which effectively would have meant nationalisation, particularly of RBS; or the Asset Protection Scheme? Appendix 3 of the Report seems to suggest that injecting more capital might have been better, on a simple value-for-money basis. If I read the Report correctly, the NAO suggests in paragraph 21 that you might have saved between £200 million and £4 billion had you decided to go down the route of more contingent capital to RBS. In light of that, why do you say so confidently that APS was a better route, from a value-for-money perspective?

Sir Nicholas Macpherson: There are a number of reasons for that. First, the APS gave greater protection, in terms of ensuring that RBS was not ultimately nationalised. The second quite important reason was that we were not certain at that stage whether the Asset Protection Scheme might need to be used for another bank. Indeed, even now you could envisage admittedly very extreme circumstances where you might need it. So we felt that it was in the wider interests of financial stability to get the scheme up and running. I should say that the contingent capital option was quite a late runner. Had we gone down that route, it would probably have delayed eventual agreement, which in itself might have undermined financial stability because the markets-

Q6 Joseph Johnson: But the APS was not quick to get off the ground. You announced it in January and did not sign any deals until November, so it took the best part of a year. Would it have taken less time simply to offer more contingent capital? It is not a very complicated process.

Sir Nicholas Macpherson: It is not a particularly complicated process, but my recollection is that as the year went by the contingent capital option began to look more attractive, but Tom may want to expand on that.

Tom Scholar: Yes. In January, when we first announced the intention to move ahead with the scheme, a contingent capital option would not have been possible; it would have had to have been actual capital at that stage. During the course of the year, markets gradually improved, and with them, the outlook for the two banks concerned, with the consequence that in the case of Lloyds, it was able to exit and raise capital on the markets, and in the case of RBS it became possible to imagine, in a way that was not possible a couple of months previously-

Q7 Chair: Hang on. Was it the change in confidence at that stage that changed the potential options?

Tom Scholar: Correct. For that reason, it was available only in the closing stages of the negotiation, and even at that point we felt we were not sufficiently certain about the outlook to want to give up what would have been, as Nick said, a scheme that was potentially available for the whole sector.

Q8 Joseph Johnson: Clearly, you were weighing up a lot of very difficult sets of pros and cons in every solution that you were examining. To dwell for a second on the option of injecting more capital, or contingent capital as became possible later in the year, in retrospect that would have had considerable advantages, in the sense that had you injected more capital and been forced ultimately to seek the de-listing of RBS, effectively to take control of it and take it off the public market, you would not have faced the problems that we have faced over the past year, with respect to some of the objectives set out in the intervention, particularly with respect to lending. We have had a situation where RBS has breached its lending commitments-it came nowhere near meeting them. Had you been in absolute control of it, which would have been the result of an intervention along the lines of contingent capital or capital injection, we would not have faced that at all. Do you acknowledge that?

Sir Nicholas Macpherson: No, I do not accept that. The first point I make is that this year RBS is on track to deliver its lending commitments. There was a problem in 2009, to which no doubt we will come back. I think there are real risks in the Government getting into the banking business. It is always nice to think that the state will be better at lending, but in my experience, having observed nationalised banks around the world-there were some good examples in France in the early 1980s-the state is not good at managing risk. I can see the attractions in thinking that if the state was in charge of the lending process we could just go out and hand out money willy-nilly, and no doubt the lending figures would look a lot better. But speaking as a Treasury official, the Treasury is both an economics and a finance Ministry. I certainly do not think it is in the taxpayers’ interest for the state to get into the banking game and, in the long run, it is not the interests of the economy.

Q9 Joseph Johnson: Why did we have lending commitments at all in this agreement if you did not believe they were enforceable and had no real interest in pursuing them? Why did the Treasury bother with them at all?

Sir Nicholas Macpherson: All of us agree that we want to see greater lending. We have just had a credit crunch without precedent in our lifetime-in fact, probably without precedent in 100 years. Banks, individuals, some companies and particularly the state need to de-leverage, but we do want to get lending going. As part of these interventions, there were discussions about that, to try to look at what was in the collective interest as opposed to the individual interest. Lending agreements certainly have a role, and that informed the previous Government’s intervention. I think it is a matter of record that the current Government is also considering options in that space, but I think that is very different from nationalising a bank and effectively telling it to run at a loss to subsidise lending, often to individuals and companies who may not be good credit risks.

Chair: I want to come back to the issue of lending agreements, because there is a lot to explore in that, but let us stick to the earlier things.

Q10 Mrs McGuire: I do not know whether I should declare that I am a customer of the Royal Bank of Scotland, and have been for many years, but I put it on the record anyway. One of the things that astonished me about the other part of the NAO Report was the fact that a timetable was set, between January and November, for the identification of assets to gather the data, yet they were unable to provide that information within the time frame. Was that because the time frame was too tight, or was it an issue to do with governance of the banks? Alternatively, was it an issue to do with directors being cavalier and non-executive directors not conducting their own due diligence?

Sir Nicholas Macpherson: First, let me declare an interest: I am a customer of the Bank of Scotland. I think all those factors are relevant. You have to understand why the Royal Bank of Scotland was particularly vulnerable in 2008. It had expanded its balance sheet very rapidly through acquisition, not least of ABN AMRO in October 2007. It became clear when we entered into discussions on the Asset Protection Scheme that the systems of the Royal Bank of Scotland, in terms of really understanding the assets it owned, were not, to put it mildly, well developed. The problem throughout 2009 was that you were looking at several million separate assets and for the Government to satisfy itself on that was a very big task.

Chair: What does that tell you? When I read that bit I thought, "Goodness! What does that tell you about the regulatory framework of banks?"

Q11 Mrs McGuire: It is a question of whether it is an issue of regulation or an issue of incompetence on the part of the bank. As a permanent secretary, you have been here on many occasions justifying IT systems that Government operate. Here we have one of our major financial institutions, which we find out has 20 different IT systems, yet it appeared to be a successful business. Given that you have had to defend sometimes very difficult situations in terms of how Government operates, were you not astonished to find out that a leading player among the financial institutions was operating in this way?

Sir Nicholas Macpherson: It is fair to say that I was surprised, yes. This is a classic example of over-expansion taking place too rapidly, hubris and all those things. When the music stopped, RBS was more vulnerable than any other bank.

Q12 Mr Bacon: But is this not what bank regulators are for? For example, I remember that years ago the Saatchis wanted to buy Midland Bank. The Bank of England waggled their eyebrows and said, "Hm. Not really a good idea", and it did not happen. I know that some of them were abroad, and a lot of the assets ended up being abroad, but regulators talk to each other. Why was it allowed to get to the point where it was not merely too big to fail but too big to manage?

Sir Nicholas Macpherson: The first people who were clearly responsible were the board of Royal Bank of Scotland. They had a duty to their shareholders. If I was an RBS shareholder I would feel a little disappointed by that. I have seen different forms of regulation over the years; I was working for Ken Clarke the weekend Barings went down, and I do not think Barings was a particularly happy example of good regulation. I do not think that Johnson Matthey or BCCI were.

