To be published as HC 1069-ii

house of commons



Treasury Committee

Independent Commission on Banking

Wednesday 8 June 2011

Mr Stephen Hester, Mr Douglas Flint, Mr Bob Diamond and Mr Antonio HortA-Osorio

Evidence heard in Public Questions 149-333



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Oral Evidence

Taken before the Treasury Committee

on Wednesday 8 June 2011

Members present:

Mr Andrew Tyrie (Chair)

Michael Fallon

Mark Garnier

Stewart Hosie

Andrea Leadsom

Mr Andy Love

John Mann

Mr George Mudie

Jesse Norman

Mr David Ruffley

John Thurso


Examination of Witnesses

Witnesses: Mr Stephen Hester, Chief Executive, Royal Bank of Scotland, and Mr Douglas Flint, Group Chairman, HSBC, gave evidence.

Q149 Chair: Thank you very much, both of you, for coming in this afternoon. We have a pretty detailed outline proposal from the Commission to examine. It is rather more detailed than some thought we would have at the time that they said they would produce an interim report, and I think it is particularly important that we have as much as possible in a public debate about the pros and cons of what they have come forward with.

In response to it, we have received a number of documents, one of which came almost immediately afterwards, from HSBC. Very recently we also received a note on a possible way of making the ring fence work, with which I would like to start. Could you, first of all, say why you have made that proposal?

Douglas Flint: We made the proposal because in our discussions with the Independent Commission, and indeed with politicians, we were guided to give as much thought as we could to how to operationalise some of the proposals that the ICB was coming out with in its preliminary thinking.

Q150 Chair: Do you think that we need a ring fence?

Douglas Flint: I can see, given what has happened, why there would be thought given to it, yes.

Q151 Chair: I am talking from a public policy perspective, so if you were able, which is asking a lot of you, to set aside your fiduciary duty for a second in this privileged environment and just tell us whether you think, from a public policy perspective, whether some sort of ring fence is required and whether you support it, that would help.

Douglas Flint: I think it is required. I think that while I would prefer that there wasn’t one, I think, given where we have come from, the principle responsibility of policy makers should be to ensure that the supply of credit to the real economy is uninterrupted through volatile conditions, and I think that the impact on the supply of credit that came from peripheral activities, particularly the securitisation and structured credit markets which impacted the capitalisation of major banks and therefore interrupted the flow of credit because they were capital impaired, was tragic. Therefore, while an enormous number of things have been done to prevent the repetition of what happened, I think if I were a policy maker I would seek to set aside the real economy funding capacity from the intrafinancial sector trading activity.

Q152 Chair: Turning to the details of the proposal you have put before us in a three-page note, which will be published and put in the public domain at the end of this meeting, could you briefly set out how you think derivatives should be treated or would be treated under your proposal, which is that we use IFRS9, part of the international accounting standards, to define the ring fence?

Douglas Flint: The benefit of that is that it is objective, it is auditable, there are clear rules and it effectively gets to, in old terminology, what might have been a banking book versus a trading book. Effectively, the accounting standard says accrual accounted assets can only be those that have originated in the business model, which is for the collection of interest and principle, where there is no complexity to the structure and so on, and therefore there is a clear dividing line between that and assets that are held for the benefit of trading in their value.

Q153 Chair: As far as derivatives are concerned, that is a pretty tight ring fence, is it not, because is that not building society treatment for derivatives?

Douglas Flint: You would then go on to say that you need derivatives in the ring fence bank because you would need to be able to hedge interest rate and foreign exchange risk. For example, to provide fixed-rate mortgages, you need to be able to adjust interest rates, so you would get down to what would be like a building society scenario that said that only derivatives that are qualified as hedges of those assets would be admitted into the retail bank, so effectively they are changing the cash flow characteristics of core lending to businesses and individuals, and derivatives that are there for the positioning for value change would not be there. You would have on-balance-sheet lending and derivatives that hedge the characteristics of interest rates and foreign exchange in that model, yes.

Q154 Chair: Could I turn to you, Mr Hester? Do you agree that we need a ring fence?

Stephen Hester: I think that there are not black and white answers to these things and one has to take-

Chair: Although we have had a pretty clear answer from one-

Stephen Hester: I will try to give a clear answer, but it may have some more complexity. In terms of the Commission’s proposals, I think that they endorse a number of things we wholeheartedly agree with that are designed to remove implicit subsidies for banks and to allow banks and society to cope with future systemic crises: better liquidity standards; more capital; resolution powers and plans, including the 2009 Banking Act, and indeed any further tweaks that were needed to allow supervisors the huge powers that that gives; and bail-ins to give a source of capital beyond the Government in extremis, one step short of liquidation.

I think all of these features are being adopted by the rest of the world, including us through the Basel process, which-

Q155 Chair: It is the ring fence part of these proposals that has been most controversial, and I would be grateful if you would go on to that-you are on ground that is less controversial at the moment.

Stephen Hester: I am sorry to go on, but I think it is easier to understand. I think that all of those features that the Commission is supporting do go to achieve the risk objectives that we and the rest of the world have. I think that in the ring fence part of what they are saying, there are some risks that would need to be addressed, and one of the things obviously we seek to do is, if a ring fence is introduced anyway, to work to look through the different flavours of ring fence to address those risks.

I would compartmentalise the risks or the areas of concern that I think would need to be worked on as follows: the first is the subject of risk. In other words, as I see the ICB’s terms of reference, it is partly to deal with systemic risk and risk to the UK economy, and it is partly about costs, employment, shareholder costs, lending costs to customers and so on.

Q156 Chair: Sorry; before we get on to this, I just want to be clear in my mind on the question: do you favour the principle of trying to create a ring fence?

Stephen Hester: On the subject of-

Chair: Was your answer a yes or a no?

Stephen Hester: I believe that creating a ring fence increases some of the systemic risk and decreases the ability of banks to withstand the risk and has significant cost to it, and those are the headings on which one would have to work to try to mitigate them and ensure that, if you like, the benefits from the other recommendations of the Commission are not taken away or reduced by-

Q157 Chair: All right. So if it increases both risk and costs, you are against a ring fence?

Stephen Hester: The reason I am not being as black and white as you would like me to be is that banks have subsidiaries the world over. The simple fact of having a subsidiary of itself is something that happens, so that is why one does, in a sense, have to get into the detail to try to avoid what the negatives can be that I have just set out.

Q158 Chair: But you cannot be in favour of a ring fence if you think it is going to increase systemic risk as well as cost. Normally those are seen as pulling in different directions.

Stephen Hester: It is our belief that it will be hard to design a ring fence that improves upon the risk-cost balance over and above the other proposals that the Commission is supporting and that are being pursued through Basel and the other worldwide reforms.

Q159 Chair: So it is practicality? It is too difficult; is that your objection?

Stephen Hester: No, I don’t think it is too difficult. Some of this is trying to understand and say there is a cost and reward comparison, but if we think about the risks that we are trying to avoid, of course, in the financial crisis the majority of the world’s banks have come through regular lending, far more than through derivatives or complex financial products. One of the things we need to ensure is how we are addressing those systemic risks. I think all of these things on bail-ins, on extra capital and so on do that by, as is the risk with ring-fencing, reducing the diversification of assets funding and earnings within banks. In the same way as you would like a diversified UK economy, a diversified bank has some extra strengths, and if you reduce that diversification, the credit rating agencies tell us it is likely to weaken the strength of banks.

My concern is that from a systemic standpoint there is a risk that you have to work on of moral hazard-that you create a protected beast that has some sort of overt, "In a crisis, don’t worry; the Government will support you". Of course those kind of protected beasts, domestic banks, were the source of the vast majority of banks that went bust or nearly went bust-not RBS, I completely grant you-so we need to be careful that we are not creating a ring fence that will contain exactly the things that systemically lost a lot of money: Irish banks, Spanish banks, some of the US banks, Bradford & Bingley, Northern Rock and so on-and giving it a public imprimatur saying, "This is a protected subsidiary that we will support", that encourages moral hazard while the other parts of banks are made more volatile because you are saying that in no way will you support them.

I think that focusing attention first of all on how the whole banking system doesn’t need public support and all the tools we have to do that is the most productive way of doing it. If we want to enforce further subsidiarisation, these are the headings that we have to work to, to make sure that we don’t create the extra costs and risks that could be created in a subsidiarisation or a ring fence.

Q160 Chair: Did I hear you right when you said that the cost of funding does not vary between banks that are covered by a guarantee and those that are not?

Stephen Hester: No, sorry, I don’t think I-

Chair: You didn’t mean to say that?

Stephen Hester: I didn’t mean to say anything about that.

Q161 Chair: Isn’t it true that the ratings agencies flag up a differential between those two in their ratings and, therefore, in the price of capital?

Stephen Hester: One of the measures of whether we will have all succeeded in making banks truly stand on their own two feet once the process of reform has completed will be that the rating agencies do not ascribe value to the concept of sovereign support, and that is, I think, a way that we can tell, a few years down the road, whether in fact we have been successful in all the different reforms that are halfway through digestion, as it were, because clearly, backward looking, that is one of the measures we can see of implicit support today.

Q162 Mr Ruffley: Mr Hester, in the ICB, we see, in annexe 3, the statement-I think it is commonplace-"The prospects of Governments intervening to bail out systemically important banks effectively subsidises them." We are on to the good old subject of implicit guarantees that the British taxpayer gives to all banks. I am not particularly talking about the particular cash bail-out that your bank benefited from. Could you tell us what the size of that subsidy is, approximately, for the whole of the industry, not just your bank? What do you think it is worth to British banks?

Stephen Hester: I think that as far as I can understand, not being a professional economist, this is a subject on which there has been no ability to get economists to agree, and there is a very wide range of different estimates. What I have personally focused on in the couple of years or so that I have been in the job and worrying about a systemic bank is: how do we make sure that, whatever the number is, we eliminate it? I believe that the extensive reform processes that are under way and in train will do that job, whatever the number is. I suppose I have not found it productive to be more expert than the economists who cannot agree on the subject.

Q163 Mr Ruffley: Yes. In annexe 3 there is reference to the Oxera report, which I think your bank commissioned.

Stephen Hester: You see, all these are backward looking, and to me-

Mr Ruffley: Of course.

Stephen Hester: -we must learn lessons from the past, but what are more important are the forward-looking issues. Forward looking, have the reforms that are in train done the job, or will they have done when they are completed by doing the subsidy?

Mr Ruffley: Sure. Just stick with this. The ICB, of course, does, in annexe 3, attempt to reconcile the Oxera number, which I think your officials rely on, and also the Haldane work from the Bank of England. The ICB, reconciling all this, says that the subsidy is worth considerably in excess of £10 billion per year for the whole of the industry. Do you recognise that figure? Do you think that is about right?

Stephen Hester: I recognise what you are quoting from, and all I can say is, I know that there is a whole range of academic and practitioner dispute.

Mr Ruffley: So you do not think that is a fair estimate?

Stephen Hester: As you point out, Oxera came up with a smaller one. I am not sure that I see the ability or even the benefit of agreeing what the number is. The point is, whatever the number is, let’s try and make it zero in the future and let’s examine the reforms that are going through to help achieve an outcome.

Q164 Mr Ruffley: With the greatest respect, if you want to reduce it to zero and you do not know what it is now, how do you know you have reduced it to zero?

Stephen Hester: I think that is because we have to examine the sources of potential public subsidy and the circumstances that might lead to banks calling for Government support and address them.

Q165 Mr Ruffley: We will have to come to a number, won’t we?

Stephen Hester: I don’t believe so. The best brains have not been able to so far, but what the best brains around the world have diverted themselves to, through the Basel process and being associated with it, is how to reduce and eliminate the things that weakened the banking system so greatly, and I think that is the best use of time and effort.

Q166 Mr Ruffley: Sure. With regard to the ICB proposals, what are the things you are going to support in this document that will get the subsidy to zero, which is your stated intention?

Stephen Hester: The things that we support include-maybe this is not an exhaustive list, but the ones off the top of my head-strong capitalisation for banks in equity terms; strong liquidity, in all cases stronger than the past; resolution powers that allow the authorities to take banks apart in whatever way is necessary in a crisis, and that may not be the way that we design now or that a particular view today might be-a crisis could have any shape in the future-and bail-in powers that say, "If, in extremis, more capital is needed, there is a hierarchy of where you get from and the Government does not appear on that hierarchy".

Those are the crucial ingredients of ensuring that, first, banks are less likely to fail in the future; secondly, they have much greater capital resources to fall back on if they fail; and, thirdly, even if they then run out of those capital resources, that creditors pay rather than the Government. I think that these are the crucial things and, indeed, this is the view of all the international authorities because these are the pursuits that Basel all around the world is doing that really will address the issue, and I truly believe they will address the issue once they are through. The Commission is quite eloquent in supporting and explaining its support for all those features.

Q167 Mr Ruffley: I realise you do not want to dwell on what the estimate of the value of the subsidy may be, but for your bank-not the industry, for your bank-what do you think it is worth?

Stephen Hester: I suppose, at its most fundamental, we know-

Mr Ruffley: Is it higher than £1 billion or less than £1 billion?

Stephen Hester: -RBS would have gone into liquidation were it not for Government support, so on one level you can say that was the measure and that is, in a sense, what has given me and my colleagues a huge interest coming in, as it were, after the event to try to think about what the sources of weakness were, what the way they were transmitted is, and what the right reforms are, both to our own bank and more broadly, to avoid that. I think we have had a very close-up view of these issues, as it were.

Q168 Mr Ruffley: You want to eliminate it and I think the British taxpayer would want it eliminated, but, as you know, Sir John in the report says that total abolition and elimination of the implicit subsidy to all the banks that the British taxpayer provides is unlikely. Do you agree with that?

Stephen Hester: I think that it is likely that if all the reforms that we have talked about and that are under development and rolling out around the world are prosecuted, it will not be necessary in the future for the Government to support, through capital, banks in a crisis. I do think that there is a normal function of all central banks, which is liquidity support-that is a very different matter-but, in terms of capital support, I do think that can be avoided in a future crisis.

Q169 Mr Ruffley: Could I ask whether you think any of the implicit subsidy has fed through to bonuses and high remuneration at RBS?

Stephen Hester: I think, to the extent that banks were able to carry less capital and fund cheaper in the past than would be true in the future, then one can say that that implicit subsidy, whatever its amount, could have fed through to lots of places. Obviously it could have fed through to the price of loans to customers and, therefore, to the general economy. It could have fed through to the levels of employment in banks, in all bits of banks, and it could have fed through to bonuses, so I think one could assume that there might have been some leakage to all of the above.

Mr Ruffley: Including bonuses?

Stephen Hester: I think that is entirely possible.

Q170 Mr Ruffley: What do you understand by the phrase "explicit non-guarantee" that is used by members of the Vickers Commission?

Stephen Hester: I think I might have to say "pass" on that.

Mr Ruffley: You have heard of the expression? Sir John has used it in the Vickers Commission-

Stephen Hester: I am afraid I haven’t memorised the report and so immediately that phrase is not springing into my mind.

Q171 Mr Ruffley: I can help you. You very helpfully said to this Committee that you wished the British taxpayers’ subsidy to the banking system, which is very generous of them in my view, to be reduced to zero, certainly in relation to your own bank, which is good. We like that. But what is going to happen if you do not get to that zero point and, more particularly, what happens if the Government say, "The way we get to this zero point is to say we are not going to bail out RBS in the future"?

Stephen Hester: There was a series of reforms that have already happened and some that are rolling out. One reform, of course, which is already enshrined in the Banking Act, is that the regulators can at the point of failure take any bit of any bank and say, "That is going down and this bit is not going down, and this is how we are going to deal with it". These are the powers that they have. The US have given themselves that power as well. In fact, they used it at one point in the last crisis, in WaMu. How are we to know today what the shape of a future crisis will be, what the points are and what the bits that are going to be essential to economy are or are not? It is very hard to know that today.

There are very sweeping powers that the regulators have-I think, correctly-that, of course, were not there before that will allow those choices to be made in a crisis, if necessary. Now, I hope that that will not be necessary and that there will be many steps before that in terms of capital liquidity and CoCos and so on to get there, but there is, I think, that insurance policy.

By the way, in a less perfect earlier guise, this was used in Bradford & Bingley. Bradford & Bingley was separated into two at the point of crisis and some bits were kept going and some bits were not. The powers have been greatly improved that are available to the authorities since that occasion, so this is not new stuff, although it has been taken on a great deal further, and I think it is an essential piece of the armoury that will allow us to treat the problems of the future and not to have to imagine them today and perhaps get them wrong.

Q172 Mr Ruffley: Final question, Chairman. Is it the case though that if there is some element of subsidy remaining, you are wanting to keep this support from the Government, and that in extremis you would want to say to the world, "This is not going to go down. Not everything is going to be lost. The taxpayer will stand behind some of this business", but if you do that, you are going to get the implicit subsidy because you would be able to borrow more cheaply in world markets than if you didn’t have the taxpayer standing behind you?

Stephen Hester: As I meant to say, I think the stated objective of world Governments, not just the UK Government, to not be in a position where Governments provide capital support in a future crisis is the correct one, and I think that is the one to which we should all be, and indeed are, working. Now, that does not mean to say that crises will be avoidable, but I think that there are a whole series of ways of absorbing those losses or letting people suffer the losses that would be-

Mr Ruffley: Before the taxpayer has to pick up the tab.

