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UNCORRECTED TRANSCRIPT OF ORAL EVIDENCE
To be published as HC 1780 -i

HOUSE OF COMMONS

ORAL EVIDENCE

TAKEN BEFORE THE

Treasury Committee

Independent Review of the Financial Services Authority's Report into the Failure of the Royal Bank of Scotland

Tuesday 24 January 2012

Sir David Walker and Mr Bill Knight

Evidence heard in Public Questions 1 - 87

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Oral Evidence

Taken before the Treasury Committee

on Tuesday 24 January 2012

Members present:

Mr Andrew Tyrie (Chair)

Michael Fallon

Andrea Leadsom

Mr Andy Love

Pat McFadden

John Mann

Jesse Norman

Teresa Pearce

Mr David Ruffley

John Thurso

________________

Examination of Witnesses

Witnesses: Sir David Walker, Specialist Advisor to the Treasury Committee, and Mr Bill Knight, Specialist Advisor to the Treasury Committee, gave evidence.

Q1 Chair: You have not brought a large audience with you today.

Sir David Walker: Boring old fart.

Chair: Not on past form, David. Thank you very much for coming to see us this morning, but more particularly, thank you both very much indeed for the work you have put in on behalf of Parliament to help us get to the bottom of what really happened on the RBS failure. We are extremely grateful to you for doing it. It is something that Parliament has not tried to do before, which is to send specialist advisors into a quango to find out what really happened, and it may set a precedent for the way we may need to keep an eye on a number of the quangos that answer to us, including the ever so mighty Bank of England, in the future. Can I begin by asking first Sir David and then Mr Knight whether you now have a clear grasp of why the FSA published only a one-page summary about the failure of RBS and whether you think that was reasonable?

Sir David Walker: Yes, I think we do have a clear grasp. It was a mistake. It was unreasonable. It was based-and this is my partner’s territory-on a view that bodies like this may say as little as possible when there is no enforcement charge to be brought. But in the circumstances, as Adair Turner makes clear in his letter to you thereafter, there is a huge public interest in this that deserved a proper analysis and account of what happened, so it was a mistake. I am sure there was no agenda other than the desire not to say more than they had to.

The only other thing I would add was that I think you know from a conversation that we had at the time, between the publication of that document-the one-pager, or less than one page-and then the commitment to undertake this exercise, I thought it was unfortunate that they said that they had found no failures of corporate governance.

Q2 Chair: That sounds as if it was an understatement on the basis of what you have subsequently said in your written report. Mr Knight, do you want to add anything?

Bill Knight: I do not think I have anything to add to that, Chairman. I think that sums it up.

Q3 Chair: Just to clarify one point in your initial remarks there, Sir David, do you think that there should be acceptance that there is a public interest override to nondisclosure on enforcement issues?

Sir David Walker: Can I pass that to my partner because he is much more expert on process than I am?

Chair: Was that too hot a question? It has gone straight to the lawyers and we have not even passed the first set of questions.

Bill Knight: I think there is a balance, actually, to be struck. I think that individuals who give evidence in circumstances where they are protected by the law of confidentiality are normally entitled to rely on that.

Q4 Chair: I am sure everybody would agree with that, but I asked you whether there should be an override in exceptional circumstances.

Bill Knight: I think in practice that has been achieved in this case.

Chair: I am asking you whether that should be a precedent.

Bill Knight: I do not know the answer. I think that individuals do have a right to privacy.

Chair: We are agreed on that. I am asking you whether you think that there should be an exceptional case override.

Bill Knight: I would have thought not. I think each case has to be considered on its merits. I would not put in a principle of exceptional case override.

Sir David Walker: We would not disagree on many things and I do not think we have, but on this I disagree with my colleague. In exceptional cases where the public interest is so massive in having an account of why the taxpayer-and the taxpayer part of this is the least of it, given the damage to the wider economy. I think that justifies an override notwithstanding the importance of the principle.

Q5 Chair: You were nodding your head in agreement with Sir David having just said the opposite. Have you changed your mind?

Bill Knight: No, I would not wish to enunciate a general principle. I think each case should be decided on its merits.

Chair: Always good to get clear advice early on in the morning.

Q6 Jesse Norman: I apologise, it is not actually clear to me, Mr Knight. Either something is decided on a general principle or it is decided on a case by case basis. If it is decided on a case by case basis, then presumably there could be an exceptional case in which the decision went the other way. If that is true, you are agreeing with Sir David.

Bill Knight: Sorry, but I do not want to be tied down on it. I think that individuals have rights. If they are told that their evidence is confidential, then on the whole I think that should be respected. That is my starting point.

Q7 Jesse Norman: Thank you very much. Sir David, how would you briefly describe the FSA’s performance in regulating the Royal Bank?

Sir David Walker: I pause because it is necessary to begin with the predicate that the policy environment globally was massively inadequate, so we have to start with that very substantial disengagement, if you like. On the whole, they operated well within that very unsatisfactory environment. There were exceptions and in the interests of economy, time and prioritising I would think that the most significant was failing to see that the proposed ABN AMRO acquisition, despite the fact that they had no formal power to stop it, was wholly special and posed questions for capital, liquidity, leverage and risk assessment of a dimension that justified putting a taskforce on to it, which they palpably failed to do.

Q8 Jesse Norman: It was, as I recall, a contested takeover where they were making a cash offer. Is that right?

Sir David Walker: Substantially. It was certainly contested. It was largely a cash offer. Whether it had to be exclusively a cash offer was a matter that might have been a subject for discussion with the regulator.

Q9 Jesse Norman: But both of those features ought perhaps in your view to have alerted the regulators that something serious was up, in addition to the size?

Sir David Walker: Yes.

Q10 Jesse Norman: Mr Knight, do you want to add something?

Bill Knight: Yes, I agree. Indeed, the FSA frankly admit that it was a mistake.

Q11 Jesse Norman: In the statement of purposes, I think it is, we ask that as much written evidence accounting for the failure as is reasonably possible should be put into the public domain. Are you both satisfied that as much information as possible has, in fact, now been put into the public domain or would it be possible to add substantial chunks of these PWC reports and other information as requested?

Bill Knight: Yes, I think that when we appeared before you in private session we said nothing would be hidden from you and I think we have achieved that. I do not think there is anything that has been hidden from this Committee.

Jesse Norman: Of course, that is quite a separate question as to whether more information could be put in the public domain.

Bill Knight: Yes, of course more information could be put into the public domain. These reports, Pricewaterhouse’s reports, are over 700 pages long. This is summarised in a very short space, but our view is that summary is fair and, in the context of trying to decide what happened here, our view is that is a fair summary. Yes, of course, there could be more information, but we think we have a fair summary.

Sir David Walker: If I may add, there is nothing, Mr Norman, that has not been published that in our view has any materiality or which if you had it would lead you or us to reach a different view of the story, the narrative, the account.

Q12 Jesse Norman: That is a very strong and very helpful conclusion. Thank you. In the FSA’s document it says that in autumn 2007, in light of market conditions, the FSA CEO and chairman did consider whether the FSA should intervene in the ABN AMRO acquisition but determined it should not. Now, amazingly, as far as I can see, there is no explanation as to why they determined that they should not intervene in some way. The report agrees that that decision was reasonable. Do you agree with that view? You have hinted that you do not think it was reasonable, that they should have intervened in some way, albeit they did not have formal powers to do so.

Sir David Walker: There is a problem in the whole report and in the process in which we have been engaged, which is the judgment of history-hence my answer to your first question-this was a major error of omission that they did not stop it. The answer at the time is a bit more nuanced and difficult. I do not qualify the historical verdict. At the time, for one, they were not aware of the acuity of the liquidity exposure of RBS because they did not focus on it. That was a wider failure of regulation.

Q13 Jesse Norman: This was a culpable negligence to pay attention to liquidity issues of very highly wholesale financed banks?