Q13 Mr Bacon: With respect, I do not think that the failures of BCCI, Johnson Matthey or Barings were going to crash the world. RBS had a balance sheet of £2.5 trillion, which was larger than the UK’s gross domestic product and growing like Topsy-like a corporate leverage artist on speed-and the regulatory system was not stopping it. That is what I do not understand.

Sir Nicholas Macpherson: Clearly, there are lessons about regulation and the Government is seeking to do something about it.

Q14 Austin Mitchell: If we are declaring interests, I am a Halifax customer, but I voted against de-mutualisation, so I am in the clear. What Sir Nicholas said sounded to me like this was an "anything but nationalisation" expedient. You were ideologically opposed to nationalisation-God, shock horror!-and therefore you would do anything to avoid it.

Sir Nicholas Macpherson: No, I do not think that is the case. We did nationalise Northern Rock-

Q15 Austin Mitchell: With a certain amount of distaste?

Sir Nicholas Macpherson: No. I do not want to go over Northern Rock again, but it is a matter of record that the Treasury concluded that nationalisation was probably the right approach rather earlier than nationalisation actually took place. We used it effectively with Bradford & Bingley. I do not think we should be against nationalisation at any price, but we should realise that nationalisation carries a price. Once a company or institution is 100% in the public sector, the dead hand of bureaucratic control, combined perhaps with over-optimistic political direction, can sap the value of that institution.

Q16 Austin Mitchell: We will leave that, because you are the big hand of bureaucratic control in many respects.

Sir Nicholas Macpherson: I do not want the Treasury to run banks.

Q17 Austin Mitchell: You said this scheme was better than the Irish scheme; it had to be, because the Irish debts were huge and many of them were corrupt. How does it compare with TARP? In TARP, which has been much criticised, they were buying the assets, whereas you were just guaranteeing them. Is that the difference?

Sir Nicholas Macpherson: Tom, do you want to answer that one?

Tom Scholar: The TARP money ended up being used in a number of different ways. They used the money also to provide direct capital injections into banks, rather as the UK Government did. You raised the question of the Irish scheme. They were dealing with a very different problem from RBS. There were a number of Irish banks, which were much smaller and much less complicated. Most of their assets were property loans to Ireland and the UK. It was therefore much easier to get a handle on the exposure taken on by the Irish Government. The reason we chose an insurance scheme, rather than an asset purchase scheme, was that we felt we could implement it more quickly and would take on less unquantifiable risk to the taxpayer.

Q18 Austin Mitchell: You have guaranteed all this stuff. In paragraph 11 on page 6 of the Report, it says that the "banks encountered major difficulties in providing the Treasury" with information. They do not know what they have got, what it is worth, where it comes from or whether it is legal. This is extraordinary. Among it is my mortgage, actually. Although paragraph 11 says that a lot of the problems arose because the computer systems at RBS did not all match up, so they could not tell you what was there, it could also be that a lot of what you are guaranteeing is actually junk; it could be stuff from the States. It could be collateralised debt obligations; it could be bundled-up subprime debt; it could be simple junk. You could be lumbered with it at the end of the day. Do we know how much is junk?

Sir Nicholas Macpherson: We used the period of 2009 to do some serious diligence on those assets.

Q19 Austin Mitchell: But that is serious due diligence by a financial institution that is involved in setting up all these things. It is an interested party.

Sir Nicholas Macpherson: We reached an agreement in principle to set up the scheme in February. It did not go live until November. We used that period to do really intensive work to try to understand the assets. We did not have 100% knowledge at the end of that process, but in my view we developed enough knowledge for this intervention to make sense, in terms of value for money.

Q20 Austin Mitchell: So you can tell us what proportion is junk?

Sir Nicholas Macpherson: Subsequent events have borne that out. The Asset Protection Agency is now in charge of it; it has now developed very well-designed models to understand it. They produce regular reports setting out precisely what their expected losses are.

Q21 Austin Mitchell: Can you tell us what is junk?

Sir Nicholas Macpherson: What we can tell you is the expected loss at this time, or at least at the time the Asset Protection Agency last made an announcement. Tom will tell you what that loss is.

Tom Scholar: In last year’s annual report, the Asset Protection Agency reported the expected loss-to RBS, not the taxpayer-as of the end of March of last year as £57 billion, which is less than the total amount that they are required to meet themselves.

Q22 Chair: The figures in the report are based on September. Do you have any more up-to-date figures than that?

Tom Scholar: The figures in the report on the pool of assets that are covered are as at the end of September. The latest available estimate on the future total expected losses is end of March last year. In the next few weeks, at about the time of the RBS annual report, the Asset Protection Agency will put out a report with an updated loss estimate.

Q23 Chair: So there is only an annual update?

Tom Scholar: Every year, they publish an annual report.

Q24 Chair: But you are saying that all this is based on last March’s figures? The estimate is £57 billion-

Sir Nicholas Macpherson: Within weeks, you will have a new estimate. Given what has happened to property prices since last year, I would-

Q25 Chair: You think it will go up?

Sir Nicholas Macpherson: No. I would be very surprised if the estimate of loss went up.

Tom Scholar: For example, if you look at RBS’s third-quarter statement, you will see that the reported impairments have gone down compared with June.

Q26 Chair: I want to go back to Jo’s very important point at the beginning about why you chose the option of asset protection. You said it took you nine months to go through all the assets to try to establish what you could and could not put into the Scheme. By that time, asset guarantee became an option. Did you at that point-in September, October, November-do a value-for-money study of those two options, or did you feel that you were so far down one road?

Sir Nicholas Macpherson: We very much did. In my role as an accounting officer, I thought this was a critical decision. We put a lot of effort into understanding the trade-offs. Tom and I were certainly agreed in advising Alistair Darling, the then Chancellor, that this was the best option in the circumstances at that time.

Q27 Chair: You have said you expect the total value of the bad assets to stay within the £60 billion threshold. Is that judgment based on recent events in the UK economy, potential events in the Middle East, the euro economy-question mark, question mark?

Sir Nicholas Macpherson: Yes.

Q28 Stephen Barclay: May I come back to the letter of direction? You said that you conducted really intensive work, yet at the end of 10 months of really intensive work you did not know whether the assets were tainted. If there is a major failure of systems and controls in a firm, would you expect regulatory enforcement action? [Interruption.]

Chair: Saved by the bell.

Tom Scholar: The role of the FSA is to look at both prudential regulation and conduct of business in relation to retail business in this country. Any allegation of any kind of criminal activity clearly would be for law enforcement agencies, but would not be a matter of financial regulation.

