To be published as HC 1534 -iii

House of commons



Treasury Committee

Independent commission on banking: final report

Wednesday 26 October 2011

Andy Caton, Graham Beale and Chris Rhodes

Evidence heard in Public Questions 225 - 279


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

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

Oral Evidence

Taken before the Treasury Committee

on Wednesday 26 October 2011

Members present:

Mr Andrew Tyrie (Chair)

Michael Fallon

Mark Garnier

Andrea Leadsom

Mr Andrew Love

Mr George Mudie

Jesse Norman

Mr David Ruffley

John Thurso


Examination of Witnesses

Witnesses: Andy Caton, Corporate Development Director, Yorkshire Building Society, Graham Beale, Chief Executive, Nationwide, and Chris Rhodes, Group Product & Marketing Director, Nationwide, gave evidence.

Q225 Chair: Thank you very much for coming to see us this afternoon. We are taking some more evidence on the ICB. I would like to start by asking whether you feel the downgrade has affected your ability to raise wholesale funding?

Graham Beale: We have been talking to Moody’s for most of the summer so we knew this was coming, and they made it quite clear that this was a sectoral adjustment to remove systemic support, very much on the back of the Government and the ICB making it very clear that systemic support would be removed and taxpayers would not be put at risk. So we had a long discussion with Moody’s and they made it quite clear in their announcement that this was not a reflection on the financial strength of Nationwide, which was unchanged, but this was a sectoral adjustment.

In terms of the consequences, at the very fringes of what we do, I think there will be some investors that for rule-driven mandates will not be able to invest in Nationwide, but I think in terms of its impact it will be minimal, so we do not expect any consequence and we have been active in the market very recently. We are not getting any sign of any breakdown in confidence.

We did see a very small blip in consumer driven activity, particularly balances in excess of the FSCS limit because it does not help when they see Nationwide on News at Ten alongside some of the bank names.

There were again tiny movements in what we do, so I think net it will not make a big difference at this stage but it is disappointing because we think that the raters have been quite heavy-handed with their assumptions and there is a lack of transparency about the way that they operate, so it is very difficult for us to engage with them at any level of detail to either demonstrate that we are stronger than they are assuming or at least to understand where they are coming from.

Q226 Chair: On that last point, the Committee is becoming increasingly interested in the way the ratings agencies are operating. It would be extremely helpful to have a detailed note on exactly the point you have raised, which is the opacity of their approach, and if you feel it is defective as well as opaque in other ways to let us know. Would others like to add anything that has not been said?

Andy Caton: I support everything that Graham said. The Yorkshire Building Society also got downgraded in this process. Fortunately, like Nationwide, we have been upgraded on a stand-alone basis so this again purely reflected Moody’s own view of potential sovereign support. Like Nationwide, it does not stop us from accessing the market in our view. All of our wholesale funding in terms of term issuance is collaterised these days, so that is either through covered bonds or through securitisation and there will be some mandates that we will no longer be able to issue to because we are not-

Chair: So it will affect you quite a bit.

Andy Caton: It will limit our pool but fortunately we do not have a huge appetite for wholesale funding and we have already proved that we can issue in the core European and UK markets as a split-rated issuer so we can cover bonds with AAA on one side with one agency and with AA with Moody’s. The irritation is that there will be a lot of work behind the scenes in restructuring programmes. There will be increased costs in terms of swaps and credit that has to go behind that, so certainly more cost comes into it and obviously that means ultimately that may get passed to customers.

The impact is further down in the sector with the smaller players who perhaps do not have such established wholesale franchises, as Nationwide or Yorkshire does, and maybe are looking to enter the market for the first time and where their ratings have come out, where there have been many more penal reductions in perceived sovereign support, their options may be more severely limited. At the end of the day I think the Moody’s review is taking a view of sovereign support or likelihood based on size of organisation, potential support from Government, and complexity of organisation. That seems to me to run against what the objectives of the ICB report are about where effectively a lot of the provisions around the retail ring-fence are looking towards the building society legislation that if not coming up with the quantum of some of the limits then at least some of the principles, things like wholesale funding, use of derivatives for hedging, and so on.

Chair: That is an important point. Mr Rhodes?

Chris Rhodes: No, nothing to add.

Q227 Andrea Leadsom: Do you think your downgrade was fair? Do you think it was justified? I am looking at all three of you.

Graham Beale: I will start with our position. We obviously perform our own stress test. It is a requirement of working with the FSA to see what could happen to the business model in some extreme situations and you come out with loss projections and provision requirements, and so on. We compare that with the sort of spectrum of numbers that we get out of the rating agencies, and they are so far apart that you feel that they just have some extreme, bordering on unrealistic, assumptions.

Q228 Andrea Leadsom: So you think it is wrong?

Graham Beale: I think it is very prudent and very difficult for us to reconcile that to our own stress analysis, which we share with the FSA and is based on assumptions that the FSA are comfortable with.

Chris Rhodes: Nothing to add to what Graham said.

Andy Caton: If I could add a few things. I absolutely think it is not fair and unfortunately some of this is quite methodological and detailed and we are clearly talking about one rating agency here, not all rating agencies. There was an exercise done some years ago right across the UK banking/building society sector, which was looking at stress testing, and I think the average downgrade was two notches, which is quite extreme, and in one particular case, Chelsea Building Society, it was four notches. Any institution that gets a one-off four-notch downgrade, that is a bad day at the office, and ultimately that was one of the reasons why Chelsea ended up merging with Yorkshire. We have subsequently taken that institution on. We are perfectly happy with the portfolio we acquired that led to that four-notch downgrade, so we obviously did our own quite severe stress analysis, as did the regulator, and we came out with two very differing opinions.