Stephen Hester: Absolutely. Yes, I think that should be the objective.

Q173 Andrea Leadsom: Mr Flint, you might have a turn. In the context of what Mr Ruffley was just saying, do you then in some peculiar way welcome the credit watch from some of the credit rating agencies for downgrade of some of the banks as a result of a possible Government move to ensure that that implicit taxpayer subsidy is removed? Surely, in answer to the question about how much the subsidy is worth, there lies the answer, does it not? It is a slightly subjective question, but if you are downgraded, your cost of funds increases, presumably by the amount that previously the taxpayer was subsidising you. Would you comment on that?

Douglas Flint: I think the rating agencies in this regard are a lagging indicator. I think that the markets had already assumed, given everything that has happened over the last two years, that the implicit subsidy was under scrutiny, and indeed, all the work that has been done on bail-in and resolution and so on effectively takes away the subsidy, so in terms of intent-

Q174 Andrea Leadsom: Do you think it has already gone, in fact?

Douglas Flint: I agree with the Independent Commission. It never goes absolutely because ultimately, in the event of a systemic crisis, elected officials will always have the responsibility to determine whether the particular circumstances facing the economy are ones where they should intervene to mitigate losses that would otherwise be higher. The mechanism through which they might do that may be an individual financial institution or a part of the financial sector. The responsibility would be with elected officials to say, "Do we think that the framework of resolution is inadequate with hindsight such that losses will be exaggerated against what they ought to be and, therefore, we should come in with some form of temporary support to deal with it?" There will always be those circumstances and they are almost unforeseeable, so I don’t think you will ever get away with the subsidy going to zero.

Q175 Andrea Leadsom: Yes, exactly. Turning this into a cost of funds issue, obviously on the one hand we do not want the taxpayer to bail out the banks; on the other hand we do not want to make banking such an expensive activity that it harms the economy that way instead by making it that much less competitive and the ability to fund business so much more difficult. With that in mind, do you think that credit ratings agencies are wrong to be considering banks for downgrade? Do you think that they are simply not understanding the point? I mean, what is the case that you are making in terms of keeping your low cost of wholesale funding?

Douglas Flint: To be honest, I think they are just stating the obvious. In their ratings historically there was an implicit support rating for a bank that was systemically important to the country, that they believed Governments would come often-not always, often-to the rescue, and that was factored into their ratings. They are now explicitly saying, just as they are in relation to many off-balance sheet products where there was an implicit assumption that a sponsoring bank might come to support a securitisation or a structured credit vehicle, in a way that today they are assuming that they are not because life has moved on.

I think it’s also worth thinking about in relation to the subsidiarisation. It is almost an impossible task, and if there were 10 people in the room, you would get 12 answers to what it is. In many respects, to the extent that there was a subsidy and there is a continuing subsidy, it is priced into what the market provides in wholesale funds; for example, those who provide credit to the banking system make a judgement in their mind as to the likely possibility of default and price that into the load. That then gets effectively consolidated into LIBOR. We make our margin against LIBOR. To the extent that there is an implicit subsidy in the reference rate, it doesn’t affect our profitability. It affects the rate that we pay our creditors on the wholesale side of it and it affects the rate that we lend into the real economy. To an extent, the implicit subsidy is most reflected in the rate at which borrowers borrow because it is in the base rate, the LIBOR rate.

Q176 Andrea Leadsom: Yes. There is a huge amount of movement towards better regulation to be welcomed-improved capital and so on-but in my view not nearly enough movement towards increasing competition. I just wonder if you would comment on what Jayne-Anne Gadhia, the CEO of Virgin Money, said, which is that, "We have to make sure that there is no bank that is too big to fail. I do believe, therefore, that banks should be much smaller than the very big banks are today". To both of you: what do you think about her comments there? Are you simply too big to fail still and the only way round it is to make banks smaller?

Douglas Flint: I think that is a really difficult thing to do by legislation or diktat or even by regulation, because at the end of the day, the size of a bank and what she is talking about is largely driven by customer preference and particularly depositor preference. I think it is very easy for a financial institution to enter the market today and compete on deposit-gathering at the insured deposit level, on credit cards, to some extent, and money transmission. What is difficult for them to do is compete because of the infrastructure they need, which is much larger on SME and business banking, and it is virtually impossible for small new entrants to compete for the sizeable deposits of wealthy savers, people who have either sold a house or taken a lump sum out of their pension. You might well have your current account with a small new entrant, but I submit that if you had just cashed in your pension scheme and were looking to retirement, you would be looking for the most robust institution that you could put that money with.

Q177 Andrea Leadsom: Just to interrupt you for a second, that could be Tesco, for example, or John Lewis or Marks & Spencer.

Douglas Flint: Could be.

Andrea Leadsom: Those would be large, well-resourced organisations that you as a wealthy investor might be willing to put your life savings with. Let’s face it, over the last 10 years there has been nothing but consolidation, only enhanced by the recent crisis. Why should that continue?

Douglas Flint: I’m not sure consolidation will continue. I still think there will be depositor preference to choose institutions that, in their mind, have the strongest balance sheets, whether that is an objective view on their capital and business model or whether that is a brand effect, but I do think the brand effect together with the reputational effect of the way institutions are written up has a huge impact on depositor preference and it is not just about price. At the end of the day, depositor preference dictates where people put their money, and I think for sizeable deposits people do choose larger banks.

Q178 Andrea Leadsom: Mr Hester, what about if the taxpayer were to break up RBS and sell it to the likes of, for example, Tesco Bank, Virgin Money-all big brands in their own right-to create half a dozen, or even more, new UK banks to really enhance the competitiveness and to put pressure on SME lending and so on? Why would that not be a good idea, assuming that you don’t think that would be a good idea?

Stephen Hester: I think the first bit of your question is, in my view anyway, often misconstrued in the public debate, and the quote from Virgin, I think, is wrong. When we look at the way financial crises cause systemic problems for countries, it is not to do with individual institutions and their size. It is to do with individual risk concentrations, however they may be spread. If we look in the early 1990s at the Savings and Loan Crisis in the United States, that required a huge state bail-out of many thousands of institutions. The point was not that any one of them was big, just that a lot of institutions were exposed to the same risk and became vulnerable.

Today we see this in Spain. None of the Spanish cajas that are being supported would come to a systemic size by a national regulator, yet there is a big Government bail-out vehicle for all of them because they may not be individually huge but there are a lot of them with the same kind of risks. What we have to focus on, I think, is not the size of an individual institution but a systemic risk concentration, however divided, which can topple over many institutions simultaneously if they have a similar risk profile. That is why I believe it is a red herring, from the point of view of systemic risk, to look at the size of one institution as opposed to the risk concentration in the system of a particular kind of risk and how you deal with it.

On the competitive point, there is, I believe, no evidence that small institutions competing in the UK or any other market are prepared to or able to offer a more advantageous deal to customers than large ones, by the way, or vice versa. I don’t think size is determinant. It is not that Virgin is wandering around saying, "That’s fine, we’ll be a charity; we’ll do it for free", or, "We’ll accept lower profit margins", or they are saying, "We will pay all our workers way less so we’ll have lower costs", or they are saying, "We’ll be more reckless on credit, so we’ll give loans to someone who won’t-". These are not the real dividing lines. I really think, other than dramatically increasing costs and throwing everything up in the air, you would end up with less benefit rather than big.

The interesting moral hazard, I would say, is the other way round on deposits: that because in retail and SME land people are encouraged to believe that ultimately there is a Government backing-and indeed, some of the Government’s behaviour in the crisis supports that, and if we went to ring-fence, it would double support that because that is the entire point of saying, "Don’t worry; if you’re in the ringfence, we’ll protect you"-it means that consumers and small businesses can merrily put their deposits in an Icelandic bank subsidiary or can merrily put it in a small Dunfermline building society and not have any consequences vis-à-vis having to think, "Who is safe and who has the right dimensions?" You can turn on its head this size issue when it comes to, if you like, distorting the deposit market.

Q179 Andrea Leadsom: Yes. I don’t disagree with you on that point, but I think you’re also making a very good argument for a well-diversified group that includes a financial services arm such as a major UK retailer. Perhaps something that, in the banking world, needs to be considered more is the fact that you’re only talking about big banks and small banks. What you’re not talking about is a diversified group that includes a bank as part of its portfolio. I mean, would you like to comment on that?

Stephen Hester: I think I have always thought that we should not have one-size-fits-all models and in fact they tend to be more dangerous.

Andrea Leadsom: As we have just seen.

Stephen Hester: I think it is terrific if there are different kinds of models in the banking industry or any other industry that are allowed to flourish or not flourish and obviously within the context of, if you like, the regulatory support mechanisms that we have talked about in terms of ensuring safety. If Tesco can successfully get customers that RBS cannot, terrific. Hopefully that will make us sharpen our act up and we will compete back again. I think that is great.

Q180 Andrea Leadsom: Mr Flint, last question.

Chair: Brief question and a brief answer, please.

Andrea Leadsom: Would you favour the taxpayer breaking up RBS and selling off more of Lloyds than is currently proposed in the interests of good competition?

Douglas Flint: I don’t believe it would make a great deal of difference to the competition. I think the competition comes from small and large institutions equally. I agree with Stephen on that, so I think you would have more entities. I do not think that for the consumer it would necessarily make much of a difference.

Q181 Mr Mudie: Mr Flint, I only got your proposals off the computer a couple of hours ago, so, although they are welcomed, can I just ask you about them? When we had Bill Winters in front of us, I was pressing him on the retail banks being more stable than the investment banks and how separation would be the best method of confirming that stability. He was going for ring fence, and when I was pressing him about, "You’re only after the money", he said, "No, I’m not only after the money. We’re only after the money in the bad times". Yes, I read it and it is in there verbatim. In other words, when the investment side runs into trouble they go and get the surplus funds from the retail bank. That was interesting. You read it verbatim. Does your proposal on ring-fencing prevent money moving from the retail ring-fence side to the investment side?

Douglas Flint: I think one of the critical unspoken pieces of the provisional proposals was what the arrangements could be between the ring-fenced bank and the non-ring-fenced bank, which is why we believe that the ring-fenced bank has to be broad in its scope, because I think the biggest risk is that if the ring fence is very narrow, you end up with a bank that is rich in deposits and has less lending.

Q182 Mr Mudie: No, I think your proposals may go too far for some, but I think they are very sensible in the terms that you have put them down. But I am primarily interested in the movement of funds. Does this still permit surplus funds from the retail side going across to the investment side to be invested elsewhere?

Douglas Flint: What the interim report said was that-

Mr Mudie: No, I am asking on your proposals, the ones we have in front of us.

Douglas Flint: On both proposals as they stand today, funds could go across subject to existing large exposure limits, which are extremely small. The large exposure limit would be no more than 25% of the capital base, so that would be tiny. If one took current bank regulation today, the exposure between the two banks would be extraordinarily small, and that is one of the problems if the ring-fenced bank was very narrow, because if the wholesale bank had to do corporate lending, how would it fund itself? You would end up grossing up the balance sheet of UK banks because you would have one bank with too many deposits lending into the wholesale market and another bank with far too few deposits borrowing from the wholesale market. I think you would have quite a lot of frictional cost and quite a lot of uncertainty as to whether that model worked, which is why I think that if we go down a ring-fencing route, it has to be with a basis of: what is the best model to preserve the aggregate quantum of credit to the real economy, both corporate and personal?

Q183 Mr Mudie: I am glad you say that, but I am looking at the real UK economy.

Douglas Flint: So am I.

Mr Mudie: Yes, and I am pressing for separation, but I would settle for the sort of retail ring-fencing you are speaking about on the basis that there is more chance of corporate UK and household UK getting funds than there is under the present system of the universal bank.

Douglas Flint: What that proposal would do would mean the first call on the funding would be to fund the vanilla lending, and then the wholesale markets independently would be funding trading books, which is what they do at the moment. The vast majority of trading books are funded on a collateralised basis.

Q184 Mr Mudie: I am sure when bankers read what you say they will digest it, but the British people are just watching Mervyn and the Government on their knees to the banks to get some money for small enterprises, begging for money. Yesterday I saw the Financial Stability Report for 2007 from the Bank of England. UK corporates received 6% and Europe, United States and the rest of the world received 40% of the big banks’ lending. It is the Bank of England’s figures on figures supplied by the big banks. Now, you can see why we have under-investment in British industry, and I’m looking for, apart from the financial stability side, some movement away from the casino system to funding our economy. Do your proposals strengthen that happening?

Douglas Flint: I think if the ring fence was done in that way you would have a simple bank that lent money for the collection of interest and principal. I think it would be very difficult to direct the corporate lending, in terms of the purpose, to be invested in the UK because there are many multi-national companies based in the UK who fund themselves here and everywhere else.

Q185 Mr Mudie: I know that, but there is a lot of lacking funding, as you are well aware. Just a quick question, Mr Hester. You did not mention specifically the costs in your opposition to ring-fencing. Have you worked out the costs for your bank of the Commission’s proposals?

Stephen Hester: Because the Commission’s proposals have not been finalised, and the international, if you like, regulatory position, which would be the alternative or the extant, you do not have either to completely compare against each other, so I cannot give you a figure. But what we have done is worked out where the extra costs directionally come from and therefore what would be the levers to pull in order to reduce them while also reducing the systemic risk. Today there are still a thousand flavours of variance within this, it is very hard to give a single number, but we certainly-

Q186 Mr Mudie: At this point in time, you are not in a position to oppose the ring-fencing of retail just on the basis of cost because you cannot work out the costs?

Stephen Hester: No. As I said earlier on, directionally we believe there is a whole series of things that the Commission are endorsing from the international change that reduce risk, and that supra-imposing subsidiarisation on top of that is likely to negate an element of that and to involve a bunch of cost, but it is very hard to say absolutely in principle that you cannot have a subsidiary, because we have lots of subsidiaries, so I cannot tell you we oppose a subsidiary in principle. It is a question of how these things are implemented.

Q187 Chair: Can you let us see the work you have done on that, Mr Hester?

Stephen Hester: Once we are in a position to publish it, because clearly these numbers are very price-sensitive.

Q188 Chair: When do you think that will be?

Stephen Hester: If we made something available that we were able to publish in a price-sensitive sense, we would.

Chair: We would be very interested in it.

Q189 Michael Fallon: Mr Flint, you have considered that your proposal would give a broader scope to the retail ring fence. Why does it not follow from that that the taxpayer exposure then would not be greater?

Douglas Flint: I do not think it would in substance, because I think the taxpayer exposure is ultimately to intervening where the economy is exposed to a loss that would be greater absent that intervention because the regulatory system has failed. Crises come from an interruption to the supply of credit, not from the loss of capital. The loss of capital may precipitate the loss of supply of credit, so the more that can be done to ensure that the core credit availability is in the same place and the funding is in the same place as the assets for core economic lending, you reduce the circumstances where the elected officials have to make a judgement as to whether they need to intervene.

You can look at Germany and look at Landesbanks that are entirely wholesale, and they repeatedly have been subject to support because the impact to the economy has been dramatic for letting these institutions fail, because they support the Mittelstand and the German corporate sector and, therefore, they are systemically important in their own right, albeit they do not take retail deposits. Looking at retail deposits as the systemic piece, I think, is kind of wrong. The important thing is: does the economy get a better protection from an interruption to an adequate flow of credit to the economy? I believe that a broader ring-fenced bank achieves that.

Q190 Michael Fallon: What kind of balance sheet management and liquidity management activities would be excluded then from your scope?

Douglas Flint: Clearly that bank needs liquidity, and at the moment those balance sheet assets would almost certainly qualify for inclusion in the ring-fenced bank because they are essentially high-quality Government bonds held to maturity. They would be a business model based on holding an asset for the collection of interest and principal, and they would have no complexity to the instrument. Our balance sheet management and our Treasury activities are effectively taking surplus cash, the liquidity of the bank, and investing in high-quality Government bonds. You would want that to be in the ring-fenced bank.

Q191 Michael Fallon: You also suggest that some of your retail products, insurance and guaranteed bonds and so on could be included if you were the agent rather than the principal.

Douglas Flint: Yes.

Michael Fallon: Are you not trying to have your cake and eat it there?

Douglas Flint: No, not really. I think you can argue both ways. There are retail products today that are provided on a market-to-market basis and, therefore, they would not necessarily qualify. What we are saying is you need to explore that. Do you do that by acting as an agent or do you do that by saying you can carve out a small proportion of the capitalisation of the bank and say that can be made available for such activities? I do not think it is a particularly big deal one way or the other. It could be in a separate subsidiary altogether.

Q192 Michael Fallon: How confident are you that a ring fence, which by definition has holes in it, will remain durable, and that firms with clever and innovative people will not simply start finding ways round it?

Douglas Flint: I think, in our industry, that has historically always been a risk. I think that we clearly have the prospect now of a much more forward-looking and interventionist supervisory regime, but the principal reason for going to IFRS-and my background is not as an accountant-is it is an objective auditable standard and, therefore, what goes into the ring fence has to be vanilla. There is a panoply of rules and these rules are auditable, and it is not dependent upon whether you are HSBC or any other bank. These are independent rules and capable of being independently audited.