Q29 Stephen Barclay: In the interest of declaring, I worked for the FSA for four years, and was an owner of the policy handbook, hence my question on whether you would have expected any enforcement action. As far as I am aware, no individual at RBS or Lloyds has been subject to any enforcement action. There was clearly a failure of systems and controls. You were the architects of the regulatory regime; did you have any discussions with the FSA in terms of individual enforcement actions?

Tom Scholar: As you know, the FSA have conducted their own internal review of what enforcement actions they should take, and they have concluded that they will not take any, and have given a commitment to publish a report explaining why they have taken that view. I would not want to prejudge that-nor could I, because that is work that they undertook, rather than us. Throughout this period, we have kept them very closely in touch with our work on the Asset Protection Scheme and what it was telling us about the state of systems and controls and risk management within RBS. That is something that they are concerned about; it is something about which RBS management is also concerned about. Do not forget that it is new management, and in answer to an earlier question, the new management of RBS has been fully cooperative throughout the design and implementation of the scheme. That is something that they are looking to put right, and the FSA have also said that in future they will adopt a much more intrusive approach to regulation.

Q30 Stephen Barclay: But no individual has been subject to an individual fine. There have been discussions about the role of the finance director, but as far as I am aware, no individual at RBS or Lloyds has been fined. Is that correct?

Tom Scholar: As far as I know.

Sitting suspended for a Division in the House.

On resuming-

Q31 Stephen Barclay: I think we were dealing with the fact that intensive work was done for 10 months, yet a letter of direction was required. Given your concerns about the assets being tainted, what conclusions did you draw about the work of the auditors, Deloitte, on those assets?

Sir Nicholas Macpherson: I do not think it falls to us to assess auditors’ performance, but I think there is a generic question about the role of auditors in relation to banks during the banking crisis.

Q32 Stephen Barclay: You could not trust the work of the auditors?

Sir Nicholas Macpherson: Certainly, some quite serious questions have to be asked about the accounts that were signed off during that period.

Tom Scholar: On the technical issue of the direction, the direction related to the standards set out in Managing Public Money, which are the standards typically required in the public sector. Obviously, that is a different test from the one that the auditors must apply.

Q33 Chair: Can you expand on that? Several people around the table are interested in that issue of the auditors. What are the questions? Where does that take you, in the Treasury, with responsibility for that?

Mr Bacon: And who asks them? You said serious questions have to be asked, not that you would ask them.

Sir Nicholas Macpherson: Well, you know-

Mr Bacon: I do not know; that is why I am asking the question.

Sir Nicholas Macpherson: I think the relevant bodies who oversee auditors and the profession itself perhaps need to ask themselves some questions.

Tom Scholar: Inasmuch as this is a matter of financial regulation, the FSA is the body responsible for looking at standards of auditing and the quality of audit applied to financial institutions. As a matter of government policy on audit in general, inasmuch as it applies to companies in general, that is a matter for the Department for Business.

Q34 Mrs McGuire: Frankly, that is a rather passive answer to a question about the role of auditors and the fact that various parties were involved in what happened to the banking industry. The taxpayer was left to pick up the bill for it. Have you had any discussions with the professional bodies, and the Institute of Chartered Accountants in both England and Scotland, to look at some of the issues that this particular crisis has thrown up? We are not talking here about individual auditors; that might be a different matter, and you might be reluctant to comment on it, but I want to know whether or not you have engaged in any discussion about how, in future, the professional bodies can adopt a different way of working with an intricate financial industry.

Sir Nicholas Macpherson: That is a very fair question. We have not engaged directly with the professional bodies, but we have had conversations with both the FSA and the Department for Business. I would hope that some important lessons will be learned from this.

Mrs McGuire: I think this is different from important lessons being learned. I do not wish to draw a parallel, but after Enron and Andersen, everybody said that important lessons had been learned. What I and perhaps other Members of the Committee are looking for is something more proactive than "lessons will have to be learned".

Q35 Mr Bacon: I am quite shocked by your answer. Obviously, one would expect the FSA to look at this, but you are the major finance Ministry of a major country. There was an enormous crisis that crashed the whole world, the consequences of which we will suffer for decades. As the finance Ministry, you have not engaged directly in the issue of auditing when plainly it was a big part of the problem, although not the whole problem.

Sir Nicholas Macpherson: There are a huge number of lessons we need to draw from this crisis, and we need to address them. Inevitably, much of the Treasury’s activity until recently has been concerned with managing the crisis. The present Government is seeking to reform the regulatory system. In the coming period, I would expect the Treasury to seek to cover the waterfront of issues, and this is one of them. There is a limit to how much you can deal with at any point in time, but I totally take your point. I think there are very important lessons here. RBS is a case study. You gave the example of Enron; Enron had more, perhaps, illegal activity underpinning it, but this is a classic example of corporate hubris. The takeover of ABN AMRO should be a case study of lack of due diligence.

Q36 Mrs McGuire: I do not think we are asking for a solution here today, Sir Nicholas. I thought my question was pretty simple. I would have thought we would have a more positive response. At any point over the past two years, have you engaged with the professional bodies that regulate or work with the large firms that audit these very intricate financial institutions? Has there been a conversation about this? Have you said to them, "Would you like to look at the lessons that the Royal Bank of Scotland and HBOS have thrown up?"? Has there been anything like that?

Sir Nicholas Macpherson: I can say that I have not personally directly engaged with the professional bodies.

Q37 Mrs McGuire: I would not necessarily expect you to talk to everybody.

Sir Nicholas Macpherson: I am happy to come back to you on what the Treasury is doing on this front. I just do not feel equipped to give you a definitive answer.

Q38 Stephen Barclay: Perhaps we could have a note, in terms of some time scales.

Sir Nicholas Macpherson: Yes.

Q39 Austin Mitchell: Do we know what other services the auditors were selling to the banks?

Sir Nicholas Macpherson: I cannot tell you offhand, but it is in the nature of auditors that they can often provide a number of services.

Austin Mitchell: It is also in the nature of auditors that it might colour their perception of the actual accounts. We do not know.

Q40 Mr Bacon: Is that something that the Vickers Commission on banking will look at?

Sir Nicholas Macpherson: I do not think the Vickers Commission will be looking directly at auditors. Their remit is to look at the competitiveness of the banking system and the particular issues around wholesale versus retail banks. I am not aware that they are looking at the audit issues.

Q41 Chair: You are clear about the direction in which this Committee will go in its conclusions on this issue.

Sir Nicholas Macpherson: I am very happy to come back to you on it. If in the light of that both we and you feel that we need to be more vigorous in this space, I am very happy to pursue it.

Q42 Stephen Barclay: I fully accept the point that, at the time, no doubt your team, the regulator and the Bank of England were working very long hours; it was an extremely difficult time, and we need to recognise that, but to go back again to the point at which the letter of direction was sought, did you seek an indemnity from the bank, in terms of the assets about which you were concerned? Did you get warranties, in terms of your concerns about those?

Sir Nicholas Macpherson: A number of assets were excluded from the scheme on the basis of the information that we had. The problem was that even after those seven, eight or nine months of work, we did not have enough information to take a view on every single pound of assets.

