Session 2010-11
Publications on the internet

To be published as HC 785 - i i

House of COMMONS



Public Accounts Committee

Banking support and Asset Protection

Wednesday 16 March 2011

Nathan Bostock, Eric Daniels, Stephen Hester and Tim Tookey

Evidence heard in Public Questions 105 - 217



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Oral Evidence

Taken before the Public Accounts Committee

on Wednesday 16 March 2011

Members present:

Margaret Hodge (Chair)

Mr Richard Bacon

Stephen Barclay

Stella Creasy

Jackie DoylePrice

Chris HeatonHarris

Joseph Johnson

Mrs Anne McGuire

Austin Mitchell

Nick Smith

Ian Swales

James Wharton


Examination of Witnesses

Witnesses: Nathan Bostock, Head of Restructuring & Risk, RBS, Eric Daniels, Former Group Chief Executive, Lloyds Banking Group, Stephen Hester, Chief Executive, RBS, and Tim Tookey, Group Finance Director, Lloyds Banking Group, gave evidence.

Q105 Chair: Welcome to you all, thank you for coming, and thank you particularly to Eric Daniels for making probably a last appearance -

Eric Daniels: One hopes.

Chair: -y ou hope, be for e a parliamentary select committee . I am going to start with a very general question. The Bank of England made this estimate of the cost of the subsidy to the UK taxpayer, so theoretical underpinning costs, and they came to £100 billion, across the banking system, as the 2009 cost to the taxpayer. From your point of view, as two leaders of two banks, what value for money has the taxpayer got for that £100 billion underpinning and some direct investment?

Stephen Hester: I might have a quick crack at that. Just a couple of comments: in my view there has been an implicit subsidy from Governments around the world to the banking system. It was not the UK alone; it was all around the world. The value of that implicit subsidy I think is impossible to accurately quantify-

Q106 Chair: So you do not accept the Bank of England figure?

Stephen Hester: No, I do not accept the Bank of England figures. I am not an economist and I am obviously not an econometrician, but research that we have seen, which I think will be published in the coming weeks, and I will provide you with a copy if and when it is, comes up with dramatically smaller figures.

Q107 Chair: Could you share with us what you think the figure is, because that is quite interesting. On the whole, one would accept the Bank of England’s-

Stephen Hester: I have seen figures that are less than a 10th of that amount. But my point is not that one figure or another is accurate. I would accept that there has been an implicit subsidy. One can debate the size of it; I believe it is much smaller.

Q108 Stephen Barclay: Have you published those figures that suggest it is less than a 10th?

Chair: They are publishing on Friday.

Stephen Hester: I have seen work in progress, but as soon as there is something that is finished we can certainly make it available. But the second point that I would make is that all of these figures are backward looking, however you would calculate it, and clearly one of the most important things that is under way is the reform of the banking system, such that it no longer has any implicit subsidy from taxpayers in any country, whether here or otherwise, and if one forward-projects the dramatic increases in capital for banks in liquidity and the other reforms like living wills and resolution, I believe that we will get to the place that we should be at, where there is no longer an implicit public subsidy, and we are certainly very supportive of that being the case.

Q109 Chair: The job of this Committee is to follow the taxpayer pound and to assure the public that we have had value for money for the investment of that taxpayer pound. The figure that we have been working with is £100 billion-let’s not quarrel about the figure-but whatever it is, £10 billion is still, were that correct, a fantastically substantial amount. What value has the taxpayer had out of both the implicit and explicit investment that we have made since the financial crisis?

Stephen Hester: Again, I think that there are many different ways to attack that issue. Of course there are series of direct and ongoing receipts that the taxpayer has had through fees paid to the Bank of England and to the Treasury for explicit liquidity support: fees paid on the Asset Protection Scheme, and so on. Hopefully there will be handsome returns from ownership of the shares of RBS and Lloyds, but that is obviously to be seen in the future. Over and above that you then move into broader societal issues about whether the functioning of the financial markets has a benefit to all of society or not, and I think it does.

I want to be very clear: my point is not that you can do a mathematical calculation and say, "All is fine." My point is the contrary: all is not fine, such that reform is needed, such that these implicit subsidies disappear, however you might argue about the numbers.

Eric Daniels: On the methodology that I understand was behind the £100 billion number, I would somewhat agree with Nick Macpherson who said it depends on the day that you do it.

Q110 Chair: It is a 2009 figure. For 2008, the Bank of England said it was a £10 billion implicit and explicit subsidy, total subsidy. But 2009, it was £100 billion. So they looked at calendar years.

Eric Daniels: The way in which they approached it was to look at the difference between the standalone rating and the cost associated with funds as a standalone institution versus the support rating. They took that differential and used that as the basis for the calculation. What I would say is that no bank today, or during 2009, was able to raise money at the support rating. The actual cost of funds to the bank was at the standalone rating. I think the idea that using that differential to calculate the socalled subsidy is simply not correct. I challenge the assertion.

Q111 Chair: Accepting the challenge, nevertheless we all accept that there is a substantial investment by the taxpayer in supporting the banking system during the banking crisis. Did the taxpayer get value?

Eric Daniels: I think I can only repeat what Stephen said, that the explicit support that was given-whether it was liquidity support in the form of CGS or SLS-was, in fact, at very attractive rates for the taxpayer. The investment in the equity of the banks, as Stephen said, remains to be seen, but I think we all believe that the taxpayer will get a very handsome return for that investment.

Q112 Stephen Barclay: Just sticking with the Bank of England research, that also commented that the dominant influence in the lack of lending to companies was the reduction in the supply of credits by the banks. Do you accept that finding?

Stephen Hester: That would not be the data that we have. I think that the data that is pretty consistent all around the world is that post-recessions, what happens-in the generality, of course; there are individual cases that are different-is that people try to get their borrowing under control. Savings rates go up, deleveraging happens, borrowing goes down, and so in every industrialised country around the world you saw an increase in savings rate, a paying back of borrowing as people desire to be more conservative, and I think that is by far the dominant effect on the lending.

Q113 Stephen Barclay: Absolutely, the Bank of England cited a number of factors, but within those various factors they said the dominant one was the one I cited. Given that they have access to a wider data set than you do, and they can request your data, and they can request data from the regulator, why do you think, in your opinion, the Bank of England got it wrong?

Stephen Hester: I do not think my position here is to per se criticise the Bank of England, and indeed I do not have in front of me line by line, if you like, the report that you are citing, with all its context, but all I can say to you is I believe that the dominant influence-not the only influence, but the dominant influence-in the reduction of lending has been people’s desire to borrow less in the context of an uncertain economic outlook.

Q114 Ian Swales: On this topic, Mr Hester, you talked about the implicit subsidy, based on the Chair’s first question, and you seem to be suggesting in one of your remarks that you would see, in effect, that disappearing. Now, as I understand it, one of the main factors behind that is the Government standing behind deposits in the banks, and in effect standing behind international operations as well as UK operations. When you say you see that disappearing in the future, by what mechanism do you think that is going to happen?

Stephen Hester: The mechanisms, if you like, that are under way-well advanced, in fact-can possibly be divided into two categories. The first is banks holding huge amounts more capital and liquidity reserves, quite properly-obviously I am not here to defend the past, since I have only been in post two years-and that means that the likelihood of banks needing external support once those reforms have been fully worked through, the Basel III process, dramatically falls. Then secondly, there is a huge change in what happens in the less likely circumstance that a bank nevertheless fails in the future.

What the last crisis unveiled, and I have spoken about this a number of times in advocating reform, is that it was quite hard to pass on losses, pass the shareholder to creditors, which is normally what would happen in any other company, and the state found itself jumping into the middle. There are a whole series of parts of reform around things called CoCos and things called bailins-sorry to use technical terms-resolution mechanisms, changes in legislation, living wills. There are a series of things in this category that the world’s regulators are advancing, designing and changing, such that in a future crisis not only would a bank be less likely to go under because they had more strength to start with, but there then would then be a smoother recourse to creditors, as opposed to Governments, and not the need for Government intervention.

So the combination of those, plus banks managing themselves, learning from the crisis, getting out of risk position, should get us to the position where Government support of the capital variety, is not needed. There will always be a role for central Bank liquidity support, but there should not be a role for capital support, and that is why I have always advocated that these reforms take place. I think we are going in absolutely the right direction, and as they bite that will be the result.

Q115 Ian Swales: On a specific, then: retail depositors. Do you see the Government’s scheme to support retail depositors disappearing in this new world that you are describing?

Stephen Hester: Obviously retail depositors, or the retail deposit insurance, is funded by the banks through levies. That is true here, it is true in the United States, but I cannot speak for every country. So although the Government can offer an overdraft, in the end it is the banks that pay for that scheme. My guess is that scheme will stay; you could argue for its enhancement, but it has already been enhanced. You can clearly have a debate about its size, but quite properly it is paid for by the banks.

Q116 Chair: I want to get you back to this value to the taxpayer. I want to get you back to the value. You believe you have value in the sense that you are paying for the money that we, the taxpayer, are lending you. One of the aspects of the deal, and it would be good if you could both answer this, was that we wanted to keep lending going, both mortgage lending and business lending, and both of you abysmally failed in 2009. RBS was £22 billion short on the business lending and Lloyds £8 billion short, on the figures that we have in front of us. 2010 looks a bit better, but only because we have changed the goalposts, so instead of looking at net lending we are looking at gross lending. I would have hoped one of the ways we could measure value for money for the taxpayer would have been your role in securing growth in the economy, particularly through the SME sector. Why did you fail, and in that context how do you expect us to say you have given value for money?