Q229 Andrea Leadsom: What has been the impact on your cost of funds?

Andy Caton: It is quite difficult to judge that in a market that is still, frankly, quite dislocated in terms of pricing. I would have to look at Yorkshire’s cost of funds versus if we were AAA-rated. I guess that would be 30, 40 basis points on a new five-year issue.

Q230 Andrea Leadsom: You mentioned the fact that your wholesale funding is now collateralised.

Andy Caton: Not all of it; new funds.

Andrea Leadsom: But is that largely since the 2008 financial crisis? Were you previously issuing unsecured, uncollateralised products?

Andy Caton: We were doing both. Fortunately we had entered, as Nationwide have done, the main European covered bond market, which is the way European mortgages are basically financed, and we did that in the latter end of 2006, so fortunately we had funding already in place and we had an investor franchise already in place.

Q231 Andrea Leadsom: Mr Beale, Moody’s report says that Government is likely to continue to provide some level of support to systemically important financial institutions. Would you consider that that would cover Nationwide?

Graham Beale: Yes, I do, and there is still one notch of support assumed in our rating. The point that we made to the rating agencies is that they are taking the view that certain institutions are more systemically important than others-and I think at certain levels they are-but for Nationwide with 15 million retail customers, 15 million taxpayers, we will never get into a situation where we need taxpayer support, but in the hypothetical situation that we did I am absolutely convinced that the Government would look very seriously at supporting Nationwide, certainly relative to an equivalent position for Lloyds Banking Group or Royal Bank of Scotland, but LBG and RBS have more support assumed within their rating than the equivalent support assumed within Nationwide’s rating.

Q232 Andrea Leadsom: But do you think that the Government would be supporting Nationwide or just the depositors?

Graham Beale: I think their principal concern would be the depositors, but the depositors are Nationwide at the end of the day.

Q233 Andrea Leadsom: Final question: do any of you anticipate that as we get closer to the ICB’s proposals being implemented that there might be further downgrades as a result?

Graham Beale: We know that Standard and Poor’s and Fitch are going through the same process that Moody’s are going through, so our rating with Moody’s is stable and therefore that suggests they are content for the immediate future. But the same process is going on with the other two principal agencies so I expect that there will be more ratings adjustment as a result of removing systemic support from financial institution ratings.

Andy Caton: I would not have a view on that. I would have thought the action has been done in terms of the building society sector, and potentially as the implications of the ICB report for universal banks come in, there may be more action in terms of those larger players, but obviously that is for the rating agency to decide, not us.

Chair: Very interesting and helpful evidence, thank you.

Q234 John Thurso: Mr Beale, in your evidence to us you have one of your big bullet points as being a leverage ratio over and above Basel III is wholly inappropriate for low risk institutions. Nationwide is the sixth-largest; I think you come after Santander, do you not?

Graham Beale: We are the third-largest, actually.

John Thurso: Whatever, but in the banks after the big five, you are number six. Why is it appropriate or what is the problem that you have with the same leverage ratio that they have?

Graham Beale: It is quite a complicated topic. The leverage ratio is a fairly crude metric. It is a crude measure of the financial strength of the balance sheet and the ICB, I think quite rightly, said that it should be a backstop measure. The concern that we have is that where you have a balance sheet, such as the Nationwide balance sheet, which is very large, but is also populated by very low-risk assets, it does tend to discriminate against that type of balance sheet.

Q235 John Thurso: Let me tease that out because that is the point that I want to get clear. Looking at the banks, they effectively had not enough tier one capital and were therefore unable to absorb the losses and that effectively is they were inadequately capitalised because they did not have sufficient equity. A mutual does not have equity as such, so how do you respond to or how should you respond to or why are you different to that circumstance?

Graham Beale: I think the first thing is to be absolutely clear that the majority of the assets that sit on our balance sheet are prime loans secured on residential property, so they are very, very low risk in terms of their characteristics, and if you look at the capital that you require to underpin the losses that you would experience from a portfolio of that sort, it is a very low amount of capital. It is a lot lower than the leverage ratio either at 3% or 4% because within the ICB recommendation at the moment their recommendation would be that we should operate at a 4% limit. We can get to 4% but we have no margin for headroom or error in any sense. We would be right on the line at that sort of level.

Q236 John Thurso: Can I just ask you, if you are asked to increase from 3% to 4%, and you obviously cannot do a rights issue, how do you increase your capital?

Graham Beale: I think there are three things that we can do, none of them very palatable. We could increase our pricing so that we generate more profit, which generates more capital.

Q237 John Thurso: You would just retain the profit basically?

Graham Beale: We would retain the profit, which would not be the right consumer outcome, and I think in terms of our competitive position it would undermine our position.

We could move into new lending activities, which are significantly higher risk than the ones we would traditionally undertake, which would generate-

John Thurso: Sorry, I keep interrupting. But that is what various smaller building societies did to try and compete, because they went into corporate property rather than-

Graham Beale: But you asked me the responses and one response would be to change the risk profile of the balance sheet so we would take more risk, we would generate more revenue, we would therefore generate more retained earnings and capital, so we would respond like that. Again, counterintuitive both to what the ICB are trying to achieve and counter-cultural to the way a building society would operate.

