Financial Regulation: a preliminary consideration of the Government's proposals - Treasury Contents

Examination of Witnesses (Questions 684-764)

Q684 <Chair: Good morning to both of you.

Lord Turner: Good morning.

Mr Sants: Good morning.

Chair: >Thank you very much for coming along at this time of considerable change in financial regulation. Can I begin by asking you, Lord Turner, whether you think that it is right that so much power should be transferred to the Bank of England?

Lord Turner: I think that the—

Chair: >That was a very long pause before a response. Were you deciding to be yes or no at that point?

Lord Turner: Chairman, the pause was not, if you are into the business of interpreting my pauses, about what I want to say in general to that but exactly how I would say it. Overall my answer is, no, I don't think there is a problem. I do think it makes sense certainly for there to exist a macro-prudential capability, which is within the Financial Policy Committee. In my own review last year I argued that that was a crucial missing bit of the existing tripartite structure. So I have been a very strong supporter of that. Although I don't personally think it was necessary to break up the FSA and move the PRA into the Bank, I think it is certainly a feasible solution. Indeed, I have been on the record of saying that if I was starting with a greenfield site, that is what I would have done and it is now going to happen. Insofar as I did not agree with the plans, it was solely that I thought we didn't need to have the change to get the benefit.

Chair:> So we are getting to first best via second best, which you would have stuck with because we had got used to it? An unusual chain of arguments there but we'll go with it.

Lord Turner: I personally had the point of view that the first best is a separation between prudential regulation and consumer protection, with prudential combined with the central bank. I do think that is the first best. My belief was that it wasn't necessarily worth the restructuring costs of getting there, but the Government having decided that we are going to face the restructuring complexity of getting there, the key is to get to what at the end I think will be a better system.

But to return to your problem of is there too much power in the Bank of England, I don't think so because I think, in the two crucial areas of the Monetary Policy Committee with the interest rate decision, and the Financial Policy Committee with the macro-prudential levers, there will be a significant external representation on those and there will be high visibility of the analysis and decisions that are made. I think that's the check and balance to what might otherwise be too much executive power.

Q685 <Chair: And all those people who are bleating about the over-mighty Governor have it wrong?

Lord Turner: I think there will be a challenge for the Governor, simply in the management of his time, or in some future case her time, or whoever is the Governor, because when you now look at the sheer workload of the Monetary Policy Committee, the Financial Policy Committee, the chairmanship of the PRA and the vice-chairmanship—as it's likely to be—of the European Systemic Risk Board, this is simply a huge diary management challenge that the Bank will have to think about, how to effectively use the Governor's time and effectively delegate other decisions. But in terms of the institution of the Bank, I think these are a reasonable set of powers to have been brought together.

Q686 <Chair: Setting aside the management of the Governor's diary, how do you feel about the problem of democratic accountability with this institution having so much power?

Lord Turner: Well, I think there is a reasonable accountability. The way, as we know, it has been set up on the monetary policy side is through the fact that it is the Government and Parliament that set the inflation target and the Monetary Policy Committee and the Bank deliver within that. So I think that is a clear separation.

I think on the financial policy side it is more complicated because it is much more difficult in relation to the issues of macro-stability and macro-prudential to set down a policy guideline equivalent to a 2% inflation target. Therefore, one of the crucial things will be how, within the details of the forthcoming Act, one clearly defines what are the powers, what is the remit and what is the objective of the Financial Policy Committee.

Q687 <Chair: What about accountability to Parliament? How do you think that should be done?

Lord Turner: I think that the accountability will come through the reports to you, the publicity of the probably semi-annual financial stability reviews, which will set out the analysis and the clear justification for the actions that have been taken. But I do think there is an important aim here, which is tricky to get right, of giving to an authority like the FPC the ability to take decisions that Governments might not make at times in the electoral cycle. What we are trying to do is have a mechanism where a trusted independent authority can slow down a credit boom even if the elected Government at that time, with a majority in Parliament, rather likes the good feelings, positive feelings, among society being generated by that credit boom. I do think we need to create mechanisms that enable a trusted authority to do that. I think, therefore, the challenge will be for the Bank of England to earn that trust over time. But I think there is a role in society for us to have institutions that have power, that are trusted to exercise power, rather than us necessarily defining precisely under what constraints they operate.

Q688 <Chair: I would like to ask Hector Sants one question before handing over to Chuka Umunna. I think everyone is agreed that the FSA made an effort to own up to the mistakes that it had made in the run-up to this crisis. We are giving the bank a great deal more power now. Do you think the Bank of England has owned up to all its mistakes?

Mr Sants: I think that—

Chair: >Another very long pause.

Mr Sants: Well, I think that the central Bank's involvement in the crisis was of a rather different nature to the micro-prudential regulator. It is perhaps easier for a micro-prudential regulator to identify specific actions in relation to individual firms that it might have taken, and if it had taken events might then have followed a different course. So, in that sense I think it was right and proper that the FSA should be more forensic in its examination of what it had and had not done and it was right and proper that it then made, as you say, significant changes to the way that it went about supervising firms. I do expect those changes, may I say, to be carried over into the PRA and the CPMA. It's very important that we don't fail to learn from the past.

Chair:> I was asking about the Bank.

Mr Sants: I think in relation to the central Bank it has demonstrated, by its actions that it's now very much supporting the creation of the FPC and the clear consensus that a central bank needs to be involved and should be in the lead of overseeing financial stability—

Q689 <Chair: Those are Government decisions about structure. I am asking you whether the Bank, as an institution, owned up to mistakes it made during the financial crisis.

Mr Sants: From my perspective, if you take in the round everything that it has said, including its most recent pronouncements on the new structure, yes. Was that a more elaborate and lengthy process than the very straightforward approach that the FSA took? Yes.

Chair:> So, lots of little snippets of remarks. If we join them all together and sew them up, we can get to the point that amounts to a comprehensive analysis and admission of mistakes.

Mr Sants: I think that would be the way I see it, while the FSA had a cleaner, more straightforward approach.

Chair:> To 'fessing up?

Mr Sants: Yes.

Q690 <Mr Umunna: Thank you, Chair. I would like to follow up on one of the Chair's questions to you, Lord Turner, but I just want to first of all revisit a very interesting interview that you did in Prospect last year. I was quite struck by a number of the responses that you gave when the reform to the tripartite regime was put to you. You said that the institutional architecture is the least important issue. You went on to say, "There's a spectrum of activities from the monetary policies of central banks through macro-prudential analysis, micro-prudential supervision and customer protection issues and whenever you divide it up you will create interface problems and you will have to manage them." Is that still your view?

Lord Turner: Yes, it is. That is why my overall tendency with many organisational challenges is to be a small "c" conservative and to believe that whenever you go for organisational structure change you will create new problems even as you solve old ones. I think if you look around the world on the organisation structures that different countries use to deal with this spectrum of activities, there are pros and cons of different ones, and indeed there is no real correlation through this crisis.

Q691 <Mr Umunna: So we are still going to have problems with the new structure?

Lord Turner: Now, having said that, within this spectrum—and it relates to the answer I gave to the Chair—if I were to work out where I would do the divide, I do think the new divide will be a somewhat better divide than we had before. In particular it will help to close this gap in relation to the crucial area of looking in an integrated fashion at financial stability and macro-prudential. But we have to recognise that like any organisational change of this form, it will deal with one set of interfaces, it will make that work better, and it will create some new problems. We will undoubtedly have, between prudential regulation and customer protection regulation, some complex issues which span that divide. Let me give you an example. The issue of with-profits policies in the insurance area and whether with-profits funds, the balance with which they belong to shareholders or policyholders and the treatment of those, is simultaneously an issue which has certain prudential aspects and an issue which has certain fair treatment of consumers and policyholders aspects.

In future, we will have to—once we have two separate organisations—create some mechanisms that enable us to discuss and co-ordinate that issue. We will also, by splitting up the prudential authority and the consumer protection authority, have two separate teams of supervisors visiting the same bank or insurance company. That will, to a degree, create some duplication; there will simply be more meetings. My own judgment is that the benefits of making sure that there is an integrated approach to these fundamental issues of financial stability and macro-prudential balance are more important than these problems, but I do think we have to recognise that as we make one interface better we are bound to create new problems of interface. That is simply a fact of life.

Q692 <Mr Umunna: I suppose what I was getting at is that one of the problems was, of course, that the crisis demonstrated that the three bodies—the Bank of England, the Treasury and the FSA—in some senses were not always talking as closely as we would have liked them to. In the interview you pointed to this as being a problem and said that you believe that the closeness of the links required could be achieved by intelligent working relationships across the existing institutional divide. I got the strong impression from the comments you have already made in answer to the Chair that in some senses you give the impression that you think this regulatory overhaul is a bit of a waste of time. You said it is not necessary to make the change to get the benefit of the reforms and I am just left wondering, given that I think the transition costs of this reform are going to be in the order of something like £50 million, whether it is really worth it, given the comments you have already made about being able to refine and improve the existing arrangements.

Lord Turner: Let me be crystal clear, because I think I have been crystal clear and consistent on my point of view. I believe that, in theory, if one was starting anew to design a system, I am more in favour of the new planned system than the previous one. I am a supporter of a twin peaks approach, in theory, and I think it will, when we get there, have certain advantages over the present situation. I also, however, believed—and I argued this point, but I lost this argument, you sometimes lose arguments in life—that we could get the vast majority of the benefits of the new system by doing two things. One is by separating the internal organisation of the FSA between a consumer protection side and a prudential side, and the other is by creating a financial policy committee that bridged the Bank of England to the FSA. Indeed, had there been a different result of the general election, it was my intention to argue—and, indeed, I was already arguing—that if the FSA was going to stay as it was, we should make that division and we should make that bridge.

Mr Umunna:> So you think it is £50 million well spent?

Lord Turner: So that is what I argued for, but Governments have to make decisions and we will now go through this process and, as I think the Chairman correctly put it, my own belief is that once we go through the transitional pain of this transition the new system will be a better system than we have at the moment. I think that is a clear position that I have set out.

Mr Sants: Could I maybe make a more general point here, which is no organisational structure is going to be perfect. There is no way organisational change alone is the solution to learning everything that needs to be learned from what has happened in the last few years. There is a need to co-ordinate across the entire spectrum of regulation; conduct risk can become prudential. So, in theory, you either have to have one monolithic organisation, which avoids the problem of institutional gaps but raises the question of focus, which was an issue that was rightly raised about the FSA in the past, or you make divisions. Wherever you place the divisions, you will have a co-ordination problem. Organisational structure is not the substantive point here.

Q693 <Mr Umunna: My last question is to Lord Turner. You are the leading authority in these matters but you are absent from the field once we've completed the transition to the new arrangements. Are you surprised that there has not been a place found for you in the new regulatory structure once it is put in place? Some might think it is a bit like having a striker on the subs bench. Do you feel you should be back on the field once all these new arrangements have been put in place?