Q43 Stephen Barclay: That was not my question. My question was: did you ask RBS to confirm ownership, or were you concerned that, for example, there were some client assets within the potentially tainted assets, because obviously there is a far higher regulatory burden attached to client assets? What I am driving at is: yes, understandably the Treasury could not confirm this; you did your best in the time available. Did you therefore turn it back to RBS and say, "Okay. We will take these on, but within a certain time frame we expect you either to have confirmed ownership or replaced these assets"? Did you seek that indemnity?

Tom Scholar: Yes, we did. At the time of accession, RBS had to give the Treasury a contractual confirmation that, so far as they were aware, and after all due and reasonable inquiry-I am reading from the letter of direction-there was no such material or systemic criminal conduct affecting the covered assets. That was at the time of accession. They were then required to report annually on that; and also if they became aware of any such activity at any point, they had to report it immediately. The rules further specified that in the event of that happening, there would be a risk of termination of the cover provided.

Q44 Joseph Johnson: What percentage of the £325 billion of RBS assets covered was being referred to in the letter of direction? How big was this pool of junk, as Austin called it?

Tom Scholar: I cannot recall the percentage figure. I think it was a small percentage about which we were directly concerned, but given what we discovered about the quality of risk management and the poor systems and controls within the business, we were concerned that there might be other problems which had not come to light.

Q45 Joseph Johnson: So, it was a general blanket letter to the Chancellor at the time, saying that there was an unspecified amount of assets that might be fraudulent?

Tom Scholar: Again, we can come back to you with the answer to the specific question about how many assets there were.

Q46 Chair: I think it would be really helpful for us to have a copy of the letter of direction that you sent to the Chancellor and his reply, if that is possible.

Sir Nicholas Macpherson: Certainly. You should have it.

Chair: It probably went to my predecessor.

Sir Nicholas Macpherson: All of these were published towards the end of the last Parliament.

Chair: The NAO can perhaps provide that for us.

Q47 Stephen Barclay: You are spending many millions on advisers. I was slightly surprised that none of these advisers told you that your lending targets were unenforceable. Did you not expect them to point that out to you?

Tom Scholar: The advisers were looking at the quality of assets. That was the only area on which we asked them to work. That was the specialist advice.

Q48 Stephen Barclay: You did not have anyone advising you on the lending targets that you set for the banks? For all the millions of pounds that you were paying for advisers, none of them were advising you on the targets that you set?

Sir Nicholas Macpherson: I think we felt that the advisers could not tell us anything that we did not know.

Q49 Stephen Barclay: So you knew that they were unenforceable, did you? These targets were unenforceable. It would be pretty bizarre if a bank took the view that it was not creditworthy to make loans to a firm, but they would go ahead and make them because there was a target there. That would be a pretty strange decision for them to make, not to mention that the direction of travel from the regulator was for them to increase their capital base and therefore they would be less likely to be making loans to, say, a construction firm, because that would have capital implications. What I am driving at is whether, when you made this deal with the banks, you got the right concessions and whether the concession that you sought on lending targets, which we know is unenforceable-I would advise that it was known to be unenforceable at the time it was made-was anything more than cosmetic. Were you getting advice from your advisers on it, or was that a decision made purely by the Treasury? If so, why was it taken when it was unenforceable?

Tom Scholar: That was a Treasury decision. It was not within the area of expertise of the advisers, so we did not think they would be able to do that.

Q50 Stephen Barclay: Not within their expertise? The credit risk policy of the bank and the criteria on which it would lend were not within their expertise?

Tom Scholar: I am sorry; I misunderstood. I thought you were talking about the target within the context of macro-policy and macro-conditions in the economy. In terms of the specific credit decisions, the lending commitments explicitly said that they were to apply to lending based on market demand and commercial judgment, so there was nothing in the lending commitment that would make the banks depart from that. What the lending commitment did do was summarise the potential benefit to the lending capacity of the banks of the additional capital cover that the Asset Protection Scheme provided.

Q51 Stephen Barclay: But you have a huge hole in your target, which is saying, "We will put it down to the banks; it is the banks’ judgment." The Bank of England said in December 2010 that the dominant influence, in terms of there not being much lending, was tight credit supply. The issue we all experience with local businesses in our constituencies, particularly if you look at industries like construction, is that they cannot get loans because the bank credit risk committees say they are not prepared to lend to them; they are not the right risk. You set a target which left it open to the banks’ judgment and therefore was unenforceable. My point is: did you get the right concession? What other concessions were potentially available for you to secure, given that the concession that you did secure was unenforceable?

Sir Nicholas Macpherson: I think there are limits to the role of the state in directing lending. As I said earlier, lending agreements were part of the package of these announcements. It was a collective action problem. What we wanted to try to ensure was that banks lent where it was profitable to do so. If you look at the lending, in 2010, according to the National Audit Office, these banks were on target to deliver their lending targets.

Q52 Chair: But you have reduced the target.

Sir Nicholas Macpherson: In 2009, they did hit their mortgage lending targets; they did not hit their corporate lending targets because there was a massive repayment of debt by the business sector, largely on the back of a reviving corporate bond market, which allowed big corporates to borrow very large amounts.

Q53 Joseph Johnson: You are suggesting that there was demand for capital that went unmet, and that there were no businesses going without capital. You are suggesting there was no credit crunch?

Sir Nicholas Macpherson: I am not suggesting that at all. As I said earlier, there was the biggest credit crunch in 100 years. Inevitably, in those circumstances, there will be sectors of the economy that will try to restore their balance sheets. Banks inevitably had to restore their balance sheets to a degree. The policy challenge during that period was: would they seek to restore their balance sheets at such a rate that it would damage the economy? What the lending agreements tried to do was deal with the collective action problem. Looked at from the narrow perspective of a bank, it might not be sensible to lend, but this was to try to provide an umbrella to create circumstances where the banks would lend.

Q54 Matthew Hancock: But in 2009, that did not happen, did it?

Sir Nicholas Macpherson: In 2009, in gross terms, both RBS and Lloyds lent a reasonable amount of money. Part of the problem was that that gross lending was completely overwhelmed.

Q55 Joseph Johnson: Why could you not foresee that there would be net repayment? In an environment where businesses need to de-leverage it is inevitable that there will be a certain amount of repayment of existing borrowings, and that should have been factored in from the start. It should not be used as an excuse to justify why the targets were missed by a mile.

Sir Nicholas Macpherson: I do not remotely seek to use it as an excuse. Lending is driven largely by economic activity in the first place.

Matthew Hancock: Is it not also driven by the rates and covenants on the lending? In the argument about whether there is not enough demand for lending-that is one of the arguments cited in the Report for why lending targets were not hit-if you try to say, "There was not enough demand and therefore the banks did not supply it," unless you consider the net price, including covenants and all the other things that are part of a lending contract, you cannot look at the interaction of supply and demand. Because all of these costs, covenants and interest rates went up, that meant demand was restricted. That is why the lending targets were missed. They were missed in the targets put in place during the rescue.