The third option would be to de-lever, to reduce the size of the balance sheet, so we could retrench from the marketplace and we could reduce our asset size. It puts you in a strange position because with the assets that are left to generate the capital required by the business going forward, again I think you have to go up the risk level a little bit, but the outcome from that would be a reduction in supply of credit to consumers and it would undermine our competitive position again. So again, not a very satisfactory outcome.

Q238 John Thurso: The critical point in all of this is if you carry on behaving as the Nationwide, as a trusted, respected low-risk mutual, you probably do not need any more capital, but there is always the risk that your successors might decide to become more aggressive and do things other building societies did, so there has to be some mechanism to deal with that. What would your suggestion be? If you could come to Government and say, "We recognise the problem but you are trying to solve it the wrong way," what would you want done to deal with that that allowed you to continue to operate the way you do?

Graham Beale: We operate very comfortably under the current Basel regime, so if you look at the solvency ratios, which are risk-weighted, they do take into account the characteristics of the balance sheet and the risk profile of the balance sheet, and we operate today with a core tier one ratio of 12.5%, which is stronger than any of the banks’ equivalent position and that is without having done anything other than operate the way that we have always operated. We did not have to take any emergency actions throughout the crisis.

I think the solvency ratio is the real mechanism because it is a much more sophisticated mechanism. It is risk-orientated so it takes into account the characteristics of the balance sheet. The ICB are arguing that the leverage ratio should be a backstop ratio and, to a degree, while I can pick holes with the logic of the ratio, I can understand to have an absolute backstop. I think as far as I am concerned, to calibrate Nationwide alongside some of the much larger and much riskier banks, which is where they have slotted us, has been quite penal in its consequences.

Q239 John Thurso: You only have Nationwide capital markets, you do not have all of that stuff. You are a ring-fenced operation.

Graham Beale: The Basel regime is coming up with a leverage ratio around about 3%. We are much more comfortable with operating at 3% than operating at 4%. It does not sound like a big difference but it is quite a big difference in terms of the consequences on the business model. While I agree with a lot of the content of the ICB’s report, I think when it comes to the calibration of capital of leverage ratio there is another process, which is the Basel process, which is much more sophisticated, it is based on much more detailed information and I would much prefer to rely upon that process to come up with the right calibration metrics than the sort of recommendations coming out of the ICB.

Q240 John Thurso: Very quickly, because this is obviously-I see you nodding to all of that, I take it as read that -do you have anything to add?

Andy Caton: If I could just add one thing, there is a lot obviously there about Basel and the leverage ratio. Clearly the point is that mutuals do not have access to a core tier one equity instrument that can issue in place of share equity, and the regulatory framework is clearly focusing not so much on top level solvency or capital ratios but on core tier one, and our old tier one instrument that we used to issue, permanent interest there in shares, is now effectively irrelevant. The replacement instrument is a gone-concern instrument, PPDS, only been issued once, and there is no primary market issuance opportunity there.

So there is work going on, on a replacement instrument, but the jury is very much out as to whether there is any demand for that from the institutional investors. Until that is solved I cannot see that there is an external capital market issuance solution. If it has been benchmarked off a joint stock company share, as being the benchmark for capital, with variable returns based on profit, there are clear conflicts with the objectives of a mutual organisation.

Q241 Chair: Mr Caton, in your evidence a moment ago, you said that the cost of funds to you might be 30, 40 basis points, that is a heck of a lot. I have just been reminded that the ICB make an estimate overall for the effects and put it at 10 basis points. I admit that this is based on some estimates in their annex 3, which I have just reread, which looked pretty general. How do you reconcile these two figures?

Andy Caton: That is the impact of ICB. That will be the impact of the downgrade activity that has gone on in the markets, so for example in the senior unsecured bond markets Yorkshire Building Society’s cost of funds would be quite materially different to a large UK institution that is perceived as a national champion.

Q242 Chair: So you get hit disproportionately?

Andy Caton: Absolutely. And in the markets that we are funding in, which are largely collateralised, currently we can issue AAA AAA in the securitisation markets, the difference in funding between us and any other AAA AAA issuer would be very, very small. In the covered bond market where we are not AAA AAA we would have a fairly material funding cost, and that comes from two areas. One is what we have to pay to the investor and the other one is all of the credit charges when we bring euros into sterling, for example.

Q243 Chair: You were criticising the ratings agencies a moment ago, though the primary cause, the primary driver of that huge increase in costs-and it is a large increase-40 basis points, that is being driven by the ICB proposals themselves, isn’t it?

Andy Caton: No, I would not be saying that. I think that is purely downgrade-driven. I am not saying that the ICB proposals are doing that. What I was trying to say, in some of my comments around rating agencies is I am not sure the rating agencies are recognising the principle and direction of travel I think the ICB are going in.

Chair: I will not pursue that point for the moment in the interests of brevity.

Q244 Mr Love: Mr Beale, I just wanted to ask you the wider question that arises from John Thurso’s contribution a minute ago. Do you think there is a failure to understand the mutual model inherent in the ICB’s recommendations and their failure to recognise the unique position that you are in?

Graham Beale: We did spend quite a long time giving evidence to the ICB, so I hope we gave them a good insight into the way our business model works. I went through some of the evidence that Sir John gave to this Committee on this point, and I think he made a statement along the lines that a leverage ratio of 25, which equates to a 4% leverage ratio, is not unduly prudent. I would disagree with that in the context of prime residential mortgage assets. Let me give you an example, just to try to illustrate the point, if you look at our balance sheet, we have about £100 billion prime mortgage assets sitting on the balance sheet and our charge for bad and doubtful debts last year was something of the order of £33 million, quite low within the context of our numbers, but that was one year, and if you assume that the average life of the mortgage asset is five to six years and you made £33 million of loss each of those five or six years you would be in the territory of £170 million to £200 million of losses from a portfolio of £100 billion of assets.