Eric Daniels: I think I would characterise our performances somewhat differently. I am very happy with the performance of Lloyds. We extended over £30 billion of new mortgage lending during the past year. We have helped over 50,000 first-time buyers. We have lent approximately £44 billion, I believe, to corporations and small businesses-£11 billion specifically to small businesses. We in fact exceeded our commitments to Government during this past year.

Q117 Chair: Only because the goalposts have changed. I am sorry to interrupt you on that, but when the targets were first set they were net targets-that was 2009-and you both failed abysmally in 2009, which was a key year for growth. In 2010 you are doing better, I accept that, but only because we have changed, and presumably in your negotiations with the Treasury, you are now on gross targets, which I do not think are a terribly helpful measure, but I accept that they are the measure that has been set.

Eric Daniels: I think that I would give you two responses. In the first place, we increased our net lending to businesses during the year, so this is not something where it is simply chicanery.

Q118 Chair: What is your net lending to business in 2010? I have it down as a negative.

Eric Daniels: I believe it is positive. I do not have the number to hand.

Q119 Chair: What is it? Does Mr Tookey know?

Tim Tookey: It was positive overall.

Q120 Chair: What? A billion or something? I think our advice from our officials was it was still a negative.

Tim Tookey: I can confirm it was marginally positive on a net basis-

Q121 Chair: Can officials help?

Tim Tookey: -for SMEs for year two.

Q122 Stephen Barclay: Just whilst they are helping, can I just clarify that gross lending to a company can go up, whilst the actual money the company gets , the net lending , goes down? In other words, if I have a first loan with you worth £1 million, and that is under an existing loan agreement and I pay that back, because of the fee structure in terms of that loan, and I take a second loan from you worth £1.5 million, probably with higher fees, charged with more security, you would present that as gross lending of £1.5 million, but the actual money that I as a company would have from you would be £500,000. Do you accept that going to gross lending, which is the target for 2010/11, can give quite a misleading position as to the amount of the bank’s money that has been placed with a company?

Eric Daniels: No, I do not believe it is misleading at all. I think it is a very accurate representation of the banks’ willingness to lend. The distortion that the net lending figure causes is, as Stephen pointed out earlier, in a recovery period, when you often see demand for lending go down a great deal, and so you see a lot of repayments. Companies want to get their balance sheets in order. What we see are two factors: one is lots of repayments among midsized companies, and among big companies not only repayments but also going to the capital markets directly. So increasing gross lending in that kind of environment I think speaks very well to the banks’ willingness to lend.

Q123 Stephen Barclay: Did you not make those points to the Treasury when they set the target?

Eric Daniels: There were lengthy discussions with the Treasury when we set the targets.

Q124 Stephen Barclay: So some of those criteria would have been factored into the original target that was set?

Eric Daniels: No, I think that the original targeting was done at the very last minute of a very complex process , so there was really no thought and no real -

Q125 Stephen Barclay: So you signed up to them with very little thought having been put into them?

Eric Daniels: No-if you will let me finish please. This was after a very complex negotiation on GAAPs. At the 11th hour we were asked to commit to lending targets, which we did, but we also caveated those, because we were not given enough time to negotiate thoroughly. We basically agreed that it would be subject to demand-the demand had to be there-it was subject to liquidity, subject to having capital, and subject to creditworthiness. Those were the four conditions, and that was the agreement that we struck. It was not a lengthy negotiation: again, there was no time.

Q126 Stephen Barclay: I t strikes me that there are relative priorities: on the one hand, the Government are saying they want you to lend more. On the other hand, every financial services party is saying they want you build your capital base up . The Bank of England is saying they want you to repay them more quickly, and your own remuneration is saying , "L et s get the share price up, because that is what the bonuses will be paid on. " W hat is unclear to me is how you assess those relative priorities , or is it your argument that you can do all four at the same time?

Eric Daniels: Is there a question there?

Q127 Stephen Barclay: There are four different priorities there. One of those, which we are just looking at, is the lending priorities, which you have missed on the commercial lending. I am trying to understand how you prioritise the lending priorities vis-à-vis what strikes me as different priorities that have been set-your own internal remuneration priority for staff, compared with some of the Government’s other objectives and the regulatory objectives, which are pushing in other directions. How do you prioritise those different issues, or are you saying that it is your expectation you will deliver all four at the same time?

Eric Daniels: I think you need look no further than last year. Last year Lloyds repaid some £60 billion of Government funding, first, increased its gross and net lending, increased its share price, working for the shareholder, and what was your fourth?

Q128 Stephen Barclay: You have regulatory pressure, Bank of England pressure, Government pressure and your own -

Eric Daniels: Sorry, we increased our capital by 25% from 8.2% to 10.2%

Q129 Chair: Can I get an answer on that lending issue, because my note now tells me Lloyds did have a positive-apologies for that-but RBS had a negative on the net.

Stephen Hester: Let me take up your points. I think the first point is that we should be very clear that since I have taken the helm two years ago RBS has done everything it can and continues to do to support its customers in the UK, and is, as a consequence of those efforts, not only lending very large amounts of money but substantially in excess of our national market shares, as was shown on the Merlin figures that were published last month.

But if I could shed some light on an important apparent misunderstanding, the lending commitments were legally binding commitments, and if we had failed under them we would, could and should have been sued by the Treasury. My understanding is that the Treasury concluded there were not grounds to do that; i.e. there was no breach of them. I am not surprised that there was no breach of them, because I was heavily involved in the discussions at the time, when I had just arrived, with the last Government, which was obviously concerned to ensure that the recession was not exacerbated by a lack of confidence in financing markets.

Q130 Chair: There was a breach. I am really sorry to stop you, you can finish, but there is just this-

Stephen Hester: I am trying to explain, so I hope it will be helpful to you. The key concern of the Treasury and Ministers at the time was that there would be a disappearance of foreign lenders in the UK market and an artificial credit crunch as a result of the disappearance of people who were previously lending a lot of money, and that artificial withdrawal of funds would make the recession worse. That was the concern. What the intervention with Lloyds and RBS was designed to do was to give reassurance that, if the foreign banks all disappeared and if credit demand continued at a very high level, there would be adequate capacity from the domestic banks to make it. The way that the targets-at least I can speak for RBS-were calculated was on a back of the envelope assessment, on short notice, by the Government and Treasury, of the kind of figures that foreign lenders represented, what the gap in the market might be if demand did not go down and foreign lenders disappeared, and therefore what increment might be required. Therefore, we said that we would lend up to this amount if there was a demand on creditworthy terms. Now, in fact what actually happened was two things: number one, demand, as it did in every other country and as it does in every other recession, in fact fell-it did not stay at the high levels; and secondly, foreign lenders did not leave the market in anything like the quantum that was feared. Those were good things, and as a result the lending commitment was met, but was met without the full amount being required, either by borrowers or through the complete flight of foreign lenders, so that is in fact what happened.

Chair: Nick wants to come in. We are going to have a vote in two minutes. Do you want to do it before the vote or after?

Q131 Nick Smith: Very quickly: in both of your introductory remarks, Mr Daniels and Mr Hester, you talked about a handsome return for the taxpayers owning RBS and Lloyds’ shares. What is your latest estimate on what that handsome return will be?

Eric Daniels: I do not believe that we can call the-

Q132 Nick Smith: I am sorry, I cannot hear you. Can you speak up?

Eric Daniels: I do not believe anyone can call the stock market in what will happen in the future. I think all the signs are very good: Lloyds share price increased quite dramatically last year as we returned the bank to profitability. I would hope that, as we continue to enhance profitability, the share price will continue to rise.

Q133 Chair: So you agree with John Varley that there is nothing-it sounds to me as we draw this bit to a close-for you to apologise for?

Eric Daniels: I beg your pardon?

Q134 Chair: You agree with John Varley, Barclays, that there is nothing to apologise for? It sounds to me, out of all this, that you are feeling fairly confident; you feel there is nothing to apologise for.

Eric Daniels: I am not sure I can draw the connective tissue from one statement to the other, but if you ask me in general, are we remorseful, or is there a cause for concern in what happened during the banking crisis, I would say absolutely yes. We had clearly a lot of shareholders who were dependent upon our dividends. We clearly have not paid a dividend, and that is disappointing.

Q135 Chair: Taxpayer? We are here representing the taxpayer.

Eric Daniels: Again, as I stated earlier, I believe for the liquidity support that was granted, the CGS and the SLS, the banks paid at or above commercial rates, so the taxpayer did very well. In terms of the GAAPs, which I understood was the primary subject of discussion today, in the case of Lloyds, we never formally entered into the programme, yet we paid £2.5 billion to the taxpayer to get out of the agreement, so I think the taxpayer did very well indeed on that.

As for the shareholding, I think I answered that question. I believe that as our share price continues to go up, and the bank continues to become increasingly profitable, the taxpayer will do very well indeed.