Q193 Michael Fallon: We are not going to end up with different shades of vanilla, are we?

Douglas Flint: No, the rules are extraordinarily tight.

Q194 Michael Fallon: What is the difference between your proposal and the Vickers proposal in terms of functions that may have to be duplicated: Treasury, risk management, HR and so on? What is the difference there? Is there are a greater saving with yours?

Douglas Flint: Vickers didn’t actually conclude. There is nothing in our proposals that wasn’t in the "it could be done this way" in terms of the definition of what goes into the ringfence. He had not gone beyond, and indeed was seeking thoughts as to: do you put all the infrastructure into one of the banks and then sell services to the other? Do you have a shared service company that supplies services to both? That is very much tied up with the work that we are all doing for the FSA/Bank of England on resolution planning, which basically says, "Ensure that the core payment mechanism, money transmission, ATM networks and so on are all available in the event that anything happens so that the infrastructure can support the core function of banking in terms of money transmission and protection and so on".

Whether you do that by one bank owning the infrastructure and renting services to the other or you have a separate service company, there are two big issues to deal with that we have highlighted to the Commission. One is to make sure that there is not leakage in VAT since we do not recover our VAT. That should be possible. The other is: we think that the more you separate pieces, ring-fence wholesale and infrastructure companies, the more you potentially weaken the covenant that the pension schemes have and, therefore, there would be a cost in terms of probably recapitalising pension schemes. Instead of having a single covenant with a great diversification, you have one entity owning a pension scheme and selling services to other parts, so there would be some cost.

I think the biggest cost in the ringfence, potentially, is determining to what extent you ringfence the infrastructure as well, because both sides use it, and indeed, in the retail side today, the small businesses and retail customers benefit hugely from the fact that the major corporates pay for the fixed costs of the money transmission system and the incremental costs, and the profitability comes from the smaller side, but they do share the fixed cost sharing.

Q195 Michael Fallon: But you do say that your own proposal would have "certain inefficiencies". What are those?

Douglas Flint: "Certain inefficiencies" is: instead of having one counterparty you have two; you have people with employment contracts; you have service-level agreements between two banks, or maybe two banks and a service company. You are creating a more complicated administrative structure, and one would try to-

Q196 Michael Fallon: I am sorry, but how much more complicated is yours than the Vickers proposal?

Douglas Flint: He had not defined that. He had not defined how the support infrastructure for the two banks would be separated, so I am not sure it is any different from his, because it is still in evolution.

Q197 John Mann: I want to ask some questions on investment banking, but before I do, I just wanted to ask you one question, Mr Hester, and first congratulate you on the fact that your bank is making slightly more loans to businesses in my area than Lloyds TSB and noticeably so, though the comparator is probably not a particularly good one, but at least we are seeing some signs and I am getting some feedback that some money is moving. I am pleased to see that. But, listening to what you said, and you used the term "regular lending", I am just scratching my head a little bit. You are questioning choice for the consumer. Ten years ago there were 15 retail choices for the consumer in my area and now there are six on the high street. That is a phenomenal reduction in choice, and there seems to be some quibbling about whether there should not be a lot more choice available again.

We are not exactly out of the recession. I don’t know if it was your bank, but some banks certainly lent to private equity companies who then have led to 42,000 people potentially losing their home with Southern Cross, where, in essence, an asset was speculated on and the taxpayers potentially are being asked to pick up the bill on that. We are looking at some of the minutiae here, and I wonder whether you feel a bit pleased with the approach that was taken. I just wonder how you managed to get away with it.

Stephen Hester: Sorry, get away with what?

John Mann: Nothing much has changed, has it? I’m going to come on to investment banking in a minute. We are quibbling a little bit about choice and we are talking about what kind of firewall, if any, there should be and how that should be configured, yet the taxpayer is about to potentially pick up further consequences of the banking collapse. I am asking how banking gets away with it.

Stephen Hester: I guess, as you know, the thing that I think everyone agrees on is that there should be change. Governments agree on that and banks agree on that, and certainly my job ever since I came into RBS at the point that it was collapsing has been, in the context of RBS, to create substantial change, so I certainly would not for a second try to defend that there should not be change. I think substantial change is happening and ongoing. I agree that change was warranted.

Q198 John Mann: Let’s look at investment banking because, Mr Flint, you, a few years ago, said banking should be "predictable and shouldn’t produce surprises". Are we going to see the situation, if these proposals do go through and there is a retail ring-fence, that the Government could be asked again to pick up the costs of an investment bank that goes into difficulties?

Douglas Flint: I think that probability has been reduced absolutely significantly. I think you can never say never, because elected officials would have to make a judgement at that time as to whether there were circumstances where not intervening would be a worse result than intervening, but if you think of many of the things that have happened in the last 18 months, it’s a staggering list. Just in relation to investment banking, the structured credit world, the securitisation industry, CDOs, structured investment vehicles and correlation trading effectively have all disappeared. I mean, they no longer exist. The imposition of-

Q199 John Mann: But Mr Hester said, "The big problem was regular lending". Of course, the regular lending had to be financed, such as the Icelandic banks. So, regular lending was at the heart of the problem.

Douglas Flint: Right. I wouldn’t have put that into a category of investment banking. I think the paper that the Bank of England has just put out with the FSA on the terms of reference and the way the Prudential Regulation Authority will supervise going forward in terms of being much more intrusive, much more reflective of understanding at higher level the business model and where the profitability is made and using much more judgement as opposed to metrics and so on, is a welcome enhancement to that side of the equation, but I agree with Mr Hester. Many of the most egregious losses in this part of the world were on fairly simple lending, so there was nothing opaque about it. It was bad judgment.

Q200 John Mann: But the lack of competition in investment banking is part of it, isn’t it? We could take, for example, the Kraft buyout of Cadbury, we could take Glencore, or we could take the funding of private equity. If we take Glencore and Cadbury, lots of investment banks were all jumping in together to fund the buyouts and make huge profits on the back of it. That does not necessarily benefit the British economy. Is there not a big weakness in this report that it fails to get to grips at all with the lack of competition in investment banking when it comes to these kinds of buyouts?

Douglas Flint: I’m afraid I don’t agree. I think there is a great deal of competition and-

John Mann: In some areas, but not in others.

Douglas Flint: I think in most areas, and the money that is made by these banks and these deals is made because they have brought to institutional investors who operate pooled investment vehicles propositions that those investors independently believe are valuable. It is a marketplace. The proposals are brought forward. An investment community of hundreds, if not thousands, of insurance and pension funds determine whether those are assets that they wish to buy, having been packaged and presented with a prospectus that has gone through a great deal of due diligence and legal scrutiny. If that creates value for the economy, that is a good thing.

Q201 John Mann: But the due diligence and legal scrutiny are the lawyers and accountants-you criticise them yourself in your paper-making huge fees again, so it is a constant turnover of buyout and buyout and buyout with huge fees being made and a lack of competition in there, because if you’re the investment bank who is in the middle of it advising, you have the inside knowledge to be able to judge in what way things should go.

Chair: I think that had better be the last-

John Mann: Chairman, you don’t like the questions because the questions are challenging. Some of the assumptions-now, you’re entitled to your view. I am elected to this Committee and I am entitled to my view.

What I am putting to you is the fact that there is a fundamental weakness in this report in that it fails to get to grips with the lack of competition in investment banking, so it will be business as usual at investment banking. To come back to my initial question: is there a scenario that either of you can see where the taxpayer would be expected to bail out, because of the activities of an investment bank, even where there is a firewall built into the system?

Chair: We will have a quick response to that from each of you, if we could.

Douglas Flint: Simple response: no, I don’t believe that would happen going forward.

Chair: Mr Hester?

Stephen Hester: I agree.

Q202 Stewart Hosie: The ICB suggests a 10% equity baseline in large banks. Do you understand the rationale for choosing 10% rather than 8%, 9%, 11% or 12%, and do you agree with the 10% baseline figure?

Douglas Flint: Pre the ICB coming out, we had published our annual results for 2010, and we said, reading the runes, we believe that it is likely that a core equity 2:1 ratio between 9.5% and 10.5% is likely. We had no inside knowledge. It just felt around the world that that is where the world was going to, and if you put it into old money, that is probably equivalent to 13 or 14% on a Basel II basis, so it is like three or four times the capital requirement that was the minimum requirement historically. We have estimated or calculated that on a 10% equity 2:1 ratio we believe we can make a return on equity-and this is an important point-of around 12% to 15%. Last year we made 9.5%. We calculated our cost of capital at 11%, so last year we didn’t make enough money to cover our cost of capital.

We believe that with a 10% capital ratio it is possible to make a bit more than our cost of capital and hopefully progressively 2% or 3% spread over the cost of capital. I think it is really important that the business model that follows all the regulatory changes and capital calibrations that take place is economically viable, because there is a huge investment community out there that is looking to see whether there can be a business model that returns sufficient to meet costs of capital and at the same time-and where you, I believe, should have concern or just a watchful eye-that that cost of capital doesn’t require to be supported by an unsustainable cost and intermediation so that the cost of credit has to go up to make that cost. We believe that at 10% it kind of works, so 10% was not a surprise.

Q203 Stewart Hosie: Is there not a danger, though, that that becomes the minimum figure rather than the maximum figure?

Douglas Flint: It will become the minimum figure.

Q204 Stewart Hosie: That may drive some institutions to hold more.

Douglas Flint: It will.

Q205 Stewart Hosie: Would that not have a consequence in terms of your ability to lend, and certainly the costs you might be forced to pass on?

Douglas Flint: I think there is a tipping point. I think that if the requirement goes beyond the ability to charge for it in a world where we will continue to be competing with institutions that have a lower requirement to make returns because they may not be privately owned or in jurisdictions that won’t necessarily implement Basel III that will be a problem, at which point the only way you could meet these requirements is to deleverage the balance sheet. I think there is a general recognition that if 7% is the agreed ratio for equity under Basel III, which it is, and if people are now talking about a 2% or 3% systemically important surcharge, which seems to be what people are talking about, you kind of get to the 10%, and I think at the 10% it may be possible to meet cost of capital without on-costs that are damaging to the economies.

Q206 Stewart Hosie: But the ICB have also said that in the absence of generally loss-absorbing debt-this is something you touched on earlier, Stephen-the capital ratios will have to be higher. So they are suggesting, and Vickers said to us, it was 3% tier 1 of total assets in addition to the 10% against the risk-weighted assets. How would that balance fit? If you think you can just about do it at 10%, what would happen with that package of 10% on RWAs and 3% of tier 1 against total assets?

Douglas Flint: That’s okay.

Stewart Hosie: That still works?

Douglas Flint: It still works. Can I take one minute? I just jotted it down coming here. It is staggering when you look back at what has been achieved by the policy framework in the last 18 months. We have redefined capital in a way that has restricted it to loss absorption. We’ve agreed a 7% minimum core tier 1 ratio. We’ve introduced a leverage ratio for the first time outside of America. We’ve introduced a liquidity regime to both cover liquidity and sustainable funding. We’ve mandated central counterparty clearing for over-the-counter derivatives, straightforward derivatives. We’ve introduced a new macroprudential regulation all the way round the world. We’ve established in the UK a new tripartite regulatory structure under the Bank of England. We’ve changed the intensity and scope of supervision in the UK.

We’ve proposed additional regulation and capital for systemically important institutions. We’ve brought much of the unregulated sector into scope, including closing down structured credit, securitisation, CDOs, correlation trading and so on. We’ve added regulation to the shadow banking sector, in particular to money market funds. We’ve required a greater number of non-executives to be approved by the regulatory authorities. We’ve enhanced board oversight. We’ve introduced board risk committees. We’ve mandated bonus deferral and clawback. We’ve embarked upon moving from an incurred loss accounting provisioning model to expected loss. We’ve announced a review of the trading, but we’ve announced a review of risk-weighted asset calculations to make them consistent. We’re under way with the creation of massively complicated recovery and resolution plans.

Chair: That is a very long minute.

Douglas Flint: Two more: we have added powers to bail-in creditors and we’ve formulated idiosyncratic and industry-wide-and on top of that we did the Independent Commission. But, like you said, the thing has changed out of all recognition. To focus on just one piece, the capital piece, is one of an enormous number of-

Q207 Stewart Hosie: The reason I am doing that is because I understand precisely the progress that has been made, but we still have David Miles suggesting much higher capital requirements. We have the Swiss authorities talking about 19% equity, plus the CoCo, contingent convertible bond, option on top of that. I’m trying to find where the banks need to be safe for the public and still able to take risks and best lend and make a profit. I’m trying to get to the balance in the view of the banks and the view of those looking at it from the outside.

Douglas Flint: Given that we will have bailinable debt and given that we will probably have some contingent capital on top to replace the old subordinated debt, I think, in terms of core equity, if we get much above 10%, we risk costs to the economy in terms of increasing the costs of intermediation or deleveraging the banking system, because it will be just about impossible under today’s structure to meet the required costs of capital.

Q208 Stewart Hosie: If it went 1% above the 10%, what would each 10% rise in equity costs mean in terms of cash not available to lend, or even a direct impact on GDP growth? Is there a metric or a calculation you have for that across the sector?

Douglas Flint: Yes. If it was 10 times, our capital base is about £140 billion globally, so you take another 1%. You’re taking hundreds of billions of credit capacity out of lending.

Q209 Stewart Hosie: You have made those points presumably to Vickers and the Commission about this?

Douglas Flint: Yes.

Q210 Stewart Hosie: Just one final question on this, because we’re talking about a loss-absorbing debt and other instruments. There is a lot about this. Would either of your banks buy loss-absorbing debt instruments from other banking institutions?

Stephen Hester: No.

Stewart Hosie: That is helpful.

Douglas Flint: Because there would be a deduction for it, so it would be very, very inefficient.

Q211 Stewart Hosie: Is there a market for them at all?

Stephen Hester: Yes, I believe there is. "Buyer" means it is not our job to hold those things. I’m sure we would trade and so on and so forth, but I believe that there absolutely is.

Q212 Chair: Mr Flint, what proportion of your bank would be in the ring fence, on the definition of ring fence you have provided to us?

Douglas Flint: In the UK, because it would just be the UK-

Chair: You have not done the calculations?

Douglas Flint: I haven’t done the calculations.

Chair: Why don’t you come back to us-

Douglas Flint: Can I get it, and I will come back to you rather than guess?

Chair: -when you have had a chance to examine the proposal, which is after all an IFRS-driven proposal. You could also give us the same answer for RBS, Mr Hester.

Q213 Mark Garnier: Can I carry on with the contingent available debt and the bail-in debt? I think you both agree that this is a good idea. Have you worked out what sort of pricing model there will be on this debt in terms of the secondary market, or indeed in the primary market, because that is where you’re getting the money in?

Douglas Flint: Today, technically, debt being issued is bail-inable because the Bank of England has the power to do that-

Mark Garnier: To exercise it.

Douglas Flint: -in the event of collapse. My own view is that one of the risks of contingent capital, and indeed of bail-inable debt, is that you end up with a kind of barbell. There will be the top end of the banking world, where people believe that the banks are well-run, diversified and so on, who will be able to raise capital, and the only contingent capital raised so far has been by banks that would undoubtedly fall in that sector.

There is a great danger that outside that, there will be people who just couldn’t at any price-it is not a question of pricing-raise it. One of the risks, I think, that has to be better analysed is whether you precipitate consolidation that is unwanted, or you precipitate crisis that is undesirable, by forcing people to go to the market to find that they can’t get riskier contingent capital or can’t get it at prices that in any way are economic, and therefore their business model fails and the market discerns that they can’t get money at that price.

Q214 Mark Garnier: I think that this ties in very much with the competition question and also the implicit guarantee question, because as you said, if you are a big, robust bank, you are going to be able to issue this CoCo debt or bail-in debt, but if you are a small bank trying to raise capital, as you said, you have more risk of collapse. As you said earlier, inevitably at some point, even if you were rid of this implicit guarantee, the Government will say, "It is more economically viable to bail out a bank than it is to suffer the consequences of a failure of a bank". That ultimately means that you are increasing the competition-or the lack of competition, rather-because you, as the four big banks, will find it easy to raise this type of debt, whereas everybody else will not, for the reasons you have discussed. Do you agree?

Douglas Flint: I have said publicly that I think one of the potential real unintended consequences of designating systemic institutions is that you concentrate activity in them. By so designating those institutions, I personally find it difficult to believe that fiduciaries’ trustees wouldn’t take a list of 20 or 30 banks and say, "Well, that is enough to be getting on with. These are the banks that we will deal with". If you were a fiduciary, it must be compelling to say, "There is a list of institutions globally designated as systemic".

Q215 Mark Garnier: Those ones will be able to raise CoCos?

Douglas Flint: I think they will get bigger.

Q216 Mark Garnier: They will get bigger. Do you think this whole idea of contingent debt and bail-in debt is a bit of a red herring? I think, Mr Hester, you said a bit earlier in response to one of Mr Ruffley’s questions that the ideal way of financing a bank is a strong equity base. I mean, are we barking up the wrong tree with this altogether?