Sir David Walker: No regulator did. It was part of the policy environment. But there were more specific things that-exonerate may not be the right verb. I will identify two. One was that on 10 August more than 95% of the owners of RBS voted in favour of the proposed merger. There is a very interesting question that we do not spend time on here. Where were the shareholders in responsibility for all this? But leave that aside, I think that if there had been an intervention in August or early September, which would have been a time when technically it would have been possible, this would have destabilised RBS. There is no question that the time for intervention of the kind that we now all see would have been highly desirable, appropriate, necessary, would have been much earlier, which is why we say in our document the regulator should have control, clear control in black letter primary legislation, and the way that control should be operated is right at the front of the process before all this gets into the public domain.

Q14 Jesse Norman: Very final question, thank you very much for that. Do you think that this process has been one that ought to be replicated for all of the public institutions that were in any kind of supervisory or regulatory responsibility with regard to the crash; that is to say a thorough self-examination with external review as necessary in order to ensure proper transparency and, as it were, accountability to the public?

Sir David Walker: My view I think would be there is a good case to be made. This is the most dramatic. There is one other that is perhaps nearly as dramatic. Probably, would be my view.

Q15 Chair: HBOS is the other case you were referring to before? You are basically saying yes on HBOS? It is a valuable procedure.

Sir David Walker: Yes.

Q16 Mr McFadden: Isn’t there a problem in asking the FSA to review the collapse and their own actions in this way, in that they have an interest in passing blame in two directions? Firstly, to RBS itself, of course, for the decisions it took, and you mentioned ABN AMRO and the way they ran the bank. Secondly, to kick blame upstairs to the politicians knowing that the heat of the political debate will mean that if they mention a letter from Tony Blair or they mention Ed Balls or they mention other politicians, that will take a huge amount of attention away from their role as the regulator and their job to actually supervise the system. Is that not what they have done in this report?

Bill Knight: I think that where an institution reports into itself they do have the advantage of being able to put their own point of view, certainly. What I would say was the advantage of it, though, is that it gets the facts out. Here is a document now that does state the facts. The judgments and conclusions the FSA themselves say can be a matter of public debate. With these facts as stated in here the debate can commence. While admitting that there is truth in what you say, I do believe the great merit of this is that there is a correct statement of fact that has come out.

Sir David Walker: Could I add to this, Mr McFadden, that there is also a question of the efficiency of the process as well as the outcome. In relation to the efficiency of the process, my expectation would be that if as an alternative route this Committee or whoever engaged lawyers and accountants to do a full investigation of the kind that the Governor proposed in this room a week ago-or at least indicated he might have preferred-it would have taken a much longer time, perhaps two or three years, not 12 months, and would have been hugely more expensive. It is quite interesting that the FSA review team was a bit more than 10 man-year full-time equivalent and the total cost of that was between £2 million and £3 million. The PWC investigation cost very significantly more than that, and that was focused exclusively on the enforcement part of the exercise, not on the history, which probably is of larger interest certainly in bringing the facts to light. So, the cost consideration is also relevant.

Bill Knight: If I may, it is also worth pointing out that part 3 of this report is a summary of an independent investigation.

Q17 Mr McFadden: Costs are a factor, but the cost of the collapse was of a vastly different order and, of course, the whole country is still paying for that. The point I am trying to drive at is that I accept your point about costs but in asking the regulators themselves to review their own role in this, don’t they have a vested interest in saying, "Well, mistakes may have been made", but trying to pass the blame in the two directions that I spoke about?

Sir David Walker: My sharp answer to that, Mr McFadden, would be that if the Committee cannot in a situation like this trust the regulator to do an objective appraisal-maybe with the scrutiny of people like Knight and Walker, but leave aside our role-then the Committee has a problem with the regulator and his or her integrity, and that is much more serious.

Q18 Mr McFadden: Can I ask you about a specific point in the report on enforcement action? This is of huge concern to our constituents who are paying the price of this bank collapse and they see no one as really having carried the can. We have had one person who has been banned from working in banking. A lot of people walked away with an awful lot of money. We have had the political controversy over Fred Goodwin’s knighthood and so on. First of all, can you confirm it was the same part of the FSA that initially recommended no enforcement action that then reviewed that decision in this report?

Bill Knight: I do not think that decision was reviewed. It was made on the basis set out in the report, and it was made, as I think Lord Turner says, by a team who were very keen on ensuring that all proper enforcement was taken.

Q19 Mr McFadden: But it does seem extraordinary to the general public that no one has had any charge brought against them for this collapse. Isn’t there a case for at least an independent review of the FSA’s decision on that specific point?

Bill Knight: There is no allegation here of dishonesty, and I think that is a massive first point. I think Lord Turner makes the point in his foreword that it is surprising to the general public, as you say, that no enforcement action was taken, but that so far as they can see is the law. There is no question here of dishonesty or even lack of integrity.

Q20 Mr McFadden: Apart from the FSA, RBS and PWC, who else did you speak to or take advice from in your role as reviewers of the review process, if you like?

Bill Knight: On that, our terms of reference specifically tell us that we are not to take a view on the desirability of enforcement proceedings. That is the first point. Those are the terms of reference that you set us, so we did not take that view as instructed. We interviewed directors of RBS, we spoke to the partners of PWC, and we took our own legal advice and we instructed accountants to check the figures in the report. That is what we did.

Q21 Mr McFadden: Finally, just on the process point going forward and following on from Jesse Norman’s questions and looking to other situations where other organisations may be asked to review their own role in what happened a few years ago, is the better model what happened in this case, where the organisation or regulator themselves reviewed, with someone like yourselves appointed to make sure that process is honest, or a separate approach, where it is not the organisation itself that carries out a review of their actions, but actually someone else-a fully independent team or a judge or somebody standing outside the process who is sent in to do it? Having been through this experience, which of those two, looking forward, do you think is probably the better process?

Bill Knight: I think that each has its advantage and disadvantage. Can I say one thing about this model? I think it is absolutely vital if you go for this model that the board or the governance of the organisation concerned accepts, individually and collectively, responsibility for ensuring that the report is fair. I think that is absolutely vital. That is what they have done here. The board of the FSA have given us an assurance that in their view this is a fair and balanced account. I think that is terribly important because that means that examiners such as ourselves and the board are working together and they take this very seriously, believe you me. They do.

Q22 Mr McFadden: But the problem is, to use the famous adage, they would say that, wouldn’t they?

Bill Knight: I agree so, as I say, each has its advantages and disadvantages. The advantage of this is speed and cost and getting the facts out. The facts are right, we are confident about that. The disadvantage is perceived lack of independence by an independent examiner, but experience shows, certainly in the case of Companies Act inspections, that such inquiries take a very long time, cost a great deal of money and often are quite noncommittal, actually.

Sir David Walker: Could I make two observations, Chairman, just in enlargement of responses to Mr McFadden? One is that notwithstanding that-and we discussed this with the Chairman right at the beginning-I am not competent to judge enforcement matters. Whether enforcement might succeed if charges were pressed is a matter for legal or judicial judgment. However, in one area we did suggest to the FSA and to the enforcement team we were surprised that a particular matter had not been examined. I think we say it here, but I will say it now, which was to do with competence, not integrity and not dishonesty-the criteria for enforcement are incompetence of a negligent kind, failure of integrity or dishonesty. The particular competence question that we were very concerned to raise was whether Sir Fred Goodwin had discharged his responsibilities as a delegate competently. We thought that was an important question, which is dealt with now in the enforcement report, which I think had not been addressed in the degree we felt necessary in the earlier work that led to the December 2010 statement. The conclusion was a negative conclusion, though nonetheless we think it is hugely significant, which is why we think it is an area for future policy we might discuss later if you wish, to give much greater attention to that.

The other matter, which is quite different, which relates to Mr Knight’s response, and it is a point he has emphasised and impressed me greatly with, is the importance of having the board of the body committed to the description of what happened. Of course, there is a prior question-one this Committee is addressing-which is that there is not much point in having the board committed to the view that is being expressed if the Committee does not have confidence in the board itself. It leaves aside the very important question of the population of the board itself and whether it is appropriate, which is why in this document we say that vis-à-vis the PRA-which in a way is the principal, though not the only successor to the FSA-it is very important that there be on that board people with particular skill sets, impliedly to a greater extent than are present in the FSA board.