We set aside, under our own calculations, the capital underpinning that portfolio which is around about £1.2 billion, so against the £200 million of losses, taking the top end of my range, we have capital underpinning it of in excess of £1 billion. If you applied a 3% leverage ratio, which is at the lower end of the spectrum, between 3% and 4%, the capital that that would require is £3 billion, so you can see £200 million of losses. We, on a very prudent basis, have capital in excess of £1 billion, the leverage ratio would require £3 billion, so that is the sort of spectrum, if you like, of difference in terms of assessing the risk of the assets.

Part of the difficulty is that where you have a balance sheet, which contains prime assets, prime is a very broad definition. We go out of our way to write the lowest risk business that we can so the average loan to value of our portfolio is less than 50%, but within the same definition you could have £100 million of assets, which are loan to value of 50%, income multiple, say, an average of 2.5 times, seasoned, fully performing. On the other hand you could have a portfolio, same value, where the loan to value is 75%, 80%, 90% where the average income multiple is four or more times, where it is fairly recently written, so there is no maturity in there. They would both be called prime under the IRB, which is the method that we use to assess risk. We would take those characteristics into account and come up with quite different risk factors for the two portfolios.

But they are both called prime and when you apply the leverage ratio, which is just this blanket 3%/4%, it just fails to recognise the inherent qualities of the two portfolios, which is why it is a very blunt and crude instrument, and which is why the solvency ratio, which does look in detail at the characteristics, is a much more accurate assessment of the risk and the level of capital that you require.

Q245 Andrea Leadsom: I am interested to know, Mr Beale, what percentage of your mortgage portfolio is interest only versus repayment mortgages?

Graham Beale: We would need to confirm, but it is going to be 20%, 25% at the most.

Chris Rhodes: I think it is worth knowing in the context of that, the average loan to value of the portfolio, which sits under 50%.

Chair: That has fallen a lot.

Chris Rhodes: No, it has always been that kind of number.

Chair: Been high for you?

Chris Rhodes: Yes.

Q246 Mr Mudie: There is some suggestion that there will be increased pressure on you to attract deposits; do you see that? Are you concerned about it? Are you concerned about its effect on your smaller societies, and is there anything that you would want the policy makers to do to head that off?

Andy Caton: The concern I might have is that within the retail ring-fence quite rightly there is a very sensible suggestion, there is a legislative cap on the use of wholesale funding for the universal banks, the bits of their retail business that have been separated off and been put into the ring-fence, that absolute number is not set down for building societies and legislation, it is 50%. We all operate with lower levels of that in reality. Yorkshire’s is about 20%; historically it has been 20% to 25%, for example. So my concern would be within the retail ring-fence if there is still a funding gap, and obviously the quoted banks have quite a significant funding gap in aggregate, would that provoke them in rapid order to try and become very competitive in the retail deposit market in quite a short term way? We saw just that behaviour in the mortgage market, from players like Northern Rock, where we had illogical pricing, if you like, which created competitive distortions, ultimately was not in customers’ interests, ultimately created other knock-on consequences where, for example, smaller players might have gone at the risk curve for the wrong reasons because they were squeezed out of the core market. If that type of activity happened in the deposit market, clearly I do not think that would be very helpful.

Graham Beale: It is difficult to judge what the consequence of the retail ring-fence would be in terms of pressure on taking retail deposits. I think we need to get a lot closer to understand the construct and how it would operate before we could say with any certainty what the outcome would be.

In terms of funding today, I think the bigger issues are the more immediate problems that we have with the impact of the concerns in Europe on the wholesale markets and the difficulty in funding, and I think a combination of ratings actions and the dysfunctional market conditions that we have seen over the last few months. Some players are having to refinance their balance sheet using retail funds whereas they would traditionally use wholesale funds. So they will come in and they will take the price of retail funding. And retail funding today is incredibly expensive, where we have Bank of England base rate at 0.5% and if you want to bring one-year fixed-term money on your balance sheet today you would probably have to pay in excess of 3%. It really has ratcheted up.

That is putting a pressure on access to funding for some of the players because it is price-driven and at 3% it is quite difficult for some players to make a margin out of that. But that is a consequence of the market conditions today, nothing to do with the ICB and retail ring-fencing.

Q247 Mr Mudie: In your evidence you put forward some changes in the Building Societies Act; is that related to these changes and are you in discussion with Government about such changes?

Graham Beale: We have preliminary discussions going on with HMT. What we are saying is that with all of this regulatory change the Building Societies Act has not been reviewed for 25 years now so it is quite out of date in certain respects. There is one particular section-it is section 9B-which prohibits a Building Society from offering a floating charge, and yet the provision of a floating charge is a standard mechanism, where you are doing a repo transaction and other financing transactions.

So what we are saying is we do not want to change the fundamental nature of the Building Societies Act and the nature of limits that apply to our business model, but in the detail there are things that today just make day-to-day operations, particularly in Treasury, quite complicated.

Q248 Mr Mudie: Mr Beale, the real thing is, are these changes in your eyes necessary before these changes, these reforms, come in or are they just incidental?

Graham Beale: I think they are incidental.