Q136 Nick Smith: Mr Hester, can you answer my question please, as we seem to be going through the middle of the banker’s fight back here: have you got an estimate on what the taxpayer’s "handsome return"-your phrase-will be?

Stephen Hester: Obviously we have put out details of the fees we pay, but in terms of our future share price I am afraid I am actually legally not allowed to forecast it, nor is it prudent for me to do so, so I am afraid I cannot give you a share price for the future. Of course then it is not in our hands, not just what happens to the stock market, but whether, how, when and in what manner the Treasury, through UKFI, decides to dispose of the shares, so I cannot.

Q137 Stella Creasy: Mr Daniels, can we come back to what the taxpayer can expect? When you do expect Lloyds to be paying corporation tax?

Eric Daniels: That would be a profit forecast, which I certainly cannot give you. What I would say is that Lloyds is well on its way to absorbing the accumulated losses, and nothing would please me more than having Lloyds pay corporation taxes.

Q138 Stella Creasy: So when do you expect to be profitable?

Eric Daniels: We are in fact profitable.

Q139 Stella Creasy: And yet you are able to defer that liability for corporation tax.

Eric Daniels: I beg your pardon?

Chair: We are going to go do a vote, and then we will come back and pick it up. I am really sorry that it gets interrupted in this way: it always provides a difficult session. But we will get into it when we come back.

Sitting suspended for a Division in the House

On resuming-

Q140 Chair: A pologies for that . We had a couple of votes, which is very disruptive, but that is how the cookie crumbles. I just want to get back to this issue of value to the taxpayer, which is our remit, which is why we are focusing on it. You have both really justified that you believe there has been proper value to taxpayer s from the fees paid in the schemes in which you have participated. I hope you have had a chance to look at the Report that formed the basis for our inquiry. Have you had that? I am assuming that that has been distributed to you. We have taken evidence on that from Treasury officials: Tom Scholar, who presumably you have dealt with a lot. In his evidence and in the Report, if you have a copy of it, both the Report and his evidence state that the fees were well below commercial prices to get the stability and confidence back into the market. Quite proper good objectives, but nevertheless below commercial charges. Let me just see what he said; this was in evidence to us: "If you look at what subsequently happened to the commercial price of providing a similar guarantee, yes it is true, as the Report says, that the commercial price remained higher for longer than people were expecting." So the price that the Government was charging was lower. If you accept that, and I see that Eric Daniels is frowning, but if you accept that, how do you still come forward and say that you think that there is proper value to the taxpayer-that we have been properly rewarded out of the Credit Guarantee Scheme, for example?

Eric Daniels: If I may, Lloyds never entered into GAAPs: we simply paid to leave the agreement that we had made in March, so I think the taxpayer got a very good deal.

Q141 Chair: And what about you? You are well into it.

Stephen Hester: Of course. Forgive me, because at different points, I thought we might have been talking about value to the taxpayer from different things: obviously the Bank of England numbers, the price at which shares were subscribed, or the Credit Guarantee Scheme, but as I understand you now, you are talking very specifically about the Asset Protection Scheme.

Q142 Chair: I am now focusing on that.

Stephen Hester: Got you. With respect to the Asset Protection Scheme fees, I think truthfully there was no-and indeed is no-private-sector equivalent insurance policy that was viable at the time that would allow you to say that the fee was high or low against something that was demonstrable. So by definition it is a matter of opinion. Clearly the board of RBS recommended entry into the scheme, and as a matter of legal duty could not have done so if it felt that the scheme in the round, in all of its terms, was wrong for its shareholders-82% of whom are of course, in the circular process, the Government-and so in that sense we did not feel that the fees were inappropriate.

But what I would say is that the Asset Protection Scheme, we believed at the time we entered it, and we said so publicly, was unlikely to cost the taxpayer anything. The taxpayer, we thought, would make a profit. At every stage of reforecast, that continues to be our view. I believe it is also the view of those concerned in the Government, and that is entirely appropriate; it was an insurance policy and I think the taxpayer should make a profit out of it. I have no complaints about that, but it continues to be the case, and as I say I think the taxpayer will make a profit out of that scheme, but I cannot tell you that there was a definite market price which the fees were higher than or lower than; there was not. So it was one entered into by both parties at the time.

Q143 Chair: And the Credit Guarantee Scheme, where, if I just read from the Report-I will try not to read the lot-"the fees charged to banks under the Credit Guarantee Scheme to guarantee new wholesale debts were designed to be on a commercial basis, but not so large as to prevent banks from using it, but sufficient to provide a reasonable return … However, we estimate the benefit"-I am skipping a bit, so apologies for that-"is substantially more than £1 billion."

Stephen Hester: If you mean the benefit to the taxpayer, I do not know, but I know the taxpayer has made a big profit on it.

Q144 Chair: I think it was to the banks. That is the benefit to the banks.

Stephen Hester: I know that the taxpayer has not had to pay any money at all under the Credit Guarantee Scheme, and the taxpayer has received hundreds of millions or billions-I do not know the answer, but a lot of money-in return. But again, I think that was entirely appropriate, because the taxpayer was providing a guarantee, and you are correct to say that the guaranteed fee-

Q145 Chair: It provided you with cheaper money.

Stephen Hester: -was calculated in order to represent market prices. But it is also true that that guarantee was not otherwise available from someone else, and so one can have a debate about whether the market prices were theoretical or not.

Q146 Chair: But it allowed you access to wholesale funding at a cheaper rate. Or probably wholesale funding full stop , and then wholesale funding at a cheaper rate.

Stephen Hester: No, the cost of the wholesale funding plus the guarantee cost was calculated such that it was equivalent to the notional cost that you would have otherwise borrowed without that guarantee. However-and as a consequence the taxpayer has made a profit-what I am saying is that we are dealing in notional cost, and in fact that borrowing would not have been available in those amounts, and therefore it is impossible to know the counterfactual of what you would have borrowed at actually as opposed to theoretically.

Q147 Stella Creasy: So you disagree with the Treasury, who acknowledge this subsidy and are reviewing the fees?

Stephen Hester: If we are talking about the Credit Guarantee Scheme-

Stella Creasy: Yes.

Stephen Hester: -I do not know whether I am disagreeing with the Treasury or not.

Q148 Stella Creasy: The Treasury recognise that they have subsidised you to the tune of a billion pounds.

Stephen Hester: I am saying to you that the Treasury has made a profit, and the value of the guarantee was set in a way that was designed to be market priced. However, there was a degree of theory as opposed to practice to that because it was impossible to test, and indeed it is entirely probable, within the market conditions of the time, the theoretical prices would not have pertained, and so that is what I am saying to you.

Q149 Stella Creasy: So there was a subsidy, then, essentially of a billion pounds? You would accept that it was not value for money for the taxpayers?

Stephen Hester: Did the taxpayer make a profit? Yes. Was it calculated in a theoretically accurate way? Yes.

Q150 Stella Creasy: Did you get a good deal?

Stephen Hester: I think that the banks needed that support. The banking system needed that support.

Q151 Stella Creasy: So it was a good deal for the banks. But from our perspective, in terms of the value for money of the deal that was done, and the acknowledgement of the Treasury that it needs to be reviewed because it essentially represented a billion pound subsidy to the banks-

Stephen Hester: I think just because one side thinks it was the right thing to do does not mean to say it was the wrong thing for the other side. It could be right for both sides, and I would submit to you in this circumstance it has been right for both sides.

Q152 Stella Creasy: So you think it is right for us to subsidise the banks to the tune of a billion pounds in the Credit Guarantee Scheme.

Stephen Hester: I do not recognise that figure; what I am saying to you is I think it is right that the taxpayer has made a substantial profit out of this scheme, because the taxpayer was giving something valuable to the banks. Theoretically that was priced on an arm’s length basis. Whether in reality, and by what amount, it was not, I do not know.

Q153 Chair: I have to say that I think you have to take a very narrow view of profit, because the wider impact of the banking crisis can hardly have been a profit. Can I move back to lending, because that was where we were? I just wanted to clear up that point. You both feel that you are lending well now. I have some quarrel with the way the target has been devised. Also, I did not want to intervene too much on you, Mr Hester, but I do have some quarrel to say you did not meet the target set in 2009. Okay, nobody took action against you, but you did not meet it. Recently we have had the Engineering Employers’ Federation report, which I assume you have seen and we have too, which accepts that cash is beginning to flow, but what they have said is that about a third of their companies are finding that the costs of borrowing have increased substantially, particularly-and this is the interesting thing-in the last couple of months. The impact will be more on SMEs than it will be on others, the larger FTSE companies, who can raise it through bonds and equities. Again, going back to our remit, the taxpayer’s interest, the deal is taxpayer puts money in, and what we hope to get out is better lending to businesses, and particularly the SME sector. What is your comment on the Engineering Employers’ Federation finding?

Eric Daniels: I do not really have much to comment on; I disagree with it. The cost of borrowing for SMEs has not been this low for many years, and what we are seeing is, in fact, some increase off very low levels, which reflects the higher cost of funding for the banks. As we all know, the markets, over the past year, whether it was last May, last September or more recently in February, got quite jittery when the possibility of contagion from Greece, Spain or Portugal and so on was looming. So the cost of funding for the banks has gone up, and that is reflected in some part-not across the board, but in some part-in new lines and facilities for our customers.