Chair: Let us get into exactly that subject.

Q23 John Thurso: Sir David, that is a question I want to ask about, but just to put it in context, can I ask you very briefly some questions about your impact on the actual report? Bearing in mind the start point for all of this was that prior to the intervention of this Committee the FSA position was that no report was necessary or desirable, and this, which is probably one of the most important reports anybody has read about what happened in our financial services industry, is a direct result of this Committee requiring it and you being our eyes and ears on it, so I am very interested to know, first of all, how much of an impact you had. Perhaps just briefly, how many drafts of the reports were there? How much interaction did you have? You have the five areas that you sought more information on. Can you give us some idea of that process and at what point the FSA became willing partners?

Sir David Walker: Do you mind if-

John Thurso: Yes, whichever.

Sir David Walker: This is the division we have sorted.

Bill Knight: I think it is fair to say they were willing partners from the outset. We saw lots of drafts. I recall four main iterations to the report, but also we consistently saw the more difficult bits in isolation as well. It was a continuous process that went on right through the summer. We both read the long and the short bits. We made continuous comments. We were satisfied on our comments. The FSA were meticulous in dealing with every comment that we made, coming back to us on it. I think the process worked well. It was a difficult process because it is a very difficult subject matter, but as a process I think it worked well.

Sir David Walker: I crave the Committee’s indulgence because we bring different skill sets to this. To give an example of the easy, we spent very little time on liquidity. You could say, "That is very strange because it is actually the liquidity that brought them down"- brought them to the exceptional assistance they needed on 8 October 2008. But the liquidity story, the dependence on the wholesale markets for funding, is just a hugely unsatisfactory story of a generic policy that was defective and a lack of attention, which the FSA acknowledge. We satisfied ourselves that the facts are correct in that account of what happened. That was the easy area.

The hard area, which is protean in its complexity and really difficult to wrestle with, was the functioning of the RBS board, where decisions ultimately were taken to proceed with ABN AMRO, and not even to think about liquidity. That is the error of omission, if you like. The difficulties there are I think best described as being a concern with accuracy but also with fairness. The two adjectives that are relevant are forensic and historical. This is the forensic; this is what actually happened. The judgment that is really difficult is: were the decisions that were taken-though bad decisions plainly with hindsight-bad decisions when taken at the time or were they in the circumstances reasonable decisions? That is really hard to gauge. How much challenge was there in the boardroom of the kind that, as you know, is immensely important in a wellfunctioning corporate governance? That is really hard and I have to say, with my colleague, we found the dialogue with the FSA around those questions wholly-well, we were in the same place and we were trying to find the truth.

Q24 John Thurso: I think you have put your finger on one of the things that the predecessor of this Committee found when interviewing the chairmen and chief executives of particularly HBOS and RBS but also other organisations, was a very big flaw in the corporate governance structure of particularly those two banks and the lack of challenge, so I am not surprised that that is a big area. But it leads me on quite neatly to the question I wanted to ask you. One of the five points that you brought forward was a fuller description of the nature and degree of involvement of the FSA board in setting or endorsing relevant policies and, for me, also the non-executives of the FSA board. How guilty were the FSA board as being a bit like the RBS board and leaving it to the execs to get on and rubberstamping?

Bill Knight: Well, this is a subject that is dealt with at length in the report. There is no doubt that the FSA board did not spend a great deal of time in the review period on basic banking prudential supervision. They make that quite clear. I think, quoting from memory, out of 61 major matters brought to the board in 2006-2007 only one related to banking supervision. They spent a great deal of time on other matters, treating customers fairly, equitable life, split capital trusts, mis-selling of pensions, all the other problems that the FSA were dealing with. That was one aspect that came out very clearly.

Q25 John Thurso: Can I just ask you on that because I think it goes to the heart of what we expect non-execs in any of these bodies to actually do, which is do we expect them to challenge what the executive put forward as the work to be done, or do they accept the work that the executive give and challenge the competence and way in which the work is done? The two are quite different and I think, Sir David, from that nod you see where I am driving. It is a huge problem or culture difference that we need to look at.

Sir David Walker: May I give two observations, Mr Thurso? One is-and this is policy-relevant in a positive way now here in this country, partly as a result of the work of this Committee-that the FSA board were, like just about everybody else, victims of the intellectual environment. They thought that markets were inherently stabilising and efficient. Many of us certainly were part of that belief, which proved to be wholly erroneous, massively, dangerously wrong. I think that criticism of any board does need to aim off for the fact that the policy environment was one in which the areas of concern that were appropriate for a regulator were to do with conduct, mis-selling, all that stuff, and that the dispersal of risk into the wider markets made the system more whole and stable, which was, as I say, a massive misjudgment.

As far as your specific question is concerned, I acknowledge that my view is-perhaps the word is "hawkish". I would be in the camp of saying that the responsibility of non-executive directors-not only in financial services, which is our focus here obviously-in a board environment, which is after all the most important policy decisiontaking entity in the free world after elected bodies like parliaments and councils and so on, is to be much more challenging of the executive proposition in the normal course than has ever been the practice hitherto.

Q26 John Thurso: Across the board, if you look at most FTSE boards, there is a very considerable degree of groupthink and an unwillingness to challenge the core philosophy of management. I am sure there are notable exceptions but my firsthand observation is that most boards are very collegiate, which is quite a good thing, but that means there is no opposition. Are we at the point where that has to be severely challenged and perhaps the gene pool for non-execs should be widened out and be more than just other previous advisors and chief executives of other companies? Do we particularly have to have regard to that when it comes to public institution non-execs such as the FSA and the PRA?

Sir David Walker: Basically, I agree with the thrust of your thinking, although I do not think it is as binary as that. It is not quite black and white. I do think we are going through a phase of improvement. Non-executive directors now-and, of course, I generalise; it is easy to find exceptions-do recognise that they have this responsibility to challenge. It is very important to be clear about the chronology of what happens in the boardroom. It is the role of the executive to propose a strategic initiative-we acquire ABN AMRO or develop a new product or trading area or whatever it is-in any business. It is then for the chairman to organise a proper discussion. You have to define what is strategically significant with this; but if whatever it is is strategically significant it is for the chairman to organise a serious discussion around that, expecting and encouraging challenge from his non-executive colleagues. It is then for the chairman to sum up, "We agree with the proposition" or, "We disagree" or, perhaps most likely, "We agree but think it ought to be modified or delayed or possibly accelerated". Then the executive has to be fully empowered to implement. There is a real balancing act in this and I would not want in my broad acceptance of your analysis to be misconstrued as undermining the authority of the chief executive. The executive is there to propose, to be challenged-

John Thurso: I completely agree with that.

Sir David Walker: -then to implement.

Q27 John Thurso: But let me then just come back to the FSA board and your assessment or an assessment of their actions in relation to the RBS affair. Could they have done anything better and is the board of the FSA culpable in any way for what actually happened? What are the lessons we need to learn for the future?

Sir David Walker: My answer to that question is no, not culpable. I think we have to change the policy expectation of what the board, like in FSA, does and, therefore, the Committee’s views and the legislation in relation to the PRA and so on are hugely significant. In the circumstances of the time, given the pressures that were on the board in other matters to prioritise conduct issues, I think it is quite hard to fault the board.

Q28 Chair: Can I just pick up that last point you made, Sir David, where you say that we need to change the policy expectation for what the board does with respect to the PRA and to the FCA? What you are saying there, I think, is that these institutions need a strong nonexecutive cadre of people capable of challenging-not at the time that policy is being formed but at least retrospectively capable of getting into the merits of decisions that have been taken and ensuring that scrutiny takes place.

Sir David Walker: Yes.

Q29 John Thurso: Is that what you mean? Therefore, you support what the Committee has said, presumably, on Bank of England reform, which encounters so many similar problems? You take the fifth?

Sir David Walker: It is a curate’s egg, Chairman. The question posed initially and the answer that I was giving related to the PRA and the FPC-

Q30 Chair: The PRA is going to be in the Bank.