Q249 Mr Mudie: Last question in terms of the national savings index-linked scheme that was just withdrawn. Did that have an effect on you? Is there anything you would like to say and put on record in terms of a more level playing field?

Graham Beale: It had an effect on the sector. There would have been a marginal effect on Nationwide.

Mr Mudie: Yes, sorry, I did not mean that.

Graham Beale: The position is that it is a very attractive proposition and it typically allows an investor to invest up to £15,000 tax free, which is in excess of the cash ISA limits, and what I do not want is to see that sort of product offering withdrawn. What I do want is to be able to see Nationwide and Yorkshire and any other mutual being able to offer an equivalent product on the same terms in terms of the tax free status, which would then give us the level playing field and we could compete on equal terms. There is nothing I can do to get anywhere near close to a £15,000 tax-free limit, which is offered by NS&I.

Andy Caton: I do not need to add to that at all.

Q250 Chair: Very helpful again. I wonder whether it would be possible for you just to set out for us numerically your rough estimate of the division of the exceptional market conditions that you described a moment ago, the effects of weaknesses in the rating methodology and the ICB ring-fence itself, so we can see the relative contribution each of these is making to forcing up-

Graham Beale: I think that is going to be quite difficult to do without giving-

Chair: I am just trying to extract what you just said and translate it into some numbers for us.

Graham Beale: I think in terms of trying to deal with them in a certain sort of order, and, Chris, you will have to help me if I struggle-

Chair: Take it away if you want to think about it.

Graham Beale: I would rather take it away, but just very briefly as an overview, in terms of retail ring-fence, I think today the impact on Nationwide from a cost perspective will be minimal because we do not have to do any major restructuring to satisfy the component parts of a retail ring-fence entity because we are that already. I do not think it is going to massively change any of the other factors that would be influenced by cost. We did not see, as a result of Moody’s, any material increase in our ability to fund.

Q251 Chair: Consumers feel they are being ripped off because they see this gap opening up. Part of it is not your fault at least-or any financial institutions’ fault, perhaps none of this is your fault. It is helpful for us to have it illustrated in a simple way.

Graham Beale: We will take that away and we will try to come up with a quantification, but I think from our perspective it is not going to be a large number. I do not think it is going to explain this perception that you have just outlined.

Q252 Mark Garnier: The Daily Telegraph on 12 September quoted a London-based banker as saying, "The ICB report essentially takes free banking outside and shoots it in the back of the head." Fairly dramatic words. Do you think that is a fair assessment of the prospect of free banking, and does it matter?

Chris Rhodes: I do not think it does impact free banking at all. The reason why I would say that, although there is a lot of detail yet to be worked through, effectively the retail ring-fence replicates what Nationwide and Yorkshire and others already do, so we are a retail institution. Most, if not all, of our activities will sit within the retail ring-fence and we currently offer free current accounts, accepting all the challenges that are about nothing is free and foregone interest, and so on. But the actual structure of the products today will not need to change because of the ring-fence.

Q253 Mark Garnier: Mr Caton, you said earlier, that the cost of your funding is going to go up so the mutuals are going to be much more difficult. If we try or if you try to hide the extra costs within the account, at the end of the day still the cost of having a bank account has gone up. There is no such thing as free banking, it continues to be lower returns on the deposit accounts, higher costs of credit; is that the case? Is the consumer going to be spending more money or rather losing more income as a result of these changes?

Andy Caton: I would almost reiterate the answer that Chris has already given. First of all, let me re-emphasise I am not saying our cost of funds would go up because of the ICB proposals; it is the ratings impact and the consequent knock-on in terms of wholesale funding markets that would increase cost of funds and, again, all of our activities would sit within the retail ring-fence so unless there is a change in the external market in which we compete in then we would not change our pricing stance as a result of that.

Q254 Mark Garnier: What you are all agreeing on is that the ICB is not going to make the slightest bit of difference to the concept of free banking?

Chris Rhodes: I do not believe so. When we talk about the cost of funds, it is going to be difficult to respond to that question. My estimate is the euro issue over the last three months has put 30 basis points on the cost of new retail funding, so the uncertainty in the marketplace, which has caused the dislocation in the wholesale funding markets, has added 30 basis points to savings and cost of funds, and that is, to my mind, far bigger than anything that will flow from the retail ring-fence.

Q255 Mark Garnier: If you remain with free banking, does that not provide a significant barrier to entry for any other entrants coming into the marketplace or wanting to come into the marketplace?

Graham Beale: They have to take a very long-term view because the set of costs of establishing a personal current account as a product is probably the most expensive product that you could offer, and you do need to build quite a large critical mass in order to start to get the numbers to work, so you have to take a very long-term view. So it is a barrier to entry in terms of the current conventions. We have to remember that 80% of UK consumers enjoy so-called free banking, and it would be incredibly unpopular to have an alternative pricing convention for current accounts.

Q256 Michael Fallon: Mr Caton, would you have liked to have seen Northern Rock remutualised?

Andy Caton: Yes, I would.

Q257 Michael Fallon: Why didn’t you buy it then?

Andy Caton: We have been quite busy doing a few mergers recently and we recently were interested in acquiring the residual part of the Egg banking business. But in terms of market structure that, I think, was a great opportunity for putting some more critical mass into the mutual sector as a whole. I do recognise that there is a fiduciary duty, if you like, to return value back to the UK taxpayer through sale and disposal of Northern Rock. The complexities of taking that organisation on, in our view-as an organisation we did look at it-were a little too large. But I think there may be a prospect that you could still put Northern Rock genuinely back into the mutual sector, but you would have to come up with a financing structure that maybe Government and taxpayers got their returns over a longer timescale than could be achieved with a clean sale.