Lord Turner: It is going to take us about two years from now to put these arrangements in place and I am very happy concentrating at the moment on delivering that. When that is done, I am going to be very happy to do something else.

Q694 <Chair: You have no idea what you think that might be?

 Lord Turner: I have really no idea.

Chair: It took a moment or two to get to that answer as well.

Lord Turner: Mr Chairman, are we going to continue analysing pause length throughout this?

Chair:> Depends how long the pauses are. George had a quick rejoinder to an earlier question.

Q695 Mr Mudie: How you answer questions here, does that affect what you're going to do in the future, do you think?

Lord Turner: Does what?

Mr Mudie: How you answer questions here, does that affect—

Lord Turner: I have to say I do not spend time thinking about this. I am very happy concentrating on the job we have in hand.

Q696 Mr Mudie: Hector, when you and the Chairman had that very polite, coded exchange about the FSA openly admitting their mistakes but the Bank of England dropping them in little hints here and there and you had to join the dots to see, you left us all in the dark. What was the biggest mistake the Bank of England made in the last three years? At least we would have something to start our search.

Lord Turner: I will let Hector answer.

Mr Mudie: I am giving him time to think so it is not a pause.

Mr Sants: That is appreciated. Of course, the word "mistake" is always emotive, isn't it? I think maybe a better way of thinking about these things is what would we like to learn from in the future. I think that two points come to mind as I look back over the period. First of all, to pick up the earlier exchange, it was rightly pointed out that the level of communication, and the level of interest, from the central Bank in financial stability issues was recognised by all to have been very low, to say the least, in the pre-2007 period. As the crisis began to build—recognising, of course, it went through a number of phases, maybe of a more domestic nature pre-Lehman Brothers and of a more global nature post-Lehman Brothers—I think it would be fair to say, and that everybody would recognise, that the central Bank was slow to recognise the need to really engage with the financial stability question. So that, of course, takes us back to why it is right, and I fully support and have been on record as supporting, as Adair has as well, the creation of the FPC and the fact the central Bank must lead on financial stability matters, i.e. must be in charge of the oversight of the system. It is absolutely not right that the micro-prudential regulator should have such a responsibility. The FSA never was, never should have been, in charge of the stability of the system. The central Bank should be and, in my view, should have shown more interest in that issue even under the previous remit. So that, I think, is one point I would make.

I think the other point I would make is relating to the fact that in a crisis the traditional, conventional wisdom of the interaction between the provision of liquidity support and solvent institutions becomes a very difficult judgment to make. There are times when in the round that very much becomes a forward-looking judgment that needs to be made early to avoid the situation compounding itself. As events demonstrated, significant liquidity support did end up being put into the system through the SLS and other measures and that could have been done earlier. So, I think the importance of that judgment around liquidity support and the importance of a central bank taking a clear responsibility for financial stability were the two issues. The current proposal clearly shows that those lessons have been learnt. Then there is this very interesting question around a series of tactical decisions, but I think they're now lost in the mists of time and not really relevant.

Chair:> Lord Turner wanted to add something. If you could be very brief.

Lord Turner: I just wanted to say that I think the most crucial mistakes were not, I think, a set of tactical issues but an entire philosophy that goes back over the last couple of decades, and which was shared by finance ministries and central banks across the world, which was a belief that monetary stability defined by the inflation rate alone was a sufficient condition for a stable economy.

Chair:>We have had your evidence on that before.

Lord Turner: There was a belief that you didn't have to focus on financial stability as an activity in itself. That was the dominant intellectual belief of central banking and of the economics profession throughout the world. I think any tactical mistakes have to be understood in terms of that, I think, quite fundamental philosophical mistake.

Mr Sants: And the final point you'd make, of course, is about the Basel regime. The Bank of England sat around the Basel regime table along with the FSA, so insofar as the rules undoubtedly have been proved to be flawed, that was a joint responsibility and I guess if you looked at the media at the time that probably wasn't as clear.

Chair:> I've not met anybody who is prepared to stand up for Basel, but there we are. Jesse Norman.

Q697 <Jesse Norman: Thank you very much, indeed, Mr Chairman. Before I ask my question, I must say what you have said in coded Mandarinese, Mr Sants, is extraordinary. The Bank of England could have shown more interest in stability before 2008—

Mr Sants: 2007.

Jesse Norman:> 2007. This is a central bank whose principal job is to watch these billowing monetary aggregates and bank lending, and keep an eye on the stability of the system. I think it is extraordinary that that should have been allowed to occur, and I am grateful to you for clarifying that issue.

The question I want to ask now goes back to the issue of the power of the Governor of the Bank of England itself. If you look at the Governor's current situation, he sits on every major committee, and a series of new powers and committees have been added to the remit of the bank. He is surrounded by a team, all of whom have been created or brought in through his own office and patronage, broadly speaking. The court of the Bank of England is not an enormously effective institution, it appears, in holding him to account. What forms of accountability are going to be exercised on him over and above periodic disclosure?

Lord Turner: I think there are different forms of accountability you have. In relation to things to do with the internal operational cost-effectiveness of the Bank, I think the court process is fairly effective, but it really has nothing to do with challenging the actual decisions that are made. To that extent the court is in a very different position from the board of the FSA, which does get involved in substantive decisions about actual policy. That is not the role of the court at the Bank. I think in relation to the policy decisions, it does derive from the fact that crucial decisions are made by committees of which the Governor is the chair but where his say-so does not always sway. The fact is that on the Monetary Policy Committee, which has been defined as the single most important thing that the bank has done—that will change with the Financial Policy Committee—the Governor does not always get his way. There have been times when he is outvoted on that committee. The votes are clear; the votes are public; the arguments are public; and the analysis is public. The inflation report provides a clear understanding of the intellectual basis on which the MPC has made its decisions.

So, in relation to monetary policy, I don't think we do have a problem of accountability. I think the challenge, as I said, is going to be on the financial policy side where one could be pulling different levers with somewhat different objectives—countercyclical capital in order to slow down a credit boom. It is less easy to reduce it to a clear set of votes and it is less easy to define the objective as, "Parliament has said the objective shall be 2%". But I still think it is possible in that area to set up a process that will be seen as one where while the Governor is clearly leading that process intellectually and analytically, there are checks and balances through the external members of that committee and the visibility. I think the challenge is simply to make that visibility and openness and sense of potential challenge work on the financial policy side in exactly the same way that it has, I think, effectively worked on the MPC side. I don't think on the MPC side people have said that we have an unaccountable, over-powerful Governor. In fact, it's a much more open system than if you look at the Federal Reserve in the US, where there has in the past been a feeling that people will not oppose the point of view of the chairman, whereas we do have a process where people are willing to oppose the point of view of the Governor.

Q698 <Jesse Norman: On the monetary side, it is very striking that inflation has been above the target now for a long period of time, for many well known reasons, and the Governor has been writing letters to the Chancellor like confetti. Given the power of the Bank and the increasing power of the Bank, do you think this failure to hit the inflation target reflects its powerlessness or its insubordination to the will of Government, since Government has set a 2% target?

Lord Turner: I think on the inflation target we have the process working. The reason why the inflation target was set not as an absolute, but as an absolute with a range around it and a trigger point of a letter, was precisely to recognise the fact that there can be certain circumstances where a reasonable judgment is that inflation, either up or down, has gone beyond the bounds for exceptional reasons, but is expected to come back in future. There are, as you know, a set of reasonable explanations, particularly in terms of the impact of the depreciation but also the impact, for instance, of VAT changes and so on, which can help explain what has occurred. It is really for the Treasury and you to question the Bank about that, but I don't think the fact that there has been this overshoot in any way suggests that the process is wrong. I think the process is working and requires the discipline of the Governor having to write a letter setting out why he and the committee believe that this overshoot is temporary. There are some reasonable prima facie reasons for believing that that is a good argument.

Q699 <Jesse Norman: That's very helpful. Thank you. Just changing the subject to the position of Ireland where we are met together with it in great crisis. Do you think that the exposure of the banks to the Irish situation, and therefore in some sense our bailout, is the result of a failure of regulation and, if so, how would that be corrected by the new system?

Lord Turner: I think it's very important to understand the nature of the exposure of the UK banking system to Ireland, and it is useful for me to take this opportunity to clarify the situation because there has been—

Chair:>If you can manage to do it briefly.

Lord Turner: I will do it as quickly as possible.

Chair:>I know it is a very big subject that has been opened up.

Lord Turner: There has been some commentary that we are, as it were, significantly exposed to the Irish state or the Irish banks. That is broadly speaking not the case. The holdings of Irish Government bonds by the UK banks are not at all worrying in their scale; we are well aware of the figures, we look at it, we think about any consequences that will follow. That is not a true issue. Nor, indeed, is the direct exposure of the UK banks to the Irish banks out of line with what you would expect or at a worrying level. The reason why the UK banking system has some significant exposure to the Irish economy is that there are two of our major banks, RBS and HBOS, which have significant businesses in Ireland. Most obviously in the case of RBS, it owns Ulster Bank, which has been there for decades. It was owned by NatWest, which was then bought by RBS a long time back. So what you have there is an exposure, which seemed to be a perfectly sensible thing to do: why wouldn't a bank own another bank in a closely linked, nearby economy? It's not the product of a sudden splurge or an irresponsible entry.

Ulster Bank is a large bank, both in north and south in Ireland. Inevitably, therefore, it is exposed not to the Irish state or to the Irish banks but to the general conditions of the Irish economy. What we do, therefore, when we run our stress tests on RBS or on Lloyds to determine their capital adequacy, the tests cover assumptions about how bad it could be in the Irish economy, exactly as we do in the UK economy. So, the processes that we are using to make sure that those exposures are understood by us, and are adequately allowed for in our capital adequacy, are exactly the same when we are looking at a residential mortgage extended in Dublin as a residential mortgage extended in London. But the crucial point I want to make is that the fundamental exposures of the British banking system are to the Irish economy, not to the Irish state or to the Irish banks.

Q700 <Jesse Norman: Except you haven't quite answered the question, which is about why the failure occurred. I take it we don't want to be writing checks for £7 billion or whatever our total exposure is going to be—more than that even. Some failure has occurred. It was modelled in the stress test; what has happened?

Lord Turner: There was a failure, as Hector has already mentioned, of our entire capital adequacy regime. We have been running banking systems across the world with far too light capital requirements, with insufficient shock absorbers in the system to deal with the bumps on the road. In addition we had, both in the UK and in Ireland, in some cases some very poor extension of lending to, for instance in particular, commercial real estate. We have that problem in the UK as well as in Ireland. A regulator can only to a degree keep control of that. The key controls on that should be either the ongoing capital rules or the macro-prudential rules. Indeed, the Irish situation illustrates above all the desperate need for macro-prudential rules. What ought to have been happening back in 2005, 2006 and 2007 is a mechanism that would have enabled the Central Bank of Ireland to impose countercyclical capital requirements on the Irish banks. That is what was really needed.