Q154 Chair: Do you want to add anything?

Stephen Hester: The average cost of SME loans that RBS made last year was 3.5%, and, as Eric says, that of course, by historic standards, is extremely low. What is true is that relative to base rate there have been some changes, but if I can draw an analogy perhaps apposite to the moment, it is a bit like petrol prices going up, and the reason petrol prices have gone up is because the cost of buying oil, out of which petrol is made, has gone up. Exactly the same thing has gone on for banks: the costs relative to base rate for banks to get money has gone up, and so consequently that is passed on, even though the absolute rates are historically low.

Mrs McGuire: O n this s ubject, I would quite like to just do a very quick follow up on what has just been said.

Chris Heaton-Harris: Mine is as well.

Mrs McGuire: Alright then.

Q155 Chris Heaton-Harris: It might even be the same thing. First of all, thank you for coming, because it is not often a group of politicians meets someone less popular than themselves, so it is really kind of you to give us that sort of charitable feel. It is really a question to you, Mr Hester. I imagine most of us around this table have had constituents and companies write to us, small businesses especially, who are having problems securing loans, and in 2009 Peter Ibbetson, who is your Small Business Chairman, said that 93% of SMEs are currently able to roll over overdrafts at RBS at the same or lower rate. I was wondering, if he measured it then, what is that measure now?

Stephen Hester: I do not have the precise percentage. I do not think it has changed a lot, but I am very happy to write to you afterwards to confirm that. But our overdraft price promise, which I think is the primary component of what was put in, remains in place.

Chris Heaton-Harris: I am happy to pass over to Anne.

Q156 Mrs McGuire: I would just like to question the 3.5% average. Obviously Mr Daniels did not give us a figure for Lloyds’ average lending to small companies. Frankly, 3.5% lending to small businesses does not chime with what we are hearing out there, and I am wondering whether or not there are other costs that need to be taken into account when small and medium enterprises are trying to access finance. I do not have permission to reveal some of the details here, but certainly the small businesses in my area did not give the impression-and it has been verified with your bank by me, through questioning the bank-that 3.5% was anything like what they had been asked to pay. Are there fees, or have the fees gone up? Have the securities that have been asked for gone up?

Stephen Hester: Clearly the figure I gave you was an average, so there will be some above and some below. You are correct to say that for some kinds of borrowing, in addition to that there can be fees associated with taking out the loan, or whatever it might be.

Q157 Mrs McGuire: Have those fees increased?

Stephen Hester: And those fees, probably on average, have increased.

Q158 Mrs McGuire: Once, twice? 50%, 100%?

Stephen Hester: I think I can say with great certainty that, even when you take account of fees, the average cost of borrowing for SMEs is amongst the lowest it has been in decades. However, it is higher relative to base rate than it was, for the reasons that I have sketched out. Another way to think about it is, if you like, are the banks profiteering? In other words, are the banks taking, somehow, an inappropriate margin out of the middle between their cost of borrowing and the others?

What I can say, again, is we publish our figures every three months on this, and if we take our Corporate Lending division, our UK division that lends to businesses of all sizes, the return on equity of that division has obviously been loss making through the recession and very low, and so is not a good advertisement for our shareholders, but has now got back to below our target, but roughly to 12%, which we think is roughly our cost of capital. So you can see no evidence either on the bottom line of profiteering, or indeed on the average for businesses. But it is certainly the case that, in the same way that petrol prices have gone up, bank input prices have gone up, and that gets passed on through different means. It has to be.

Q159 Mrs McGuire: So if I say to you that a farmer in my constituency came to me who had previously had an arrangement fee to sustain his overdraft, or to maintain his overdraft, increased from £500, I think, if my memory serves me correctly, to almost £5,000, that would not be considered profiteering? I have to say to you, one of the arguments that is constantly put to Members of Parliament is that as a taxpayer I own 83% of this bank, and people feel that those dramatic increases in arrangement fees are perhaps hiding the true costs of borrowing.

Stephen Hester: As I said, I think our numbers are very transparent, and you could look at them every three months, we publish them as to what our profits are, and what that is in each of our business lines, so you can see the aggregate. Of course, that does not tell you the answer for any particular borrower, but you can see what the average is. And again, using my petrol price analogy, petrol prices have gone up fast and a lot, but that was because oil prices went up fast and a lot, and exactly the same has happened with the cost of borrowing for banks, which in turn is, if you like, our goods that we sell to customers in the form of lending.

Q160 Mrs McGuire: But they have not gone up 10 times. An arrangement fee from £500 to £5,000 sounds to me like a tenfold increase.

Stephen Hester: As I said, the total cost of banking services in lending is lower than it has been in decades

Q161 Chair: Mr Daniels, do you want to add to that at all on this exchange?

Eric Daniels: That is a very complete answer.

Q162 Mr Bacon: We have heard different Members from different parts of the country. In my own constituency, which is in East Anglia, in Norfolk, I met with the Federation of Small Business on Monday morning, and the predominant theme that I was told about-it was really for them to talk to me, rather than me give them a speech-was the difficulty in accessing bank lending.

Austin Mitchell: The same here.

Mr Bacon: When I was first elected in 2001 that was not the case. I did not get business people banging on my door about that, nor in 2002, nor in 2003, and so on until the banks between them crashed the whole world in 2007/08. Obviously there have been huge problems since then-we are all trying to get out of the mess, you are all trying to get out of the mess. I do appreciate that you are being told to do things that are contradictory. I think Mr Barclay alluded to this earlier: you are being told to lend more; you are also being told to conserve your capital-your natural instinct, I suppose, is to protect your capital if you are not sure about the quality or the value of your assets-and you are also being told to strengthen your capital and improve your balances sheets, and it is very difficult to do all of these things simultaneously. In fact, some of them are obviously completely contradictory. But nonetheless it is the case that you are saying that there is a lot of lending happening, and we are all getting the message from different parts of the country that it is very difficult for business owners to access the loans that they need.

I had one example of an individual who set up a business three or four years ago. He found it easier to access money then, when he was setting it up, than he does now when it is successful, cash generative, and he wants to invest in equipment because it will help him to get leading edge, blue-chip customers and help him to grow and possibly take on more staff. Why is there this disconnect between these two world views? Mr Daniels, do you want to start perhaps?

Eric Daniels: I think that we have a couple of things to look at. One is: what is the real demand for credit? I know there are a lot of anecdotal stories, and if there is a particular member of your constituency that has an issue with Lloyds, I would very much appreciate it if you would write to, in this case, Mr Tookey, but we would be very anxious to hear about that in Lloyds. But I think if you look at the evidence it says that the actual overdraft usage or line utilisation usage-so in other words, we extend the line of credit and you can draw it down any time you wish to-is actually falling. So this is already preagreed, there is a preagreed price for it, the facility is there, but customers are not drawing down; they are drawing down less than they did before. So that says something about demand.

The other thing that I would tell you is that, if we look at the market in 2006/07, which you alluded, to when your constituent was starting up, we had an awful lot of flaky lending in the marketplace. You need look no further than Ireland or Iceland or some of the continental banks that were very much in the SME market in the UK. They were in the mortgage market. It was a lending freeforall. So covenants came down, conditions were almost nonexistent, pricing was ridiculously low: that is not an appropriate way to bank. What was happening was we were seeing an awful lot of competitors-especially not the main competitors-changing conditions and changing the market, and an awful lot of people who probably were not really terribly creditworthy, and if we had been sensible as a society we probably would not have allowed them to get into debt. It was not good for them, it was not good for the economy and it certainly was not good for the banks. But that was the frenzy that we were in. Today we have hopefully all learned lessons. We have returned to some much more traditional practices and rules around prudence.

Q163 Joseph Johnson: A question to Mr Hester and Mr Daniels please. You have both, to a greater or a lesser degree, got the dead hand of the state gripping the entrails of your respective organisations. Mr Hester, you have been quite explicit in recent weeks in identifying a certain amount of talent flight from your organisation. I would be interested to know to what extent you feel that is due to the large Government shareholding in your organisation.

Stephen Hester: This is in some ways a difficult position, because I think we need to be crystal clear that RBS would not be here today were it not for support from the state, and so while some consequences go with that, I think it would be entirely unbalanced to not start with that recognition and say, if there are some consequences, the outcome is worth the consequences. So that would be my first answer.

The second point I think is that all businesses, whether or not they are owned or partly owned by Government or by the state, I think have a duty, and it is good business practice, to try to be sensitive to the environment in which they operate, the communities that they serve, and there are sometimes tradeoffs in doing that, and I would like to think that a number of those issues would be true of us whether or not we had compromises, if you like, and whether or not we had state ownership. But in a sense there is a time for everything, and I think what I would say to you is that the time, I believe, is fast approaching when the benefit to both the state and RBS of the state privatising increases. Clearly the state can use the money in terms of budget deficit, and in terms of the symbolism of economic recovery that a privatisation would represent. In the case of RBS, there is the worry that RBS is somehow subject to different, more conflicting and more complex requirements than all of its competitors. So I think the right answer to this is not to, in a sense, bemoan the past-far from it, we have to be grateful for the past-but more to say the right way going forward, the winwin, is to advance privatisation when that is possible.

Q164 Joseph Johnson: Can I put the same question to Mr Daniels, please?