Stephen Hester: I think it is one of the most essential tools, because the key missing ingredient between banks and other companies was at the point of liquidation-in any other company when you go bust, your creditors take a haircut once your shareholders have lost the money, and then the company, if it is viable, continues under a different capital structure. There wasn’t a way of doing that with banks, because in liquidation, the whole system came down and so on, so you need to have a different mechanism for banks to allow the same to happen as would happen for an industrial company: in other words, for losses, once they get past the shareholder, to be borne by the creditors. That is why my view is that bail-ins is the single-most important-there are many important things-feature of the new tools that we now have in law here, and they are in law in the United States, to avoid the state putting its hand in its pocket in the case of crisis. In that sense, I think that you don’t necessarily need to go further than is currently in law. In other words, the authorities today now have the ability to institute bail-ins, and you don’t need to issue special instruments with them. There is a different discussion about CoCos, which is a different form of preference shares.

Your other point I would also like to take up, and that is to say that I do think that we have to worry about moral hazard. We have talked about one kind of moral hazard, small versus big banks, but ring-fencing can be another form of moral hazard, because you are saying, "Anything inside this, don’t worry, we will protect". In a few generations’ time, that could be tomorrow’s expansion as people under the protection of the state. So to my mind, if you go down the route of ring-fencing, make it incredibly small and tight so there is absolutely no room in two generations’ time for that to be the state halo of protection that goes into all sorts of activity, as we have seen with many of the banks that have failed that are supposedly domestic, plain vanilla models, but nonetheless went into adventurism, even in their domestic markets in Ireland, in Spain, in Germany and in the UK.

The bail-in tools will protect all banks, of any size and any shape, from the state putting in money, because it means the creditors are next in line after the shareholder. That is the way to deal with risk. If we have to do subsidiarisation, let’s make it really narrow so it does not create a further distortion on top of that and a further hidden cost on top of the overt capital ratios, which you talked about earlier.

Q217 Mark Garnier: When you say "all banks", you are suggesting that CoCos can be issued by Tesco Bank and everyone?

Stephen Hester: I think, in a sense, you can leave that up to the banks. If you have bail-ins, bail-ins can apply to all creditors in rising levels of seniority and so it is then up to the bank as to how many layers of creditors it happens to have, and the creditors themselves will have a point of view on that, and whether they will give money to that bank and so on and so forth in designing the capital structure. But I don’t think one has to be that prescriptive, frankly. Most big banks, I suspect, operate a broader and more sophisticated range of people who put their trust in them. If you are a small bank, it is retail depositors who, frankly, are looking to the Government guarantee, which is potentially a source of moral hazard, but for the broader banks, I think they are going to the route anyway of some intervening layers of capital.

Q218 Mark Garnier: One thing the ICB does highlight is that once you get close to the trigger point for debt conversion, you start undermining the stability of the CoCo and therefore the bank. Effectively what is happening is, if you are an owner of a CoCo, you are effectively writing a put option on the bank. Do you see that as a significant disincentive for people to invest in them?

Stephen Hester: You see, in theory, this was one of the failures of the system that I think we have to learn from, because the banks developed layers of subordinated debt and preference shares that were supposed to be a class of creditor that was next in line when the shareholder ran out of money, and we found it didn’t work in the crisis, because the only way you could get your hands on that money was a liquidation that caused much more damage.

A crucial bit of learning from this crisis is: how do you move from shareholder to creditor in attributing losses, and the Government stay on the sideline? CoCos are simply a smoother form of subordinated debt and preference share in allowing how they were designed to work to actually work, and bail-ins are the next level of severity. When you have run out of that, that is how you avoid getting the Government involved as a regulator, but as a capital provider, and so I think fortunately the world agrees on this. It is not something where the UK has to have its own invention that no one else agrees on, which might be the risk of ring-fencing, but as it relates to bail-ins and as it relates to CoCos, this is something that will be uniformly agreed, I think, around the world.

Mark Garnier: That is very helpful, thank you.

Chair: You have expressed a view for a narrow ring fence that it does not sound as if the proposal put forward by HSBC would satisfy. It would be helpful if we had a chance to look at that proposal and if you could give us a comment on it, because it is clearly going to be part of public debate.

Q219 John Thurso: Mr Flint, is it practical to ring-fence without ring-fencing a balance sheet?

Douglas Flint: I think you would be ring-fencing the balance sheet. My understanding of the proposal is you would have two subsidiaries in the UK: a ring-fence subsidiary and a non-ring-fenced subsidiary. So it would have a separate balance sheet, yes.

Q220 John Thurso: We had evidence from Mr Cohrs, who was before us yesterday on his way to the FPC, who said that in his career at Deutsche Bank, he had tried-and I think implied failed-to demerge or separate out balance sheets. Is this as big a technical problem as he was making out to us, or is this a practical reality?

Douglas Flint: It is a huge technical problem. I think the bigger technical problem would be to take out the wholesale side, because the duration is extraordinarily long and complicated and you would need to novate so many contracts. We have moved balance sheets and moved activities and it can take three or five years to get all the customer consents.

I think if you were novating the wholesale balance sheet into a new entity, that would be incredibly onerous, and indeed, practically it would be very, very difficult. It might be easier to move the retail balance sheet, but it would probably need some support from the legislature to effectively give legislation that allowed the transfer of deposit accounts, just as when one bank takes over another, to novate them to a new entity, especially on the retail side. If you took the entity today, it would probably be easier to move the retail and small business side out than it would be to move the wholesale side out.

John Thurso: The core point there for us to take on board is that it is not just a question of accepting the principle of ring fence; it is the mechanics of it that will need a great deal of technical thought?

Douglas Flint: And almost certainly some legislative support.

Q221 John Thurso: Mr Hester, a completely separate question: if the interim report proposals were enacted, as it were, what would that do to the value of the Government’s shareholding in RBS?

Stephen Hester: Because the proposals are not fixed, I can’t give you a quantitative answer. It would reduce their potential value. I think many of those fears are in the share price today, so I am not trying to say the share price would go down, but clearly it would reduce their potential value.

Q222 John Thurso: But you would see it only as a reduction in value, pretty well whatever happens?

Stephen Hester: Yes. I think, if we go that route, there will be greater costs and those costs will be in some way divided between shareholders, customers and the economy as a whole: tax take, employment, whatever it would be. There are so many flavours, it is very hard to be more precise, but I think, directionally, we can be clear that, because the devil is in the detail, one of the things that we are trying to do is to work through all of these issues with the Commission to understand what is the best balance of avoiding undue systemic risk, of looking at cost to the economy, and how does one balance these essentially difficult things?

Q223 John Thurso: Can I ask whether you discussed that at all with ICB?

Stephen Hester: Yes, yes.

John Thurso: Are you at liberty to say where those discussions are going, or is that something we should ask them?

Stephen Hester: No. I think our understanding of the way this is set up is obviously in the end, this is a matter for the Government and Parliament to decide, and the Government and Parliament-no doubt informed by your own views through these hearings and so on-will make its own evaluation of the report that the ICB puts forward, but our principal effort at the moment is to help the ICB in developing its recommendations, while of course not keeping secret our views, either in this forum or to our shareholders, whoever they may be.

Q224 John Thurso: Thank you. The third point-and perhaps I will come back to Mr Flint-were you surprised that there were was nothing in the interim report on the corporate governance?

Douglas Flint: Not really. I mean, the Walker report that is very recent covered that to some significant degree, so no, I wasn’t.

John Thurso: Were you, Mr Hester, surprised that they hadn’t addressed it?

Stephen Hester: No. I think that the shortcomings in the banking system are at the moment not ones of governance, and as we have seen, you can have lots of boxes ticked on governance and still the wrong decision is made.

Q225 John Thurso: I raised that with Sir John and his team when they were before us, and they said it would certainly be in their final report, and we in particular discussed the difference in culture between retail banking and investment banking, and the perfectly proper fact that you might well argue that investment banking requires a different approach from retail banking, and he and his team agreed that the culture was important. Is that something you would like to comment on? Do you see that as an important aspect that should be looked at as part of this, or is this simply something to be left to Walker and not to worry about?

Stephen Hester: I think culture is incredibly important to any company. It is not clear to me how you legislate for culture, and when we look around the world and look at the banks in trouble through, if you like, expansion sprees, we could think of the Irish banks, we can think of Northern Rock, we can think of many, many banks, and I don’t think you will find them very uniformly associated with one culture or another in terms of the subject matter. But obviously a culture of balance, of sensible risk taking, all of these kinds of things, which I think translate across many different business models, is incredibly important. I don’t know how you would write a rule for that, that is all.

Q226 John Thurso: But one of the arguments of course about separation and whether it is full separation or whether it is ring-fencing is that different people have different objectives, and the plain vanilla ring-fenced commercial retail bank has a higher regard possibly for prudence, whereas the more risk-taking investment bank has a higher regard for reward, and that in their proper places, these cultures operate quite well together, but if you conflate them, you can get the worst of both worlds.

Stephen Hester: Among the biggest losses in the world are retail and commercial banks. Look at Ireland. RBS has lost significantly more money in loan impairments than it lost through investment banking activity, so I think this is a real mistake if we try to attribute loss to one particular kind of activity, or indeed, if we try to guess in the future where loss might come from-it can come from all sorts of different ways-and to isolate something and say, "That can’t be risky", when the facts are the opposite. Most of the risk that has exploded in people’s faces-the largest number of institutions-has been domestic lending in different markets, mostly when they are stable.

Q227 John Thurso: I am sorry to rush you, but the Chairman is very keen to get through. The point I am trying to make is that you could look at RBS and say the activities that lost were those classic commercial activities, but the reason was that the people in charge of them had taken on the attitudes of a different culture, and had they been behaving as they used to in the good old days-and I know that is a caricature-it wouldn’t have been so bad. That is the broad thrust of the argument.

Stephen Hester: For a few months, I was asked to serve as non-executive deputy chairman of Northern Rock after the Government nationalised it and the Government were reconstituting the board. Northern Rock obviously is a celebrated non-investment bank that went in. None of the managers who drove Northern Rock’s expansion had investment banking backgrounds or lived in metropolitan areas or anything like that-the Dunfermline Building Society, the Spanish cajas, the German lenders’ banks, the American Savings and Loan. That is why trying to somehow say, "This is a protected species and everything is fine and good, and the Government can stand behind domestic lending", can have unintended consequences in the opposite direction. That is not the lesson of history, and that is why I think that our solution should be able to avoid crises or pay for crises in any kind of banking, because any kind of banking has shown it can produce losses and excess risk.

John Thurso: Thank you.

Q228 Jesse Norman: We do not have much time, so I would be grateful if our guests could keep their answers tolerably short. Mr Hester, what is your current exposure to Ireland, and how has it changed over the last year?

Stephen Hester: Our exposure to Irish Government debt, as such, is very low. Forgive me; I can write you an email, but RBS owns the third biggest bank in Ireland and the biggest bank in Northern Ireland, called Ulster Bank, and so in that sense has a very large exposure to the Irish economy.

Jesse Norman: No kidding. That is what I am interested in.

Stephen Hester: The total assets in Ireland are to the order of £40 billion.

Jesse Norman: Still?

Stephen Hester: That is right.

Q229 Jesse Norman: When you last came forward there was £40 billion and you thought a significant portion of that was impaired.

Stephen Hester: Well, Ireland was in fact something like 70% of our impairments in the last quarter as a global bank, even though it is 4% of our balance sheet. I believe that-

Jesse Norman: How much would that be in terms of-

Stephen Hester: Can I write to you? I don’t have absolutely the precise number. It is all disclosed in our first quarter report, but I’m very happy to. I believe that we and the other banks are getting to the peak of the impairment cycle and things will come down. Of course, that a little bit depends on how the Irish economy unfolds, but as I say, it does give us a different window, if we weren’t needing one in the UK, of seeing how domestic lending, which is what happened in Ireland, is not risk-free.

Q230 Jesse Norman: Thank you. On a scale of one to 10, how would you rate the corporate governance of RBS before the crash?

Stephen Hester: I wasn’t there, so it is-

Jesse Norman: But you have a bit of insight, don’t you?

Stephen Hester: -invidious for me to make a comment, but what I would say, without having done a personal audit, is that I don’t think the issues around RBS were to do with the formalities of governance. They were to do with the judgments made, and as far as I could tell, the formalities of governance were conventional, normal and followed. But obviously this is going to be the subject of an FSA report, which they will give their own view on, which has clearly gone through a lot of detailed scrutiny.

Q231 Jesse Norman: You would support the publication of that report?

Stephen Hester: I do support. I think it is important that if there are things that are not in the public domain that are relevant to why RBS failed, those be given an airing, or indeed around the regulation of it.

Q232 Jesse Norman: Thank you. What are your current funding costs?

Stephen Hester: Funding costs?

Jesse Norman: Yes, in relation to LIBOR.

Stephen Hester: Well, obviously that depends on which bit of funding and what maturity.

Jesse Norman: I mean to the bank as a whole.

Stephen Hester: If we were funding short term, we can fund at LIBOR or below LIBOR; if we are funding three or five years, it is 200, 300 basis points over LIBOR.

Q233 Jesse Norman: Sure, but I will put it this way: how is your net cost of funds compared to, say, 2007 and 2008 before the crash?

Stephen Hester: I would say that-again, forgive me, probably the simplest is if I write to you with the accurate numbers, but it will have at least quadrupled.

Q234 Jesse Norman: Right, thank you for that. When I asked Bill Winters what percentage of profit before tax is allocated to bonus, he said for banks generally it was about 25%. Is that your view, roughly speaking? Would it be more or less than that?

Stephen Hester: It varies massively by business activity.

Jesse Norman: But I mean overall.

Stephen Hester: I would say that it would be-I would think it would be less than that in a diversified bank like RBS, but if you were to just look at the narrow investment banking arm, which is of course where the larger bonuses are paid, it would be often a higher percentage than that.

Q235 Jesse Norman: All right. Would it be wrong, as a rule of thumb, to take the amount of subsidy from the taxpayer guarantee and to just use whatever percentage it was in terms of the amount of money that had been paid on a taxpayer guarantee basis into bonuses?

Stephen Hester: I think that you would have to, as I said earlier on, try to reach a conclusion as to whether cheaper funding for banks had benefited customers. Let’s take the UK: by far the biggest thing that went on in the UK was lending at razor-thin margins on mortgages for house purchase, which fuelled the house price boom we had. So in that sense, you could say that every person who borrowed on a mortgage had narrower margins than was prevalent on mortgages in other parts of the world. As I said, also you could say the shareholders benefit and you could say that some bonuses benefit. It is impossible to attribute, and is probably a bit of all the above.

Q236 Jesse Norman: But on average, one might take that view. Can I ask Mr Flint one last quick question, Mr Chairman? You said that you felt that investment banking was generally a rather competitive activity. Twenty years ago it cost 2% to raise equity in the London markets, and now it is somewhere between 4% and 6%. Why do you think that has happened, and do you think that is a sign of a lack of competition?

Douglas Flint: That is a great question, and indeed, there has been a study done recently as to why that would be the case. There is certainly no lack of competition and people bidding for the business. I think that the deal sizes are getting larger and the due diligence, and indeed the costs of failure are very high too, so it is the market clearing price. Whether it is the right price or not, it is the market clearing price and there are 10, 12, 15 banks bidding for each deal. I don’t think that those who choose banks necessarily choose solely on the basis of costs. I think they choose on the basis of who they think will get the result, so it is a market clearing price.

Q237 Jesse Norman: Perhaps they can be blamed for not choosing. So you wouldn’t support the idea of any kind of Government cap on underwriting fees, as there used to be?

Douglas Flint: No, I think that would be intervening in the marketplace. The Government of course could determine that it would put a cap on what it is prepared to pay itself when it engages in investment markets.

Jesse Norman: That is a helpful comment. Thank you very much.

Q238 Chair: Thank you very much for coming before us today. It has been fascinating to have your initial response to the Commission report. There is a great deal more that needs to be discussed, and we are going to take a break now before we start the next session because there will be a division in three minutes, almost certainly, so we will resume at 4.30 pm. But before I let you go, I just want to ask Stephen Hester one question, which is whether he would be prepared, even if he does not have it at his fingertips now, to tell us what value he would attach to the diversification of his business . If you had a ring fence, what are you going to lose in terms of value?

Stephen Hester: In a sense, I have answered that in some ways, which is to say firstly, I can’t, because you have to design the kind of ring fence and you have to know what the alternative is, and so that leaves it a very significant range. Secondly, I have been clear I believe there is a cost. I think that that cost will manifest itself in capital levels in cost of funding, and then the question is where that is passed on. Is it just to the shareholder? Is it to banks being uncompetitive and to employment and tax? Is it to customers, or some mixture?

Chair: All right, so the same answer as before, which is quite reasonable. I think as we get more detail about that division, it is going to be extremely important that we come to a clear view about the value of those benefits. Thank you very much for coming before us today.

Stephen Hester: Thank you.

Examination of Witnesses

Witnesses: Mr Bob Diamond, Chief Executive, Barclays, and Mr Antonio Horta-Osorio, Chief Executive, Lloyds Banking Group, gave evidence.