Q258 Michael Fallon: The interest you expressed in July you are no longer looking at it, is that right?

Andy Caton: We formally withdrew from the process.

Q259 Michael Fallon: That is not what I asked you. I know you withdrew from the process. Is it still the position that you are not looking at it?

Andy Caton: We are not looking at it, correct.

Q260 Michael Fallon: Mr Beale, tell me more about challenger banks. Do you agree with the ICB’s assessment?

Graham Beale: I understand the concept and the point that they are making, which is that there are some brands, which are still striving to achieve significant market share and get to a critical mass, and Nationwide, while not a bank, we do regard ourselves as a challenger brand and we do try to put a proposition that is a challenge to the established players. We have been doing that for quite a while, particularly with our personal current account activities. But back to the earlier point about the cost of entry, and so on, it has taken us many years to get to a portfolio of accounts, which is, in the great scheme of things, still relatively small. We have a market share of accounts of around about 7% and we need to get that up to at least 10% to make the product truly viable in terms of the costs of running the product.

Q261 Michael Fallon: What is the difference between a challenger brand and a challenger bank?

Graham Beale: I think that is just playing on semantics. We are a building society, not a bank, and I think the ICB used the phrase "challenger brand" rather than bank.

Q262 Michael Fallon: During the crisis it was some of the challenger banks of the day, former mutuals, that overstretched themselves and failed. Do you think there is some tension there between the desire for financial stability that everybody now seems to want, and competition?

Graham Beale: I think that they adopted quite extreme business models. They were outside the confines of the building society because they had demutualised. They demutualised because they wanted greater freedom to embark upon high risk activities, upon Treasury activities, activities that by law-because we are a building society-we are not permitted to undertake. There are very strict guidelines about the shape of the balance sheet and the assets that sit on the balance sheet, which makes us naturally a very low-risk institution. Some old societies decided that because of those constraints, and particularly the constraint around being contained by a 50% wholesale funding limit, they would be better off changing their status and that was the perceived wisdom of the time. I think the plain fact is that there is not a single ex-mutual that has survived, and they have all either closed for business or have become embedded in a larger banking group.

To me, I think if you look at the performance of strong mutuals like the Yorkshire, like Nationwide, the last few years has seen an endorsement of having a business model, which is designed to be inherently prudent in terms of the way that it operates, and I think it has demonstrated that it is resilient within very stressed market conditions.

Q263 Michael Fallon: Some people have suggested that the ICB reforms spell the end now for free in-credit banking; do you think that is a good thing?

Graham Beale: I am not sure. We have dealt with that question. I am not sure that it does spell the end of that. I come back to my earlier point about while there is no interest on certain credit balances, because of the provision of the products and all of the benefits that they bring, it is still for a large proportion of the consumer population a very good and attractive proposition, certainly compared with what you get outside of the UK. If you were to compare it with personal current account pricing conventions in Europe or America, it would be a quite different proposition.

Q264 Michael Fallon: Turning the question round; does the existence of free in-credit banking remain a barrier to increased competition in the retail market?

Chris Rhodes: I think to some extent it does because it is both expensive to recruit retail current accounts, so you only need to look at some of the adverts that are out there at the moment-£100, £200 to switch an account, so it is clearly quite expensive to recruit a new customer. Then the earnings stream is delivered off the back of in-credit balances, which take time to grow, and fee income in respect of overdrafts, which again take time to grow as the book matures. In order to grow a current account book you have to accept a relatively high acquisition cost and quite a low return on capital for a period of time. If you classed that as a barrier to entry, then yes.

Q265 Mr Love: Can I bring us on to cash machines? There was a recent announcement in August by RBS to restrict the use of other banks’ cash machines to their basic bank account holders. Can you tell me how many basic bank accounts Nationwide and Yorkshire have and whether you have any similar restrictions to the use of cash machines?

Chris Rhodes: We have about a million basic bankers and we have no restrictions on the cash machines. But I think the move you talk about by RBS will create some challenges for those of us who have not made that change because the ATM system is effectively an ecosystem with a reciprocity agreement between all institutions. Our customers can use Nationwide ATMs for free, and we just incur the cost of running the ATMs, or they can use another institution’s ATMs. The cost of that is about 26p for each cash withdrawal and 16p for each balance inquiry, so we benefit from income from other institutions using our network and we pay costs for our customers to use other peoples’ ATMs.

As soon as somebody restricts access to the whole estate then effectively someone else is going to pay the income cost and the ecosystem moves. The cost to Nationwide at the moment of basic banker transactions at other peoples’ ATMs is £14 million. We get some offset because other institutions use our ATMs. If that changes so we no longer have the income the net cost grows. So they are taking a benefit and effectively imposing costs on others, which may cause other people to have to change their stance because it is moving cost around. Cost does not disappear, it just moves around.

Q266 Mr Love: You agree with all of that? How many basic bank account holders?

Andy Caton: There have been attempts in the past to put charges on ATM withdrawals from certain larger players in the market and we have always fought very heavily against that.

Q267 Mr Love: RBS have tried to justify this decision basically on cost grounds. They are trying to save money.

Chris Rhodes: They save their costs.

Mr Love: They have 1.1 million basic bank account holders. Roughly how much would they save and do you believe there may be other reasons why they are restricting it in this way?