Sir David Walker: But it will have a board and we have expressed here strong views about how the board should be composed.

Chair: You are taking the fifth, aren’t you? It must be like what we hear about the secret services: once in the Bank of England, always in the Bank of England.

Sir David Walker: I do not agree-

Q31 Chair: Could I just ask you one other very factual question, unless you have something else you want to add on that point or subject?

Sir David Walker: Well, the only observation I make in our discussion, and of course I respect there is a wider one elsewhere, is that I would see the matter of competence and industry knowledge-financial service markets knowledge-as of much greater importance in the composition of that top body than has been the practice, recently at any rate.

Q32 Chair: Do we have the wrong people?

Sir David Walker: Something like that.

Q33 Chair: Something like that. We are getting there. I just want to clear up one factual point. Did you see all the RBS board minutes and all the FSA board minutes for the whole period relating to this report? I just want to check whether you did.

Sir David Walker: We had access to them. We saw a lot but not all of them. We could have seen all of them.

Bill Knight: I think I read all the FSA board minutes, yes.

Q34 Chair: Just to clarify one other point on the non-executives, you said that only one of the 61 matters they looked at were of a prudential nature. I think that was the evidence you gave a moment ago. They were asleep on the job, weren’t they? Doesn’t that score as asleep on the job, bearing in mind that we had already had Northern Rock for part of that period?

Bill Knight: No, no, the period-

Chair: For none of that period?

Bill Knight: For none of that period. The period referred to is 2006-2007 up to-

Chair: I see, not 2008?

Bill Knight: No, it is in the report. They became much more engaged after Northern Rock.

Q35 Teresa Pearce: First, thank you for the work you have done. Poring over those minutes must have been extremely tedious, I can imagine.

Bill Knight: No, actually, it was very interesting.

Teresa Pearce: Really? Well, maybe we will get to see them one day. Is it fair to say that in the review you have done of this report you believe that the report is fair and comes to accurate conclusions?

Bill Knight: Yes.

Q36 Teresa Pearce: In part 2 of the report, they talk about poor decision making and mistaken decisions, which is another word for wrong decisions. I think a couple of the words used earlier about the views that were taken, during the period this report refers to, by the banking industry and the FSA sometimes were erroneous or dangerously wrong, that sort of language. Why do you think that we can now be sure that the views that they have arrived at are right when they have been so wrong in the past? Is there something specific that has changed in their-

Sir David Walker: Is your question about the FSA?

Teresa Pearce: My question is about the FSA’s report into RBS-given that the FSA has been so wrong in the past, why do you believe that they are right now?

Sir David Walker: We may do this together. I think there are three areas of material improvement that make me answer that question with a fair degree of confidence but not total confidence. If the question is-which is not the question you asked, Ms Pearce-could this happen again? It is very unlikely, but you never say never.

The three things that have changed, which give us a lot of confidence, are first what I call the black letter regulation. The regulations about capital-the amount of capital, the quality of capital, liquidity, the nature of liquidity, leverage limits and all that-are now enshrined or are in the process of being enshrined on the basis of a major international initiative. I do not want to disparage it. It is hugely significant and necessary, but at the end of the day either a bank has the right capital and the right liquidity and so on or not-it is a box-ticking thing and the FSA must ensure that they have that. There are reporting and IT questions and all the rest, but ultimately it is not intellectually difficult. Once you set the numbers, complying with them is a matter of rote.

The second area is the scale of resource committed by the regulator to looking at RBS or other major institutions like it. I was frankly amazed to find that five people in supervision were doing RBS and Barclays for critical parts of this time, and palpably unsatisfactorily, as the FSA acknowledge. They are now putting much more significant resource into supervision.

The third leg-it is a kind of three-leg stool in my book-which I think is the most difficult part, relates to quality of resource. I think it is better now, but the jury is out on whether it is yet good enough, and we shan’t know for some time. It is not enough in these supervisory roles just to throw more accountants or lawyers or former investment bankers and whatever it is into teams. They may have an important role to play, but I think that there is a need for experience and quality of judgment, which in part comes from experience in this area. I think the FSA still have some way to go, as do most regulators on the planet, in getting enough high quality experience into the supervisory process, which is why in our observations to you we say that for the future getting the relationships of trust, the right relationship between the supervisor and the board, is of absolutely critical importance and conformity with the black letter requirements alone is not sufficient.

Q37 Teresa Pearce: Do you think in what you said there about the box ticking and that sort of thing, the attitude and the culture of the organisation is also very important? You have looked at the board and the CEO and delegation and where the responsibility lies, but the culture must come from the top. Do you think there has been any change in that or do you think there needs to be further change?

Sir David Walker: No, I think my read-I do not know whether Mr Knight agrees with this-would be that the culture at the top has changed. I would be very surprised if the answer, if you were to ask them about the importance of this supervisory relationship and the culture that is necessary, were very different from the views that I take. I think the problem is just getting the people in. To have a culture of the kind that I believe to be necessary requires very high quality people, and whether they have enough of them-I think the people they have are high quality. I think they may need more. There is cost in that. I think it is a journey not yet complete. I bring to mind, if I may, the distinguished former Governor of the Bank of England-and I stand reproached as a Bank of England chap of long time ago-who said, and I thought it was very telling, that good judgment in banking comes from experience. The trouble in banking is that most experience comes from earlier bad judgment, which is why experience is so-

Teresa Pearce: They should be very experienced now.

Sir David Walker: It is relevant to the quality of the supervisory team that probably there is a need still for greater experience toward not the top level but the second level down in the FSA or the PRA to come.

Q38 Teresa Pearce: Just a further question. One of the criticisms obviously is that the industry is investigating itself and the view is that the industry did not regulate itself well so why should it investigate itself well. One of the remarks, I cannot remember which one of you actually said this, was that nothing has been hidden. Although nothing has been hidden, not everything has actually been seen. Would you support the idea of all the minutes of the board being published? If not necessary, do you think it is desirable?

Bill Knight: I do not think it will add very much, I have to tell you. I have read them. I have read the FSA board minutes. You will find there is an awful lot about treating customers fairly and matters of that sort in there. I do not know, are FSA board minutes published now in the normal way?

Chair: No.

Bill Knight: No. I see no reason why summary minutes should not be published.

Q39 Teresa Pearce: Although you do not think it is necessary, you do not think it would be desirable or it would at least alleviate the fear among people that there was something-

Bill Knight: Yes, it would certainly do that.

Teresa Pearce: Be more open.

Bill Knight: There would have to be safeguards presumably for individual confidential cases.

Sir David Walker: My view is that it would be a wholly bad initiative. I would be against it. The reason I would be against it is when I did my report on corporate governance in banking a couple of years ago, I think I said in my covering note or something or other that one of the most interesting-and for me most interesting because most unexpected-sources of input was from a group called the Tavistock Institute here in London, who are behavioural psychologists. One of the things-the Chairman mentioned it-would be how boards behave, how groups behave, how, for example, the efficiency of a big group disintegrates quite rapidly. If you get above a board of more than eight or 10, the efficiency starts to go away quite quickly. I mention this because the behaviour of people in any group-you are talking about a board-being recorded will be different. What is said will be different if they know that what they are saying is going to be published. What we actually want, which goes back to Mr Thurso’s questions, is boards behaving in a tough, rigorous, challenging way. If everything I say in the boardroom that is challenging, "Oh, Chief Executive, you have this wrong, you have failed to understand", I cannot say that if it is going to be published. I think that is a great loss. It arises in a very specific way now-and some of us have wrestled with it-I would be sceptical about the publication or the availability to the regulator of board performance evaluations. I think that boards should have their performance evaluated on a regular basis, often done by themselves with external facilitation. If that report is to be made available to the regulators or published to the shareholders-and you can make a perfectly good transparency case for that-then the value of the whole process will be, in my view, significantly undermined.