Chair: That is a statement.

Q56 Matthew Hancock: Is that true?

Sir Nicholas Macpherson: What I conclude from this is that lending targets were a perfectly sensible approach, but it is very difficult for the Government to seek to determine the level of lending in the economy. The Bank of England has pumped hundreds of billions into the economy, yet even now net lending is flat, or even falling, so sometimes you are pushing on a string. I wish there were some simple way in which you could get out of a credit crunch and that there was, in a classic Stalinist way, a path by which we could seek to plan the economy, but sadly markets do not work that way.

Q57 Chair: There is a tension between our desire to see the banks lending more and the desire for them to get their gearing down.

Sir Nicholas Macpherson: Yes. This is the fundamental tension. What we all want is an optimal path. It is a classic economics Ministry versus finance Ministry trade-off. We want to get our money back from the banks; we want to see successful banks. It is something which Britain historically has been rather good at, so it would be a pity if we got out of the banking business as a nation, but we also want to see them lending and want to get the economy going.

Q58 Mr Bacon: Are you saying that the Treasury should be split?

Sir Nicholas Macpherson: Certainly not. I think the Treasury is uniquely placed to internalise these tensions.

Q59 Chair: Perhaps we can just deal with the issue of lending. In your discussions with the banks, was there a debate on whether it should be gross or net? That is almost a yes-or-no question.

Sir Nicholas Macpherson: Tom spent many hours, days and years negotiating with banks, so he will answer that question.

Tom Scholar: Yes, there was, particularly during the second year as it became apparent that there was a very high-

Q60 Chair: But in the first year was there a debate?

Tom Scholar: I cannot recall precisely.

Q61 Chair: So in the first year, nobody predicted the extent to which people would pay back their loans?

Tom Scholar: I think that the scale of repayments, not just in those two banks but right across the sector, surprised a lot of people, including a lot of economists, so we were not alone in being surprised.

Q62 Chair: In paragraph 3.14 on page 31, there are a whole range of sanctions that were considered to try to put some beef into the lending aspiration. They were all rejected, and I find it difficult to understand why, because some of them look more doable than others.

Tom Scholar: First, there was a sanction, which in the end has not been used, but was in the scheme.

Q63 Chair: Because it was an unusable sanction, which is really Stephen’s point?

Tom Scholar: It was there and could have been used, although in the event we chose not to. The main reason we chose not to was that in the Treasury’s assessment a year ago, the failure of the banks to meet the targets set was due to market conditions. That was the assessment published by the Government in the Budget last year.

Joseph Johnson: Which the Bank of England subsequently contradicted?

Stephen Barclay: Yes; that is the point.

Sir Nicholas Macpherson: I do not think the Bank of England did.

Tom Scholar: The Bank said that it was due to a mixture of-

Q64 Joseph Johnson: It was predominantly a tight credit issue?

Tom Scholar: Yes. I do not know what "predominantly" means; it might be 55:45, but I think the Bank acknowledges in its report that there was certainly an issue of demand.

Sir Nicholas Macpherson: Anybody who has done serious work in economics knows it is notoriously difficult to separate out the demand curve from the supply curve. That is the Bank’s judgment. I respect the Bank of England hugely, but to this day I think there is an active debate about the relative role of supply and demand.

Q65 Matthew Hancock: Anybody who has any serious economic background knows that you cannot talk about supply and demand unless you talk about price. The price of credit in margins clearly went up.

Sir Nicholas Macpherson: The price of funding went up in this period.

Q66 Chair: I am trying to get an answer about paragraph 3.14 on page 31. There is a whole series of sanctions, some of which are pretty doable. All of them were rejected.

Tom Scholar: We felt that some of them would be counter-productive, in terms of further undermining capacity to lend; a fine or penalty would come under that heading. We thought that requiring the banks to transfer shortfalls in lending to another lender would not be practical. As to the question of linking chief executives’ remuneration more directly, in the second year of the lending commitment, in the Budget in March last year, a new provision was introduced to say that the two banks, in setting their remuneration, should consider this issue directly and that UKFI should discuss that with them, and that has been happening. That was in the second year of the lending commitments. In the first year, there was clearly a policy decision to be taken as to whether to include something like that. There were arguments both ways. The argument in favour was that it would be a sanction; the argument against was the feeling that it might add to an expectation of bonuses at a time when the Government was urging restraint. There was also a concern that it might lead to counter-productive behaviour in the banks if the chief executive had a personal incentive to do something that might not be in the interests of the shareholders of the bank, who obviously included the Government. That was a finely balanced decision. The policy decision was not to include it in the first year.

Q67 Chair: And the naming and shaming, which seems to me dead easy?

Sir Nicholas Macpherson: Of course, we did publish the results, so you will know that both banks missed their commitment on corporate lending.

Q68 Matthew Hancock: I want to press you on the period between the announcement of the APS in January 2009 and November 2009, when it was completed. You said that by the end of it, you realised you would not get a full risk exercise on every single one of the millions of assets that were in a mess, and you took the decision to go ahead for financial stability reasons, which I think is entirely understandable. Did it surprise you how long it took to do that due diligence?

Tom Scholar: Yes, it did; we expected to do it more quickly. The reason it took longer was the one we discussed earlier: the poor state of systems and risk management.

Q69 Matthew Hancock: Given that by November you knew you would not get full sight of the whole package that you were to take on board, could you not have made that judgment earlier and, therefore, have signed the thing off when you first expected to, before the summer? You would have had less sight, but you still would not have had 100% sight of it by the end of it, if you had gone on forever.

Sir Nicholas Macpherson: The important point there is that from the moment it was announced in February, both RBS and Lloyds were getting a benefit in terms of market perception from the Asset Protection Scheme, so the intervention was delivering stability well before the scheme went live. Indeed, in Lloyds’ case, they ended up having to pay a fee to us for the benefit they received.

Q70 Matthew Hancock: So the expectation of the scheme was doing the job?

Sir Nicholas Macpherson: Yes.

Q71 Matthew Hancock: So it did not matter that you did not have the scheme in place?

Sir Nicholas Macpherson: It clearly did matter, because we wanted to nail it down. There were also a whole lot of issues with the European Union around state aid which we needed to resolve, but the lesson from this-and the lesson from the States and Ireland-is that all these interventions always surprise you, in terms of how long they take to get up and running.

Q72 Matthew Hancock: Do you think that in future you would make the judgment earlier that you had had enough of a look at it to know how you felt about it, and that you would therefore be able to put it in place, rather than leaving it to drag on for 10 months as you did?