Chair: >We will come on to that in a moment.

Mr Sants: You have to remember the Irish banks are regulated by the Irish regulator and therefore we're talking about European standards.

Chair:> Hector, I'm bringing in John and we can come back to this subject in a moment.

Q701 <John Thurso: Let me ask you, Lord Turner, the question. You said in a speech, I think in March, that we need some new combination of macro-prudential tools. What tools, what will be most effective and what can we put in that doesn't need international agreement?

Lord Turner: This, of course, is going to be the crucial issue for the interim FPC when it is established. In preparation for that, there are people in the relevant bit of the Bank already producing papers that will be before the interim FPC when it first meets. Clearly the debate about what those tools should be is important. I think we know some of the tools. One of the tools is a countercyclical capital requirement, the ability—in addition to the consistent continuous capital requirements in Basel III—to impose additional capital requirements on the banks when credit conditions are expanding rapidly. That is clearly set out in the Basel III regime where it talks about an extra layer of capital of up to 2.5% of risk-weighted assets, though—almost certainly—with freedom for national authorities to go beyond that. That, in itself, will be a powerful tool. It is not a tool that one would imagine switching on every six months or so. I think it is a tool that would highly likely not to be applied at all for five or six years and then would be brought in when there is a major credit boom emerging—as a very important tool.

Q702 <John Thurso: Can I just ask you on that one: five years, seven years goes by, suddenly the assets bubble appears, the tool is brought in, there is a squeeze and suddenly nobody can get mortgages. Have we thought through whether this is a realistic proposition?

Lord Turner: The answer is that I think it is. It is obviously the case that the impact of this is to constrain the supply of credit that would otherwise exist. But I think we all recognise now that if in 2005, 2006 or 2007, before the crisis, we had had a mechanism to slow down the supply, both of residential mortgages and commercial real estate lending, we might not have the increases in public debt and recession that we face at the moment. Would that mean that if we had done that in 2005, 2006 or 2007 somebody would have had less mortgage availability than they otherwise would have, that they would have had to borrow with only an 80% loan to value ratio not a 90% loan to value ration? Well, obviously. But we have realised that the process of credit expansions, booms and busts, is one of the most destructive things in the economy, and we cannot create macro levers that slow that down without that meaning that at the margin somebody in those specific circumstances is prevented from getting credit that they otherwise want. That is the consequence of that.

Q703 <John Thurso: Do you think it is important that we make it clear what the consequence is? We are talking now about this wonderful thing of macro-prudential tools. The average guy in the street hasn't a clue what we're on about, but when the mortgage doubles or they can't get the mortgage, then they will and that will translate back to Parliament. So we need to be robust about this.

Lord Turner: That is absolutely right and other countries are familiar with this. At the moment there is, for instance, a very significant property price boom going on in Hong Kong. Hong Kong is unable to move an interest rate lever because, of course, it has a currency board system where it is fully pegged to the dollar and therefore its monetary policy is essentially that of the US. It is, therefore, trying to slow down that property price boom by, for instance, and I was going to get to this, variations of maximum loan to value ratios. Many other countries like Hong Kong, like India, like Singapore are used to the idea that these levers are pulled. Of course, when they are pulled, somebody who would rather have liked to borrow a whole load of money to buy a house that they thought would have gone up in value is unable to do that. We do need to be honest with people. This is, in the famous phrase, mechanisms to take away the punchbowl before the party gets out of hand and that is not always a popular thing to do.

Q704 <John Thurso: Coming down off the very high macro level, as Hector said earlier, organisational change of itself doesn't really achieve a great deal, it is what you do with it. The macro-prudential tools are an important part of the toolkit. The other side of the equation is behaviour, and one of the behavioural sides of the banking crisis was broadly around the whole question of remuneration. Can we have regulation of banking without addressing remuneration and the bonus culture?

Lord Turner: Well, we are addressing it and I think we are addressing it in a way that is appropriate for a regulator. I don't think you can expect a regulator to be the authority that expresses, as it were, society's preferences for how much people are paid. If society has a point of view about inequality, the relevant tools and the degree of progressivity of the income tax system, all things like that, what you can ask a regulator to do is focus on whether the structure of how people are being paid is creating incentives for excessive risk taking. Before this crisis, it was the case that people were being paid cash bonuses at the end of a year for what looked in that year to be fantastically profitable trading activity, well before we knew whether this was what looked profitable but had simply left a trail of toxic waste for people to look after in the next couple of years. That is why our focus has not been on the level of pay, but on things that require a certain proportion of it to be deferred and that require that getting that deferred element is then subject to looking at the performance over the two or three years to make sure that it still looks as if that was a profitable, sensible activity. That is what we have done.

We played a major role in the development of the international Financial Stability Board code, which was agreed at the Pittsburgh Summit in September 2009, and we have been as forceful as any authority in the world at implementing that. I don't think this will be transformational, but I think it will play a useful role. If I can just illustrate why I think it will be a useful role: I have sat on the remuneration committee of a major bank, and it is true to say that before the crisis when we were deciding the structure of remuneration, we did not, I think, adequately think about, "Does that have some consequences for the riskiness or otherwise of behaviour?". We focused almost entirely on, "What do we have to pay to get this person in order that the competition doesn't get them?" I think we have provided in this regulation a set of rules and guidelines that will change the behaviour of good remuneration committees so that they will be focusing on and integrating risk considerations into remuneration considerations. I think that will be a step forward.

Q705 <John Thurso: You neatly sidestepped what society thinks. I think society has a very clear idea that people getting £12 million or £15 million a year for no capital invested of their own is bonkers, but the evidence we've had is that if we try and change it in this country all the bankers will go elsewhere. Are we just stuck with paying ludicrous amounts of money in a way that completely devalues the concept of capitalism, or can we do anything on our own?

Lord Turner: As you know, I think those are important issues for us to think about and they are issues that concern me but they are not ones that I think a regulator can directly address. I think we can indirectly address it through, for instance, adequate capital requirements. It is my belief that some of the trading activity that occurred was blown up to a level that was not required by the economy and did not serve an economically useful purpose, partly because we allowed it to because we set far too low capital requirements for trading activity. We have already very significantly increased the capital requirements for trading activity and we are now engaged, through the Basel Committee, in a fundamental review of capital requirements for trading activity, which could produce further major changes next year. From a regulatory point of view, that is the relevant tool that we have available. Will it be transformational? Not necessarily. I think there is something about the financial system that means that at the end of it there will still be high pay for things which many people in society will not believe are useful to them, but that is not something that we have the power to entirely fix.

Q706 <Andrea Leadsom: Thank you, Chairman. Just going back slightly, back in 2007 I was working for a major UK funds management company whose senior fund managers—award-winning fund managers, I should say—for two years had not been buying bank equities, specifically and very openly saying that there was a credit bubble going on; money was too cheap; the Bank of England needed to raise interest rates; don't touch bank debt; and particularly don't touch building societies. And yet the FSA completely failed to see Northern Rock coming, or at least completely failed to do anything about it. What about the new structure is going to make that any different? There were all the signs out there for at least a couple of years. Why will the new system enable us to avoid that kind of problem in the future?

Mr Sants: I think we need to come back to the points that Adair has already covered to some degree. We do need to distinguish between the role and the effectiveness of firm-specific supervision, and the role and effectiveness of overall oversight and intervention in the system as a whole. As everybody, I think, is in general agreement—the Committee, ourselves and others—there was no process in the then tripartite system to invest in any one body responsibility for looking at the overall system and the degree of risk in the overall system. The FSA, as we have said repeatedly, did not believe it was—and was not—charged with financial stability responsibility and was not looking at the overall risk in the system, and nor was the Bank. I have already observed that is the central bank's role going forward and fully support the creation of the FPC in consequence.

Within that, however, even if you do have a system that then develops too high a degree of risk, which then potentially puts individual institutions at risk through the systemic issue, there is the question of the degree to which those institutions might be able to isolate themselves from that systemic risk in terms of their own particular circumstances; business model and capital liquidity management. I think we've also been through in this Committee more than once namely that the firm-specific rules of capital and liquidity were the responsibility of the Basel Committee and then subsequently interpreted in Europe through the European regime. The Bank of England and the FSA were jointly involved in this process as part of the international collective. Those rules have been proved to be fundamentally wrong. There was an intellectual failure of the international regulatory community in respect of that global set of rules that the UK and the FSA applied. On top of that, the FSA had a supervisory approach, which was to intervene only when things had gone wrong, so it was not doing any great business model analysis, which compounded the problem. But the individual supervisory actions are the least important in that chain of events.

Q707 <Andrea Leadsom: So, going forward, under the PRA, surely when it all boils down it's about personal accountability, isn't it? So, in the event of a failure of a firm in the future, or the suspected failure of a firm or a set of firms, who will be accountable? Will it be you or will it be the Governor? Obviously you will be chief executive of the PRA. So whose role will it be to take responsibility for that failure?

Mr Sants: If it is a systemic failure of the overall system and it is deemed in hindsight—presumably we'll assume those people in those roles in the future have been doing their best to make sure these failures do not occur—that they could have made an intervention using one or many of the tools we've just been touching on through the FPC, then obviously the FPC and the central Bank would be held to account. Of course, we have just observed in the debate on accountability that the FPC is a committee—it is not one person—but it would be the FPC and the central Bank accountable for systemic failure.

Andrea Leadsom:> So you're saying that there isn't—

Mr Sants: If it was a firm-specific event, then you would look to the PRA and the chief executive of the PRA. But could I just make one point here in passing, which is a really important point in terms of the philosophy of the PRA? The philosophy of the PRA, its intention and the way it should be judged should be different to the way that in general the FSA has been judged. It should not be judged on stopping firms failing for idiosyncratic, firm-specific reasons: it should be judged on whether those failures then carry costs to the system. If you look back on actually what went wrong, arguably there were three main failures in the tripartite system. The first was the lack of a bank resolution system and the second was a poor financial compensation scheme. The third was probably the absence of a financial stability oversight mechanism. If Northern Rock had been resolvable over a weekend in a way that did not create cost to taxpayers, did not create detriment to society and did not cause a problem for users of the banking system, then I would say going forward the PRA would consider that a reasonable solution.

We are not trying to take idiosyncratic failure out of the system. If you do that, you do not get innovation and you do not get economic growth and a vibrant economy. So, the PRA should be judged by whether it can avoid failure which comes with a cost to the system, not whether it can avoid failure. Orderly failure should not be seen as poor performance by the PRA.

Q708 <Andrea Leadsom: But, Mr Sants, my question is about accountability and you're telling me that this remains spread amongst FPC and the bank and the PRA. I am asking about individual—

Mr Sants: No, micro-prudential is with the PRA.

Andrea Leadsom:> Is it your problem in future if an individual bank goes bust? Because, let's face it, if a large bank goes bust there are automatically systemic risks. They don't go bust in isolation; we've just discovered that. So, who will be accountable? Is it you or is it the Governor?