Q40 Teresa Pearce: One final question. The FSA report relies heavily on the evidence gathered by PWC and that evidence, as you mentioned before, is very lengthy and very in-depth. In your report you say that if the Committee were to read the PWC report they would learn much about the detail. I have to declare an interest; I used to work for PWC. Do you think it is advisable for us to read those reports? Do you think it is necessary?

Bill Knight: No.

Q41 Teresa Pearce: You would not support them releasing those reports to us? I know they belong-

Bill Knight: Well, that is a different question. If you ask me would you gain a lot if you want to know about the reasons for the failure of the Royal Bank of Scotland and why no enforcement proceedings were brought through reading those reports, I would say no because I think that the summary that you have deals with those issues.

Q42 Teresa Pearce: The summary is sufficient. You did, I think, say you had conversations with the partners who prepared those reports?

Bill Knight: Yes, we did.

Q43 Teresa Pearce: Do you know which department of PWC they came from? Was it audit, tax, forensic?

Bill Knight: I fear I have forgotten. I should know. We could let you know.

Sir David Walker: I think it was quite a team of audit people-

Bill Knight: There were three reports. They were done by different people.

Q44 Teresa Pearce: Because although I have the utmost respect for PWC as my previous employer, could you not see that maybe a company that sells their services to banks and has quite a large department that sells their services to banks, maybe it would not be in their commercial interest to support rigorous enforcement and people might see that as a conflict of interest?

Bill Knight: No, I could not accept that. I think they did a thorough job.

Q45 Teresa Pearce: You think it was completely ring-fenced and-

Bill Knight: I do. I think it was a thorough job. I have read the report. I would not support that.

Teresa Pearce: I would be interested to know which section of PWC it came from though.

Q46 John Mann: I am interested in this point you made, Sir David, just now about behavioural psychology because there has been a lot of bandying around of the word "culture" in terms of behaviour, but that has rather been sidelined in terms of everything since. Here we have a report by the FSA on the failings of the FSA, one could say. How do you think the organisational psychologists would analyse that?

Sir David Walker: Well, in my respectful submission, you could perhaps ask the behavioural psychologists. When I referred to Tavistock-there are obviously others-I was very struck by the importance of behaviours in ways that are not a function of ticking boxes, making sure the capital is right or the liquidity is right. Those behaviours are influenced by all sorts of factors like the style of the chief executive or the style of the chairman or the size of the board, the vulnerability to groupthink.

Your question I think, Mr Mann, is specifically about the FSA. I think more important than behavioural psychology there in explaining what happened, and I think this does emerge pretty clearly from the FSA report, was that the FSA was, let us say, a cog with a lot of other cogs in the international regulatory environment, which-as the report acknowledges and we sought to emphasise-was a huge blight, if you like, on the whole process from start to finish. The fact that there was no attention paid-almost literally no attention paid-to liquidity was not a matter of culture. It was just policy thinking. People did not think liquidity mattered because the markets had abundant liquidity and you could always go to the market and do a conduit or commercial paper transaction or whatever. I do not think that is a cultural thing. It was an intellectual mindset, a belief in a functioning of these vast markets that was wrong.

Q47 John Mann: It was also convenient, and one of the interesting questions when it comes to externals on any organisation, it seems to me, is that if they are more of the same and in the same mindset, then their contribution may be specialist but it is going to be almost by definition very limited. But the question, particularly thinking of an organisation like the FSA, is who is asking the difficult question or does the comfort zone become overarching. Let me ask a follow-on to that because I think it is an interesting area that someone has to get to grips with. Who would be the appropriate body in the future to decide whether a public report is justified?

Sir David Walker: Well, I am not sure it is for me to advise on whether the Treasury Select Committee would-a financial service entity would obviously be expected to or might be expected to have a view.

But if I could come back, Mr Mann, to the predicate of your question of who should be challenging, the problem for the FSA-and whether it is the board or the executive for this purpose is substantially immaterial-before late 2007, early 2008, I cannot emphasise enough the global policy environment was one of not blind faith but acceptance that the markets were inherently stabilising, that the system was sound, that the areas of product development, like the development of a credit default swap market, had shifted risk out of the banking system into insurance companies or elsewhere. That proved to be wrong as a matter of fact, but people did not know. When one is asking for challenge of what had become the conventional wisdom, one is really looking for individuals in the organisation and the board who say, "Well, hang on a minute, is this international intellectual concordat right or is it seriously flawed?" Some people in some entities were saying, "Well, hang on a minute, can this go on forever?" Of course, if I may say so, for governments and I think oppositions, for banks, for employees, they were good times from which everyone seemed to benefit. I know that some chief executives have said to me subsequently they felt that this could not go on forever, but they thought actually the other guy had inferior systems and if someone got into difficulty the other guy would run into trouble first.

Now, you could say that leads to a sharp question about the FSA, why weren’t they on to that? Well, I think the arguments here set it up rather well: there was not much concern about capital in the way that is now considered appropriate. If I give one statistic, which I think is truly dramatic-it shocked me and I know about these things-the FSA’s calculation now of the Basel III Tier 1 capital of RBS at the end of 2007 was 1.97%. What would be required now is not less than 9.5%. They did not do that calculation at the end of 2007, but on the calculations that they did, they thought RBS’s capital was kind of okay. They needed a bit more so they raised as much as they could in April 2008.

Q48 John Mann: Is there any need for a similar type of exercise to be carried out looking at HBOS, in your view?

Sir David Walker: I think we have given a view on that-probably.

Q49 John Mann: Lord Turner in 2010 said, "A report into the failure of RBS would add little, if anything, to our understanding of what went wrong". Why do you think he said that?

Sir David Walker: As we said, right at the outset, I think that was a misjudgment and if I might suggest his view, I would imagine-I think I know his view now is that-having done this exercise, there emerged matters of understanding that have been hugely beneficial for the regulator. Of course, information is laid out to the Committee and we have transparency in the way that Ms Pearce was talking about, but I would think the regulator has learned a huge amount from this process.

Q50 John Mann: My final question. A change, be it of attitude, approach, mindset, systems, and so on, within the regulator. Am I hearing you right, you are saying that you think that has changed significantly as a consequence of the process and the production of this report, or is it something that had already happened and, therefore, this report merely sat alongside what was already happening?

Sir David Walker: I think it was happening. I would think the doing of this report has sharpened up some aspects of that, but the shock of Northern Rock and the matters with which this Committee was concerned, and on which you have commented, really shook the FSA in a way that caused them to do some fundamental re–thinking of the way they operated. I think a lot of that was in train, certainly by the time we arrived.

Q51 Mr Love: Sir David, I am happy to put this question to you because it will be put to me and other Members of the Committee after this session, and that is how do you respond to the accusation or the criticism that you have gone native on this report?

Sir David Walker: I am not sure how many times I have appeared before this Committee, but each time I have appeared on private equity or corporate governance, and now on this, I have been accused of not being independent, but that is for the Committee to judge. It is independence of mind not where one works. I do feel quite strongly about two things: people who are privileged, if you like, or fortunate enough to be in senior positions in the City-in the past in my case-have to be able to manage conflicts of interest. I would submit that if you are a senior person in the City and you can’t manage conflicts of interest you should not be there at all.

In the past, there has been abuse, I do not doubt-certainly in the distant past-and one of the things that the SIF process of the FSA needs to be satisfied about is that people who are being put on boards are capable of managing conflicts of interest. That is more important the greater the weight you place on having people in positions like this or on boards, who know about the business. My submission would be that-although I am reluctant to concede even this-there is always a danger of going native or losing one’s independence, but I take the point of principle, and you will have to judge whether I have lost my independence on this point, that the cost of that is very small, as against the benefit having people who know what they are looking at doing these things.

Q52 Mr Love: I do agree with you that there is a benefit to that. Let me come to Mr Knight. It has been said in this session this morning, certainly in your response you said there would not be any point in producing the PWC report. Sir David was thoroughly against-hostile-to reproducing the minutes, and I can go into that in a minute. We ought to remember, and this Committee is acutely aware, that £45 billion worth of taxpayers’ money is shoring up RBS at the present time and that is not to mention all the liquidity support that has been given from the Bank of England. Don’t you think that there was a necessity for more transparency in the way that this has been handled?