Q239 Chair: Let’s begin. Thank you very much for coming before us this afternoon. We have something to get our teeth into now with the ICB report. Perhaps I could begin by asking you, Mr Horta-Osorio. It is a very interesting piece of evidence you have provided us with that is being put into the public domain, which is very helpful. Perhaps I could just begin by asking a very straightforward question, just to make sure we are all on the same playing field. Do you agree that banking receives a subsidy?

Antonio Horta-Osorio: Good afternoon, Chairman, and good afternoon to everyone on the Committee. Relating to the subsidy, there are several studies, as you all know, that strongly argue there is a subsidy in the banking system. This subsidy would arise from the fact that retail deposits are being protected by the taxpayer, so they foresee that would make an implicit guarantee to the rest of banking activities, and in that respect, the studies that I saw, without trying to argue about the amount of the subsidy or its intensity, look like credible studies to me. I would nevertheless emphasise that it depends on the point of the cycle. It depends on the measures that are taken through time in terms of-

Q240 Chair: That is fine. I am just trying to make sure we are all on the same page. Mr Diamond, do you agree that there is a subsidy?

Bob Diamond: I wouldn't call it a subsidy, Chairman.

Chair: Is that a no?

Bob Diamond: Well, if I can give you a sense. Your phrase-I think it was with the Independent Commission-was "contingent liability". The phrase I tend to use is "implied Government guarantee". I think we are all talking about the same thing, not a transfer of funds from taxpayers, and I think unquestionably there was an implied Government guarantee during the crisis. As Bill Winters pointed out during his testimony, which I agree with, it is unclear in the period before that whether the implied guarantee was there or not, but most importantly, I think I agree with everyone on the Treasury Select Committee and certainly the Independent Commission on Banking that one of the goals of the Independent Commission on Banking and their recommendations should be to eliminate any implied guarantee.

Q241 Chair: We will come on to that in a minute. I am just trying to be clear that we are agreed that there is an implicit subsidy. You can call it an implicit guarantee, but we are talking about the same thing.

Bob Diamond: I think we are all talking about the same thing.

Q242 Chair: And banks are in receipt of it. Could I come back to Mr Horta-Osorio? Are there ways in which that subsidy can get transferred to the investment side of a universal bank from the retail side? If you look at your evidence, footnote 33, I think it is, on page 20, says, "A subsidy could result from the investment banking arms of universal banks having access to the insured deposits at retail banks. Even if they do not access them, the possibility itself distorts the transfer price and funding costs allocation." I am just trying to be clear that that is what it means.

Antonio Horta-Osorio: My opinion on that point is the following: if we agree that a subsidy exists, as you just said, then when investment banking activities are part of a universal bank, they potentially benefit from the reduced cost of funding of those retail banking activities, which are covered by their first years. In that sense, I would say that it is possible that investment banking funding costs do not fully reflect the risk inherent in the business.

Q243 Chair: Do you agree with that, Mr Diamond?

Bob Diamond: I do not, Chairman.

Q244 Chair: Can you explain why?

Bob Diamond: Could there be a cross-subsidy in a bank? Yes, there could. I can only talk about how we operate at Barclays, and our retail deposits do not fund our investment bank. They don’t going forward; they haven’t in the past. We have a very strict policy, and my background in banking began in the money markets and in the funding markets, and it is very important to me and has been the policy at Barclays for quite a while that we charge the exact rate with which the wholesale activities fund in the market. There is no transfer pricing.

Q245 Chair: But when people buy your stock, they are buying it knowing that there is an implicit guarantee, aren’t they?

Bob Diamond: Going back to the earlier discussion, to the extent that there is an implied Government guarantee, I think we could discuss for quite a while whether investment banks benefit from that and whether retail banks benefit from it. If you look at the Moody’s ratings, they give more notches to Nationwide than they give to the universal banks and Barclays, so much of the evidence suggests that retail banks benefit more, if there is an implied guarantee based on rating agency notches. I’m not going to support necessarily rating agency notches. I’m trying to bring up one way that you could look at that. But in terms of your narrow question-is there a subsidy between the retail bank funding or deposits and the investment bank?-absolutely not.

Q246 Chair: Mr Horta-Osorio, do you think that a ring fence could contribute to the protection of taxpayers and reduce the implicit subsidy?

Antonio Horta-Osorio: I do think that the main advantages of ring-fencing are twofold, which is to protect key economic functions such as retail deposits and payment systems, and secondly to reduce the complexity and inter-connectedness between different parts of a universal bank. Those, as per our submission, are in my opinion the main benefits of subsidiarisation. But as you just said, I think there is a collateral advantage, which is that you have different parts of the universal bank that can fund on their own feet, on their own merits if you want, on their own risk, and therefore in their own cost of funding, and in my opinion they can keep a universal and integrated approach to clients, given that you still have a holding company. You can still keep the diversification benefit at the holding company level and you approach customers in an integrated way, but separated. And I do think that that separation, I repeat, protects key economic functions, reduces complexity and inter-connectedness, which is a critical part of recovery and resolution plans, and also has the advantage of limiting any potential subsidy from spilling over to other parts of the retail bank.

Q247 Chair: So you see some advantage to the proposals if we can find the right place to put this ring fence?

Antonio Horta-Osorio: Yes, I do, and as you just said, I think it is very, very important to very carefully consider where to place the limits. The value here is in the detail. It is critical to be sure what type of customers are, in my opinion, better, and in what type of province to make the separation, because customers are not mandatorily changed by laws. A retail customer may decide or the high net worth individual may decide he wants to use an investment bank, and a highly complex company may decide she wants to use a retail bank, so I think a separation by products is more important and is easier to control and to enforce.

Secondly, I think it is very important, Chairman, to have a long adjustment period to implement this, because it is highly complex and we have to be mindful and careful about the cost to the economy, so a very, very detailed and robust cost analysis between the benefits to society and the costs to banks, which will also impact on society. The cost-benefit analysis is critical and a long adjustment period is very important.

Q248 Chair: Since you do not think there is any transfer of the subsidy from one part of the bank to another, that you already have de facto separation as far as the subsidy is concerned within Barclays, you presumably must think a ring fence is a crazy idea.

Bob Diamond: I certainly wouldn't say "crazy", Chairman.

Q249 Chair: What possible purpose could there be to it if there isn't any cross-subsidisation within Barclays?

Bob Diamond: Can I just back up a second? In our submission what we said is that any regulatory recommendation, whether it’s coming from Basel or from the Independent Commission, in my view should pass three tests, and the three tests have to be passed together.

The first is: does it make the financial system safer and sounder and does it prevent taxpayer money from ever being put at risk?

The second is: does it promote the economy and does it promote job creation? I think those two sometimes naturally conflict, so, when asked a narrow question of, "Can ring-fencing protect depositors?" the answer certainly is it can, but the question is: what is the cost versus other ways of doing that? Because the economy and job growth is also important.

Then the third test that I think is critically important is that we maintain a level playing field with the major financial centres and the major economies around the world. With that said, I think we talked about this in January somewhat, but operational subsidiarisation is something we feel strongly about, and in spirit it is exactly what the Independent Commission is looking for, so, we do believe that retail depositors should be protected. I want to make sure that is clear. Our goals are exactly the same.

I think the problem we are trying to solve, Chairman, is how can we know that if a large bank or a small bank-but pick a large bank-got into trouble, let us say, in the derivatives market, the branches could open on Monday morning or Tuesday morning, the small businesses could still operate and the money transmission could operate, and we really believe that subsidiarising by how we operate the business rather than through capital is the appropriate way to go. We absolutely believe that the regulators, if they smell trouble, have to be able to protect the depositors and the small businesses. The way I think of it simply is the branch-based business: the people, the buildings, the technology, the electronics, but the businesses that use the branch area because they tend to not have another alternative. I think our spirit is the same. We are trying to solve the same problem.

Lastly, and I am very sorry for rambling, there is such a wide area of ring-fencing in terms of how close it comes to really operational subsidiarisation or how far it goes in terms of separating the institutions completely.

Q250 Chair: So, you can envisage a ring fence such as is described by the ICB, which could be of benefit?

Bob Diamond: It would not be my first choice, but definitely we are working very hard with the Independent Commission-

Chair: I know you are, but could you answer my question? Can you envisage a ring fence which could be of benefit-a ring fence such as described by the ICB?

Bob Diamond: We wouldn't see it as the best option, but is there a way to make it work, Chairman? Yes, we do think that there is a way to make it work.

Q251 Chair: Would you be prepared to set out in a little more detail than we have here-after all, you have given us only three or four pages and on this key subject only a couple of paragraphs-on what that ring fence that could be of benefit should reasonably consist of? Would you be prepared to do that for us? Put it in some detail so that we can put it in the public domain.

Bob Diamond: Yes, because we will present you with the things that we presented to the Independent Commission, so they will be coming to you.

Q252 Michael Fallon: Mr Horta-Osorio, could we turn to the divestment that has been recommended by the ICB? They say the Government should seek agreement with you. Are you working towards an agreement or are you just going to oppose that proposal?

Antonio Horta-Osorio: The ICB report, as you know, is a preliminary report. We strongly believe that the market is a competitive market. We have seen no evidence that justifies that divestment. Our board position is very clear on that as we issued on RNS when the preliminary report was published, and our board strongly believes this is against the interests of our customers and therefore against the interests of our shareholders, including the taxpayer. Therefore, we are engaging with the Commission, we are seeking to see the evidence and we will continue to engage over the next few months. It is still early days.

Q253 Michael Fallon: But if the ICB confirms its recommendation in the autumn, will you seek agreement or will you still oppose it?

Antonio Horta-Osorio: We continue to engage with them because we haven’t yet seen any evidence that might justify a change of our board position.

Q254 Michael Fallon: Yes, but if they don’t change their position, what will you do?

Antonio Horta-Osorio: Our board will continue to evaluate this as we progress.

Q255 Michael Fallon: You said that the original divestment that you were required to make by the European Union was sufficient to create a viable challenger bank. Why should we trust your judgment on that rather than the Commission’s?

Antonio Horta-Osorio: It is not only my judgement or Lloyd’s board’s judgment. It was the judgment that the European Commission made at the time, that HMT made at the time. Neelie Kroes, the European Commissioner for Competition at the time, said their view was that the sale presented an effective and serious challenge with a 5% market share, and on top of it, as you know, our potential bidders-and I’m only speaking about public information-have been coming out and speaking, like Sir Richard Branson from Virgin or Lord Levene and Gary Hoffman from NBNK saying that our sale, as it is, is a credible and viable competitor and they are looking forward to bidding on this process. This is the same information that we are having from other potential bidders.

Q256 Michael Fallon: But Sir John Vickers said that the new challenger bank, without further divestiture, would have, I quote, "A fragile balance sheet and a weak funding position." Why do you think he came to that conclusion?

Antonio Horta-Osorio: I understand that. It is important to note that divestiture evolves in time, and given the dynamics of the UK market, as the mortgage market in net terms is falling and deposits are continuing to increase as banks deleverage, the relationship between assets and liabilities of this bank is improving over time. By the time that this sale will be completed, which will be around the end of 2013, the loan to deposit ratio of this bank will be in line with other successful banks, so that is very important information.

On top of it, I would also like to tell you that, as you know, when I came into the UK market, I was managing Abbey National. Abbey National was a very similar bank to this bank and it became a very credible and challenging competitor.

Q257 Michael Fallon: But a minute ago you were telling us that the European Commission’s assessment of two years ago was more valid. Now you are saying that Sir John’s report of only two months ago is already out of date. Which of those facts is right?

Antonio Horta-Osorio: No, sorry. What I said is exactly from-it is not only my opinion that this sale presents a serious competitor in the UK market, which you asked me. It is also the opinion of the European Commission at the time, HMT at the time, and it's the opinion of the bidders at the moment, as we are receiving indications, so I think there is overwhelming evidence that this will be a serious and effective challenger.

Q258 Michael Fallon: In the document you gave us, you have accused the Independent Commission of inconsistency in requiring you, with a 25% of personal accounts, to make further divestments but not RBS with 24% of the SME market. I asked Sir John Vickers about that when he appeared in front of us, and he said, in effect, the RBS divestment was a fait accompli. What do you make of that?

Antonio Horta-Osorio: I would agree with you that this appears anomalous. We have also asked that question and we have not yet seen any evidence to support the difference.

Q259 Michael Fallon: Do you accept that you still have the largest market share in most segments of the retail market?

Antonio Horta-Osorio: We have the largest market share in some and not in others. For example, on SMEs, post-sale, we will be number 3, in personal loans we will be number 4, in credit cards we are well behind. Our branches post-sale overall will be 19% of the market, so overall market share will be 20-something % overall.

Q260 Michael Fallon: In your talks with the ICB, have they given you any ballpark figure about how many additional branches they would like to see you dispose of?

Antonio Horta-Osorio: No, they have not given us an indication yet of what an additional divestiture could look like, but we are engaging with them and will continue to engage over the next few months, as I told you. It is still early days.

Q261 Michael Fallon: What would substantial enhancement, in your book, look like? What is your fear? How many branches might that amount to?

Antonio Horta-Osorio: We don’t even know if it is branches. It could be another type of assets or type of liabilities. We are engaging with ICB. The report just came out a month and a half ago, and we have some months ahead of us before September and we are exactly engaging upon that and upon the evidence they have.

Q262 Michael Fallon: And they have given you no idea how many branches they mean?

Antonio Horta-Osorio: No, and I repeat that they have not told us if it was branches or other types of liabilities or assets.

Q263 Chair: It was reported in the press yesterday, I think, that you are beginning the sales process de facto by sending out an information memorandum to potential bidders. Is that correct?

Antonio Horta-Osorio: Yes, that is correct. As I was appointed CEO only three months ago on 1 March, one of my first decisions was to speed up this process, because I strongly believe that the timing we have as decided by the Independent Commission and with the agreement of HMT and Lloyds is not a very long timetable, and I have personal experience of this given my previous agreement at Santander to purchase the branches of RBS, which was in the summer of last year, and would probably take three years to be executed; i.e. three years to do this sale in terms of getting to a buyer, making the contract and then doing the effective transfer of assets and liabilities to a new buyer is an extremely complex process, point one.

Second point, at the moment we are completing the integration, which will be finished by the summer, of Lloyds and Halifax and Bank of Scotland and therefore we have credible, very experienced resources that will be liberated by the summer, and they can be used in this process, which is very similar to concentration, which is in this case a divestiture. So, the fact that we have the resources and the fact that the timetable is not very long made us accelerate the process, Chairman, and we are effectively sending the memorandum out this week.

We first sent out a teaser. We have had several manifestations of interest. The people that showed credible interest, which we have identified by now, will receive the information memorandum with the view of having serious indicative offers by the end of July so that we can start engaging with the most serious bidders in terms of trying to see what deal we can have.

Q264 Chair: And this isn't leaving the ICB with a fait accompli?

Antonio Horta-Osorio: No, I don’t think so. It is to accomplish the timetable that we have according to European law, and I think to have credible buyers and see what the interest of those buyers is is critical to accomplish this process, and it should also be in the ICB’s interests.

Q265 Chair: Just looking at this slightly more broadly, have you had a chance to read the report that we produced on retail banking competition?

Antonio Horta-Osorio: Yes, I did, very carefully.

Q266 Chair: Is there anything in there, any big point of substance, with which you disagree?

Antonio Horta-Osorio: Not that I can recall. On the contrary, there is a very important point of substance with which I agree, which is exactly the importance for increasing competition in the retail market, of having a better and safer switching process, which we are strongly in agreement with and which we have proposed to the ICB as the solution on our own initiative, which the ICB also adopt on their preliminary report.

Q267 Chair: Another proposal of yours is that banks should produce information to retail customers in a form that can enable them to find out how much they are really being charged on a comparable basis across banks. Do you think that that is workable, technically?

Antonio Horta-Osorio: Yes, I do, and the reason why we proposed those two solutions is because this is quite important in terms of our core set. I strongly believe that the UK retail market is competitive, and I believe we can elaborate on it if you want. It is competitive for structural market reasons and for client behavioural reasons, which are different from other European countries I know, or other countries where I have worked before, but you can always have a more competitive market. Can you agree whether it is competitive or not? I do strongly believe it is, but it can always be more competitive, and key to having a more competitive retail market, in my opinion, are two pillars.

The first, as you mention in your report, is an easier switching process. There has been progress made in terms of customers being able to switch effectively and without risk, but more progress can be made. We are proposing a seven-day automated redirection of direct debits whereby customers in seven days can be sure that their account and their direct debits are automatically redirected to the new account without any risk. All banks have now endorsed that solution and the Payments Council as well. That can be implemented in two years and has much lower costs and a much shorter timeframe than account portability, for example.

The second pillar is more transparency. Transparency, together with the ability of changing providers in any sector, if the customer is not happy, is what drives competition. It is not mandatorily asking customers to change banks. In terms of transparency, we strongly believe, as we proposed to the ICB and we gave you evidence, that we could have simple statements whereby customers can see the opportunity costs of holding their money in their current accounts. We think that the simplest example would be to have it versus base rate. Of course, base rates now are very low-0.5%-but three years ago it was 4% or 5%, so it would be much more significant, and you could also use other examples. But base rate is a rate which is in the markets. It's an official rate, and customers could see what their opportunity costs are versus the service and benefits from their current account.