Eric Daniels: I do not believe that we have lost significant numbers of people. We have a natural attrition in Lloyds of somewhere around 10% of our people per year. We are not seeing anything really remarkably different from that.

Q165 Joseph Johnson: Great . T he follow up question to both of you is what top rate of personal income tax do you think is consistent with London maintaining and perhaps enhancing its position as one of the world’s important financial centres?

Austin Mitchell: It is an optional question.

Eric Daniels: I would not begin to know how to answer that question.

Q166 Joseph Johnson: You do not have a view?

Eric Daniels: I could not begin to answer it.

Q167 Joseph Johnson: In what sense?

Eric Daniels: I have never studied it; I do not have a basis to offer an opinion. I think it is a complex subject, and if I were to give you an answer, it would superficial at best.

Q168 Mr Bacon: How much truth do you think there is in the point-made by a parliamentary colleague of mine who used to be a swaps trader for many years-that a lot of this bonus culture is nonsense in the sense that lots of people would not leave London because they like London too much. London has too much to offer compared with virtually everywhere else. If you are out in Geneva at eight o’clock in the evening it is dead; there is nothing to do. Whereas in London there is plenty to do, everything to do, and it is one of the world’s greatest cities, and that in itself has a centripetal force that is probably more important than bonuses, and the talk that somehow you have to keep up the bonuses at the right level, otherwise everyone will suddenly up sticks and get on a plane, is overstated.

Eric Daniels: Is there a question?

Q169 Mr Bacon: Yes, the question is do you think it is correct that that is overstated?

Eric Daniels: I think that that may not be the right measure. I might ask, "How does change happen?" It rarely happens with the bank: it happens over time and it happens on the margin. What we do know is that a particular bank hired more people in Singapore last year than they did in the UK. If you look at the rise of the Dubai financial centre, again, you are seeing more and more jobs going over there. It is not the middleaged derivatives trader who has two kids in school and so on: it is the young, up-and-coming 25-, 28-year-old who is looking to build a career, and they see that their prospects are brighter elsewhere.

Q170 Mr Bacon: So you m ight not see it other than almost imperceptibly, but if you look back on it several decades later, you might suddenly realise there had been a very big change.

Eric Daniels: Yes.

Q171 Jackie Doyle-Price: I am just reflecting on what you particularly said, Mr Daniels, about the fact that risk had been in the price for many years in the run-up to the banking crisis, and that is what got us into this mess, and looking also at the targets and the caveats you have placed on it in respect of demand and creditworthiness. Where that takes me is, I am reassured from a taxpayer value-for-money point of view that the taxpayer is not just going to be standing in there supporting poor credit risks. But in that sense, to what extent are those targets having any meaning at all? For you, are they targets, are they aspirations, and how confident are you that you will meet those lending targets for businesses particularly?

Eric Daniels: I am absolutely confident I will not since I am no longer in the chair.

Q172 Jackie Doyle-Price: As a sector then, how confident, looking at it-can I then conclude that they are meaningless?

Eric Daniels: I think that question might be better asked of Mr Hester, who has something to do with it.

Stephen Hester: I think that the job of maximising support for customers in the UK is one that, in any event, the banks should be doing the most on because that is their business, and I believe the banks certainly-it is true of RBS-are doing even more than perhaps in any event they would be in response to the obvious needs of society, one manifestation of which is the political dialogue and the lending commitments that are associated with that. We can see that as an example in the context of RBS’s market share, but I see that every day in our internal workings.

What, however, is unfortunately the case for those who would like a neater world is that no one can tell you today what amount of borrowing UK business can usefully use in the coming year, and we do not have a centrally planned economy, and even if we did I do not think you could answer that question. It is of course the case that an element of what is being done is to build confidence. I think this is a crucially missing bit of the dialogue: crucial to economic growth-and the UK is in trouble if we do not get economic growth-is confidence. There are lots of bits of confidence: a piece that the banks can help with is the confidence that if people have a good proposition, a bankable proposition, that money is there and people are trying to help them now. Banks have many flaws, there are many individual cases where I am sure they can do better, but I do think that we take it very seriously that it is our job to first give people confidence and second to back that up with substance where it is bankable. What we cannot do is, in a centrally planned way say, "That will definitely be amount of money x or y, and here you can have it regardless of whether you have the right proposition or not."

But this issue of confidence should not be ignored, and I do think that one of the important changes in recent months is that people have realised that looking backwards all the time and recriminating all the time and, if you like, looking on the negative side of life, is not going to help us grow. It is very important to learn from the mistakes and put them right, but in the end what we need to be doing is looking forward, trying to get growth and wealth creation, and the banks have an important role to play in the business confidence to start with, and then in the provision of support when the right propositions come along behind that, and that is what we need to do. We are doing it imperfectly; we need to try to continually perfect that.

Q173 Jackie Doyle-Price: And the continued presence of the taxpayer in the banking system is enabling you to do that, let’s be frank. One of the things you said is that you are doing more than perhaps you wanted to. What we have seen is-and you have both made this point in different ways-that many businesses have been reducing their credit exposure and turning to other sources of finance. To what extent is the taxpayer being asked to prop up the riskier side of lending?

Stephen Hester: Although you could not often tell it from public debate on the subject, I do not believe, when you sweep aside the debating points, that Government is actually asking the banks to go back and do some more reckless lending. I do believe that most people think that the banks should try to lend responsibly and support their customers in that way. In that sense I think the banks are trying to both lend responsibly-as Eric has pointed out, in some instances that means differently than in the past-whilst at the same time trying within that envelope to support their customers. Certainly when I think of the people on the ground in RBS, and again I am sure there are many individual cases where we get it wrong so I am not in any way trying to say that we are perfect, they know that they have to try and find a way to support the customer. We do not always succeed. 85% of the time, if a small business asks us for a loan, we say yes. Sometimes with us that small business has to jump through more hoops than it might have done in the past: more covenants, more financial disclosure. Because the business may be weaker, it may be suffering with the recession; standards may have changed. One way or another we are trying to keep the same flow of money going as we did before, at least in terms of your likelihood of getting a loan.

Q174 Jackie Doyle-Price: Are you pricing that risk effectively or is the taxpayer supporting that?

Stephen Hester: Of course hindsight is a wonderful thing; the banks thought they were before and they were wrong. Right now the banks are trying to price risk effectively. Whether that is indeed what we will have done will take some years to find out, when you look in the rear-view mirror and find out what actually did happen to the economy and so on and so forth. That is certainly the intent.

Q175 Chair: Mervyn King said rather worryingly in the interview he gave recently in the Telegraph, which I assume you also saw, "The search for yield goes on. Imbalances are beginning to grow again." You paint this rather rosy picture, but the Governor of the Bank of England appears not to agree.

Stephen Hester: I do not know whether this was what he was meaning, because I was not present when he made the remark-I am always nervous about interpreting from newspaper articles-but I think the point is very important to understand, and I think we do all understand: what happened to the world was as a result of a series of unsustainable economic imbalances, many of which are still out there. The banking system had a big part in that but not a sole part in that. It is incumbent upon the whole world to keep working away at economic imbalances, whether it is, in the UK, our fiscal imbalance, our balance of payments imbalance, the imbalance of household saving versus borrowing, the imbalance that was in banks’ balance sheets. There are a whole series of these things which still have not been corrected and will probably take a lot of years to correct. That is why it is so important that all of us work together to do so.

Q176 Chair: Take his comment at face value, which is the only way we can do it; it was in quotation marks so I assume that he did say it. "The search for yield goes on. Imbalances are beginning to grow again". You would challenge that, would you?

Stephen Hester: I am not going to comment on remarks that I only read about in the newspaper. I think it is wrong to do that. All I can say to you is: the problem of imbalances in the world has not been fixed. To some extent the first steps of the cure made worse imbalances, because the first steps of the cure in some countries were to increase budget deficits and other kinds of imbalance which then subsequently need to be worked down.

Q177 Chair: I do not think he is talking about Government budget deficits, he is talking about banks. If you do not want to answer it, say you do not want to answer it.

Stephen Hester: I am doing my best to answer it.

Q178 Chair: It is pretty clear to me. Mr Daniels, do you want to comment on that?

Eric Daniels: I have nothing further to add.

Chair: What does that mean? Do you think he was right? He is wrong?

Eric Daniels: I did not read the article

Q179 Stella Creasy: Let’s turn to something else he also mentioned in the article, which is a very big debate that is happening here in Parliament and something that I think all of us look at when we look at the value for money of the decisions that were made over the last couple of years to invest in the banks. We have not solved the "too big to fail" problem. In fact, let me quote from Mervyn King directly. He said, "We've not yet solved the ‘too big to fail’ or, as I prefer to call it, the ‘too important to fail’ problem. The concept of being too important to fail should have no place in a market economy". If your banks were to collapse, the Government would have to step in to protect your customers. As we have all talked about, many of our constituents are customers of yours and to prevent there being a contagion to other banks is something that we dealt with the first time. Implicitly you are still guaranteed by the taxpayer. What needs to be done to end the "too big to fail" culture? Is it to break you up into smaller banks? If not that, what else can be done?