Chris Rhodes: We have a million, and we would save £14 million. I do not know their numbers and how their customers transact but we are not of a dissimilar size and it is £14 million for us.

Q268 Mr Love: The centre of all of this is the idea of free ATM use. Where would the tipping point come? If other banks continued to restrict the use of ATMs, in particular free ATMs, where would it come to a point where there was too much being paid by a smaller and smaller number of institutions towards the overall costs of the-

Chris Rhodes: I think that one is hard to answer because at what point does that £14 million, which will grow over time, become an unacceptable cost to the Nationwide membership? I am not sure I can answer that now because we would have to see over time in terms of what it did.

Graham Beale: I think in terms of the actions that have been announced so far, while I think it is uncomfortable and it starts to break down the reciprocity that the system requires, it is something that we can absorb. But if it became the convention that most institutions were starting to restrict some or all of the cash machine transactions, then I think the process will be broken. I do not think we are anywhere near that yet but I think you would probably need a critical mass to say, "Actually we are now going to restrict usage of foreign ATM machines," and then I think we would all be in a position where we would have to go back and just rethink how the cost of the ATM network is shared among the principal players.

Q269 Mr Love: Let me ask you the same question, in a sense, another way. It is an open secret that there are a number of large financial institutions that have never been quite at home with the idea of free ATMs, that have attempted in the past to end the system and to allow charging to take place. Does that play a role? I do not want to single out RBS, because Lloyds TSB have already done this some time ago, but are you concerned that this may be the first of many steps towards what would, in effect, end the free use of ATM machines and end up with introducing charges for the customer?

Graham Beale: If that trend of behaviour continues I think it does jeopardise the concept of free use of ATMs.

Chris Rhodes: If you take the big institutions, and I include Nationwide, it is two out of six so far. If it becomes three or four out of six, maybe that is a better way of describing the point at which it becomes unsustainable.

Q270 Andrea Leadsom: It is an outrage because I think you are describing you are upset about the collapse of a classic oligopoly. I have heard this put to me privately outside of the Treasury Committee, and it seems to me that free banking, and particularly the reciprocal use of ATMs, is a classic oligopoly and what you are effectively arguing against is the competition that has been created by some banks saying, "Well, we are not going to reciprocate any more," and you do not like it because you want to keep that comfortable oligopoly. I just find it completely the opposite of competition. You have just described the barriers to entry of freeing banking and the fact that it takes a very long time for any new entrant to come in and yet here you are justifying that this reciprocity needs to stay. Clearly, that is yet another barrier to new entrants. I do not know how you can justify it.

Chris Rhodes: I think it is probably worth responding on a couple of points. First of all, we are talking about basic bankers. So we are talking about those where we have all clubbed together to provide a specific product to deal with the unbanked, so it is that particular population we are talking about. Whether we should have a social conscience for that or not, I will leave for you to reflect on.

The second thing is, and from our point of view, to remove it for the basic bankers would be a net benefit and maybe we would not attract as many basic bankers as we do, but that would be a net benefit to the profit and loss account of Nationwide.

The second point, is if you have to establish an ATM network these things are very expensive. I would argue that is a bigger barrier to entry than a known tariff for the use of someone else’s machine. If you were to invest, say we have 2,350 ATMs on the high street, that is a big cost to invest whereas a new entrant at the moment can join and pay 27p for a withdrawal. I think that is less of a barrier than needing to invest in 2,500 ATMs. That is an observation.

Andy Caton: We have, in relative terms to Nationwide, a minuscule ATM network so what we are concerned about is our customers’ access to their money on a free basis, and this principle of having to pay to access your own savings, which does not sit very well with the mutual model.

Q271 Mr Love: We normally accept in this Committee that competition is good for the consumer. Are you confident if we ended up with the ending of free ATM use that would be good for the consumer in that the loss in having to pay for ATMs would be made up somewhere else in the banking system for those customers? Do you have any confidence that that would happen?

Chris Rhodes: It is a slightly complicated question because there are non-banks in the ATM market, so there are institutions who make a profit out of this reciprocity agreement. Mostly, if banks said you can only use our ATMs and you have to pay to use someone else’s ATMs accepting the fact that, if you like, Yorkshire’s customers only have access to very few and that creates a barrier to competition, we would all be financially better off because it would be the supermarket ATMs, the convenience store ATMs, where the income would disappear from.

Q272 Mr Ruffley: Just following on from Michael Fallon’s questions about competition, we have seen evidence from the Building Societies Association that they see the low level of switching between providers of personal current accounts-the fact that it is low, relatively low-as showing high customer satisfaction. We, as a Committee, are generally sceptical about that, but if you shared our scepticism would not one way of engendering competition be for a portable personal current account? How do you view that prospect?

Graham Beale: There are a few points there. The first thing to say is that typically in the UK there are something like 6 million new current accounts created per annum and around about a quarter of those, 1.5 million, are switchers. So there is some switcher activity and it is 25% of the current flow of new accounts. I am not sure I would agree that it is a low level. 25% is quite a big proportion and is growing.

There is a lot of satisfaction certainly with the way the current accounts operate and typically we are seeing net satisfaction. This is people who are incredibly satisfied less those that are very dissatisfied, in the high 70% spectrum. So, yes, they have no desire to move because they have no motivation.