Q268 Chair: As you know, the same proposal, pretty much, was in our report. Have you had a chance to look at the substance of the Lloyds proposal on this, Mr Diamond?

Bob Diamond: Yes.

Q269 Chair: Do you agree with it?

Bob Diamond: Broadly we are in agreement, yes.

Q270 Chair: If you have points of disagreement on the transparency point, I would be grateful if you could put them in writing to us.

Bob Diamond: Yes, we've been working with the OFT, as you know, in terms of the cascade of what information is most important, and we hope to have out-we are happy to send more information-by the end of this year a statement for all of our customers to increase the transparency, and we are certainly supportive of the work that Antonio is talking about, of the industry improving both the speed and the process around switching.

Chair: It sounds as if, a decade after Cruickshank, we might have some progress.

Q271 Mr Ruffley: Mr Diamond, as you are aware, the ICB says of the implicit subsidy, "The prospect of Government support cheapens bank funding by considerably in excess of £10 billion a year for the whole of the UK banking industry". Do you think that is a fair estimate?

Bob Diamond: I was watching much of the testimony that you had earlier out of interest, and I think I would echo what Douglas said, because it's exactly what I would have said. It's really hard to put a pin in this. It's very different in varied markets. It's different in different environments. During the crisis it was quite large, I think. I think the real issue here is that we work very hard together to make sure that there is no implied Government subsidy going forward. I think the impact of it-

Q272 Mr Ruffley: You said when you came to see us earlier in the year that you were not happy receiving this implicit subsidy for your institution. I think that was where you first said it. Why are you so keen to get rid of this subsidy? Why is it important that you get rid of it?

Bob Diamond: It begins very simply with the fact that strong banks want strong regulation, and I said in January when I was here that no bank suffered more than the banks that were healthy and survived because of the failure of other banks. It is of benefit to Barclays to have strong regulation and strong supervision.

We have worked supportively on Dodd-Frank; we have worked supportively on Basel; I was in Frankfurt last week; I was in Milan a couple of weeks before that working with the FSB, so we are not against strong regulation at all.

Secondly, as I said in January, no bank should be too big to fail. No taxpayer money should ever be put at risk, and we agree on that completely. In my mind, the way that works, which gets directly to your answer, is that I believe there is a benefit to the economy and to job creation of having banks like Barclays that can help their customers do business around the world, and if banks are too big to fail then the answer we have is to get rid of big banks, which I think is the wrong solution, or find ways that they can fail without creating systemic risk to the economy and to the financial system, and that is resolution and recovery. We are very supportive, and I think we are way down the road with the FSA in having Barclays fit for purpose on resolution and recovery. So, if there was a problem, the regulators would be comfortable that they could walk in and separate the deposits, the small businesses, the branch-based system and the money transmission.

Mr Ruffley, we have spent about £30 million this year in developing a technology to get us to that position, so we are very much in concert. If we can do all of that, we have removed the implied Government guarantee.

Q273 Mr Ruffley: I understand that, and that is useful to have on the record. Why do you think Sir John Vickers says in his interim proposals that if those proposals are implemented, a total abolition of the implicit subsidy is unlikely? How would there be some residual subsidy, in your view? Because you want to eliminate it altogether, don’t you?

Bob Diamond: Yes.

Mr Ruffley: Why do you think Sir John said that? Why would there be some residual subsidy after all these measures are put in, assuming they are implemented in full: bank resolutions and bail-in and so on and so forth?

Bob Diamond: I think if those solutions-the package, as we call it-are implemented on a level playing field across the major economies then we have removed the implied Government guarantee. I do worry that, in addition to the package being approved, if you take an extreme view of ring-fencing-now, I’m saying an extreme view, and it is not at all clear to me that is where the Independent Commission is-it makes the implied guarantee almost explicit in terms of UK retail deposits, and that may be what he was alluding to. I’m not sure.

Q274 Mr Ruffley: Do you want to define for us what you understand by "extreme ring-fencing"?

Bob Diamond: I think "extreme" would be Glass-Steagall; a complete separation of wholesale and retail banking or investment banking and retail banking, however you define it. It is broadly recommended by the Independent Commission that this is not ring-fencing capital; it is ring-fencing deposits. We are working very closely with them so we feel this is a workable solution that doesn’t have a big cost to the economy and doesn’t create an explicit guarantee. Again, we are early in the process and I have nothing but good things to say about the thoughtfulness of the people in the Independent Commission on Banking. They give us all the access to them and are providing a lot of information, so I am very optimistic that we will come out in the right place, but certainly it is still early days.

Q275 Mr Ruffley: If I could just go back to the implicit guarantee, you’re a very experienced banker. Don’t you have a figure in your head as to what the value of the implicit guarantee is to your institution? Is it more than £1 billion or less than £1 billion?

Bob Diamond: I am sorry; I don’t mean to be obstinate at all. The reason I don’t, Mr Ruffley, is that I believe that this is not a guarantee that was given by Government. It is an implied guarantee that is given by the market. It is given by investors. It is investors making an assumption if something went wrong and, therefore, funding at different levels. For Barclays or for JP Morgan or for HSBC who are all then in the same situation where the investor is making that decision, what it leads to is lower LIBOR rates, and since our business is priced off LIBOR, it has a very positive impact on borrowers and a potentially negative impact on savers because it can potentially lower LIBOR. But it doesn’t have a direct pass through into banks if in fact, as you have said, it is an implied Government guarantee for the system, because what it impacts is the LIBOR rate. It doesn’t flow through into banks.

Q276 Mr Ruffley: Yes. The obvious implication of getting rid of the implied guarantee is a transfer-and these are the words of the ICB-of the subsidy, the cost of that. To use its words, "It shifts to the banks from the wider public." I think we have to assume that is the taxpayer. Do you accept that when the implied guarantee is substantially removed or indeed abolished, there will be higher costs for your bank?

Bob Diamond: I think there could be. I think the real issue, to come back to the first principle, is if this is the investors making the assumption and then they no longer make the assumption, we will see higher LIBOR rates. To the extent that it is to the whole market then we will see it reflected in the funding rates.

I think the difference, Mr Ruffley, is that there have been direct subsidies. Certainly the taxpayers in the UK gave money directly into Lloyds and into RBS, and that is the real impact at the end of the day, and that is very different. I am so positive on the package of reforms and the fact that we can end this "too big to fail" so that if there is a large bank that gets into trouble or a small bank that gets into trouble, they can be allowed to fail. I think it is critically important that banks be allowed to fail, because we want our banks to take risk. We want our banks to be lending. We want our banks to be investing in small companies. They need to be allowed to fail, but what we want is failure without the systemic risk or risk spilling over either into taxpayer subsidies or into turmoil in the financial markets.

Q277 Chair: You also benefited from the subsidy though, didn’t you, that went to Lloyds and RBS? If they had gone down, you would have been next in line, wouldn’t you?

Bob Diamond: I wouldn’t agree with that at all. What I would say, Chairman, and I don’t mean for a second to be anything but grateful, because I think all of us benefited from the quick decisive action of the central banks, the finance ministers around the world-

Chair: But I am just trying to be clear. You also benefited from a subsidy. You said that Lloyds and RBS received a subsidy, and I am just trying to be clear. Barclays received a subsidy too, didn’t it, in this crisis?

Bob Diamond: I don’t agree with that, and if I can say why, I would appreciate it. I think other banks would say the same thing. When Lloyds was no longer able to fund itself and when Royal Bank of Scotland was not able to fund itself, which was a crisis in the United Kingdom, Barclays saw an influx of deposits. It was based on the diversity of our business and the confidence of our investors. We were also able to go to the Middle East and raise equity privately, the last equity that was raised in the markets.

Q278 Chair: So why are you so grateful?

Bob Diamond: I think the financial system was in a dangerous position. I think we should all be grateful, governments, companies, individuals, businesses, and certainly as a large financial institution I am grateful-

Chair: But Barclays has nothing to be grateful for; that is what you’re saying.

Bob Diamond: I didn’t say we weren’t grateful, Chairman. I apologise if it came across that way, sincerely. There was not a direct subsidy to Barclays, but I didn’t mean at all to say I’m not grateful, Chairman.

Q279 Chair: I’m just trying to be clear about your view about whether there is a subsidy there that, when this crisis struck, also benefited Barclays or not. You’re saying, "No, it didn’t. In fact we had an influx of funds. From a narrow business perspective, this was very good news. We were going to be picking up everybody’s business". Correct? Is that what you just said?

Bob Diamond: I’m not sure I understood you, Chairman.

Chair: You were saying it was good news for Barclays in a narrow business sense because you were picking up other-because you had a huge influx of funds, you said a moment ago.

Bob Diamond: I don’t think there was anything about the financial crisis. I do believe Barclays was a stabilising force. I think other banks were stabilising forces at a time of real crisis. But I take no pleasure in that. I think it was a very difficult time and I have nothing but gratitude for the actions of the central banks and finance ministers.

Q280 Mr Mudie: I think I have to disagree with you. I think if Hank Paulson and Gordon Brown hadn’t got together and took the steps they took, you would have gone down and so would have JP Morgan. The whole system would have gone down. You were lucky that you were stronger than some that went down and you had the breathing space to get that Middle East money. But there you are; I suppose we disagree.

I would just like to be clear. You may have said something to David Ruffley but in terms of your answers to the Chairman on ring-fencing, are you accepting now that ring-fencing looks inevitable?

Bob Diamond: I think an interim recommendation of the Independent Commission on Banking has to be taken very seriously. Does that mean it is inevitable? I have more respect for them that they would listen to any evidence and make the right decision. I think they feel strongly, and we are going to work with them under the assumption that there is going to be some form of ring-fencing, but that does not mean we won’t still make our case that we think that there is a better option. I hope that answers the question directly.

Q281 Mr Mudie: No, I think that is very helpful. We pressed them and I pressed them in terms of whether they had made their mind up on ring-fencing because I was hoping for total separation. Are you on the opposite side of the field? Do you see ring-fencing as a compromise that stops them going to total separation, but you would prefer somewhere between ring-fencing and where you are now? You can say it in a paper, operational-

Bob Diamond: Can I tell you why, Mr Mudie, the total separation would be harmful in my opinion for the United Kingdom?

Q282 Mr Mudie: I think it would be interesting but I would still like-you have obviously been looking at it this session. You have come forward with some questions that look very defensive and look as though they are objections to ring-fencing in your paper. HSBC brought through a paper that even made a supporter of total separation think, "Well, they moved a long way and there is a lot of comfort in those papers". I would still like to push you. When you are in with the Commission doing your discussions on the consultations, are you working positively to make ring-fencing acceptable to Barclays, or are you still discussing the full agenda?

Bob Diamond: I’m answering these questions directly, so if I feel there is a better alternative I feel it is my obligation to say it. We are working very constructively and we also appreciate that the full breakup is off the table and that the universal banking model is being supportive. Within that, we are now working with them so that, if ring-fencing is the decision, we have the best that balances safe and sound, jobs and economic growth, and a level playing field internationally. We think all three of those are absolutely critical. But, yes, to your question; we are working very positively. They are very thoughtful. It’s a very smart group of people and I think we will get to the right place.

Q283 Mr Mudie: These more than half a dozen objections/areas of worry: are these being successfully dealt with?

Bob Diamond: I think we are having good engagement and positive engagement.

Q284 Mr Mudie: So it does look inevitable, doesn’t it? Although I have to say one thing. John Vickers said in this room that he had not taken total separation off the table, because I pressed him hard on it. But I rather think it is, and I think that is your opportunity, isn’t it?

Bob Diamond: I think it is the opportunity for the United Kingdom.

Q285 Mr Mudie: There are questions on costs. If Barclays and HSBC are grabbing hold of retail ring-fencing then there is no point in nit-picking on the details of it. Just a question, dealing with the one from David, on resolution: when you answered you were well down on resolution, it was good news except all the things you said related to retail resolution and, as you saw with Lehmans, the real difficulty in resolution, especially in a crisis situation, will be in the investment side of your exercise. How detailed and how positively forward are you in terms of resolution of that? I get the impression that that is the big unanswered question in the whole exercise: a method of resolution that will be operable quickly and stop the panic in the market.

Bob Diamond: Yes, and I didn’t explain it well, then. Apologies.

Mr Mudie: No, no.

Bob Diamond: If there is a problem in the derivatives book, for example, then the idea is to separate that and, frankly, maybe let that fail. But if that fails, it won’t impact what is important to the UK economy and important to the clients that don’t have another alternative. The operational subsidiarisation says, "Let the regulators cauterise the problem and deal with that while the branches are open, the money transmission is open and the technology is open". The theory is that they can work on that. Now, does that mean it gets closed down? Does that mean it gets resolved? That is another question, and that brings in questions about: do the CoCos kick in? Do bail-ins kick in? When you take this package of measures, the regulators now have a terrific opportunity to work toward the resolution of a problem, but they also have an opportunity to wind down a part of an operation if necessary without creating the systemic risk and without creating the problem.

Q286 Mr Mudie: Don’t let me put words in your mouth, but what you are saying is you feel that if you keep the money transmission going and the retail side going, in effect, you will have time to unwind the investment side over a longer period? So the worry that-

Bob Diamond: Yes, or close it down, or whatever the situation may be. Either a resolution or resolving it by ending it. If you think about it, in that case where the capital may have now fallen below the regulatory minimum of 7%, then that contingent capital kicks in and-

Q287 Mr Mudie: Mr Diamond, my only immediate worry to what you say is-forgive me, it seems slightly complacent in terms. You know more about it than me, but when you consider the amounts of money in the investment side, to have so many unanswered questions about their status seems to me a pretty worrying situation that might have systemic repercussions. But you think you are okay?

Bob Diamond: No, we are very confident. I think you have to take the package, and I think we are comfortable in working with the FSA to be a test case, if they want that to be, the first that can have all the technology and all the legal entities in place so the regulators would feel comfortable that if there were a problem anywhere in the bank, they could cauterise that, work on that, while keeping the critical areas going. I don’t take it lightly at all. I never want to be in that position-

Mr Mudie: I didn’t suggest-

Bob Diamond: -but I want the regulators to be comfortable that if there was failure, it wouldn’t be systemic, and it wouldn’t impact the core business customers and the retail customers who don’t always have another alternative on Monday morning. I think this is really important. I think this "too big to fail" thing is the hardest to convince people that we can eradicate, but if all of us in this room together actually believed that the "too big to fail" issue was gone, I believe the way we would think about all of these issues would be focusing a lot more on the jobs and the economy and in getting confidence back, and I recognise there is still an uphill battle in convincing people that there is a way to take "too big to fail" off the table. But I am determined, and I think, from a regulatory point of view, that is the single biggest issue, and if we can get that resolved, we can really get focused on jobs and economy, so we are going to continue to invest and work hard.

Q288 Mark Garnier: Thank you, Chairman. Mr Diamond, I am going to keep you working, I’m afraid.

In your submission, you say-and I would like to turn to continued capital bail-ins now, if I may-"Much more work is required to ensure these tools achieve their policy objective and also provide sustainable, scalable funding sources for banks". Would you like to enlarge on that?

Bob Diamond: Are you talking about the CoCos and the bail-ins?

Mark Garnier: The CoCos and the bail-ins, yes.

Bob Diamond: We don’t have approval from the regulators yet to issue CoCos, and I think there are some issues about making sure it is compliant with the FSB and the G20. We feel we spent an awful lot of time with investors. We spent an awful lot of time with the FSA and with the FSB, and we think we are very close to having a CoCo that would be regulatory compliant. One of the issues still out there is: where do they fit within a capital structure? So, for example, if there is a SIFI or a G-SIFI surcharge on Barclays, is that in equity? Is it in contingent? And I think, as that plays out over the next couple of months, I sense the regulators want to wait to get the solution for that.

Q289 Mark Garnier: Can you describe very simply how you would see a CoCo? What would that be? Would it be a bond, a straight bond or more-

Bob Diamond: Yes. There are two kinds, and I’ll make them as simple as possible, and there’s one that we have a huge preference for. Both start with the assumption that below some level of capital, something happens if the company, the investors, are no longer in charge of their investment. I’ll use 7% which is the minimum capital, for example. So, if the FSA sees on the Credit Suisse CoCo below 7%, then that money mandatorily converts into equity.

Mark Garnier: So it starts off as a straight bond?

Bob Diamond: It starts out as a straight bond, yes, with a contingent. The version we prefer is below 7%, using the same trigger. Rather than a mandatory conversion into equity, the money is totally loss-absorbing but there is no mandatory conversion into equity. We prefer-

Mark Garnier: So there is a lower ranking?

Bob Diamond: As we saw in the crisis, sometimes, as people get toward a situation, you get a lot of trading in the stock and you get some games that can go on in the equity market. We also find that the fixed-income investors like this a lot more because they don’t want to end up with equity. So, if it becomes below 7%, for example, it is now totally loss-absorbing, and there can be a period-it could be two or three years-that if it comes back above 7%, and maybe even back above 9%, then it gets reinstated, so it is 100% loss-absorbing, which is what the regulators want. If there is a crisis, they want to have that money at their fingertips while they work to resolve it.

Maybe that wasn’t as simple as I started out, but apologies.