Eric Daniels: Think about what has happened over the past couple of years in terms of the much stiffer capital requirements; Core Tier 1 did not exist as a concept in 2008, and today all banks run with very high levels of shareholder capital, much higher than there has ever been in the past. In the case of Lloyds, we now carry 10% of Core Tier 1 and 15% overall capital. Those levels were unheard of a few short years ago. In addition to that there has been an enormous amount of work done on liquidity regimes. We all know that banks do not go bankrupt because of capital but rather because of access to liquidity. Again, an enormous amount has been done. The amount of liquidity that any bank holds today is many multiples of what they carried in the past. I think those are two important changes that should not be overlooked.

In addition to that, I think there has been a tremendous amount of re-examination of the system of regulation, of understanding some of the risks that probably were not well understood before. That gives a better safeguard to society in terms of managing those risks. The final thing that I would point out is "too big to fail" is perhaps a misnomer, or perhaps does not aid understanding. What is probably more difficult is when a bank is enormously interconnected and complex. That is what makes a resolution regime very difficult. In the case of Lloyds, for example, we are a very straightforward business. The Bank of England has basically told us that they believe we are in fact straightforward; it is easy for us to be resolved, if you will. I do not think it is a bigness issue, it is a complexity issue.

Q180 Stella Creasy: Just so I am clear Mr Daniels, you dispute the analysis of Mervyn King. Can I also check, then, whether you think there should be any concerns to us as taxpayers about the size of market share that Lloyds now has as a result of the changes over the last couple of years, that, in terms of competition for consumers, the dominance that you play within the mortgage and savings industry is not a problem? You do not see that there is a problem for us as consumers, that you are too big for the British market now.

Eric Daniels: No. I think this is a very, very highly competitive market. It is a good deal less concentrated than many other markets, for example, Canada, Australia, and France. In fact it is less concentrated. I think that every study that I have seen has said that UK consumers get very, very good outcomes in terms of pricing. What really matters is not the size or concentration, it is the contestability. What you see in the UK is a lot of discounting. You see a lot of free offers, a lot of interest free periods and so on. That is because it is such a fiercely competitive market. A zero balance transfer on a credit card is a relatively common thing because the banks fight each other for market share. That leads to very good, top quartile consumer outcomes. I do not believe that the size of Lloyds or any other UK bank impedes competition. Indeed, the OFT is charged with looking and examining whether they think the consumers are getting a worse outcome because of the size or structure of the industry.

Q181 Stella Creasy: So the Governor of the Bank of England is wrong and a 30% market share is not a problem. Mr Hester, what is your view about what the Governor of the Bank of England said?

Stephen Hester: Again, I am not going to be tempted by your invitation into a slanging match with anyone as distinguished as the Governor of the Bank of England.

Q182 Stella Creasy: I am not tempting you to a slanging match at all; I am asking your opinion. Are the British banks too big to fail?

Stephen Hester: What I would say to you is as follows. Of course, coming in to RBS as I did at its point of near failure, it was of intense professional interest to me as to what caused failure; what to do about it; using RBS as a specific example, how to make banks safe again, in addition to what parallels there were in the rest of the banking industry. It was something I have spent a great deal of time on and thought on. RBS is, I hope, an exemplar of the things we needed to put right. I believe that I have been very clear that very substantial reform was needed in the banking system.

What I have also been clear about, though, is my belief that size and shape are complete red herrings in this debate. When you look at the banks that were weakened and failed, or nearly failed, there is no pattern of size and there is no pattern of shape. In fact, the majority by far were small and simple: Bradford & Bingley, Dunfermline Building Society, Northern Rock. Think of, today, banks that are relatively weak: the Spanish Caixa and so on. Regardless of size and shape, it has been my view that the banking industry needed very substantial reform that would apply whether you are big or small, simple or complicated. As I said earlier on, but just simply to reprise it for you, the two components of that were to make each bank safer with more capital and more liquidity-Eric has spoken about that-then to put in place mechanisms that, even if despite that extra safety there was failure, you did not go to the Government for capital support, but you went through Co-Cos, bailouts, your own creditors in a resolution regime. I believe that when the current banking reform process has been completed and the international Basel Committee, on which the UK is well represented, is mid-stream, that we will indeed have achieved those goals and made banking safer for society as we should have done. That would be true whether you are a big bank or a small bank, a simple one or a complicated one.

Q183 Stephen Barclay: Firstly can I say, I agree with Mr Hester’s comment that it is important that we learn from the mistakes and look forward. Could I just pick upon something that a senior executive at Lehman Brothers said to the Fed, or was quoted as saying. He said, "We do not know what the value of our derivatives liabilities are, and frankly neither do you". Just starting with Mr Daniels, what has changed in the way you managed your derivatives liabilities? Was it right to present those in terms of a net position and is that still the case in your approach; I am talking about how you manage your counterparty risk?

Eric Daniels: I am not quite sure I grasped the question. You are asking "Have we changed the way in which we manage derivatives?"

Q184 Stephen Barclay: What I am asking is: you as a senior executive have to understand what is on your balance sheets, the assets, what we as taxpayers have invested in and the risk that is posed to them. A lot of companies, in term of their derivatives trading, were presenting that in terms of net-you understand these issues very well-for example, in terms of the position between your trades with Barclays. There is a counterparty risk if Barclays goes down and there is a difficulty in terms of how that is quantified, how that is then studied. PRIN 3 or PRIN 4 of SYSC have certain requirements in terms of how you manage your liabilities there. What I am saying is there are clearly faults in the way it was happening two or three years ago. What has changed in your approach?

Eric Daniels: I think one of the things that I should clarify before answering is that Lloyds is a commercial and a retail bank. While we will use derivatives, for example, in investment banking products, we use them only really for flow. In other words, if a manufacturer in the Midlands wants to hedge their interest rate-in other words they have a floating rate loan, and they want to lock in the rate of interest-we will sell them a derivative. Once we sell to them we have an open position. We lay that off within an investment bank. So for a very short period, what we will do is in fact have a derivatives exposure. But really the use of derivatives for us is mostly flow to serve customers. We do not use it as a trading position, a proprietary position. Do we in fact have some exposure to it? Yes, of course we do. What we do is we manage our limits very carefully, as we always have.

Q185 Stephen Barclay: If you had been here three years ago you would have said you manage your limits. That was not my question. My question was, have you changed your approach? Do you still present that from a net position, or have you changed your approach in term of counterparty risk?

Eric Daniels: Tim, I don’t know whether you have anything to add.

Tim Tookey: We report this information gross. As Eric said, we manage it very tightly and we know what our positions are and how they are valued on a daily basis. On top of that we very carefully analyse the counterparty risk that you are referring to on the asset side of all exposures, whether that is the company in the Midlands that Eric was using in his example, or indeed the third party to whom the risk would have been laid off.

Q186 Stephen Barclay: Perhaps you can help. I am a generalist; I am not an expert as you are in these matters. I just had a scan this morning of your preliminary report from a couple of weeks ago, and on page 125 it says, "The Group reduces exposure to credit risk by using master netting agreements … These do not meet the criteria under IAS 32", whatever that is. What that suggested to me was that you are presenting these in a way that does not meet international accounting standards. As I say I am not an expert, but why are you not presenting them in a way that meets international standards? Are you presenting them in the same way you would have done three years ago?

Tim Tookey: I am very happy to confirm that we do present all of our financial information in accordance with international financial reporting standards. That is the basis upon which our accounts have been done since IFRS were introduced in 2005. Our auditors report publically on the basis of preparation of the accounts, and that is indeed what they have given us.

Stephen Barclay: Sure, you go through the various legal checks before one signs those off.

Tim Tookey: It is more than that. It is actually a certificate from the external auditors who obviously owe a duty of care to shareholders to ensure that we do indeed comply with international accounting standards.

Q187 Stephen Barclay: You bring me very nicely onto the auditors; I was going to come on Mr Hester’s auditors in a moment, but it is timely. After 10 months of intensive work by the Treasury, the Accounting Officer of the Treasury had to seek a letter of direction because-it was before your time I accept-they were unable to confirm the validity of what your firm was saying in terms of the assets of the company. What does that say about the quality of the external audit work that was done?

Stephen Hester: I think that the first thing I would say is that there were lots of things RBS did not do well. Our job is to improve on those things. One of the things that it did not do that well was to have perfect books and records, computer systems and so on and so forth. There are countless amounts of millions of pounds and man hours and management effort going in to improve that alongside the many other things that we are trying to improve. That would be the first point that I would make to you.

The second point that I would make to you, in relation to the specifics that you are referring to-to which my first point also refers-is that the Asset Protection Scheme I think covered something like 3.5 million individual loans in RBS. No bank in the world, RBS or any other, ever had designed its systems to aggregate information in the particular way that was called upon by the Asset Protection Scheme and the different safeguards that a Government agency was used to getting. If I can give you a parallel, it would be a little bit like someone suddenly coming along the top of the UK Government saying, "We want to get every patient record from the NHS, every record from Work and Pensions and bring them together".

Therefore there were imperfections in the systems but, simply, systems were not designed to gather information in that particular way. I believe that even though I think RBS needed to improve and has been improving, not for this reason but in general, it remains substantively the case that there have been no instances that threaten the taxpayer as it relates to APS. There is no prospect that the taxpayer is going to be on the hook for anything under this category or otherwise in APS, as we do not expect to claim. So I think as it relates to materiality, the Treasury were quite right to sign off and nothing has come out since that suggested that that was a misjudgment.