Bill Knight: It was handled under the Financial Services and Markets Act, which sets out conditions of secrecy, and you can’t really avoid that, that is the law. I think what has come out of it, in our view, is a good, fair and balanced summary that hides nothing, but the way in which it was handled, the enforcement, is set out by statute. These things are confidential according to law. Nobody is making this up. So I am not quite sure what the alternative is unless you want to change the law.

Q53 Mr Love: Sir David, you mentioned in your report five different areas where you challenged what was being suggested should be included in the report. Do you think that was a sufficient challenge? Do you think the report is critical enough-I am not suggesting enforcement action or anything of that nature-of what actually happened in RBS at the time you are reporting on?

Sir David Walker: It is a hard question, Mr Love, and as you can imagine we spent a lot of time together talking about it and discussing it with the FSA. My answer is ultimately affirmative; yes, I think it is adequately critical.

If I could come back to your question about transparency on which I certainly have strong views. If transparency means publishing minutes for the great public, or including for this Committee or for shareholders, my position is the one I described before. But if transparency means information flow, then there were huge deficiencies in what is described here in the RBS story. The two deficiencies I described as being really serious were, first, inadequate information flow to the board itself. At no point did the board have any serious discussion about the dependence of the balance sheet on this overnight money. That was a huge lacuna. Another lacuna-so this is transmission of information, it may or may not be defined as transparency, depending on your semantics now really-is the flow of information to the FSA. As the FSA now acknowledge, the fact that they did not know what the capital position of RBS was on 31 March 2008, and had an impression that was, in the event, mistaken, is very serious. What is even more serious is that I don’t think RBS knew either.

That management information stuff, in my submission, is much more important than public transparency. If you don’t get that right, public transparency is a totally different discussion.

Q54 Mr Love: The question then is, if they never discussed liquidity, which was absolutely critical, if they did not know their capital position at any time, regardless of Basel III and what was expected of them at the time, isn’t that damning evidence and shouldn’t it be pronounced on a front page of a report that goes before the public? But I want to move on just briefly. You said that, of course, that under your terms of reference we were not expecting you to pontificate about enforcement, but do you believe, Sir David, that we should be changing the rules to make it easier in circumstances like this to be able to take enforcement action against individuals?

Sir David Walker: The specific question, which I think the Chairman of the FSA mentions in his letter, and which we have thought about quite a bit-well, not very long I have to say, Mr Love-is the proposition, which would be very serious if implemented, to introduce the concept of strict liability. That is to say that directors would be personally liable where things go wrong. It is a large question for debate. I would have a lot of reservations about that, not just in this case but if you said why not any director of a board of any company. The starting point, which is in a way perhaps the easiest point to make, is that I think there would be a question whether you would get directors ready to serve in those circumstances if their personal vulnerability was so great. That is not a reason for saying this isn’t a problem, but I think there are better ways of dealing with the problem. I am much in favour of beefing up the SIF process. Maybe the FSA should have even more rigorous interviews of proposed significant influence functions people. That is a new departure and I think it could be beefed up.

I am also much in favour of a thing that is currently being discussed in another context, which is in relation to remuneration. We will leave aside all the debate about say on pay and all that, but I do think there is a strong case for more substantial deferment of pay. I would include in that non-executive directors, so that related to some performance measure their fee for 2012 is not available to them, or in some part not available to them, for three or four years, by which time the company will have demonstrated success or not failure. So I think there are things that could be done that would materially help, which are not strict liability.

Q55 Mr Love: Mr Knight, Lord Turner put forward an alternative for this automatic incentive–based approach, where there would be an automatic ban on directors who had taken part in the events that we are describing in this report. Does that have any merit or do you prefer the other mechanisms that Sir David has talked about?

Bill Knight: There is already an approved person mechanism. You can’t become a director of a bank without FSA approval. I think that that is the mechanism to use, and if people are involved with failed institutions then the next time that they, as it were, apply for a job I think that has to be taken thoroughly into account and I think the circumstances have to be gone into. After all, they might have fought tooth and nail to do the right thing at that previous institution. I do not think you can just legislate across the board. You have to look at what the individual actually did. But I am very much in favour of that happening, yes.

Q56 Mr Love: Just one final question. During the course of your review, did you come across any information that might support the case for a review of the FSA’s enforcement decisions, Sir David?

Sir David Walker: No. No, we did not.

Bill Knight: When we did question it, as we did at the beginning, we carefully looked at the chief executive in the context of his delegation. Then when we went into that we found it had been looked at thoroughly at the time. So we found that they had done a good job.

Q57 Chair: Just back on these minutes again, the FSA and RBS minutes, you said that if we saw them you do not think it would add very much, and as a general remark, Sir David, you said that if minutes were published it would influence behaviour adversely. You also said, in this specific case, exceptional case, perhaps other approaches, higher levels of transparency are needed. Do you think that in order to allay the concern of some who argue that you have not got to the bottom of this, that it might be helpful if we have those minutes made available in this exceptional case?

Sir David Walker: The minutes of either the FSA or the RBS? Well, the question could be taken in two parts. As to the substance, would people’s understanding of what had happened, and what failed, errors of omission, errors of commission, inappropriate focus, deficient-

Chair: No, I am asking a question about public confidence.

Sir David Walker: I am sorry I was answering, first, the substantive question. My answer is, no. As for public confidence, frankly, I doubt it. I am not necessarily the best judge-

Q58 Chair: Given what you have said, is there a material harm for those being published?

Sir David Walker: Yes. The material harm that I would see-we go back to a question that was posed right at the beginning: are there very exceptional circumstances? My answer to that is, yes, there might be. There is, however, danger. I think if boards of regulators or of major banks feel that there is some risk-a sword of Damocles hanging over their proceedings-that their minutes will reach the public eye, then their behaviour will change. That follows as the night the day. You asked whether it would have adverse consequences. Well, I think that probably would be an adverse consequence. I would just confine myself to saying the behaviour would change. For example, one of the things that I know is-

Chair: I think we are accepting that point as a general principle.

Sir David Walker: One of the things that has been looked at is should the secretary be obliged to record everything that every board member says with a view to the sort of challenge proposition that Mr Thurso was asking about earlier. You can see what would happen. It is entirely predictable. Every non-executive director would think it was his or her responsibility to make sure that in the minutes there was some challenge attributed to his or her name. That does not advance matters at all.

Q59 Andrea Leadsom: Following on from Mr Love’s comments, I find it rather astonishing that you think that there should be no strict liability for directors. After all, if you look in the SME world, if you want to start a business and borrow money from a bank you normally put your house, your car, your children’s school fees and everything else you have, up against that as collateral; indeed, your reputation, your standing in the community and so on. So, why is it different for somebody with a small business over somebody who is a board executive in a FTSE 100 company, for example?

Sir David Walker: Small businesses can raise money in the way you describe. I don’t think big businesses can. The reason we started with-

Q60 Andrea Leadsom: No, but talking about the individual liability for that individual director, why should they have no skin in the game? It seems astonishing to me that we should accept a scenario that takes us forward where, in the event that this happens again, which it will, that again there will be nobody who can be held strictly accountable.

Sir David Walker: Even under the present system, which you may feel, Ms Leadsom, is unsatisfactory-in some ways I would concur in that-directors have accountability to the shareholders. The directors, unlike the owner of the start-up and SME, are not necessarily people who have skin in the game in the sense that they have ownership. The only ownership they have might be some deferment of their board fee. But to be a director of a FTSE 100 company one is not required as a non–executive director to have any ownership of the company, although it has become normal for executive directors to be required to have some ownership. I think that is the normal pattern, most FTSE companies do that. But for non-execs it is not normal, and I think if non-executive directors were required to have skin in the game, in the sense of stockholding in any material way, that might be an interesting departure, but if it were the departure I think they would require higher fees.