Q290 Mark Garnier: No, it’s incredibly clear, actually. It’s the clearest answer I’ve had, and I’m very grateful to you for that. What slightly bothers me about this whole thing is that when you have an implicit risk or an extra risk attached to this-clearly, your straight bonds, in the total failure, rank very highly in terms of the wind-up; CoCos obviously rank low down in a wind-up. Therefore, you have a higher risk, so that would imply that you have a higher interest rate payable-

Bob Diamond: Absolutely.

Mark Garnier: -which comes back to the implicit guarantee, because does it not follow-and maybe it doesn’t-that potentially the holders of equity, the holders of bonds, the holders of CoCos, are going to be looking at the implicit guarantee that there is attached, if you like, to the Big Four Banks in terms of assessing the risk, particularly with the straight bonds, of them losing some of their money?

Bob Diamond: Again, if contingent capital is a requirement in the capital structure for all banks, then it would be less expensive for banks that are considered better creditors and have more diversification. I said this in January, and I think it is important to say again today: Barclays funds are at lower levels in the market than Lloyds or RBS and they are explicitly guaranteed by the Government, so we have to consider that the investors are looking at a number of things. They are also looking at the health of the bank and the diversification of earnings; can they weather a storm? Because if retail banking is weak, investment banking is strong. If the UK has a tough economy, maybe Africa is doing better. There is a host of reasons, and I think to the extent that this raises the cost for banks, as long as it is a level playing field, it does not have a negative implication. It will still give an advantage to the banks that have the best management and the best business model.

Q291 Mark Garnier: Could I just pick you up on one thing you said? "The more diversified a bank you are, the easier it will be for you to issue CoCos" which therefore puts further away from us the issue of competition. It make it more difficult for other banks to be able to step in because they have less opportunity or less access to funding because you, as a Big Four, can go to the market and issue CoCos. Virgin Money won’t be able to because it is less diverse.

Bob Diamond: I think if it is well-run, it can benefit. The investors are going to look through to the risk in the operation and-I was going to go back to Mr Mudie’s question, but he didn’t let me then so I won’t be rude enough to now.

Q292 Mark Garnier: Have you worked out what the costs of using CoCos would be and how you would split it between your straight bond issuance, your equity issuance and your source of capital? Would this be a very significant amount? Would it be a small amount? How much extra premium do you think the bond market would ask for the implied risk?

Bob Diamond: It is a bit of a speculation now but we think, given the interest rates out there, a contingent convertible would start out, maybe, somewhere around a 7% type of level, a couple of hundred basis points higher than senior debt. The market isn’t deep yet; it may improve over time. We think there will be big spreads between the different-I think the good thing about this is, if one is removing the implied Government guarantee, investors are going to have to make tougher decisions on the relative value of a Lloyds versus a Barclays, or a Barclays versus a JP Morgan. I think that is a healthy thing for the financial markets. That really incentivises the strong risk management and incentivises strong management, so it is positive from a regulatory point of view.

Q293 Mark Garnier: One last question: as the financial system gets more and more strained and perhaps the banks fall closer and closer to their 10% ratio or whatever it is settled-7% ratio-is it not the case that that 200 basis point premium of the straight bond will get bigger because what it amounts to is that as a holder of a CoCo, I am effectively writing a put option on your business?

Bob Diamond: For a host of reasons, Mr Garnier, because as that comes down to 7%, people wonder why it is coming that close to a level that would trigger this, so it is probably triggering something going on and the cost of other debt would get higher in the market.

Q294 Mark Garnier: Mr Horta, would you put any of Lloyds Bank’s money into a Barclays CoCo?

Antonio Horta-Osorio: I think CoCos are an appropriate instrument and, as you were saying, Bob-

Mark Garnier: It was a very careful explanation.

Antonio Horta-Osorio: -it has to be very correctly set in terms of the striking price and other things, but I think the important thing here is that this is part of a holistic solution. To have CoCos or bail-ins and parts of the same constitutes higher capital requirements. Higher capital requirements are only part of this solution. You have three other pillars; you have four pillars altogether. You have higher capital requirements. You have higher liquidity requirements. You have recovering resolution processes to which subsidiarisation and the ring-fencing is especially important because it makes those plans more credible, and you have strong supervision. My point here, which I think is important in this respect, is: if you have better supervision and more credible recovery and resolution plans which, I repeat, in my opinion, are enhanced by ring-fencing, you could have lower capital requirements, because you get to see it holistically. When you should keep the same capital requirements or you increase them, you can potentially have less strict liquidity requirements which, for example, in the context of the UK economy, are especially relevant given the gap between credits and deposits and the amounts of gilts that banks have to buy as per the FSA requirements.

You have a £500 billion gap between credits and deposits in the UK economy, which has to be funded, and you have around £500 billion to £600 billion of gilts that banks have been buying according to strict liquidity rules. So, the way I would get it is, if some of these pillars are better in the United Kingdom, for example, than internationally-like I think is the case in terms of capital-and banks are better capitalised, supervision is more intrusive and more present, and you have appropriate now recovering resolution mechanisms that I think would be enhanced by ring-fencing. Maybe in terms of liquidity we can be more flexible. We shall have to see a solution holistically.

In terms of capital, CoCos are instruments which, I think, have a market, and investors then buy them. Lloyds has CoCos issues that investors buy and trade every day, and CoCos are less expensive for banks than pure capital because, among other reasons, they are tax deductible, and therefore it makes sense to have them. They are a lot more efficient in that respect. And in case capital is needed, CoCos come in, and then on top of CoCos, as you were discussing in the previous session, you have bail-ins in case CoCos are not enough. They come in with a purpose, in my opinion, of addressing the question, which is: do we want ever again taxpayers’ money to bail out a failing bank? The answer to that question determines whether you want this holistic solution to be more strict or less, and which parts of the pillars should be more appropriate to which economies.

Mark Garnier: Thank you very much.

Q295 Stewart Hosie: Thank you, Chairman. Mr Diamond, in your submission to us you said, "There are diminishing returns simply increasing capital ratios to make the banks more failsafe" and you said that, "Capital comes with an economic cost to banks and as a result to the customers". What impact will the ICB proposals for a 10% capital ratio have in terms of cost to the bank and cost to customers? What would happen if the ratios were pushed up, say, past the 11% tier 1 ratio you currently have? When would there be a real, noticeable impact in terms of cost to customers, and particularly a squeeze on the tightening on lending into the real economy?

Bob Diamond: I think at 11% we already see that, certainly in Barclays, and we’re carrying more capital than hopefully we need when all of the plans are in place, but our intent was, during the period of regulatory decision making, that we would prefer to be over-capitalised at the risk of our returns so that we can come back into line.

Mr Hosie, just to give you a couple of numbers to put it in perspective-because it is quite startling-prior to the crisis in 2008, if you look at the UK-based banks, they had about £180 billion in equity. If you think about the same banks that are here now as were here then-£180 billion-about £150 billion was put in during the crisis: Barclays raising in the Middle East; the Government putting equity into some of the banks; the full impact of Basel III, when it is complete, will be £160 billion to £180 billion. We have gone from £180 billion-same banks, and I would argue with less leverage and less risk today than they had then-to half a trillion, £500 billion. When you hear some of us say, "Look at the aggregate impact of all these changes on what happens to the economy", we want to be a pro-growth bank.

The UK Government is a pro-growth government. I was at a terrific conference on Monday and Tuesday in Atlanta where you heard Secretary Geithner speaking and Chairman Bernanke, and one of the things that came over very clearly was that when you look at the growth rates of the UK economy, the US economy and the European economy against the emerging economies over the next three, five, seven, 10 years, it is very stark. We are looking at 2% to 2.5% growth rates versus 6%, 7% or 8%, and I think it is incredibly important for us to look at the aggregate impact of all these things on our economy and on our companies.

Q296 Stewart Hosie: So, 10% is too high then?

Bob Diamond: In my opinion-and I want to make sure I say it that way, as I respect what the Commission is doing, and I think the Commission expects that the SIFI, G-SIFI add-on will have international banks like Barclays and the international operations at that level as well. I hope it is less than that. I think that the system has become significantly improved and, as Antonio said, if you look at the other packages on clearing exchanges and derivatives on exchanges, if you look at the resolution and recovery plans, if you look at the series of things that have been done to make the system safer and sounder, I do worry that we are making some of the capital levels too high.

Another way I would look at it, and this is a very good way to look at it: prior to the crisis in 1970, the minimum capital, the minimum core equity, was 2%. Under Basel III, it goes to 7%, but if you measure that 7%, if we just went to 7% under the Basel II rules, it is 14% or 15%. So we have gone from a 2% minimum-now, most banks weren’t at the minimum, by the way. Most banks were at 4% or 5%-to operating at 14% or 15% based on a similar basis of Basel II. I just think in the United Kingdom we have to sit back and say, "What is the aggregate impact of all this?" The second thing I would say-

Q297 Stewart Hosie: Sorry, do you know what the aggregate impact is in terms of net loss of lending or net loss of profitability or net impact on GDP growth? Do you have a figure?

Bob Diamond: One of the things you see is a complete lack of non-UK-based banks lending in this country. The first thing that happened during the crisis was the foreign banks pulled their lending out, and one of the problems that we are facing is Lloyds and Barclays are working hard, and we are all in other agreements to pick up the fact that the foreign-based banks pulled their lending out.

Q298 Stewart Hosie: So let me just move on from this. Mr Horta-Osorio, are you happy with the 10% figure in terms of the capital ratios? Does it suit your bank?

Antonio Horta-Osorio: I agree with what Bob said, and I think the Commission is doing exactly as you were saying, Mr Hosie. This cost-benefit analysis is very important and is not easy to do, but it is very important to do it because of the potential impacts on the economy. I do think that the other parts of the solution are important in determining the appropriate level of capital, together with an international level playing field. For example, the ring-fencing, given it diminishes the risk, may require, on a pro forma basis, if you want, less strict levels of capital.

Q299 Stewart Hosie: I want to look at the relationship between the capital ratios and some of the other tools. There has been talk of CoCos, convertible bonds and the other loss absorbing instruments. If things weren’t going great, you could easily see a situation where the people who held your convertibles or your CoCos were going to take a hit and would be pushing you to put your capital ratios up through the roof to avoid them taking a loss. How would the relationship work between the holders of these things and the bank and your capital ratios? How would that work?

Bob Diamond: That is why I feel strongly, and we went through two versions, one that has a mandatory convertible factor. I think it has the opportunity to create a dysfunctional trading market around the time that capital may be approaching that level. I think the buyers are fixed-income investors. I think they tend to be quite sophisticated and I think they are going to look at-they will never have all of their investment.

You asked Antonio whether he would buy Barclays’ CoCo. I think one of the things you should recognise is that CoCos wouldn’t fit well on bank balance sheets full stop because of all the Basel rules. My expectation, and what we have been working on, is that these should not be sold to banks. These should be sold to real investors. I think that is healthier for the financial system as well.

Our discussions have been with Blackrock, with PIMCO and with the big pools of fixed-income money to try and get as much information from them about exactly the questions you are asking. How many would they potentially hold if they were priced correctly? Which funds would typically hold them? I am happy to share that with you and happy to have anyone come in and give a presentation. We have quite a bit of research now.

Q300 Stewart Hosie: That would be very helpful, because there is a lot of talk of this in the media but very few people understand it.

Bob Diamond: We think the market is huge. Larry Fink will say the market is huge.

Antonio Horta-Osorio: I would like to add that there are some interesting recent examples of Rabobank and Credit Suisse, which have recently issued CoCos successfully.

Q301 Stewart Hosie: Yes. Just one final question, because I know we are slightly short of time. To go back to this implied subsidy, Bob, Barclays did access the special liquidity fund, didn’t it? It got money more cheaply than it would have done if it had gone to the market.

Bob Diamond: Those are tough questions and, again, I do not want to not be appreciative for-there were times when in the special liquidity-

Stewart Hosie: I thought it was a straightforward question.

Bob Diamond: -scheme it was important for all banks to be in, but the scheme was set up so that there was a premium, so that it was a market rate. Now, could it be exactly a market rate? I don’t think so, particularly in crisis, but all of the schemes for funding set up by the Bank of England had, at the time, a serious intention of coming as close as they could to making sure that the banks paid the spread between where they could get funded in those schemes.

Q302 Chair: You become cagey from time to time, but it is wonderful to watch the footwork. You did say something I strongly agreed with earlier, which is that a great deal rests on the cost-benefit analysis, and of course that is in annexe 3. Have you done any internal work on the quality of annexe 3 in Barclays and, if so, could we please have a look at it?

Bob Diamond: Yes.

Chair: We think that that is of crucial significance for this debate.

Q303 John Thurso: Bob, can I come to you first? You said something very interesting earlier, I thought, which was that if we could deal with the "too big to fail" issue, we would look at this differently and we would look at the economy, growth and jobs. In your view there is, therefore, an implied trade-off between financial stability and growth. How would you take "too big to fail" off the table?

Bob Diamond: Mr Thurso, I have said here publicly and I have said to the FSA that I am prepared, as chief executive of Barclays, that we should be put through the wringer on this. We think we can have a plan in place some time between September of this year and March of next year, with all the technology in place, with the investment I talked about-about £30 million-to really be stress-tested, to stress that if an accident occurred, would the regulator feel comfortable about cauterising the risk and then keeping the rest of the bank open? I think it is critically important.

I think, if you take it to the other extreme, only two things can happen. One is we do not have big banks, and you know I am a believer in the universal banking model-Mr Mudie in particular does. But I think, particularly in the United Kingdom, to be comfortable with large banks being headquartered here, they want to believe that they are not too big to fail, so it is very important. The other extreme is that we take risk off the table and we are so safe that if banks are not taking risk and can’t fail, we won’t have any failures but we won’t have much of an economy. We won’t have risk and we won’t have lending.

The last thing I would say-and I think this is important in terms of focusing banks just on a domestic economy-when I moved to London with Barclays in 1996, the darling of the UK banking industry based on market value was Lloyds. It was a very different Lloyds than Antonio is running today. Its price earnings ratio, if I recall, was 42 times, and it got there by exiting everything outside of UK retail and business banking. But in a sense it was then captive to one market and one product, and deposits chased domestic assets. If we ring-fence to too far an extreme and create an environment where UK deposits have to chase UK assets, I think it has an aberration in terms of the risk and an aberration in terms of asset prices. Foreign banks would exit because pricing would be altered significantly. If you look at what is going on in Spain with the cajas, if you look at what is going to go on in Germany over the next couple of years with the Landesbanks, if you look at the US experience with savings and loans, and if you look at the experience in the United Kingdom during the crisis, in essence Bank of Scotland was not able to fund Halifax, Northern Rock and Bradford & Bingley. We can see the worry I have of the extreme form of ring-fencing. We have created an environment where UK retail deposits could only be invested in UK assets.

Q304 John Thurso: In a circumstance where a bank fails and is resolved in a climate where there is not a systemic crisis, I can see that a bank-even a very big bank-can be dealt with in that way. The problem we went through was that a great number of banks suffered because they had taken the same risks and made roughly the same investments, and therefore it spread across a number of institutions in a number of countries and was systemic. Do you think what you are proposing could survive a systemic shock as opposed to simply an institutional shock?

Bob Diamond: Yes, again, Mr Thurso, with a package. Antonio referred earlier to the package with resolution and recovery plans, with living wills, with CoCos, with bail-ins and with a significantly enhanced capital structure. It is not just the capital that we had talked about earlier-even at 7% it is equivalent to 14% under Basel II-but much stronger roles around liquidity. I think today we carry £130 billion to £150 billion of cash or cash equivalents, where pre-crisis it was £25 billion to £30 billion, and also lower leverage. When you look at the package, I do believe that.

Q305 John Thurso: To what extent is the relationship between what will be the FPC and their role of systemic oversight important in this mix?

Bob Diamond: That is a very good question. In terms of the macroprudential environment?

John Thurso: Yes, because we are in danger of having a banking commission over here that could take a lot decisions and FPC over there that could take a lot of decisions, but the two are inextricably linked.

Bob Diamond: I think the FPC’s decisions would more be around extremes in the environment and whether or not they should be adjusted for at a macro level. I think the regulator is much more focused on the micro-supervisory.

Q306 John Thurso: One other question along the same lines but slightly different: you talked about subsidiarisation by activity. So that I am clear, does that mean that you would not have a link between bits of the balance sheet; you are simply segregating activities?

Bob Diamond: I was saying how we operate and how we manage, so that things can be separated. I think there is still the ability to flow capital and there is still the benefit of group funding-

Q307 John Thurso: But do you have the visibility at a balance sheet level between those activities, even if there is a free interchange?

Bob Diamond: Sure. Yes.

Q308 John Thurso: So are you actually able to do a risk-adjusted return on capital for each activity?

Bob Diamond: Sure. Particularly because we directly charge the market cost of funding to the activities.

John Thurso: Thank you.

Q309 Chair: Your proposal for operational separation, for example, on derivatives: does that require separate balance sheets?

Bob Diamond: I think the operational subsidiarisation is very much looking at if you think of it as how you manage the bank as opposed to separating by geography or separating by business, so that the balance sheet can operate on an integrated basis. Again, Chairman, there is a separation of retail deposits and the wholesale businesses, but it is how the businesses run so that there is a service company that is responsible for all the money transmission, so that can always be protected no matter what happens in an institution and the branch system. There are leases set up on the branches that are separate in bankruptcy remote-

Q310 Chair: But the answer is no, isn’t it? My question-

Bob Diamond: Yes, the answer is no.