Tom Scholar: I do not think it would have been sensible for us to have brought forward the final decision. First, as my colleague says, the promise of the scheme was in any case providing support. Secondly, the due diligence exercise was an exercise in diminishing returns. In the first few months the numbers moved quite significantly. Simultaneously, we were in discussion with RBS about which assets would go into the pool to be covered. By the time we got into September, October and November, which was also the time of finalising the negotiations with the European Commission, it was moving considerably less, so by the time we got to November, we felt we had sufficient assurance that we could set the first loss-do not forget that the first loss is absolutely critical in driving taxpayer value-at a level that would prove robust to future developments, and it has turned out to be.

Q73 Matthew Hancock: But you do not think it was worth doing it earlier, given those diminishing returns in time?

Tom Scholar: No. I think we needed to take the time that we did.

Q74 Matthew Hancock: You mentioned the exit fee that Lloyds had to pay. One of the findings of the Report, in paragraph 16 on page 8, is that the analysis of RBS’s exit fee, which of course it has not paid, "did not include the breadth and depth of analysis we would expect". Why was that?

Tom Scholar: You can look at the calculation of a possible minimum fee in a number of ways. The way in which we did it, as paragraph 15 on the previous page says, was to charge the maximum fee possible consistent with leaving RBS well capitalised. Of course, we had to agree that with the FSA. They had to be satisfied that RBS would pass the stress test. What the NAO is referring to in its comment is a different approach to calculating fees, perhaps by reference to the methodology used in the case of Lloyds, but of course Lloyds was in a different position because it was exiting the scheme and RBS was continuing.

Q75 Matthew Hancock: But you would want to agree a minimum fee for exit before an exit.

Tom Scholar: Correct, but in the case of RBS the fee was the very last thing that we agreed in the whole package because our desire was to charge the maximum possible fee consistent with leaving it well capitalised. In order to do that calculation, we had to know how much capital support we were providing through the scheme and get the FSA to factor that in.

Q76 Joseph Johnson: Is that not doing it the wrong way round? Should you not work out what the fee should be based on an analysis of the cash flows, then charge it and recapitalise RBS if necessary?

Tom Scholar: I think your question shows what the consequence would have been of a higher fee.

Q77 Joseph Johnson: You would have had to stick in more capital and increase your shareholding, rather than give away value?

Tom Scholar: In any case we were an 84% shareholder.

Joseph Johnson: But you were giving away value.

Q78 Matthew Hancock: So you are saying that the fee was not based on analysis of the value to the bank of the support the taxpayer was giving anyway-it was more a finger in the air about what the market could sustain?

Tom Scholar: We were trying to balance a number of considerations. The bank had to pass the FSA stress test. The Government was concerned that the shareholding should not rise so high that in practice the bank would have to be de-listed. As the Report says, that was a policy decision taken back in January and confirmed again later in the year.

Q79 Matthew Hancock: Hold on. That says that in order to keep the taxpayer ownership down, you charge a lower fee than you might otherwise have done, so you did not have to recapitalise as much, which is not very good for taxpayer value for money in a narrow sense, is it?

Tom Scholar: We saw taxpayer value issues as being better protected by keeping the bank as it is now, with a partial private-sector ownership, because we see that as better protecting the value of the bank in the long run and as facilitating exit.

Q80 Matthew Hancock: I buy that entirely, but although the difference between an 83% and a 90% public ownership is a difference in taxpayer value, it does not alter the structural ownership; it is still a minority shareholding.

Tom Scholar: But there comes a point at which it is no longer credible to go on treating these issues-

Q81 Chair: So were we on the cusp there?

Tom Scholar: Absolutely on the cusp, yes.

Chair: So it would have made a difference.

Q82 Matthew Hancock: But it was not due to lack of capacity. If I may say so, you were widely regarded as working heroically during this period, but you were also in a stretched team. Was it due to lack of support?

Sir Nicholas Macpherson: I think we were overstretched in 2008. Through 2009, Treasury capacity had strengthened considerably in this area, and actually I think the Treasury effort on this was of very high quality. The NAO concedes in paragraph 16 that a minimum fee in the range of £1.4 billion to £4.4 billion could have been justified. The bank had already paid £2.1 billion. If it is still in the scheme next year, which RBS certainly expects, it will be paying in excess of £2.5 billion.

Q83 Chair: I think it has been very difficult for any of us to second-guess your judgment. One can understand the issues that you took into account as you made the judgment on the fee level. As I read the Report, where the NAO criticism comes is on whether you did all the appropriate work underpinning the taking of that judgment. You knew much better probably than the NAO and certainly than us as to whether that fee was set at about the right amount, but on reflection, should you have done the extra work that the NAO suggests you should in coming to that judgment, or do you think that the way you approached it was okay?

Tom Scholar: As you might imagine, we have looked at this very carefully, particularly since receiving the Report. I think that it is a fair criticism to say that we could have done more analysis in this area. However, even with the benefit of hindsight-we have gone over this very carefully-and even with that extra analysis, we still would have ended up with a fee of £2.5 billion, because the critical thing driving that figure were the considerations in paragraph 15-the maximum consistent with financial stability.

Q84 Matthew Hancock: I want to ask a bigger-picture question. You referred earlier to trying to get the de-leveraging on an optimal path to satisfy the two competing constraints. It seems to me that in order to execute de-leveraging while keeping the domestic economy in reasonable shape there should be a focus on foreign asset sales, because the disposal of foreign assets can reduce your wholesale funding requirement without having a direct impact on the domestic economy. Do you think that the existence of the APS has any impact on whether that is a strategy that can be effectively pursued by RBS?

Tom Scholar: I do not think it does influence that strategy. It is certainly possible for RBS to dispose of assets that are covered in the scheme. Indeed, they are disposing of them, which is one of the reasons why the pool is shrinking. I do not think that the existence of the scheme in itself distorts that judgment.

Q85 Austin Mitchell: I think it has been a very educative session. It makes me think that instead of going into politics I should have taken that trainee job with the Yorkshire Penny Bank all that time ago. I could now be subsidised by the state, drawing fat fees in the process. I was intrigued by Sir Nicholas’s sensitivity. There you are, the head of the biggest bully Department in the Government, which goes round bullying all the other Departments and snatching money from them, yet you are squeamish and sensitive about the banks; you touch them with a feather duster. How do you know that you are not being fooled by the banks? They say that they are not lending to business because people are not coming forward to demand loans, but small businessmen in my constituency, and I think in every other constituency, say, "The banks won’t invest in us; we can’t get the money. Everything is grinding to a halt", builders particularly. Who is telling the truth in this matter?

Sir Nicholas Macpherson: I am acutely aware of the problems that small businesses have at present in accessing loans and so on. The Treasury takes that very seriously.

Q86 Austin Mitchell: But there is nothing you can do about it?

Sir Nicholas Macpherson: I do not quite accept the "feather duster" criticism. Both the last and present Governments have applied special taxes to the banks, first the bonus tax and now a banking levy, which will raise £2.5 billion a year; I do not think the banks are overjoyed by that. I hope that it may indeed influence their behaviour. At the heart of your question is the role of the state and its ability to intervene in markets to secure a wider economic benefit.