Mr Sants: For individual banks failing it would be the PRA and I, as the chief executive, would take responsibility for that, no doubt accountable to the board with the Governor as the chair. But it is normal practice, which I subscribe to, for chief executives to take responsibility for their organisations. I'm just making the point, however, that failure of a bank is not necessarily to be deemed a failure by the PRA; you need to look at the circumstances of that failure and the consequences. I am trying to wean people off an expectation that you operate a no failure regime and explain that, going forward, if you can have failure without cost to the system that would not be a failure from the PRA's point of view.

Q709 <Andrea Leadsom: What worries you about the next failure? Where is that going to come from? Is that going to come from off-balance sheet risk, is it going to come from shadow banking? What do you worry about most?

Mr Sants: Clearly, history tells us that crises tend not to repeat themselves in the precise nature of the crisis and the precise drivers, so the next one is likely to be different in nature from the last one. Hopefully it will also be some way off and hopefully also less detrimental in impact, but undoubtedly at some point there will be another crisis. Where is that likely to come from? I'll tell you that what worries me in the generality is that effectively where we saw the build-up in risk over the last 20 or so years, and particularly in the key period pre-2007, was within the banks and also within the shadow banking system, but basically within the managers of risk. And because those institutions, both off balance sheet and on balance sheet, were inadequately capitalised and the liquidity regime was poor, when the shock occurred they weren't able to absorb it. That's what we're now addressing through the regulatory actions Adair has referred to earlier. But one of the consequences of that could well be to push risk out of that aspect of the system, not just into the shadow system but out of the system altogether. So, you can then push risk effectively into the consumer—into the user of product and out of the manufacturer of product.

So, for example, if you have something like an ETF, you can put leverage in an ETF and then consumers themselves buy the product with the leverage. So I think the risk is the leverage moves out of the visibility of the regulator from the point of view of regulating the manufacturers of product into the consumers of product. So this is kind of a long-term issue. I don't think it is happening to a significant degree at the moment, but logically I think that is a potential area of future risk that we need to very careful about, which is why I think we need to make sure that we are reforming the trading environment and the market environment—the central counterparty environment—at the same time as reforming the capital and liquidity regime of the banks and the shadow banks. So, it will be something to do with risk occurring away from the core banking system.

Q710 <Andrea Leadsom: So just very quickly, if it were your example of exchange-traded funds, would you see it as the PRA's role to continue to monitor that and to take responsibility?

Mr Sants: No. Well, not primarily because the PRA is not the market's regulator. That would be sitting with the CPMA and potentially with the clearing and settlement component of the Bank of England. The PRA is a firm-specific regulator for prudential risk in the insurance and banking system. That is the way that the Government are proposing to set it up.

Q711 <Andrea Leadsom: So there is going to be an issue there then of you needing to pass information to the CPMA if there's something that's bothering you about the activities of a particular firm?

Mr Sants: Of course, or back to the point earlier, whenever you have an organisational divide, information must be exchanged. As we said before, the advantage of a single regulator is that firm-specific risk is looked at by a single team of supervisors who are at least meant to be looking at everything in the round. If you split it up, you get the focus and there is no likelihood of them being distracted by another mandate or competing mandates, but they have to co-operate. Risk will move around across the system, and if the various different parts of the system do not co-ordinate, that risk will be lost to visibility.

Q712 <Mr Mudie: I think it's refreshing and good that we look at a new structure, learning from the mistakes of the past. Just on that, did the FSA have a view on whether Barclays should have been able to purchase Lehman Brothers?

Mr Sants: Yes, we did. Yes, most definitely, and we had the same view—I had the same view and the FSA had the same view—as the senior management of Barclays, namely that it should not purchase Lehman Brothers if there was any possibility of it putting Barclays at risk, and at no point did Barclays ever suggest to us a deal that was of that sort of nature.

Q713 <Mr Mudie: No, but that's not the question. The report has come through that Bob Diamond had negotiated a bad Lehman Brothers that was left in the Americans' hands and Barclays were going to buy the good part of Lehman Brothers, and that was what was turned down. Is that a mistaken report?

Mr Sants: Yes.

Q714 <Mr Mudie: So it was always a purchase of bad assets?

Mr Sants: As John Varley has reported a number of times—and my recollection of events is completely in line with that of John Varley's, and since we were talking and we were the decision makers here that would seem to be where you should look to establish the facts—at no point did Barclays make a clear proposition to us in relation to the acquisition of Lehman Brothers that we then turned down. There was no structure, as I understand it, which John Varley and the board found acceptable and therefore they didn't put one to us. If they had put one to us we would have evaluated it on the criterion I have just described, but we did not have a definitive proposal put to us.

Q715 <Mr Mudie: On the question of shadow banking that Andrea was dealing with, how much of the shadow banking world—it's estimated at $20 trillion, twice the mainstream banking money—do we regulate?

Mr Sants: I think Adair is wanting to—

Lord Turner: This is an issue that we are looking at carefully within the Financial Stability Board and within the Committee for Supervisory and Regulatory Co-operation, which I chair. It's one of our most important workstreams for the next six months. I think the crucial thing, and the first thing we are going to be doing, is really defining what we think we mean by this word "shadow banking", because it's not straightforward.

Q716 <Mr Mudie: No, no, before you take up time going in a different direction, I am asking at the moment and in the past few years how much of the shadow banking market have we or are we regulating as we sit? It is all right telling us what—

Lord Turner: No, okay, but to answer that I need to first of all quickly define what we would mean by shadow banking. The shadow banking system was, in its core, primarily a US phenomenon, although with connections into the UK. The absolute core of it is a process whereby a chain connects money market mutual funds, a series of vehicles like SIVs, conduits and prime broker dealers, and indeed hedge funds and banks themselves. To begin with, a lot of that was not regulated; the capital levels of SIVs and conduits were not regulated. The money market mutual funds, which are not a significant phenomenon in the UK but were a very big phenomenon in the US, were not regulated. What they were doing was taking a maturity transformation risk. Banks take a maturity transformation risk: they have shorter term liabilities than their assets. Through this chain, that maturity transformation was occurring. There was a group of American investors in money market mutual funds who believed that they had money they could get back immediately, and at the end of a chain there was a British retail residential mortgage-backed security with a 20-year loan. If that had occurred within a bank balance sheet, we would have closely regulated how much of that maturity transformation was occurring: because it occurred for different steps along the road, we didn't broadly regulate it.

Q717 <<Mr Mudie: I think you lost me about five minutes ago, but that's not hard. Put in percentage terms, I've not heard you say of the $20 trillion—

Lord Turner: Yes, but I don't recognise the $20 trillion. The trouble is since I don't know where the figure comes from—

Mr Mudie: >That's a New York Fed research paper of July this year, available on the net.

Lord Turner: Which I have read from cover to cover.

Mr Mudie: >Well, it is in there.

Lord Turner: Yes, but that is one particular definition. There are other definitions that—

Q718 <Mr Mudie: No, no, look, we are speaking about regulation and we're trying to work it out. There is $10 trillion stuff that we regulate and there is a $20 trillion shadow system. You have just explained to me what we don't regulate; I've not heard that we regulate any of that $20 trillion. What percentage, as you've described it, of the shadow banking exercise do we regulate?

Lord Turner: I'm afraid I don't think that is a meaningful question and therefore it is not possible to give a meaningful answer.

Mr Mudie: >Okay, well don't answer it then.

Lord Turner: I'm sorry, but the shadow banking system has become much smaller than it was, we didn't regulate any of it, whatever it was—

Mr Mudie: >Well, it's $15 trillion now. That's again the same research so it's still considerable.

Mr Sants: I think we could say this, couldn't we, Adair, if this helps.

Mr Mudie: >It is still considerable.

Mr Sants: Without the breakdown of the $20 trillion, I agree with Adair, we wouldn't want to be over precise but—

Mr Mudie: >Well, what figure would you put on it? Seeing you won't take the Fed's figure, what figure would you put on? Hector, what figure do you put on it?

Mr Sants: I would say the following, what is within the UK's regulatory net we do, and have always had oversight of. We regulate hedge funds. We do not have money market funds of the size and the significance that you see in the US and the remaining small amounts of off-balance sheet conduits and SIVs owned by the UK banks, where we are the lead regulator, are visible to us. So there is very little shadow banking by entities in the UK that doesn't fall broadly into our oversight regime for prudential and financial stability purposes. The vast majority of that number will apply to activities outside of the UK and probably in the US, and until the US have completed the changes to their regulatory architecture, which includes increased oversight of hedge funds, it probably remains relatively unregulated in comparison with the UK. Is that a fair thing to say about it?

Lord Turner: Can I very quickly—

Q719 <Mr Mudie: I have very little time so I just want to ask Hector, because you are going to take this up in the future. So, you're saying to the Treasury Select Committee that it's not a major problem in Britain and it's well under control from your organisation's point of view, so we don't have to worry?

Mr Sants: In terms of the visibility of that which we have regulatory responsibility for, the answer is yes. That does not mean, of course, that we might not be systemically affected by events in other parts of the world where we do not have regulatory responsibility.

Q720 <Mr Mudie: That is where I come to you, Lord Turner, because you are involved with the G20. How confident can we be—people are losing patience with all the arguments about regulation and so on—that they have the determination to move on to that?

Lord Turner: I think reasonably confident, but it requires effort and it requires work. I can very quickly give you some figures. There is a money market mutual fund industry in the US; think of it as $3 trillion or $4 trillion. It wasn't previously regulated; it now has some regulation. There is a hedge fund industry worldwide; think $2 trillion or $3 trillion. There are debates about whether that needs to be regulated but we certainly need to oversee it. SIVs and conduits were $1 trillion or so, but are now much smaller. I think we have greater control over it, but we need to watch it very carefully, because what we learnt in the past is that these things transmute, they mutate in ways that we don't understand. We failed to see that the broker dealers—such as Goldman Sachs and Lehman Brothers—which were not systemically important in 1980, were hugely systemically important by 2008. This system has shrunk quite a lot already. Bits of it are being regulated that weren't previously regulated, in particular the US money market funds, but I think we have more work to do to make sure that we really understand it. That's why it's a key priority for us to look at now.

Q721 <Chair: Before I hand over to Stewart Hosie, we have been talking here about the various ways in which this punchbowl might get full again. At the moment the punchbowl is very empty, and it is important to find out if both of you are thinking about ways in which some normalisation of credit can resume, using macro-prudential tools, using various weapons that may be available to you. In addition to the ones we already have in play, do you think that there are some other things that we should be considering and are you considering any? In particular, do you think we can have normalisation of banking conditions without a recovery in the securitisation market?