Q188 Stephen Barclay: That is a different issue you are moving onto. First of all, Mr Tookey’s whole argument a moment ago was this was looked at by the external auditors. What that case demonstrates is a serious failure by the external auditor in all of this.

Stephen Hester: It is not necessarily my job to defend the auditors and you should obviously invite them to testify if you would like to. What I would say to you is the auditors were never called upon to audit data in the format and the fields that were-

Stephen Barclay: I’m sorry-

Stephen Hester: Do you want me to finish or not?

Q189 Stephen Barclay: You are suggesting it was perhaps the unreasonable request of the Treasury asking for information in a particular form that was different. Look at what Tom Scholar said when he gave evidence: "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 that had not come to light." He was not suggesting we were asking for information in a particularly unique format. The point is there was a regulatory duty under SYSC for you to manage your controls. You had external auditors who also were under a duty. Yet after 10 months of intensive work by the Treasury they could not rely on it. What I am trying to drive at in my question to Mr Daniels in terms of how they present their information on derivatives is, what has actually changed? What has changed in the way these are being done and in the way that these risks are being presented?

Mrs McGuire: For example, do you still have 21 different IT systems, which was one of the issues raised by the Treasury?

Stephen Hester: We still have lots of different IT systems. It will take many years for us to reduce them, and the work is ongoing to do so. If I may, I am not saying that RBS’s systems were up to scratch; I said to the contrary. What I am saying, though, is that the shortcomings that were pointed out were not of a magnitude to have led to losses to the taxpayer. Since I have come into RBS I have tried to understand whether there were things hidden in cupboards that were unknown that represented big risks and loss. Perhaps sadly, what I can say to you is that from the inside of RBS, what I discovered was really just a Technicolor version of what one could have seen from the outside. Indeed, though there were many of them, the specific shortcomings in the systems area have not led to material losses for either the taxpayer or our shareholders. The material losses, and they have been huge, came from big things, big misjudgments, big areas of concentration that were on display.

Coming to your point on derivatives, I think the management of derivatives has substantially changed and continues to change across the industry but certainly in RBS. By the way, the overwhelming majority of losses that RBS will have suffered across the cycle-and it is true of other banks-comes from bog standard lending, not from derivatives. Derivatives was a tiny fraction of where the losses arose.

Q190 Stephen Barclay: The report suggests a £1 million deterioration in three months on junk bonds.

Stephen Hester: Junk bonds are not derivatives; they are loans, they are bonds. There has been a huge amount of work on derivatives to improve the ability, which was a problem in Lehman, to offset liabilities in a legal way if you like, netting agreements. There is a huge amount of ongoing reform to clear derivatives and trade them across exchanges and through central counterparty clearing. Then there has been a huge amount of work done by all banks, certainly by RBS, to refine valuation to make more conservative reserving and to improve the risk management overall. I can certainly say to you that there has been a great deal of work. It is ongoing. It is certainly true of RBS, and it is true of the industry as it relates to management of derivatives.

Q191 Austin Mitchell: I want to move on to bonuses, which are effectively part paid by the taxpayer. I see that RBS paid out £28 million in bonuses to nine executives. We are told that this was done after exhaustive consultation with our shareholders, one of which is me. How was I consulted? How was the public consulted? How was the Government consulted on this?

Stephen Hester: There are two forms in which that took place. Every year the remuneration policy and the remuneration decisions are up for vote and all the shareholders can vote as they chose on the remuneration report. Secondly, the objectives that are set both in the remuneration report and the objectives that are set for me have been reviewed each year by UKFI on your behalf. Thirdly, prior to the payment of bonuses at RBS, the Chairwoman of our remuneration committee conducted an extensive shareholder consultation, including UKFI and our major institutional shareholders, with a big fat presentation pack going through all the aspects of bonus policy and taking into account that feedback. That is the format in which the consultation has taken place. I think it is more extensive than was the case before.

Q192. Austin Mitchell: It was given effectively by UK Financial Investments.

Stephen Hester: I cannot speak for them as to what processes they go through to decide their vote, but obviously they are the holder of the shares in RBS and Lloyds. I think they undertake that task with great thoroughness.

Q193. Austin Mitchell: Just in passing, I see from Private Eye, which is an infallible source on banking matters, that the head of UK Financial Investments is Mr Robin Budenberg who was a great giver of bonuses at UBS. He had his bonuses at UBS channelled through Jersey so he did not pay tax. Did you do that?

Stephen Hester: No.

Q194. Austin Mitchell: But the bank has lots of subsidiaries in tax havens like Jersey.

Stephen Hester: I think we have subsidiaries in all sorts of countries with high and low tax rates. I do not believe that RBS has been particularly up in lights as in some way dodging on tax, au contraire

Q195. Austin Mitchell: The taxpayer now owns lots of banks in tax havens doesn’t it?

Stephen Hester: I think the population of the Isle of Man, where we happen to be one of the larger banks, would feel a little bit resentful if you were characterising them as all there because it is a tax haven. There are real economies in places that have got low tax rates, as well as high tax rates.

Q196. Austin Mitchell: So these are just for tax avoidance purposes then.

Stephen Hester: Do people live in the Isle of Man for tax avoidance purposes? You must draw your own opinion.

Q197. Austin Mitchell: Profits made in this country, channelled through the Isle of Man , are done for tax avoidance purposes.

Stephen Hester: As I was saying, I do not believe that RBS has been the subject of particular criticism as it relates to its aggressiveness on taxation. If you can show me contrary evidence, obviously I would be very pleased to look at it. We have signed up to the tax code and I think our affairs are completely in order.

Q198. Austin Mitchell: Let me ask you about your bonus of £7.7 million, which is well beyond the dreams of your average PPE graduate when he leaves Oxford. Is it that you had produced some outstanding enormous profit for the bank or was it just that you are a greedy banker? What have you done for the £7.7 million?

Stephen Hester: I think this is a subject that is perhaps inappropriate for me to go on about for long, because I do not set my own pay. That is set by my Board of Directors and in turn voted on by shareholders, including UKFI. As you well know it is at the low end of comparable jobs in the UK and globally, albeit at the high end of society if you want to put it in those terms. One can have a philosophical discussion about pay differential.

Q199. Austin Mitchell: The taxpayers wants to know why we are paying, we are contributing, to giving you £7.7 million.

Stephen Hester: Your job as a politician is to have that philosophical discussion. What I am charged with doing is to try to run a large bank, on which many customers depend, in which the taxpayer has a great deal of financial exposure, to the best of my own and my colleagues’ abilities. It is in the hands of others how they want to pay me for that. It is in my hands whether I want to do the job for that. I think by the standards of each profession, which is in the end how these things are measured, the governance process is gone through in a very thorough way. As I say, I am not going for a second to engage you in the philosophical discussion about pay levels in society. Fortunately that is not what I am charged with doing. I have to protect your investment.

Q200. Stella Creasy: You do not have to accept bonuses though do you?

Stephen Hester: No, you do not have to accept your salary either.

Q201. Stella Creasy: A bonus is a different thing. Mr Daniels, have you accepted your bonus?

Eric Daniels: No I did not.

Q202. Austin Mitchell: That is a feeble comeback: that we do not have to accept our salary. £7.7 million is huge and the taxpayer is contributing to it, effectively.

Stephen Hester: No one is forced to employ me.

Q203. Austin Mitchell: Do you see these bonuses as an incentive to take risks at different levels in the banking industry? The bigger the risk you take, the bigger the bonus you collect.

Stephen Hester: I think that it is extremely important that the incentives that go in any industry, but in this case in the bank industry, have been reformed. There has been very comprehensive reform. In fact, RBS has been amongst the leaders in doing that both in terms of alignment of incentives and their measurement, and the ability to claw them back if the incentives retrospectively are seen to go wrong. The UK today has, in those regards, the toughest regime in the world. I think RBS is at the forefront of that process. I do believe the issue of risk and misalignment of incentive has been very comprehensively addressed. What is clear is that there are parts of the banking industry which remain highly paid, and of course it is clear that that is a matter of controversy depending on where you look. Fortunately, that is not what I am charged with. What I am charged with is trying to run this bank as well as I can by the standards of its environment.

Chair: I am going to stop that conversation because it can go on. I think others will have probably said it to you Mr Hester and to you Mr Daniels, but it is just very difficult in the situation. We come in, again defending the taxpayer. Our interest is not as the Treasury Select Committee. We are just here saying: did we get value for money from the money that was put in? I think, in the same way as we as MPs have had to understand the impact out there of some abuses of the allowance system by some Members of Parliament, you have to understand that the people are suffering from a credit crunch, which they feel you in large part caused; to then see large bonuses is a bridge too far. I think a sensitivity to that in whether or not you accept your bonuses is all we ask for; especially when we are in a position where the taxpayer continues at this point to prop you up, hopefully not for too long, but we do. I think it would just be nice to get a feel from some of the people that have benefitted from the bonus system that they understand that and respond to it, in the same way that we have had to respond as MPs to criticism of us. I think it is a very simple issue.