Q87 Austin Mitchell: It’s not that; that is a theoretical question. Here are the banks: you are shoving large sums of money into them; you are safeguarding them; you are preventing them from collapse; yet they are not doing what Government wants them to do-lending money to business. They are lending for mortgages, that is true; but they are not lending it to business. As a result, business has stalled in large parts of the country. All I am saying is: are you being too sensitive in saying that they cannot lend the money? Should you not push them in some way into lending more to stimulate the economy?

Chair: Would you give a quick answer to that, because we have been round that house quite a lot?

Sir Nicholas Macpherson: As I said earlier, the Government is in discussions with the banks and I do not want to prejudge those discussions.

Q88 Jackie Doyle-Price: I want to come back to the question of fees. In an earlier answer you alluded to the fact that the European Commission was constraining how you negotiated the RBS fee. Can you give me a bit more of an explanation of that and say how it affected the fee you negotiated ultimately?

Sir Nicholas Macpherson: The challenge in all state aid issues is that, quite reasonably, the European Commission, which has to police competition across banking, was keen to ensure that the Government were not somehow giving the banks an unfair competitive advantage, so they took quite an active interest in the properties of the scheme and also focused on the wider interventions involving recapitalisation. We had extensive discussions with the Commission last autumn. I do not think they influenced the scheme to a massive degree, but the Commission was keen for a consistent approach to be adopted across the European Union. As you know, in terms of wider competition issues, they have required both Lloyds and RBS to divest themselves of some of their branches and businesses. In the case of RBS, that is being taken forward at a fairly rapid pace; in the case of Lloyds, it is yet to happen, but I think that ultimately both things will encourage competition in the banking sector. For those of us who are frustrated by issues like bankers’ bonuses, the long-term solution is about changing the structure of the industry rather than Government berating certain individuals.

Q89 Chair: One interesting question that comes out of it is this: why, on the subordinated debt, did you wait for European legislation to stop them getting their interest on that? That seemed odd to me. It seemed to be an advantage. If you have a subordinated debt, you can make a load of money out of it.

Sir Nicholas Macpherson: It is a very good question, and Tom will now answer you.

Tom Scholar: Again, it is a financial stability thing. A discretionary decision by the UK Government to stop paying interest on that would have risked contagion to other similar types of asset class, which could have had damaging effects on financial stability, but once an international European rule came in, it was clear to everyone concerned, investors in particular, that that was an obligation we had rather than a discretionary decision, so it made possible something that would not otherwise have been possible and we were very supportive of that new rule.

Q90 Jackie Doyle-Price: To follow that up, would it have been more advantageous to set a lower fee than the Lloyds fee in order to give a signal to the markets that RBS was moving in the right direction? Ultimately, from our perspective it would have meant that the taxpayer’s involvement would cease sooner rather than later.

Sir Nicholas Macpherson: What you are highlighting is that there is a trade-off here. We are satisfied that the fees charged were reasonable. We wanted to see a reasonable return to the taxpayer, right here, right now. In the case of Lloyds, it was part of a wider package that involved private investors taking on more risk as part of the rights issue for Lloyds, but as you say, there is a delicate balance.

Q91 Joseph Johnson: I want to sum up for myself what I think is the key message of what you are telling us. The overriding objective, which you achieved handsomely, was to restore financial stability. What I conclude is that a very close second was to do so while avoiding, almost at any cost, full nationalisation of RBS and, if it came to it, Lloyds, even if that came at the expense of value for money for the taxpayer and the loss of your ability to enforce lending targets. Do you think that is a fair characterisation of what you are saying?

Sir Nicholas Macpherson: No, I do not, because I do not accept that we were trying to avoid nationalisation at any price. Indeed, we went over the arithmetic several times to work out whether nationalisation was an option. That informed a lot of our financial interventions from Northern Rock onwards. I guess that what informed our judgment was that 100% ownership carries a cost, in terms of the erosion of value in any institution. This used to be an issue of big political dispute, but I think there is general agreement now that nationalising companies in the competitive sector probably does not do either those companies or the taxpayer much good, so we were factoring in a loss of value there, but that does not mean that there would not have come a point when full nationalisation made sense. We were trying to avoid it, but had the arithmetic really stacked up, we would have gone for it. As for your wider point about lending, this was a massive credit crunch. I think Government interventions and Government policy prevented it from being a hell of a lot worse. If it had been a lot worse, lending would have fallen even more. Could we have fine-tuned our intervention to make it even more effective? I think that will be a matter for analysis and learned papers for many decades to come.

Q92 Joseph Johnson: Thank you. Do you accept that the Government would now probably find it easier in their negotiations with the banks vis-à-vis lending if they had 100% control, or would it make no difference at all, and would we be having exactly the same conversations with Stephen Hester if we had 100% control as we are now having with 83%? Do you think it makes no difference at all?

Sir Nicholas Macpherson: I think it depends on how Government chooses to exercise that control. There are certain countries in the world where the state instructs banks to lend. I am quite sure that for brief periods they do it quite successfully, but it carries a cost. The critical thing about lending is that it must be on commercial terms and subject to market demand; otherwise, you start really distorting decision-making. You can take a punt on the state knowing better than the market what to do-and sometimes that is the case; we have seen markets operating pretty imperfectly in recent years at certain times-but generally I would prefer to rely on the market rather than state direction.

Q93 Mr Bacon: I agree with you about that. Not only do I not have much faith in the ability of the state to get it right; the way these banks have been managed over the past 10 to 15 years suggests that we should not have much faith in them either. I want to ask about the first loss, the second loss and the £60 billion limit, which the Report describes as being based upon the most likely economic scenario. Let us hope that is right. But the NAO goes on to say that there is a tipping point at around £73 billion, where the taxpayer’s position would be particularly vulnerable, because at that point the incentives would change and RBS would be liable for only 10% of any further losses or, to put it another way, RBS knows that the taxpayer will be picking up the bill for 90% of any further losses. At that point, notwithstanding what is said in 2.22-that any payments made by the Treasury must be paid "by RBS plus interest if it wishes to exit the Scheme"-RBS might very well decide, "That is far too high a price to pay; we’ll carry on as we are, thank you", and they can do so until 2099. Let us hope this does not happen, and let us all be optimistic about what might happen in the economy, but there are any number of things that could blow one sideways. Are you really prepared to see RBS staying in the scheme for the next 90 years?

Sir Nicholas Macpherson: Probably what you are talking about are pretty extreme circumstances. To get to £73 billion, we will probably have had to experience another really serious property downturn, for example. If that happens, I suspect-I do not want to dishearten you-that we shall be in the business of rather bigger banking interventions across the board than just RBS’s membership of the scheme. Who knows? At that point, Mr Johnson may be right and nationalisation could conceivably come into play. My main point is that, having looked at the numbers, to get to £73 billion you are getting pretty much off the page in terms of the economic environment.