Lord Turner: The issue of the supply of credit to the economy is one that we, with the Bank and the Treasury, have debated at considerable length. We have done a very careful exercise with all of our banks to understand what their plans are for the next three years—three years in which they have to repay the Bank of England special liquidity scheme, meet our new liquidity requirements and to term out their funding—and what the consequences of that could be for their lending volumes, and whether those lending volumes are sufficient to serve the needs of the real economy. That has been an integrated exercise that we have been at work on and it has a very detailed set of figures attached to it.

What the analysis suggests is that until now the supply of credit to the economy—while problematic, perhaps, in particular areas like SMEs—is not significantly different from what you expect at this stage in a recovery from a recession. If you look at the pattern of 1993-1994, early stages of a recovery from a recession are often not particularly credit intensive. It is also clear, however, that it is at least possible that the combination of us applying new liquidity requirements and the Bank requiring the repayment of SLS by early 2012 might constrain the future pace of credit growth which might be required to support the economy. The crucial lever we have available in that, which we have debated with our tripartite colleagues, is to think carefully about the pace of the application of our new liquidity standards. We have twice this year communicated that we are not switching on those liquidity standards immediately until there is an assured pace of recovery. So, to that extent we are taking into account those credit conditions.

Chair: >That is an important and well rehearsed argument.

Lord Turner: That is the single biggest lever we have.

Q722 <Chair: My specific question was whether we can have a recovery without a recovery in securitisation?

Lord Turner: On the securitisation, I think we can have it without securitisation. It would be easier with securitisation; on the other hand I think we have to be realistic. Quite a lot—and this does relate to the previous issue about shadow banking—of what was previously securitisation was based upon unsafe forms of maturity transformation and is not coming back.

Q723 <Chair: What proportion? What was good and what was bad? What have we lost that we'd rather not have lost?

Lord Turner: I'm afraid the vast majority of the UK securitisation pattern was based upon a particular set of investors that were not sustainable. Very quickly, if I can draw the distinction: if it had been the case that UK residential mortgages, which are essentially 20-year assets, were ending up being securitised and ending up in the hands of the natural buyers of long-term assets—pension funds, insurance companies—then you would have a sustainable non-bank form of mortgage credit intermediation. That was hardly what was occurring at all. Almost all of UK RMBS was, through a series of chains, ending up in the hands often of US investors who at the end of that chain thought that they had a short-term asset. That was something that I think no amount of transparency and better regulation is going to make come back, because it was risky.

Chair: >You have given me a clear answer, and if you have further substance you want to add to it in writing we would be interested to see it.

  Lord Turner: I would be very happy to do it.

Q724 <Stewart Hosie: I have a number of questions about structure and staffing of the new bodies, but can I just go back to something you said about the future? You said, Hector, that it wasn't about stopping banks and financial institutions failing, it was about stopping failure without cost. I take it you mean failure without systemic risk, as opposed to cost?

Mr Sants: And also cost to the taxpayer.

Q725 <Stewart Hosie: Fine. So that means you would not have put £37 billion into Bradford & Bingley because their failure wasn't systemic? You'd have let them fail?

Mr Sants: Exactly right. If you had a regime, which the US to a degree had, that enabled a bank to fail with the cost of that failure being borne only by those who had subscribed the capital, and therefore did so knowing that there was a potential cost if it failed, that should be acceptable to Society. If you can have a failure where the cost only falls on those who provided the capital and there is no adverse impact to the rest of the system for systemic purposes and no adverse impact to the consumers and users of those bank accounts—their bank accounts are transferred over to another bank, for example, I would say going forward that the PRA would not see that as a failure of the PRA. It is reasonable to have a system where failure of that nature occurs because without the opportunity for that sort of failure you do not get risk and innovation.

Q726 <Stewart Hosie: Fine, and the same would apply to Northern Rock and Dunfermline?

Mr Sants: Quite so. In the US hundreds of banks fail all the time and normally this is not considered to be a regulatory failure. The consumers are not inconvenienced and historically the costs have not fallen any further than the providers of capital.

Stewart Hosie: >I just wanted to get that clarified.

Mr Sants: I think it would be very helpful if people understand that, in terms of judging the PRA going forward, that is the right way to judge it.

Q727 <Stewart Hosie: Thank you, it is helpful to get that on the record. Can I ask some questions about how we move forward now? The Government in their consultation said that whenever the CPMA disagrees with the PRA, the PRA's decision would be final—reflecting the important role of prudential judgement in the delivery of regulation. Do you agree with that?

Mr Sants: Broadly speaking, yes. I think there is a risk that that sort of language creates some notion or idea that somehow or another the CPMA is a secondary authority. That would be wrong and if that impression gains ground that would be very unfortunate, and we should try to avoid that. But the point of substance is that conduct risk can evolve into prudential risk. For example, as we've discussed in this Committee in the past, mis-selling can obviously lead to prudential risk through the build-up of poor quality assets on the balance sheet, and it can also be a very important lead indicator of poor cultures, which can lead to prudential mismanagement. So there is a clear interaction between conduct regulation and prudential regulation.

There is also interaction at the systemic level where you can envisage certain circumstances where a closure of a bank might have systemic implications, for the reasons we have just discussed. In those circumstances, and those circumstances alone, it is right that the CPMA should have to consult before taking an action with the PRA and, if the action it was taking was deemed by the PRA to have systemic implications, it is reasonable that the PRA should have an override. We all know that the cost of this crisis has been multiples of any single mis-selling event and therefore, in terms of the impact on society as whole, systemic failure is the most costly.

Q728 <Stewart Hosie: I'll come back to this perception of the CPMA as a secondary body in a moment, but what you've just said would lead us to conclude presumably that consumer protection would always be compromised in order to protect the integrity of the financial system, if there was a conflict between the micro-prudential and the systemic and the consumer?

Mr Sants: It depends how you view consumer protection. I think it would be reasonable. Obviously it is a matter for Parliament, but I would say it would be reasonable for Parliament to make the judgement that systemic failure is a failure that affects consumers. If, at the end of the day, what we want is a market that works for consumers in the round, that should include avoiding systemic failure. But you're right: the judgement has to be that systemic failure is bad news for consumers. I happen to think systemic failure is very bad news for consumers, and therefore that is something that the regulatory system should try to protect consumers against.

Q729 <Stewart Hosie:I agree entirely, systemic failure is catastrophic for everybody, including consumers, but there is a perception in the real world—not on this Committee—that this is once again Government and regulators looking after the banks with the consumer deemed or seen to be a poor second to the big picture of this.

Mr Sants: Yes, I think that's an educational challenge for Parliament and the regulators over the coming months to get over the point that we have just exchanged views on. I think that we're broadly in agreement: this is not about a structure where consumers are second choice or coming off second best. It's about creating a structure where consumers are at the forefront and that is designed to give the best possible result for consumers.

  We had a discussion earlier on about the benefits of change and everybody was relating it back to the question, "Does this mean the crisis wouldn't have occurred again?" I personally think that the biggest opportunity is not just about trying to avoid a repeat of the crisis: it's about taking the opportunity of change to improve the deal for consumers. So it's really important that the CPMA comes forward with an improved set of powers, relative to what the FSA has had, and that there is a real opportunity here to improve the lot of consumers.

Q730 <Stewart Hosie: That's helpful, but you're going to have to have high quality staff in the CPMA. Given that there is this perception at least that it may be a secondary body, and the CPMA, as you said in a previous answer, would have to consult with the PRA, how will you bring the right staff into the CPMA to do what is a very important role in its own right, while it seems to be playing second fiddle to the PRA?

  Mr Sants: This is a really important point, I think, and Adair wants to add something in a moment, but I think that is a clear challenge. As I've just said, in normal market conditions there is a tremendous opportunity here for the CPMA to make a real difference to society and that, I hope, would appeal to individuals and provide a compelling reason for them to want to work in the organisation.

  Certainly, within the FSA, broadly speaking, we have yet—we still have 18 months to go—to settle on the final numbers, but it's going to be something in the order of two-thirds of the FSA staff will be in the CPMA. The PRA will be a much smaller entity than the CPMA, and the general reaction of staff within the FSA is one of excitement about an opportunity to deliver a better result for consumers than we have had in the past. So I think there are lots of people out there who are very interested in improving conditions for consumers.

Q731 <Stewart Hosie: I'm glad staff are excited, but in your written evidence you were speaking about how the problems might be mitigated through people strategies and good initiatives such as secondments between the PRA and CPMA. Does this not really say people are going to serve a bit of time in the CPMA and hope they're very quickly going to get the move to the organisation they really want to go to?

  Mr Sants: I don't think so, no.

  Lord Turner: I don't think that is going to be the case. We are well aware that the FSA board and executive has to achieve two things over the next year and a half to two years, one of which is to divide off the PRA which will become part of the Bank. The other is to create what is the bigger successor body, which is the CPMA, and we are now going through a process of selecting a chief executive-designate for that, who we will have in place some time in the spring. It is quite an exciting opportunity to create a new body that gives consumer protection its own distinct focus. I don't think it is going to be seen as a second-best organisation at all, but certainly that is something that we are aware we need to dispel any belief about. I think it's more a belief that we hear expressed in meetings like this or from the press: it's not something that I think we feel within the organisation ourselves—the secondment thing.

Q732 <Stewart Hosie: You said, "We envisage there being some difficulty in attracting and retaining specialist prudential advice in the CPMA which will continue to have some prudential responsibilities."

  Lord Turner: This is a very specific point about prudential advice.

  Stewart Hosie: Indeed. I make the point that those are your words.

  Lord Turner: Okay, but they are related to a very particular set of skills, yes.

  Stewart Hosie: We are probing this. That's important.

  Lord Turner: I understand, yes.

Mr Sants: There is a particular point which that submission highlighted that the CPMA is not just a conduct regulator. It is also proposed that it will be a prudential regulator for those firms that the PRA is not the prudential regulator for—the non-banks and insurers.

  Within that context, there is potentially somewhat of an issue that that expertise could feel subordinated to the core activity of the CPMA, which is conduct regulation, and therefore we will want to make sure that there is plenty of expertise exchanged between the prudential regulator—the PRA—and those people doing prudential regulation in the CPMA. But that was not a comment about the whole of the CPMA.

Q733 <Stewart Hosie: Let me just ask a final question then. We do know the prudential and consumer are not unrelated: they are linked, of course they are. What will you do in practice to ensure there is proper co-ordination between the two bodies, not rivalry, and that we don't create another crack or an underlap, as we've had in previous architectures?

  Mr Sants: This is undoubtedly a major challenge and it is the principal risk in the new system, which everybody has rightly identified. I think we have to work hard at this. There are a couple of obvious measures to be taken. First, wherever possible we should continue to retain common standards of regulation and a clear interaction between the CPMA and the PRA in articulating those standards. So, for example, in the authorisations process, where we have a requirement for probity, we should not be having one judgment of probity being different to the other from the two organisations. So there needs to be convergence where standards are common.