Q204. Ian Swales: I would think it is very likely we will be voting down our own £1,000 pay rise on Monday as MPs. I do not know what people are doing around the table, but that is the discussion we will be having on Monday. My real question is, hopefully you have given us a lot of comfort in a way that things are secure and we are never going back to the days of two years ago. If we did, I think there is an element of saying: to what extent the UK taxpayer stood behind international operations of banks, to what extent that was justifiable and whether that should happen in the future. One of our colleagues who is not here was talking about breaking up the banks geographically which I think is clearly not the type of thing we should be asking industry to do. But the UK taxpayer, explicitly or implicitly, aids the banks, stands behind risk, possibly less so now and hopefully even less in the future. Should we get into that situation again, to what extent should the UK taxpayer be backing a huge international bank?

Stephen Hester: I think that firstly, hopefully the UK taxpayer will make a profit not a loss from its support; in the event, it looks like that is going to happen. Secondly, I think one of the very positive things that came out of the negative of the world financial crisis is that the world did not turn in on itself and that protectionism in all its forms did not take over. The world realised that the future still lies in a small world where we trade with each other and where we exchange all sorts of goods, services, cultures and so on. That is particularly true in Britain because we are one of the world’s most open economies with the most to lose, of any economy, from a world that turned on itself, became completely nationalistic and pulled up the drawbridges. I would say to you, in my own view, with financial services, which is a huge part of the UK economy anyway, as with the whole of the UK economy, that it behoves us to encourage a global system in which all of us play a role. I think that was what happened in the aftermath of the financial crisis on all levels and it was the right thing to do.

Q205. Ian Swales: If we had got it wrong and one of these large banks had actually crashed and burnt somehow after the taxpayer had stood behind it or rescued it-UK taxpayer money went in the direction of the Icelandic banks in effect for UK depositors. I know we have got corporate bails and so on, about foreign subsidiaries and we know some of the severe losses of some of your competitors over the Atlantic. I understand your point about global competition and the importance of financial services to the UK. But as the Chair keeps saying, we are here for the taxpayer. To what extent should their money be used for activities that take place overseas?

Stephen Hester: The taxpayer should not. The whole point of the reform of the banking system is to make sure the taxpayer here, or in any other country, does not. I am a fierce advocate of the reforms that are in process, not complete, to do that. To my mind, the right answer is to ensure that the global financial system is reformed such that this is not an issue. The wrong answer is for countries to draw up their own drawbridges and isolate themselves from the world, whether in financial services or any other form of global trade.

Q206. Ian Swales: That is one test we should be applying to the new banking world, that is the sort of area we have just been talking about then.

Stephen Hester: Absolutely.

Q207. Chris Heaton-Harris: In a way I look at you and I see a bit of John Galt from Atlas Shrugged, except John Galt was never really supported by the taxpayer. Can you see the point in time when RBS is a huge success again in the future? Is it within grasp even though it may take a number of years? Secondly, and just going back to a previous question, you said that there was a risk of misalignment of incentive within the system. Do you think it is right that the shareholder dividends were cut by up to 90% but staff payouts have been barely changed?

Stephen Hester: Clearly we are putting in every effort that we can to make RBS a success again. We have set out a plan which we believe will do that. Two years into what I thought was roughly a five year process we are on or ahead of that plan by its different matrices. I believe that so far we have reason to be encouraged. That success needs to be measured in simple terms across three dimensions. As I see it, we have three simple roles although there is a great deal of complexity beneath them. Part of it is to make the bank safe for all constituencies; part of it is to continue to serve our 40 million customers; and part of it is to get some of the shareholder value back which of course is substantially about taxpayer value. Across those three matrices I think that we have made good progress in two years, but we have a few more years of hard work to go before we can say that the job is done, if you can ever say that the job is done. Nevertheless, I think so far so good is the right way to answer that question.

Q208. Chris Heaton-Harris: What about the shareholder dividends cut by 90% but staff payments remaining roughly the same?

Stephen Hester: We are not allowed to pay a dividend, even if we wanted to, by the European Union. That is a choice that is currently outside our control. Obviously we will review it once that has been lifted in the context of whether it is prudent to do so or not.

Q209. Nick Smith: You mentioned Project Merlin and your commitments there. Mr Hester, you have already talked about committing to HMRC’s new code of practice on taxation, not just complying with the letter but also the spirit of the law. Are you confident that all your highly paid directors are not getting paid overseas to avoid paying their tax to us?

Stephen Hester: I believe that to be the case, yes.

Q210. Nick Smith: Is that the same for Lloyds?

Eric Daniels: Yes.

Q211. Stephen Barclay: Just on remuneration, again I think we are asking you to face both ways. We want you to retain your talent, we want you to return the company to profit and get the share price up so that we get our money back at the same time as we are asking you not to pay staff too much. There is an obvious inherent tension there. Can I just ask quickly, in terms of derivatives, does either bank sell derivatives to retail customers?

Eric Daniels: Not that I know of.

Stephen Hester: Not in a direct sense, although in an indirect sense I could give you an example.

Q212. Stephen Barclay: Perhaps you could write a note on it to clarify.

Stephen Hester: 25% of all farmers in the UK take out derivative products to hedge their farm payments in foreign exchange terms against Europe. A number of people take out investment products where returns are linked to the stock market, but have a protection if the stock market goes down.

Q213. Stephen Barclay: I was thinking of things like complex interest rate swaps, and whether retail customers understand interest rate swaps if you are selling those to retail customers.

Stephen Hester: I am happy to write to you about the answer that I have given.

Q214. Mrs McGuire: Over the last two years there has been a great deal of public and private anguish in relation to the banks both at a personal level and at a corporate level. The taxpayer has invested an enormous amount of money. Dare I say it, some politicians have invested a great deal of their own credibility in looking to how we can support the banks through this. Yet when I look at the wider market, I still see share prices for both Lloyds and RBS at a level way below what one would expect for banks that are appearing to be successful. Why has the market not responded in a more generous way to some of the efforts that you have made over the last two years and some of the massive investment, and indeed insurance policy, that the British taxpayer has given you?

Stephen Hester: I will have a little crack with RBS. I am afraid it is a glass half full/glass half empty answer. When we announced the situation that we faced after the financial crisis in January 2009, or in the middle of the financial crisis, our share price went to 9 pence per share. After the end of the first year, i.e. at the end of 2009, in round numbers it had gone to 30 pence, so it had tripled. At the end of this last year it had gone to about 40 pence, so it had gone up about another third. On the one hand I think the stock market has indeed measured progress back from the brink. On the other hand it is true that there are many issues still ahead of us. Going back to the answer that I gave earlier, RBS still has more risks in places than it should have. We are still an unfinished work of progress, and so I think the stock market is recognising that-which is specifically about RBS-as well as generally worrying about things that impact all banks like things happening in the Middle East, the eurozone, the path of the economy and the uncertainties over regulation. There is a combination of industrywide things that are a restraint on share prices and RBS specific things, which is why, while we have made very good progress from a starting point, we are still very much a work in progress.

Q215. Mrs McGuire: Do you have a comment about Lloyds’ position given again the taxpayers’ investment?

Eric Daniels: I thought that was a very complete answer.

Q216. Chair: One final question Mr Daniels. You retired a couple of weeks back and I would just be interested in any observations that you have got, from that position, to leave with us from your experience of living through the banking crisis that would benefit the taxpayer over time. This is the final thing.

Eric Daniels: I think so much has been written I am not sure I could really add to the body of knowledge. I think it was Stephen that said before that we saw huge global imbalances, whether it was in the US where we saw a huge increase in money supply, whether it was the lowering of credit standards and covenants in virtually every country. I think that the world wanted to see continued growth and we were willing to take more risk, consciously or unconsciously, to continue that growth. What happens of course is when you have those kind of imbalances you create asset bubbles. Throughout history you see asset bubbles, and when the bubbles burst it is very painful indeed.

Hopefully we will learn from that. We will have seen much different capital levels, much different liquidity levels with the Basel reforms. I think what is also terribly important is that we recognise that if we continue to run the macroeconomic imbalances we will inevitably have bubbles and we will inevitably have another crisis. It may not be a banking crisis. We saw property prices boom in the US in the early 1990s and then we saw the LBO, leveraged buyout, crises and so on. Booms can manifest themselves across a variety of assets; the dotcom boom would be another example. What we have to do is be very careful in terms of our macroeconomic policy, and we have to address the issues with very specific changes in regulations, which I think is well under way.

I do not think I can add too terribly much further than that. I am very hopeful that as a society we can have a very thorough debate about the role that banks play, we can have a very thorough examination of the causes for the banking crisis. Then at some point I think we need to move on and try and advance the economy, and try and advance society. I think that we do need to examine carefully what has happened over the past years, but at some point we should turn our attention to growing again and making this a more prosperous country.

Q217. Austin Mitchell: Do you regret that you were bullied into taking over the Halifax and the extra strain that that imposed on the bank?

Eric Daniels: I understand there is a wide range of opinion about it. I have always been steadfast in maintaining that I think this will be a very good deal for our shareholders. There has undoubtedly been short-term pain, but I believe if we look at the results of the past year, if we look at how quickly our impairments are coming down, and how quickly the Lloyds Banking Group has returned to health, this will be a very good deal for shareholders.

Chair: Thank you very much indeed. Thank you to both of you, and I am sorry that we kept you waiting in the middle with our voting. Thank you.