Tom Scholar: I was going to say something very similar. I just add one thing. In its report last year, the Asset Protection Agency gave various scenarios and sensitivity analyses involving different types of stress and consequences. To get to a loss of £74 billion, you have to assume default rates similar to those that prevailed during the great depression, plus an additional fall in commercial real estate prices, plus even-lower-than-expected recoveries at that time, so it is a really extreme scenario and, as my colleague has said, some other intervention would become necessary before getting to that point.

Q94 Mr Bacon: This crunch has already been described as worse than what happened in the 1930s. What I am getting at is: if this were to happen, and things went that badly wrong, it would be because of being hit sideways by economic circumstances rather than any misunderstanding of the quality of the assets that are already in the scheme. Is that right?

Tom Scholar: Yes. When we set the first loss, we expected it to be £60 billion. That subsequently came down to £57 billion. As my colleague said, we have reason to believe that that will come down further.

Q95 Mrs McGuire: We have been discussing 2099. Stephen Hester implied that he would see RBS staying in the scheme until 2012. There was a report in the Financial Times a couple of weeks ago that said that currently, RBS officers and officials from the Treasury were examining ways in which RBS could come out of the scheme this year. Would you like to comment? I am not asking you to comment on a leaked story.

Sir Nicholas Macpherson: First things first: I would love it if RBS could exit the scheme. It just takes another massive contingent liability off our books and they would have to pay us a fat fee to do it. If they did get to that point, it would be great. I saw the story, like you, and did not immediately recognise some of it. The public position remains 2012, so I think we should continue to operate on that assumption until we get new information.

Q96 Stephen Barclay: This is a wider question, really. On learning the lessons from this, I was interested in your estimates of what proportion of regulatory policy moving forward will come from the UK, and what proportion from outside it.

Sir Nicholas Macpherson: What the crisis has really underlined is just how integrated the world financial system is. National sovereignty is important, but you see it in the Basel group and in the Financial Stability Board, of which Tom is a member. To get international cooperation working really well is fundamental to achieving future stability.

Q97 Stephen Barclay: But as a proportion? The majority already comes from outside the UK, does it not? I mean the driver. We implement the directives in the UK, but the majority of policy already comes from outside the UK.

Tom Scholar: Yes, it does, and has done for many years. I think there is a greater push, of which the UK Government is very supportive, to have greater global adherence to global standards.

Q98 Mrs McGuire: I am interested in your answer to my question about the FT story. You said you did not recognise some of it. Which parts of it did you recognise?

Sir Nicholas Macpherson: I recognised that there was something called the Asset Protection Scheme and RBS. I am sorry; there is no inwardness to that statement.

Q99 Chair: I think that on the whole this is a report of a job well done within Treasury. We will see what the historical economists make of it, but clearly you have also built up within Treasury good expertise which, in the light of what we see at this Committee all too often, is a rare thing that you want to hang on to. My understanding is that they are all on civil service terms; no one is being paid huge chunks of City-style money. I can see the interest that can be excited in being around during the credit crunch. When things die down, will you hang on to them?

Sir Nicholas Macpherson: I hope we will hang on to enough of them. When we were doing the Asset Protection Scheme, we had literally 100 people working on it day and night-poring over the assets, doing the calculations and so on. Once the scheme was set up we handed it over to the Asset Protection Agency and we did not need those people doing that job any more, but you want to retain a critical mass of expertise. In the coming period, the regulatory system is going to be reformed again; indeed, as a result of legislation by the last Government, the Bank of England is now responsible for resolving banks. We had to resolve the Icelandic banks, Bradford & Bingley and Northern Rock. I will not trouble you with why that was the case, but the Treasury had to do that. Now the Bank of England can do it, so we do not need so many people operating in that space.

What the Treasury really need to retain is the ability to ask the difficult questions of our regulator. The bank will be responsible for regulation, but the Treasury needs to have sufficient expertise to be an intelligent interlocutor, and to take care of, and nurture, the system as a whole because we will remain responsible for legislation. Some perfectly good points were made during this discussion about where we might have done more; all of us have lessons to learn, but there are some people who are incredibly valuable. My friend here could command massive wages in the private sector. I think he has saved the taxpayer many hundreds of millions of pounds. He, like me, chose to forgo any bonus in the last year. Why people want to be public servants is an interesting question. All of you are public servants; you have taken the decision to operate in that space. I guess that is critical to the future of Britain.

Q100 Chair: But you really have not answered the question. I can see why people want to be around when the thing is happening; it is a life experience.

Sir Nicholas Macpherson: The Treasury is often criticised for being perhaps slightly elitist in Whitehall terms, but we are a very small institution, and to make it an attractive place to work, it kind of has to be elitist, because maintaining that expertise and ability is critical to the taxpayer and, I would argue, this Committee.

Q101 Chair: In the new regulatory framework, would it be more sensible if the Bank of England, through the NAO, was accountable to us in a more direct way?

Sir Nicholas Macpherson: As you know, the FSA is now going to be audited by the National Audit Office; the Prudential Regulatory Authority, the new institution, will be audited.

Chair: And the Bank of England?

Sir Nicholas Macpherson: This is a policy question. I think it would be inappropriate for me to say anything more, but my views given to Edward Leigh in the past are a matter of record.

Q102 Chair: Can you remind us of them, because I do not remember?

Sir Nicholas Macpherson: I do not think it would be appropriate to comment on a policy matter as a mere official.

Q103 Chair: Perhaps you could give me those views. are you saying that you gave those views to him in private? It is a matter of record.

Sir Nicholas Macpherson: I have always believed that Parliament’s role is critical. I have worked with this Committee and the National Audit Office to expand the NAO’s remit to the BBC and the Royal Household. I used to be the auditor of the Royal Household; now my good friend Amyas will be. I see the remit of this Committee and the National Audit Office as critical to value for money.

Q104 Mr Bacon: Sir Nick, a minute ago you said something very interesting about the culture and atmosphere of the Treasury and the kind of place it had to be in order to attract people. Without putting on the rose-tinted spectacles of hindsight, there is a view out there that there was a time when the Treasury, with its very flat structure and elitist approach, as you have described it, was a place that nurtured different schools of economic thought-a place where argument was actively encouraged, and there is a view that that, to a considerable extent, had become less the case; thus it became a less intellectually attractive place to work. Is there any truth in that? If so, do you seek to change it?

Sir Nicholas Macpherson: I do not recognise that. The economic crisis has forced the Treasury to take a very serious, hard look at how it works. Out of it, a lot of very positive things have happened. I would like to think that the Chancellor, whether it be George Osborne or Alistair Darling, was reasonably impressed by the candid and very open advice provided by officials, and by the capacity of Treasury officials to argue in front of Ministers, often with each other. I think the Treasury is a vibrant institution and I am determined to make it even more vibrant.

Chair: Thank you very much. We look forward to that vibrancy next week, when you come back.