  Secondly, which I think is the principal action that needs to be taken, we need to ensure that in terms of oversight of individual firms that we put in place some structural co-ordination mechanisms through formal MOUs and do not rely on informal processes and rely on the fact that at least initially the staff will have all worked in one organisation in the first place, which will obviously help. We need to institutionalise the requirement to co-operate and, as the Government's document indicated, we would envisage—to use regulatory speak—colleges for the larger firms that are supervised by the CPMA and the PRA. I think we need some structured obligations for interaction and communication. We need to make sure as well, of course, that firms don't feel we're building an inefficient process, thus we'll need to have common interfaces for collecting data, a common data set and so on. So we'll need a set of structural processes as well as hard-working communication at the senior management level.

  

Q734 Mark Garnier: My questions are to Hector Sants, and before I start can I set you the challenge of brief and pithy answers, if I may, because I think we're running a bit short of time. Following on from this and also from Andrea Leadsom's questions a bit earlier, if we follow your reasoning about what keeps you awake at night—that risk is going to be pushed to the consumer rather than to the manager of risk—what do you think that is going to make the next crisis look like?

  Mr Sants: Well, of course, if I knew precisely the answer to that, we would be taking anticipatory action now. I think that, as I say, at the end of the day a financial crisis ultimately has to be linked to the build-up of risk somewhere in the system. That is the intrinsic nature of a financial crisis. It will be the build-up of risk somewhere, either that is not fully visible to the regulatory system, or that is visible but they have misjudged the level of risk or do not have the appetite to make an intervention, which is the—

Q735 Mark Garnier: So, following that, that is absolutely where the risk goes to the consumer, because that could be hidden risk because you can't see into that. So, the crisis is going to come to the consumer, which is a lot of personal crises as opposed to huge crises that can be dealt with by the state; personal crises aren't quite so easy to deal with. Does that mean that the CPMA, rather than the PRA, are going to be attempting to mitigate this risk and how are they going to do it?

  Mr Sants: I think, at the end of the day, if consumers have built up financial risk they will do so through the owning of financial products; a mortgage, an investment product and so forth; and The CPMA must therefore equip itself to fully have the required information and data and to understand the risk that the consumer is owning. So, that takes us back to the earlier discussion about having a transparent markets process, a good clearing process, a good data process. Secondly, it must have a mechanism of intervention, which is where I think the earlier intervention on the product side—

Q736 Mark Garnier: Risk is not just about owning one product: it could be owning a number of contradictory products. You can have a mortgage, which in itself is fairly straightforward, but then you can have an overdraft and a credit card. Each one of those individually is not a problem, but you put all of them together and you've got a colossal problem for a family or a household. How are you going to deal with that? That's how I see risk being pushed down to the consumer and I don't see how you are going to deal with this.

  Mr Sants: That's a mixture of two. The CPMA intervention would be on a product-specific basis and a product-design basis, but the aggregate risks—sorry, we're back round in the circle again to our FPC discussion—that would be for the FPC to intervene, using the various mechanisms that we've already described. So I'm just making the point it's a twin process.

Q737 Mark Garnier: I'm trying to move on. Has the CPMA got the tools to deal with your element of it and what tools do you think they are going to—

  Mr Sants: The CPMA, if it only inherits the FSA's tools, does not have sufficient tools.

  Mark Garnier: So you'd need more finance?

  Mr Sants: We need powers of product intervention. At the moment the FSA's powers, in the round, are essentially to make a rule, which then would ban a product, but you have to go through a whole process in order to make the rule. If Parliament wants a genuinely interventionist, powerful CPMA, which is seen as powerful, then it needs the power to make executive-driven, direct interventions to ban products.

Q738 Mark Garnier: In response to one of Stewart's questions, you said that your staff are excited by the opportunity for better results for consumers. Let's turn to RDR, because there has been a lot of controversy about RDR among the IFA community. You set out to try and, "Improve the clarity with which firms describe their services to consumers; address the potential for adviser remuneration to distort consumer outcomes; and improve advisers' professional standards." Have you achieved that?

  Mr Sants: Well, since the RDR is not yet in force of course we can't answer that question. We believe that the measures we have laid out for implementation through the RDR process will broadly do that. I think it is fair to say, however, over the lifetime of the RDR, which traces its life back to Adair's predecessor who made a speech about some of the failings in the consumer market, it has become more focused and more realistic in its intent. We've laid out very clearly our intention to have a transparent and fairer charging system, a better qualification framework for advisers and greater clarity around the type of advice that is being offered.

  So, the RDR is set to deliver three specific elements that would contribute to, overall, a better regime for investors. I think the measures we've laid out, when they are in place and implemented, will deliver those three specific outcomes. I do not think you should characterise the RDR as the panacea to the investment market and the solution that is going to lead to a new savings culture and a fundamental change in the marketplace.

Q739 Mark Garnier: I think a lot of people would agree with that. What do you think was then behind themoneymarket.co.uk's article on 16 July saying that the FSA at a board meeting had discussed scrapping RDR?

  Mr Sants: I'm not aware of that article. We have not discussed scrapping RDR so I think it's media speculation.

  Mark Garnier: So all these reports about you potentially scrapping RDR?

  Lord Turner: I can assure you that there has been no discussion at any board meeting of scrapping the RDR.

  Mark Garnier: Fantastic.

  Lord Turner: And in fact I wasn't aware of the article, so I didn't even know the statement had been made.

Q740 Mark Garnier: I will get it forwarded to you. The other really important point about this is that the cost-benefit analysis was originally talking about £400 million cost; it has now gone to £1.7 billion. Now, let's leave aside the massive cost overruns that this has introduced—

  Mr Sants: If I may, it's not a cost overrun, just to be quite clear for the record. An FSA cost-benefit analysis invites the industry to tell us how much they think it will cost to implement a measure. The judgment of how much that is is made by us on the basis of the industry feedback. The initial consultation of the industry came up with the first number you mentioned: in subsequent consultations, the industry revised their estimates of cost. So those are cost estimates made by the industry to the FSA. Any suggestion that is the FSA's direct cost, which has not been managed, is obviously a complete misunderstanding of the story.

Q741 Mark Garnier: I absolutely stand corrected. I stand corrected and I'm glad you put that on record. Nonetheless, what you are effectively doing is taking £1.7 billion out of the savings pool, because this is going to be borne directly by savers. Here we are in a country where I think we have the lowest savings ratio of the G20, we have the highest personal debt in the G20—an average of £28,000 per person—and the FSA, which is a regulator but is also there to help the savings market, has effectively sucked £1.7 billion out of that savings market. Is that a good thing for the FSA to have done?

  Mr Sants: I think, as you say, it's a judgment and we have to make that judgment in the round. What we are looking at—and I think it will be the same data as you're looking at—is that we know that over the years there have been some very significant consumer mis-selling events, pensions, mortgages and so on. These, in total, have added up to many billions; £13 billion is one particular estimate. We have also, which I think is maybe more pertinent to the direct issue of RDR, done some sampling of the degree of mis-selling that we can estimate in respect of smaller, more regular events and we've come up with an estimate of around £250 million per year. We have some other data that suggests that's an under-estimate; it's probably more like £0.5 billion or so. The RDR is estimated to cost, in terms of ongoing cost, around £200 million a year; your £1.4 billion to £1.7 billion range includes a set of one-off costs of some £700 million. So we're looking at an estimate of the annual benefit it would bring, in normal circumstances, of a multiple above what we think the annual costs to the industry are.

  Mark Garnier: Assuming it works.

  Mr Sants: Assuming it works but, of course, we have to make that judgment and we've done it on the basis, I think, of some thorough analysis and the knowledge that there are some very big events out there that completely dwarf the annual running costs. So, I think that's a fair judgment for us to make this time around and the numbers we've laid out there do support it.

  Lord Turner: I think it is a very good challenge. It clearly is concerning when there is a large cost from the FSA itself, or from the compliance costs that we impose upon an industry, that must come from consumers at the end of the day, but the starting point is a system where pretty much everybody is agreed that we don't have a very good retail financial distribution system to start with.

  When I did the work that I did on the Pension Commission it was quite clear that the sales of personal pensions, to take one product, were involving a completely harmful degree of churn where people were just churning through different products from different providers because the commission bias, under which IFAs were operating, was providing them with incentives to do so. We did analysis that showed that very significant proportions of people's total pension pot, by the time they got to retirement, had disappeared in the reduction in yield from all the different costs that were created by this system. I think it was why, when Callum McCarthy gave his speech that announced this, he said we have a system which pretty much everybody was agreed didn't work particularly well for the consumers or for the producers, because there was so much cost going in the administrative and selling costs.

  We are trying to get to a more sensible system and I think at the core of that, the absolute core, is that the removal of producer commissions must be a sensible thing to do because the fact that people or intermediaries are paid by producer commissions is an extraordinary incentive for churn in activities, which is wasted money. So we're trying to end up with a system that has less wasted money, but the fact is we start with a system where a depressingly large amount of people's savings is disappearing in the intermediary and administrative costs.

Hector, you also wanted to make a point and a quick reply.

  Mr Sants: The biggest bit of the ongoing cost burden results from the change in the commission structure. Almost all our submissions from consumer groups are very, very supportive of banning the practice of being paid by the manufacturer of your product which must put bias into the selling process. So the main cost change is in relation to the main detriment, where I would say there is very strong support from consumers for change.

Q742 Mark Garnier: I completely accept there are a number of good things about RDR and it would be wrong to completely say it's all rubbish, because generally a lot of it is good. However, amongst the IFA community there is a reasonable proportion, about 30% or so, who are outraged by what's happening and find it very difficult and there's a significant proportion of that 30% that are now considering completely coming out of that industry altogether. Do you feel that that is an acceptable cost to implement RDR?

  Mr Sants: Well we obviously have looked closely at this issue. We have some data that suggested more like a 10 to 20% reduction in capacity could flow from the RDR measures. We've obviously deemed that to be acceptable or we wouldn't be going ahead. But in my experience in the lobbying process you tend to get fairly extreme statements made, which don't necessarily always come about in practice.

  Lord Turner: But we shouldn't exclude the possibility that some exit of capacity from the industry, which is therefore also an exit of administrative costs, may be in the interest of consumers. That's a cost that is being absorbed, isn't it?

  Mark Garnier: I put on the record I disagree with that.

  

Q743 Mr Love: Mr Sants, we've discussed this morning all the complexities of the structural reform that we're talking about and now that the consultation is finished, that may be tweaked in some way. We're just about to go on to talk about mismatch in Europe and the challenges that face you regarding that. You have a major programme of activity: we've talked about RDR; there's a mortgage market review. And against that backdrop, you're having some staff retention problems. Are you going to be able to complete this structural reform by 2012, facing all of those challenges?

  Mr Sants: Yes, but it is very difficult, for the reasons you've outlined.

Q744 Mr Love: Can I ask you then because, Lord Turner, you said in an article that there are some risks to business as usual from bringing in this structural reform: where do you see the real challenges that you face to bring it in by 2012?