Q61 Andrea Leadsom: Surely that would be a reasonable trade. But going back to it again, it does seem to me that it is in the human nature of things-I am sure that Tavistock would agree-that if you have a personal liability, if you stand to lose something if it goes wrong, then it concentrates the mind wonderfully.

Sir David Walker: You would be concentrating the mind of directors in this country in the way that no other democracy does. This does not exist in the States, in Europe, in Australia, New Zealand or Canada. So it would be a bold departure, which is not a reason for not doing it but it would be very novel.

Andrea Leadsom: Yes, rather like the retail ring-fence we are the only people doing it, but it is not a reason not to do it.

Sir David Walker: No.

Q62 Andrea Leadsom: Moving on, the FSA chose not to seek sanctions against RBS as the bank, on the grounds that it had already failed and was in public ownership. In hindsight, bearing in mind they failed to achieve enforcement against any one individual, do you think they should have looked at enforcement against the bank as a whole?

Sir David Walker: I don’t, no.

Andrea Leadsom: You don’t.

Sir David Walker: I have not given this a lot of thought, I have to say, Ms Leadsom. The bank is "bust" and it is now substantively in public ownership. It is not clear to me what incentive structure would be created by litigation against the bank.

Q63 Andrea Leadsom: I absolutely agree with you on that point, what purpose would be served in the sense of enforcement against the bank. But there is this absolutely enormous issue, which is the genuine public outrage and concern that this happened and that people are still paying for it. Not only that, but we are now significantly under water in terms of the taxpayers’ shareholding in RBS. So there is still that desire for somebody to pay for it somewhere, even if that ended up being at firm level. But just to give you a very specific example, I wonder the extent to which, on the competence issue, matters of RBS and what the board agreed to, and what subsequently took place in the bank, have been looked at in any detail. Specifically, I was told in a private conversation that, in fact, the board of RBS declined to follow a policy of investing in asset-securitised loans, but after that board decision the bank at a lower level went ahead and took part in that anyway and, of course, as we know, that was one of the major losses in RBS. So is this type of investigation been gone into in any detail?

Sir David Walker: On that specific matter that you did mention to us in a different session, we did look into it. We raised it with the FSA who in turn raised it with the lawyers of RBS. They did an investigation on our behalf and we were satisfied that, although there was a discussion about the matter to which you refer, which was widening the scope of their mortgage lending business into-I have forgotten what it is called-a looser categorisation, lower standards, in the event there was a decision against. It was not totally clear. It was not a black and white decision and there continued to be some examination of whether they might do it just a little bit. In the event, they did not do it.

Andrea Leadsom: They did not?

Sir David Walker: They did not embark on that strategy that had been the subject of quite a bit of toing and froing.

Andrea Leadsom: Right.

Sir David Walker: We did look into that.

Q64 Andrea Leadsom: Thank you. I am delighted that you did, thank you. I would like to push back on something else, which is you say that at the time it was reasonable to believe that the markets were kind of self-righting, that capital was endless and liquidity was endless, and so on. I was actually working for a big funds management company at the time and I distinctly remember, in 2007, a US fund manager coming in to talk to the chief executive saying that property prices in the States were collapsing and this would have a massive impact on asset-securitised loans. At the same time, for two years before Northern Rock went bust, the UK equity fund managers had not touched bank assets, and they were talking all over the place about the massive bank leverage and the fact that this was an asset bubble, that it was completely unsustainable. So why is it then that the FSA, and the board of RBS, seem to be the only people in the markets who had absolutely no idea that this might be an asset bubble and that it might all burst? You talk as if absolutely everybody was in agreement, and clearly, from my own personal experience, that simply was not the case.

Sir David Walker: I hope, if I may say so, Ms Leadsom, you were on the shorting side. Not many people-

Andrea Leadsom: No, long only.

Sir David Walker: Not many people shorted and if the view was as widely held as you suggest then there would have been very much more shorting, starting in late 2006, and it did not happen.

Andrea Leadsom: I agree with you on that point, but that is not to say that the discussion was not taking place that there was very big bank leverage, it was inappropriate, this was an asset bubble. It is simply not true to say that there was none of that conversation and there was this mass hysteria that everything was fine and would be fine forever.

Sir David Walker: It is a view of history, if I may say so. I can’t reconcile what you say with the fact that 95.5% of the shareholders of RBS-in my view, extraordinarily-voted in favour of the ABN AMRO transaction, and that most fund managers did not, on either side of the Atlantic, short financial stocks. Now, specifically within RBS there was a recognition, although it was a bit late, in the credit business-the American business-which became very exposed to the American mortgage market, that this market was falling away. They were slow to move to hedge those positions. When they did hedge them they hedged them with monolines who eventually went bust.

Andrea Leadsom: Yes.

Sir David Walker: They didn’t know that was going to happen. They didn’t have a very good distribution capability so they retained it on balance sheet. But in particular, the biggest misjudgment they made was to think, "Oh, the super-senior credit default swaps are AAA+ rated, they’ll be absolutely fine." That was a major misjudgment, but it was a major misjudgment that others made, although they started to change their judgment a bit earlier than RBS. I do not think the story, respectfully, is anything like as dramatic as you suggest it is.

I go back to the rather disagreeable thing I said in answer to one of Mr Mann’s questions. If you try to reconstruct the atmosphere in 2006–2007, quite a lot of people were saying, "This can’t go on forever". Not many people acted on it and one or two chief executives have said to me-of course, this is being wise after the event, which is easy-"Oh we knew it couldn’t go on forever, but we thought the other guy would go down first and we would have time to protect ourselves". There was quite a lot of that about.

Q65 Andrea Leadsom: Perhaps with hindsight, but that surely is a definition of incompetence. But just one very last question and that is did you in your investigations look at the issue of what would have happened if Barclays had won the bid for ABN instead of RBS? Did you ever consider would Barclays then have been the one that was in taxpayer ownership, and so on?

Sir David Walker: We did have a conversation with Barclays about the circumstances that had led them initially to think this was attractive, and the factors that led them to conclude they did not want to proceed.

Chair: Weren’t they lucky? Yes, they were, look at your face. Look at your face, Sir David. You have answered the question without saying anything.

Sir David Walker: Yes, they were certainly lucky. The only hesitation I have is that sometimes good luck is what you position yourself for, and I think they had done the arithmetic and they had done their homework and they had judged it-

Chair: They judged their luck well.

Q66 Michael Fallon: I want to ask you about the FSA’s role in controlling acquisitions. But first, could we just establish your own view of Sir Fred Goodwin’s responsibility. Taking this report as a whole, do you think it amounts to censure of Sir Fred?

Sir David Walker: If the criterion for censure is whether charges could successfully be brought against him under the present regime, then no. So, to the extent I am able to judge the enforcement criteria, I-

Michael Fallon: I am not asking you about his legal responsibility, I am asking you whether this report, in total, amounts to censure.

Sir David Walker: In the non-legal sense?

Michael Fallon: Indeed.

Sir David Walker: Yes.

Q67 Michael Fallon: So it would then satisfy the criteria for removing his knighthood, as it is censure by the professional and regulatory body that operates in his area?

Sir David Walker: I don’t know what the criteria are.

Michael Fallon: No, but you think the report amounts to censure?

Sir David Walker: Yes.

Michael Fallon: Right. Mr Knight, do you agree with that?

Bill Knight: I find it quite difficult. It amounts to censure on the board because it makes it clear that in their view, and the view of the FSA, the decisions of the board were mistaken, and not only with the benefit of hindsight. So that is clear, and Sir Fred was clearly a major player on that board. But in terms of individual censure I am hesitant actually. It raises questions about his conduct, but I would hesitate to find a passage in that report that I would say amounted to specific censure of Sir Fred as opposed to his role as part of the board.

Michael Fallon: So just Sir David agrees that the report does censure Sir Fred, is that right?

Sir David Walker: There is an accumulation of poor decisions, which were-as the report says-poor by the standards of the time. It is very hard to see how this cannot, in your sense, be a censure of the chief executive who was pivotal in virtually every decision that was taken.

Q68 Michael Fallon: So this is evidence that should obviously be laid before the Honours Forfeiture Committee?