Q311 Jesse Norman: Mr Horta-Osorio, obviously you have just come into the chief executive slot at Lloyds. How much of a mess is the bank still in?

Antonio Horta-Osorio: As you said, I was appointed chief executive only three months ago and, as I said recently, I can see some very significant potential in this bank-some very good people close to the customers in the retail side, in the SME side, on the call centres, very important traditional iconic brands-but the bank has substantial problems, and I had to deal immediately with the two most important legacy problems such as the PPI issue and the duration of the Irish loan portfolio. Now we are about two thirds, 75% done of a strategic review that we will finalise in the next few weeks and announce the results by the end of June. It will be, as I said as well, an evolutionary, not revolutionary, strategic review and it is still early days to comment because we are in the process of finalising.

Q312 Jesse Norman: Do you have three institutions at the moment-Lloyds, Halifax and Bank of Scotland-or do you have one?

Antonio Horta-Osorio: No. The integration, as I said earlier, is about to complete. It will complete by the summer. What we have is three different brands, which is quite important, because given the different characteristics of the customers of the bank, it makes a lot of sense to keep a multi-brand strategy whereby Lloyds competes as it traditionally competed with high clearing banks such NatWest, Barclays and HSBC, and the Halifax brand, which I want to resuscitate as a challenger brand, will compete again with the ex-building societies such as Nationwide and Santander, and it will also compete internally with Lloyds.

It is very interesting to note that the Halifax brand gets lots of customers from Lloyds and Lloyds loses very few customers to Halifax, so they are really different brands in the context of what I told you. The Halifax brands, for example, have a fantastic ISA campaign as we are resuscitating it and making it a very credible challenger, and we want to keep that multi-brand strategy but with a single-systems entity, with everything that the customer doesn’t see operating on a single basis.

Q313 Jesse Norman: Yes, thank you. I am conscious of time. Mr Hester, in an earlier session today, made the extraordinary claim that the governance of the Royal Bank of Scotland before 2008 was basically fine but that bad judgments were made. That seems to me a quite false distinction and a very bad analysis of what actually was the case. Are you comfortable that the governance of your own institution is satisfactory?

Antonio Horta-Osorio: I am very comfortable with the governance of Lloyds as it stands today. I think we have a superb board and outstanding Chairman. We have all the governance in place in terms of different committees; they operate properly, and more importantly I think we have a culture, which I intend to build and foster, of proper risk management and of separation of the risk management functions from the business areas. I think that is a critical point that went through the crisis-the banks that succeeded versus banks that did not succeed-among other characteristics such as good management, focus and a simple model. They had a very important characteristic. They had proper risk management separated from the business areas at the highest level of the organisation.

Q314 Jesse Norman: Thank you, I want to come on to that. We all, I think, admire the lead you have taken on PPI. Are you familiar with the historic problems in HBOS with Mr Paul Moore and the concerns that he raised with the then management about the quality of the risk assessment?

Antonio Horta-Osorio: No, I am afraid I am not.

Q315 Jesse Norman: Could I encourage you very much to look at that? It is a shocking indictment of the previous leadership of the institution and very important. Are you concerned that there is a systemic problem over risk assessment because, of course, one of the features of the crash was that so many institutions were using basically identical value-at-risk models and therefore, as it were, ran off the cliff at the same time? It was much more systemic risk than people anticipated or forgot.

Antonio Horta-Osorio: I am very comfortable that we have measures that are being planned, both in the UK and internationally, around the four pillars that I told you: more capital requirements, stricter liquidity requirements, better recovering resolution mechanisms and more on the ground to introduce supervision. These four pillars together as they are developing in the UK and internationally, in my opinion, will very much address the systemic risk.

Q316 Jesse Norman: I would encourage you to look at the testimony of Mr Moore. He was fired for raising a serious issue about risk assessment in HBOS and it actually merits very considerable investigation by public authorities as much as by private.

Mr Diamond, do you share my concern about the quality of risk assessment and how do we, as a country, mitigate the danger of everyone using a herd approach to value-at-risk models?

Bob Diamond: I think the work here is never done. Value-at-risk is a very helpful tool in market risk, for example, but I think any institution that is in the risk business, as banks are, has to use a variety of tools and a variety of management techniques. I would agree with you that there is no one measure of risk that anyone can rely on. I think over-reliance on DVaR or over-reliance on rating agencies would equally be at fault.

Q317 Jesse Norman: Did Barclays have an exposure to RBS and Lloyds in 2008?

Bob Diamond: I’m sure we did. UK banks do a lot of business together, so certainly in the short-term funding area we would have.

Q318 Jesse Norman: Do you think it benefited from the subsidy that applied when Lloyds and RBS were kept in the market by Government intervention, since it is a counterparty and you can go bust?

Bob Diamond: I would have to go back, but I think most of the exposure was pretty short-term funding.

Q319 Jesse Norman: That would still be an important form of additional subsidy, over and above the one that has already been discussed, if you had counterparties, even short-term ones, that were saved from going bankrupt.

Bob Diamond: I think it depends on whether it was collateralised or what term it was, but I am happy to look at that for you.

Q320 Jesse Norman: Yes, that would be very interesting, thank you. Mr Diamond, when you talked about the changing level of capitalisation of the banks, you said that there was £160 billion before 2008, £150 billion had been put in, a further £160-odd billion from the Basel-

Bob Diamond: I think it was £180 billion at the start.

Jesse Norman: About £180 billion, I am sorry, yes. But that ignores the fact that an enormous amount of capital has been wiped out as well. Do you not think that would be a fairer assessment? It’s not a net £500 billion, it’s a net whatever-

Bob Diamond: It’s what exists today. Post-Basel III there will have to be a half trillion pounds in equity in the banks, based on Basel III, so it is, at that point, equity.

Q321 Jesse Norman: Your view is that Basel III is roughly twice as punitive in terms of capital assessment because a 7% ratio beforehand becomes a 14% ratio; that’s between Basel II and Basel III.

Bob Diamond: I do not mean by any stretch, Mr Norman, to say the switch from Basel II to Basel III was not appropriate. I was just trying to give you a benchmark. If we did it on an equivalent basis, I think that changes from Basel II to Basel III have been appropriate.

Q322 Jesse Norman: I wonder if that can be right, because it would have the implication that the Swiss capital ratios, which are 19% now, would be 38% equivalent under Basel II, and it is hard to imagine anyone could run a bank on a 38% capital ratio.

Bob Diamond: It wouldn’t really. Their core equity is at 13%. I think their 6%, if I’m not mistaken, is in contingent.

Jesse Norman: All right, well, that would make a difference. Thank you, Mr Diamond.

Q323 Chair: Is the UK going to pick up business in Switzerland because they are implementing 19%?

Bob Diamond: I would have to think about that in terms of the domestic retail banking market. We certainly haven’t looked at it, Chairman, in retail banking. It’s a fairly consolidated market in Switzerland in retail. I never like to talk about a competitor, but have there been maybe some losses in non-Swiss businesses? I think we have seen evidence of that.

Chair: Yes. Thank you.

Q324 John Mann: Three quick questions, Chairman. The first one is on Lloyds. The feedback I get from small businesses in my area is that Lloyds has been far more brutal with its small business customers than its competitors; for example, widespread use of invoice financing being forced on SMEs at the moment. Is this a deliberate corporate strategy and, if it is, is it likely to change?

Antonio Horta-Osorio: Mr Mann, I have seen no evidence of that. The numbers that have been published by the Bank of England show SME lending decreasing 3% year-on-year. Lloyds SME lending is increasing 2% year on year, so 5% of both in the market, and it is an area that I have a very special interest in. I already had it when I was at my previous job when we were increasing substantially SME business, and as I was appointed in March I have immediately detached the SME business from the wholesale business to give it more accountability and visibility, reporting directly to me and present on the Executive Committee of the business. I have started a series of customer meetings once a month, but I also participate specifically dedicated to SME customers, which have been successful. We will always have anecdotal cases that I try in the bank to resolve as best as possible, but I repeat to you: we are increasing SME lending 5% above the market rate and its positive network.

Q325 John Mann: Good, I am glad to hear that. On Barclays, Mr Diamond, and what you said, I have argued for some time that "too big to fail", as a concept, has been pushed too hard and that therefore other issues have been missed, and that is not really the fundamental issue that faces us. I am in a small minority in this Parliament on that, I think, but I’ve also argued at the same time that the corollary of that is that transparency has to increase significantly, including what people’s risk really is, including whether there is a customer risk and whether the risk can be shared with the customer. If you are offering me a higher return but a bigger risk, I’m happy with that as long as I know what I’m going into. The issue of transparency seems to be fairly fundamental. I wonder if you had a comment on that.

Bob Diamond: Antony Jenkins runs our retail and small business bank. I think his mantra is, "Lives made much easier". In our retail banking operation, we have definitely made mistakes; PPI is probably the most visible example and we need to put those right, but we want to do things that are simpler and are more understood by our retail clients, and we completely support that and are moving in that direction. Transparency and clarity and understanding of risk is important and we should be held to account for that.

Q326 John Mann: Does that mean, Mr Osorio, that transparency is the fifth pillar to add to your four?

Antonio Horta-Osorio: I think transparency and switching are the two pillars on the competition side.

Q327 John Mann: The third question is going back to this issue of capital and capital requirements. If you are lending less than you would have done because capital requirements are higher, I would be interested to know from both of you what kind of lending would be reduced because of a higher requirement than you would wish to have?

Bob Diamond: Lending more, certainly in the UK, to households and consumers in the UK-in the first quarter we are at just under £10 billion, £9.9 billion; last year was about £9 billion. We clearly feel both the obligation and the responsibility-and I think Antonio would say the same thing-to pick up the slack of some of the foreign banks and non-banks that had been in the lending market and exited.

Q328 John Mann: But will a higher capital requirement hit this?

Bob Diamond: It does, and because we have raised more equity, the impact is in the cost of borrowing, and one of the things I do, Mr Mann, is I try monthly to go through cases where small businesses have accepted our terms, cases where they have rejected our terms and cases where we have agreed to lend but they have decided not to take us up on it. I think it is in that third category I am tending to learn the most, and what we’re learning is that the cost of credit has changed, and we’re trying to fine-tune that so much.

It is interesting, because if you look the absolute level, since 2007 the absolute level for percentage of lending to companies has actually gone down, but if you look at it as a spread from base rate, it is much more expensive. In a way, it has not hit them in the top line, but if rates begin to rise, which they certainly will with the recovery of the economy, I do worry about the wider credit spreads, and that is the impact that I am talking about of capital.

John Mann: Mr Osorio?

Antonio Horta-Osorio: Mr Mann, I think what you are saying is correct. I think higher capital requirements, pro forma, as you have just asked, would imply less credit availability and on a higher cost, as Bob says. What we have been doing in light of that-I have been there for only three months, as you know-is to prioritise through this review where the bank will have to be leveraged, because the bank has to be leveraged. There is a very high loan-to-deposit ratio. The areas where the bank will be leveraged will be the non-core areas, international areas and non-core activities. We want to build a great bank for households and SMEs.

As I said publicly, this is a journey. It will take time-three to five years-to make a great bank, but that’s our focus, and that makes it more difficult with higher capital requirements, and willing and doing additional lending to SMEs and supporting households obviously means that we have to fund ourselves more to support lending, which we are doing through deposits through the Halifax brand, as I told you, which is proving a great brand, which we are resuscitating, and increasing competition within the group. I strongly believe that we have to have competition within the group itself. Even if you are a big player, you have to challenge yourself and you have to have brands that attack the other brands and not only the competitors because that avoids complacency, and when you have complacency, you start to have problems.

I am a strong believer, if you want, in a challenger within a big player. What we will do is exactly this. It is to focus the bank on SMEs and households. We are increasing the deposits to the retail brands; we are funding additionally through through the medium-term markets, so we have borrowed more than we had planned in terms of the medium-term markets, which have been open and very successful through the first half of the year. We are repaying Government-assisted funding and we are going to create that bank focus on the households and SMEs.

John Mann: Thank you. Those are helpful answers.

Q329 Mr Love: I just wanted to follow that up. I think it is clear from the early evidence-and I do agree it’s the early part of the year-that you are not matching the target that was set under the agreement with the Government. I understand the arguments you make about why that may not be possible, but what efforts are you going to make seriously to make sure that you do live up to the agreements? We have a small business sector out there that is screaming at us to take action. Mr Diamond, what are you going to do to make sure Barclays plays its part?

Bob Diamond: We will keep working harder, Mr Love. I think our commitments around capacity have been met and not taken up. That does not take any pressure off. Both Naguib Kheraj, who has just rejoined Barclays as a vice-chairman, and I are spending more time with customers and clients specifically around the UK so that we get a better and better feel. Our objective is to find out ways we can increase demand. We think that pricing is something. We have to look at process. We have to look at pricing. We have to stay on it. As I said, once a month I sit down and really review specific cases so I can feel involved.

One of the issues we face, Mr Love-and I am not trying to use any excuse, because I think there is pressure on me to continue working harder to make sure that we satisfy all the legitimate demand there is from small and medium enterprise businesses. I will keep working at that.

Q330 Mr Love: Are you too conservative? I am talking about banks generally, rather than Barclays, but are banks not too conservative in terms of their lending criteria? The information coming back to us from the small business sector is that the money may be there, but the pricing is prohibitive.

Bob Diamond: Pricing has gone up, sir. As I mentioned earlier, I don’t think we are being too conservative. There is some issue with customers around pricing. There is one other thing I think it important just to mention. When I look at our small business section, our small business customers have £16 billion in deposits with Barclays. That has grown significantly this year, so we have a number of businesses that do not need to borrow, but are not investing. That is as worrying to me as why you are not investing and why you are not hiring. That is the whole issue we face of confidence in the economy and confidence in moving forward. Collectively, it is not just banks. Collectively, we all have to work at this. There is way too much cash in the successful businesses.

Of course, the ones that are desperate for the loan are not the successful businesses, so we have to work on that as well. They are two separate things, and we will continue to work very hard in that regard.

Q331 Mr Love: This is the very last one, I agree. Mr Horta-Osorio, you commented by telling us about the needs of the business. One understands that that is paramount, but we have made commitments, or collectively you have made commitments. What priority can we take from this meeting that you are giving to making sure you are one of the biggest lenders to small business?

Antonio Horta-Osorio: Mr Love, as I just told to Mr Mann, according to the Bank of England numbers, SME net lending is decreasing 3%. Lloyds, as of the first quarter, is increasing 2% on net terms, so 5% positive difference versus the market. I can assure you that we are well on the way to meeting our lending commitments. It is only one quarter, but we are under way to meet lending commitments.

Q332 Mr Love: Can you both reassure this Committee that you believe you will deliver on the commitment given with the agreement with Government?

Bob Diamond: The agreement with the Government, Mr Love, was around providing the capacity, but we are going to do everything we can to make sure that that capacity is not only there, but gets filled.

Chair: That is very helpful, thank you. George Mudie has a quick rejoinder.

Q333 Mr Mudie: Yes, I just want some advice from you, to an old politician from a very successful banker. As I see the Banking Commission, there are three horses in the race. There was a break-up, there was ring fence or there was do nothing. Now, they took "do nothing" off the table straight away, so it was a two-horse race. You have told me that John Vickers’ break-up, for you, is not on. I am not questioning that. I rather suspect-

Bob Diamond: I took that from the report, not from-

Mr Mudie: No, no, I am not challenging that. I had that feeling myself. That is why I was pressing on it and I think that is the way the wind is blowing. That leaves one horse, which is ring fence. I just cannot understand why you are not, like HSBC, bringing forward serious proposals to make the ring fence as acceptable to the Banking Commission as to Barclays. Why are you losing that opportunity?

Bob Diamond: We absolutely are, and if I implied differently, I apologise. I thought it was fair, when you said, "Is that the best decision?" to present what our alternative would have been. We are assuming there is going to be some form of ring fence, but we are going to continue-

Mr Mudie: Bob, assumption is a sin against the Holy Ghost. You should know that.

Bob Diamond: Okay, I know that line. Mr Mudie, we are working very closely with it and we are providing suggestions on what we think the best form of ring fence would be for the industry. To your point, yes, sir.

Chair: It has been a very long afternoon and we are very grateful to you for having come along today. There is as much commitment on this side of the table to a strong and healthy banking sector and industry as there is from you, I can assure you. We have asked you both and, indeed, the two people who came before you, to supply more information to us. We will have probably further exchanges in writing.

As a Committee, we think it is extremely important that, as far as possible, this debate on the interim proposal that has been put forward be conducted in public so that the public can see that there is a high level of engagement and, therefore, buy-in to whatever outcome there is in September. It is very important that we do not find ourselves in September with a proposal that you are still shooting at publicly without seeing the reasons why you dissent now.

If there is any information that you have supplied to the ICB which you think could be made available to the Committee, we would be very grateful for that opportunity. I am sorry to have kept you so long, and thank you for your inputs.

Prepared 15th June 2011