  Lord Turner: The challenges, which were extensively discussed by the board two weeks ago on the basis of very detailed presentations from the executive, are essentially these. A process of organisational change will absorb the time of many of our major managers. For instance, they will have to sit down with people and discuss with them where they are going in the new organisation and where they want to go. They will have to design training programmes and some people may challenge where they are going to go. Those processes, those actual personnel processes of selection and decision and challenge, simply take time— anybody will tell you that—and that is taking key resources away from business as usual activity. That's a fact.

  The crucial thing then is to plan that out very clearly, and we were discussing two weeks ago very clear plans to make sure that we have thought through whether there are things that can be temporarily de-emphasised, either on the policy side or on some of the issues to do with frequency of supervision for some of the lower risk authorised firms, which will free up that resource that is required. It varies according to the different bits of the organisation. There are some bits of the organisation where essentially they will, what we call, lift and shift. Pretty much the whole of our prudential policy division we know is going, in its entirety, to that side.

  Mr Love: Excuse me for interrupting.

  Lord Turner: But there are others where there is a major split, that's what we have to manage.

Q745 Mr Love: Excuse me for interrupting you, but we are limited in time.

  Lord Turner: Yes, sure.

  Mr Love: I wanted to focus specifically, since you're talking about staff retention, on the financial stability division, which has two major problems. First of all, the head has announced that he's leaving and, secondly, this is the part that will merge with the Bank of England, and therefore there's a possibility of redundancies; let's say there's uncertainty about the future. How are you coping with that and is that a major strain on you?

  Lord Turner: It's not a major strain at the moment. We are sad to lose the head, David Strachan, but there are very good people beneath him. We are continuing to do our work in that area. We are continuing to head towards, for instance, our prudential risk outlook in the spring. The work that they are doing is of very high quality. We will, with that group of people, have to be completely honest about the fact that there may be some overlap with the Bank of England and we will have to manage that through.

  But I can assure you at the moment that is not an area where I would be worried about interruption to business as usual. I would be more worried about interruption to business as usual in our core supervisory teams where what we have to do is split them in two and decide who is going which way. That's where we are more concerned and really focusing to make sure that things don't slip through the cracks.

Q746 Mr Love: Mr Sants, can I ask you the first question by a roundabout route. Say you complete it by 2012, will there be so many stresses and strains within the organisation that you won't function to an optimal level in terms of regulation?

  Mr Sants: Clearly between now and 2012, as Adair has just laid out in some detail so I won't go back over that again, we have a finite number of people and they are going to have to do an additional task in that period. The additional task in that period is this reorganisation. Reorganisations are very time consuming. We have to prioritise delivering that reorganisation in order to hit the 2012 deadline, which I believe we can do, but if we prioritise carrying out the reorganisation that involves partly, for the reasons you have just said about staff uncertainty, managers spending a lot of time internally—putting staff at the forefront of their minds—then there will be less time to carry out other functions.

  The main activity of the FSA is frontline supervision. Relatively speaking, if we look at our activity breakdown, we are a micro-prudential regulator. We spend the bulk of our time on day-to-day supervision, not on designing new policies. We are in fact trying to do as little as possible by the way of new initiatives, other than those mandated to us by Europe. So we will do somewhat less supervision in that period, but we will make that judgement on a risk basis and seek to make sure we mitigate the adverse effects. But it obviously necessarily follows that if we are doing something extra we do a bit less elsewhere.

Q747 Mr Love: That's very helpful. I want to switch now back to an answer you gave to John Thurso in relation to the mortgage market review and it's this hoary old question about appropriate regulation. Do you think, in terms of where you've gone so far, you've hit the right button in terms of appropriate, because the accusation has been made that it's too onerous?

  Lord Turner: We are very aware of the need, as we bring the mortgage market review to conclusion over the next several months, to really step back and to think very carefully about this balance, and this is one of our highest priorities over the next few months, to get this right. It is a matter of balance. If we protect some people against taking on board unsustainable mortgage commitments, at the margin somewhere else we'll constrain somebody's right to take on board a mortgage commitment that might have been affordable: that's almost necessarily the case. We are looking at it very carefully and we will be conducting a complete economic analysis of all the proposals before launching the specific proposal next year.

  But I would make two points. Can I quickly make two points? First, easy credit supply is not necessarily good for first-time buyers. One of the features that occurred in the mortgage market up to 2008 is a gradual fall in the percentage of credit going to first-time buyers as more and more of it went to remortgages and mortgage equity withdrawal, where the easy supply of credit, by driving up the price of houses, was actually making it more difficult for first-time buyers to get into the market. So the somewhat easy assumption that easy credit is good for first-time buyers is not necessarily the case. That's point one.

  Secondly, there was a clear tail of very harmful lending that occurred before the crisis, extending it to people who could not afford it and that is why, for instance, from people like Shelter and Citizens Advice there is strong support emerging to say don't compromise on the FSA proposals, which is balancing the argument from the other side of the industry of saying we've got it wrong. We are very well aware of the need to strike a balance. We'll be thinking very carefully about it and we will communicate very carefully the balance we've struck and the macroeconomic analysis.

  I called last year for a very open public debate about this. It's one of the most important decisions we've got to make and we're not going to rush it.

Q748 Mr Love: You mentioned about the tail, which you estimate, as I understand it, to be about 5% but the mortgage companies are suggesting much higher, some of them dramatically higher figures. The accusation that they are making is that you're not putting any responsibility on the consumer, and that all the responsibility, not only to carry out affordability tests but also to make an assessment of the consumers' ability to pay, they consider that very onerous and they're likely, they claim—and I'm not one to put words in anyone's mouth—that that will mean a withdrawal from the marketplace. How do you respond to those concerns?

  Lord Turner: We don't think there will be a major restriction of mortgage credit. You have to always distinguish here. It may be that at the margin some people will only be able to borrow on an 85% LTV, not a 90% LTV, but that's different from somebody not being able to get a mortgage at all, and that gets mixed up in these figures claiming that 50% will be affected. So we are looking at it very carefully.

  On the basic concept of assessing affordability, most of the major lenders believe that that is something they should do because it's something they should be interested in. They shouldn't be interested in writing a loan contract where the person can't afford to pay it back, because that's just going to produce arrears and repossessions down the line. So I don't think the concept of affordability assessment is being challenged. It's simply how we get the correct calibration of how significant the constraints should be, how tight they should be.

  In particular, on crucial issues like when you offer somebody a mortgage at 3.5%, how much should you stress the interest rate to deal with the fact that it might go up in the future? That's something where we haven't been definitive yet and accordingly, as you flex that, that's the sort of thing that either produces a big effect or a small effect. We are going to think very carefully about that in the final stages of this consideration.

Chair: You can come back to all this. A quick further question from Andy.

Q749 <Mr Love: I wanted to get this question in, and it goes back to something that John Thurso said, the interaction between these consumer protection measures and macro-prudential tools. Have you given any thought to how they would interact with each other? If you go more on the consumer protection, does that inevitably mean that we won't need to use the macro-prudential tools as much?

Lord Turner: We are not seeing what we are doing within the FSA's mortgage market review as focused on the macro-prudential side, and that is why it is focused on the tail of bad lending rather than the general supply of lending. So we're not intending, in the mortgage market review, to do things that would, as it were, have slowed down the across-the-board growth of credit in 2004 to 2007. That is a separate set of tools that have to be discussed by the Financial Policy Committee. Obviously there has to be a joining up, which is why the future chief executive of the CPMA is rightly one of the members of the Financial Policy Committee. But we do see these as complementary, and we do not see the tools that we are intending to put in place on the mortgage market review as addressing the wider issue of the through-the-cycle variation in the overall supply of credit. That would be more countercyclical capital requirements, or perhaps LTV or LTI constraints.

  

Q750 <John Mann: Thank you, Chairman. I will not be seeking to catch your eye again in this hearing.

I do have three questions and possibly a supplementary, particularly on the last question. First, I wanted to pick up your answer, Lord Turner, to Mr Mudie on what I thought was a very important issue, where you stated—I think I have this down accurately—that the FSA didn't realise the systemic risk from investment banking. Talking in confidence to FSA insiders, as I have been doing, I put to you that that's not accurate, that in fact the situation inside the FSA and the discussions that you had were not that you did not appreciate the systemic risk from investment banking, but that you truly did not anticipate the extent of the systemic risk: perhaps more fundamentally, you didn't know what to do about the systemic risk with investment banking. I put it to you that investment banking is fiercely competitive in some areas, but there is no competition whatsoever in other areas. The big question being asked is "are banks too big to fail?" Isn't the more pertinent question "are investment banks too big to regulate?"

Lord Turner: I'm not sure I agree with what you're saying there, because I do think the fundamental problem was a failure across the world to understand what was going on in the area that spans investment banking, securitisation and the shadow banking system, but that of course includes the trading activities of major commercial banks. Let's be clear at this point, the trading activities of UBS, which is a commercial bank, were as relevant to this as a standalone investment bank like Lehman Brothers or Goldman Sachs. I think there was a failure to put together the bits of the jigsaw puzzle and to realise that once there were things going on in the money market mutual funds, the SIVs, the conduits, the trading books, the investment banks and the broker dealers themselves, the totality of the system had a set of risks that people didn't understand. Indeed, let's be clear, it's not just that they didn't understand it: there was a very overt philosophy, attached in particular to Alan Greenspan but set out in documents, that you didn't need to understand how it all fitted together because you could have confidence that the free market was bound to disperse risk so that it would be constrained. I can point to bits of IMF documents that say that.

So, I am not sure that it was the case that there were a whole load of people looking at it. Obviously you then have a matter of degree, but there was a failure to understand how this new system of credit supply all fitted together. Remember in the US, the pure play investment banks—the five banks that did exist—they really did escape prudential regulation, because they were regulated by the SEC, which is not by its nature a prudential regulator, it's a conduct regulator.

Q751 <John Mann: I'm sure that we'll be keeping a very close eye on both whether there is competition, and whether there is any real regulation of investment banking.

Let me come to you, Mr Sants. When did you warn the Treasury about the seriousness of our exposure to the Irish economy?

Mr Sants: I am going to have to give you a written answer on precisely when the first meeting on Ireland was, but it was a long time ago. This is not something that has suddenly sprung on us, for the reasons that Adair outlined in terms of his analysis of what is underlying in the Irish crisis. I'm trying to think when our first Irish meeting—

Lord Turner: I would imagine probably the tail end of 2008.

Mr Sants: Yes, 2008 or something like that. It is a long time ago that goes right back into the depths of the crisis; I would guess 2008 some time.

Q752 <John Mann: During the last three or four months, how much have you been warning the Treasury?