We are trying to increase switching and transfers within the UK by increasing our proposition, by giving certain commitments and guarantees that the process will run smoothly and if it does not we will sort it out and we will take all of the pain. The notion of having a portable account number, as similar to a mobile telephone number, for example, is very conceptually simple to understand and sounds quite attractive. The trouble is that the British banking system is the product of many years that revolves around unique sort codes and account numbers, and just the cost and complexity of moving from where we are today to your suggestion would be incredibly expensive and very difficult. I am not even sure it is possible to deliver.

I think if you were starting again, you would design something along the lines that you are suggesting, but the plain fact is we have 67 million current accounts in the UK right now and just the cost and complexity of moving them into this more mobile process would be incredibly difficult to deliver.

Q273 Mr Ruffley: Is there any institution in the banking sector and the building society sector that is advocating this at all?

Graham Beale: Not that I am aware of.

Chris Rhodes: Within the ICB report the Payments Council have picked this other system that effectively will act as a redirection of payments while the account is moving from one institution to another. It seems to be the favoured solution that should take most, if not all, of the issues away.

Q274 Mr Ruffley: Could I just move very quickly on to the FCA, which this Committee is looking at. Do you agree that the FCA should have a primary duty to have regard to or consider competition?

Graham Beale: I think if you look at the principal objective the FCA have, which is to protect and enhance confidence in the financial services sector, and then you look at the three operational principles that underpin that, which are enhancing and protecting the integrity of the financial system, making sure that there is efficiency and choice in terms of consumer activity, and protecting consumers, as a package of objectives, it seems to me that inherent in all of that there is a responsibility to make sure that there are appropriate levels of competition within the UK. I am not sure what is achieved by adding, as a principal objective, a competition clause, if you like. I think as well, the closer you get to that situation we all need to understand the relationship between the FCA and the OFT in terms of who is responsible for competition within the UK.

I take the view, which I think is the Government’s view, that what the FCA has been designed to do will appropriately accommodate competition considerations but that we have established bodies that have principal responsibilities for competition within the UK.

Q275 Mr Ruffley: You are going to be regulated twice over, PRA and the FCA. Having regard to your experience of dual regulation in the tripartite structure, do you have any concerns, any fears or worries, about dual regulation under the new regime?

Graham Beale: I think it is going to be more complicated. There will be an overhead, because we will have two sets of day-to-day supervisors to respond to. I stand back though and if you look at the direction and the focus of regulation over the last, say, decade, pre-crisis we had a regulator that was almost obsessively focused on conduct of business matters and totally overlooked prudential issues, and since the crisis they have swung right the other way and they are focused entirely on prudential issues.

I therefore think that a model that says that we have a team that are specifically focused on conduct and a team that are specifically focused on prudential, one hopes we will get a more balanced approach. I am looking at this from a macro level in terms of the quality of the regulation within the UK. We will not know until we get there but the concept and the principles looks to me that we should end up with a more balanced outcome than we have experienced in the last decade.

Q276 Jesse Norman: Mr Beale, could you just expand a bit further on the current situation that you find yourself in on the funding side? You can imagine, there is a lot of concern running around political circles about the impact not merely of the eurozone but of the situation in money markets.

Chair: We have had a preliminary chat about that.

Jesse Norman: It would be nice to revisit that for a second.

Graham Beale: In terms of our own funding levels we have a liquidity ratio today, which is round about 14%, which is as high as it has ever been. We have adopted a slightly defensive position, that is, carrying more liquidity than we would ordinarily do just because of the market concerns. But in terms of our ability to fund, two weeks ago, within a matter of days, across two collateralised issuances we raised £3.5 billion, which was more than we required in terms of our day-to-day funding requirements, and we are funding quite comfortably, albeit expensively, within the retail space as well.

We are not seeing any pressure from the immediate uncertainty within the marketplace, but we are adopting a very prudent and defensive position because my concern is how things will play out in the future rather than the more immediate past.

Q277 Jesse Norman: That is very helpful, thank you. Mr Caton, on Northern Rock, imagine the Government was keen to do a mutualisation of Northern Rock now. What preferred structure would you recommend, briefly?

Andy Caton: That requires quite a lot of thinking about, but there might be a solution for using the Industrial Provident Society legislation, the Butterfield Act, and if an existing mutual or a stand-alone remutualisation was to exist, capital would have to be-we would have to make sure that the ex-Northern Rock was adequately capitalised and the form of that capital, I think, would have to require dividending back of value to UKFI over a period of time. But I think that would be the route to make sure that it could be member-owned, customer-owned, and that Government ultimately got back the money that it put into the organisation.

Q278 Jesse Norman: Inevitably though, whether you did require, as it were, a vendor note or some kind of equity structure, there would be a very long repayment process given the number of people who will be repaying versus the amount of money to be repaid?

Andy Caton: I think you would have to put a reasonable timescale on that, yes, absolutely. But one of the issues, as you know, with Northern Rock is it has a very large excess liquidity position, it has more cash on the balance sheet, which in many ways is a good thing. That cash obviously has to be put to work within the mortgage market. It would not be sensible to try and do that in very short order. You would want to do that progressively over time as well. As you did that you would then obviously rebuild hopefully the profitability of the organisation that would then follow through to the ability to pay dividends back.

Q279 Jesse Norman: Why do you think that cash has not been remitted back to the taxpayer now?

Andy Caton: I think probably ahead of the sale process. I would not like to speculate about that.

Chair: Thank you very much indeed for coming to give evidence today. It has been extremely useful. I have picked up a lot and I think a number of colleagues also feel the same way. I know we have ranged widely, somewhat further than the narrow issue of the ICB but we appreciate it and it will help us with our report. Thank you.

Prepared 21st November 2011