Mr Sants: I think warning the Treasury is probably not the right description of events. I think all elements of the tripartite system, the Treasury, the Bank of England and the FSA, have nearly continuous meetings and discussion on this subject for the last 12 or 15 months. There is always work going on in the FSA on Irish banks. That information is regularly communicated to the Treasury and we are doing it jointly with the Bank of England. So, because it is such a longstanding issue, it is something that is now embedded in our work as business as usual. It is reviewed regularly in all the deputies meetings, and principals meetings.

Q753 <John Mann: So the Government has had good time to plan its decision making then in relation to the Irish banks. Are there any other economies where you are warning about our exposure, for example Portugal or Spain, at the moment?

Lord Turner: The situation on our exposure to Portugal and Spain I would say is as follows. In both of those we again had relatively little exposure to sovereign bonds. In general around Europe, the major exposures to sovereign bonds by banking systems are not in the UK. You can see that from the results of the CEBS stress test earlier this year, which revealed significant sovereign bond exposure of some of the continental banks but not the UK banks. We do have one bank that has a non-trivial involvement in mortgages in Spain, because it has a business in that area. Those will, of course, depend upon the quality of those mortgages. Some of them, although they're in Spain are, of course, to British citizens who have taken out mortgages to buy second properties. But the scale is not on the same scale as the Irish exposure. We do not have the same equivalent of RBS owing a large Irish bank.

John Mann:> I appreciate that. Let me—

Mr Sants: Eurozone issues have been a regular part of our stress testing supervisory approach to the UK banks for well over 12 months now.

Q754 <John Mann: Mr Sants, didn't you think it appropriate, considering that British taxpayers are having now to bail out Ireland and Irish banks, that the Chairman of this Committee should be alerted to the seriousness of your concerns?

Mr Sants: First of all, I think to be quite clear, it is not a result of the failure of UK regulated entities among the UK banks that has led to the Irish banking crisis. That is a matter for the Irish regulator and—

Q755 <John Mann: No, but we're involved in the bailout and there is a specific link between this Committee and yourselves. Considering the seriousness of the situation and the seriousness of the advice that you have been giving to the Treasury, did you not think that this Committee—at least the Chairman, whether in confidence or not—ought to be alerted to the situation where the British taxpayers are being asked to bail out Ireland and Irish banks?

Mr Sants: The decision to bail out Irish banks or the contribution to the Irish package is a decision for Government not for the FSA. As I understand it from the public announcements that have been made—the decision takes into account a number of other factors, including our export/import relationship with the Irish economy, and no doubt other factors of which I'm not aware—this is not a specific regulatory intervention.

Lord Turner: Can I just make one other point? The fact that RBS has a large exposure to Ireland has been obvious to anybody who picks up an RBS annual report and realises that it owns Ulster Bank. This is not something that, as it were, the FSA has to discover and reveal to people. It's an obvious matter of public record that follows from the ownership of Ulster Bank, which, as I say, before RBS bought NatWest, was owned by NatWest for decades.

Q756 <John Mann: Yes, but it may be a surprise to the British taxpayer to have to fund it. But let me ask you a different question on a different issue, Lord Turner. You have been in post since September 2008. Isn't it the case that you have taken your eye off the ball when it comes to what is happening in Europe and European regulation, and as a result of that we have not been winning the battles when it comes to European regulation?

Lord Turner: No, I don't think that is the case. We have been focused very clearly on the European regulatory environment and many of the things that have occurred in Europe we have strongly supported. There have been debates, for instance, about the alternative investment fund management directive about things to do with passports and so on, but it includes within it the powers for the regulator to gather information to understand where prudential risks are emerging, which are precisely what we require to keep track of the shadow banking system. That has not been something imposed on us: that is something we've argued for. We are coming forward with European capital requirement directives, which are the expression into European law of precisely the things that we have been involved in agreeing in detail at the Basel Committee on a global basis. Now, of course, when things happen in European law, people may add bits of the agenda that we don't like, but the broad thrust has been things that we're arguing for.

Q757 <John Mann: Why then is ESMA based in Paris and why do we have only one seat on ESMA?

Lord Turner: ESMA is based in Paris because CESA, which existed before, is based in Paris, and because CEBS, which will become the European Banking Authority, is based in London. A deal was done a long time ago that said there were three main committees, which are now three main authorities, and they are in Paris, London and Frankfurt.

Q758 <John Mann: Yes, but some people might agree more with me that you have not had your eye properly on this issue. For example, Peter Clarke of the Man Group says, "The UK's bargaining position in Europe has been impaired". Mr Rolet, head of the Stock Exchange, goes much further: "The regulatory environment probably sows the seeds for the next crisis". That is pretty stark coming from the head of the Stock Exchange. Basically, Europe has trampled all over us while we have been restructuring in this country, hasn't it?

Lord Turner: No, I don't think that is true at all, and I don't think there is any evidence to suggest that, whatsoever.

Mr Sants: The European regulatory structure that is now being implemented from the beginning of next year was decided through a full European process, which is primarily one determined by governments rather than regulators, long before the proposal to restructure the UK environment was proposed. These decisions pre-date this entire debate we're having. These decisions were made in 2008 to 2009, not in 2010.

Q759 <John Mann: So you disagree with Mark Hoban when he says that we've been losing the arguments in Europe?

Lord Turner: We do not think that we have been losing the arguments in Europe. You win some, you lose some; that is the nature of the European debate, and it always has been, and it will be the case whoever is the Government in power. We have been working with Europe to achieve some re-regulation of our financial system, and I'm a bit surprised to hear you totally supporting those who favour a completely light touch approach against the bad European imposition. I'm slightly interested—

Q760 <John Mann: I'm asking the question because Government has made changes to our structures. A lot of time and effort has been spent on them. They don't come in until 2012, but Europe is up and running with its regulation in a month's time.

Lord Turner: Some of which are direct responses to problems that we have. Let's be clear that the problem of the Icelandic banks revealed to us that a single market in financial services can be a very dangerous thing, unless there is some mechanism at European level to check and challenge the quality of supervision in all the countries of the European economic area. We, and I think this Committee, argued that there had to be action at European level to deal with the problems that were revealed by that.

Q761 <John Mann: You are putting up a robust defence of how that has been negotiated, which is very clear for the record. Has there been any step change in the last three months in terms of how effective we've been in winning arguments in Europe and, if so, what?

Lord Turner: I don't think there has been a step change, I think this is just a continual process in which we are extensively involved, the Treasury is extensively involved and, given the nature of European decision making, there are many things that result that we agree with and there are some that we disagree with. I think if you don't want that you should probably join UKIP.

Chair:> We are going to be having Mr Barnier along very shortly and we will be able to take these issues forward there. Hector, I would like to draw this to a close now, unless John has one very quick question.

Q762 <John Mann: Just one final question. What I am attempting to see is whether over the process, particularly since you've been in post, Lord Turner, whether in essence our approach to Europe on this matter of regulation has been consistent over your time in office, or if there has been huge variations during your time in office?

Lord Turner: I don't think there has been any variation. I think you can legitimately ask whether we have won all the arguments, but I've seen no sign of a shift in our approach during that time, because it has been a consistent process. That's what I would say.

Q763 <David Rutley: I would like to turn to something at a much more micro level, which we have not discussed so far but I know many of us around this table have had some concerns from constituents around foreign exchange businesses, particularly Crown Currency Exchange. I know it's quite a complex regulatory environment—not complex, perhaps, but not well regulated—but the FSA hasn't been required to regulate all the activities, particularly on the foreign exchange activities of that company, and the administrators are reviewing the situation. That said, people are out of pocket, so it's not great. I just wondered what lessons you have learnt so far, prior to the administrators coming back? Are other companies being reviewed actively to determine whether their business models are fit for purpose? Are there any emerging thoughts about how you can improve the regulatory framework within the context of the twin peaks?

Lord Turner: What I suggest is Hector says something specifically on this case and then I'll just make one very brief point about a general principle we draw from this.

Mr Sants: It is an important case to focus on, not just because of the current consumer detriment but in terms of learning some lessons here for the legislative framework for the CPMA, which Adair can expand on in a moment. But, as you rightly point out, the FSA is not responsible for regulating foreign exchange transactions. Its only jurisdiction over Crown or similar business is in relation to the powers given it by the Payment Services Directive, in relation to money transmission—the forward activities where money is being paid to another party, not just by going in and exchanging your forex over the desk. The activity, therefore, the FSA have their engagement with is a very small portion of the Crown's business. We were not regulating Crown through the FSMA Act. We were running a registration service. We run a registration process under the Payment Services Directive. The only oversight we had was in respect to that registration, which requires a form to be submitted.

There is a significant misunderstanding here where consumers are under the impression that registration with the FSA under the Payment Services Directive in some way or other implies that the FSA is regulating and overseeing that type of activity in the same way as it does for FSMA firms: we do not. In my view that registration process does not imply any investor protection of any materiality whatsoever and, therefore, that was a misunderstanding. The power we should have had, and we've asked for, is the power to say to firms, "You cannot publicise the fact you are registered with us". The fact we run registration is an administrative service for the Government's compliance with the Payment Services Directive: it's not a regulatory activity.

So, no, we are not out there now looking at other firms because we are not regulating other firms in that space. We run a registration service. What needs to be changed is the confusion caused by that registration service. Then I think there are some wider perimeter issues.

Lord Turner: I think what this illustrates is that there is a distinction in the law and in our activities, between authorisation and registration, which I suspect is not clear to many consumers. What we essentially do on companies of this sort is register them in the same way that Companies House registers companies. The point is going forward, I do think one should consider going in one or other direction. Either we should not be the registrar of these things, or it should be done under a completely different brand name, or they should be authorised and regulated, but I do think we have a slightly uncomfortable—

Chair:> We get the point. David, you have one more question.

Q764 <David Rutley: Should they be authorised and regulated, based on what you see?

Lord Turner: I think there could be an argument for doing that. We'd have to think in detail about whether to do all of their activities. Certainly those that go beyond the straightforward instantaneous exchange of currency do not need to be regulated, because there isn't a risk in that, but for those where you end up with some sort of forward commitment from them to deliver your money, then arguably there should. But I think the crucial thing is that it's one of these things where we have to go one way or the other. We need clarity. We are in an uncomfortable position at the moment where we are being asked to do something called registration, which consumers probably think is more significant that it is.

Mr Sants: The longer term point is that it's very important that Parliament doesn't dilute the brand name of the CPMA. I think the CPMA, if it is to be set up as a consumer champion, needs to have the right set of powers, and it should only be overseeing those firms that that full set of powers apply to, otherwise you run the risk of dilution and confusion in the consumer's mind, which is what—quite understandably I might say—has occurred here, because we'd been asked by Government to take on these additional tasks, no doubt for the convenience of the process. We should avoid this convenient parking.

David Rutley:> Thank you.

Chair:> That is a very helpful exchange. We are running behind schedule and I think we all deserve a five-minute break and then we are going to resume—for, unfortunately, a briefer look than perhaps the subject demands—at competition and choice in banking. Thank you.

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Prepared 3 February 2011