Sir David Walker: The evidence is now delivered to you. How it is dealt with is a matter for the Committee.

Q69 Michael Fallon: Thank you. On control of acquisitions, your report says the current process for controlling acquisitions "is at best partial and indirect". The AMRO acquisition was, I think, the 24th, 25th or 26th acquisition that RBS had made by that particular point.

Sir David Walker: Yes.

Michael Fallon: What do you think the FSA should have done earlier to get involved in the number of acquisitions that RBS was making?

Sir David Walker: Apart from Citizens in the United States, I do not have in my head all the acquisitions they made. Obviously, much the most significant was NatWest. In the case of acquisitions in the UK, where there is a change in control, the FSA had and have full control over the acquisition process because they have to authorise the change of control. In the case of ABN AMRO, the only assets within the UK whose control was changed were the-you know, they had a broker and a relatively small banking presence in London, which was not really material to the whole transaction. So the point of leverage of the FSA then and now still is on the change in control of a UK entity, and to repeat the UK entity of ABN AMRO was very small in relation to the whole. NatWest was mainly a UK entity, so they had full control of that.

Q70 Michael Fallon: Let’s just stick with AMRO. Why shouldn’t the FSA have taken more responsibility, given the consequences of the deal?

Sir David Walker: As I think the report indicates, they should have. They should have and in my view could have. For example-and I think there is here in the report an indication that-this is what we meant by the word "indirect"; they do not have the clear statutory power of control-one of the indirect things they could have done would have been to set capital buffers, to have set an individual capital guidance level for the combined entity that would have made the transaction commercially unattractive. That was an option that they could have followed.

Q71 Michael Fallon: I think Lord Turner acknowledges that, but there is no evidence that they even considered that, is there?

Sir David Walker: No. I think we are clear that not to have stood in the way of this, with hindsight, was a mistake, but at the time much more difficult.

Q72 Michael Fallon: The mistake, surely, was not even to have considered it. They might well have waved it through after considering it, but this simply never got to board level, did it?

Sir David Walker: It got to the chairman in early September. It is important to recall that this was relatively late in the process, after 95% plus of the shareholders had voted in favour of the transaction. So for a regulator without direct power to stop it, in the face of such strong shareholder support, would have required a very strong view that liquidity, capital and whatever were a problem. Of course they should have had that sense, but they didn’t have it at the time.

Michael Fallon: But they could have.

Sir David Walker: They could have if they had been more attentive to liquidity and capital, which was not then the environment.

Bill Knight: Yes, it was very difficult by September. They were advised in memoranda, which I have seen, that the capital and liquidity requirements-the legal requirements-would be met following the takeover. So they didn’t actually have anything to go on at that point. They say they should have intervened much earlier in April when the thing was being planned. That is their position and I think it is correct.

Q73 Mr Ruffley: Sir David, you have answered in response to Michael Fallon that you think the report does amount to a censure of the chief executive, Sir Fred Goodwin, and Mr Knight has referred to bad decisions that he said were bad or wrong, even with the benefit of hindsight, that the board as a whole made. Could you just refresh our memory to the actions that you believe Sir Fred Goodwin took that are outlined in this report that amount to something that warrants a censure. So, in short, what are the things that Sir Fred Goodwin did that lead you to the conclusion he is being censured in this report? ABN AMRO, the decision to force that through, what else?

Sir David Walker: The thing that I would go back to was the matter we did raise with enforcement, as I mentioned earlier, which was delegation by the chief executive. The chief executive of an entity like RBS-this is relevant to the ring-fencing question that has been mentioned by others-can’t possibly have a detailed knowledge of all the silos of specialism that the entity is engaged in. What the chief executive is required to do, if he is performing effectively, is to choose people to whom he can delegate with total dependability and, in my view, it was a very important question whether the discharge of that responsibility was fully adequate. The conclusion reached by the enforcement team was that there was not a sufficient failure of competence there to justify an enforcement action, but I think there is still a question about the performance there. It is relevant that-and this is mentioned in the report-the view taken by an outside professional subsequently, I think a head hunter, was that Johnny Cameron would not be someone who would be regarded by head hunters as suitable for the role that he was asked to discharge if the question came up now.

So I would think that going back well before ABN AMRO there were questions about the trust, the confidence, the judgment the chief executive was making about individuals in the team that were reporting to him. That is quintessentially a responsibility of the chief executive. As we say in our document, of course, it is for the chief executive on matters like that to consult appropriately with the board and seek the chairman’s view: is this guy the right person to have in this role? But ultimately, the board needs to support the chief executive in those judgments, and if it is not ready to support him, the board has a problem with the chief executive. So the sense in which there is censure here is that those judgments were made clearly by the chief executive, but in many of them that confidence was proved to be misplaced. That relates to failures of a flow of adequate management information; for example, failures of adequate risk assessment. To give a specific example, when the decision was taken in 2006 by the board to embark on a significant P&L revenue strategy in the credit trading space, not thinking about leverage, not thinking about balance sheet or asset quality, the board were not presented with adequate risk information, the kind that would now-

Q74 Mr Ruffley: You see that as a shortcoming of Sir Fred, one example?

Sir David Walker: Well, he was responsible for the whole structure that presented this to the board, yes. So there are a number of things of that kind that, cumulatively, in my opinion, amount to poor judgment even by the standards of the time, which were lower than standards are now.

Q75 Mr Ruffley: Just before I move finally onto another subject, Sir David, wearing your hat as a very distinguished practitioner in the City of London, can you cite any examples of individuals being stripped of their knighthoods-not for malpractice, let me put it another way-for being censured?

Sir David Walker: No, I don’t but I do not know that I would know, Mr Ruffley.

Mr Ruffley: No, but you are a City practitioner. We aren’t around this table. It is not something that you have come across before?

Sir David Walker: There are cases historically.

Mr Ruffley: That is what I am asking.

Sir David Walker: The answer is I don’t know.

Mr Ruffley: Does Mr Knight know?

Bill Knight: No, I don’t. I can’t think of any.

Q76 Mr Ruffley: Can I just turn to the report. It does indeed criticise certain FSA methodologies and policies, but what it lacks is any specific reference to mistakes that individuals in the FSA made at the senior management level. Why is this?

Bill Knight: It does not specifically identify people below very senior individuals in the FSA, that is true.

Mr Ruffley: Those who were making some of the decisions on a delegated basis; any particular reason for that?

Bill Knight: The truth is that the major mistake, which is that the conclusions drawn by the FSA, which the evidence that we have seen supports, is that, by and large, officials were doing what was expected of them. It was what was expected of them that was wrong and, therefore, the responsibility has to lie at the top of the FSA. There are one or two exceptions to that, but they are not dramatic. The real problem is with the rulebook itself and with a decision, taken in April 2007, not to intervene in the ABN AMRO acquisition, which in such a massive transaction has to be a matter I think-

Chair: Can you speak up, I am sorry-

Bill Knight: It has to be a matter for the top of the FSA. So my understanding of this is that there are no terrible crimes committed by people in the FSA.

Q77 Mr Ruffley: A final question for you, Sir David. Is there anything you have seen, in the course of your review, which would suggest not only that the FSA was perhaps under-performing but also that Her Majesty’s Treasury senior officials were asleep at the wheel or under-performing, as well as individuals at the Bank of England? In short, do you think there should be a review of some description as to what the senior officials at the Bank and at the Treasury were doing during this time period?

Sir David Walker: I have nothing to say about the Treasury, and the Chairman will be able to reproach my lack of independence because I was there for 16 years.

Mr Ruffley: Although not, thankfully, during this time.

Sir David Walker: Not during this period. Vis-à-vis the Bank of England, the only thing I would say, which is I would like to think a constructive criticism and it is certainly intended as such, is that if you look at the reviews on what we would now call financial stability produced by the Bank of England in the period before the crisis, they were very perceptive. The criticism I would make is not that they were not perceptive but that they were not hammered home hard enough. This goes back to the questions that Ms Leadsom was asking earlier. Serious people were saying, "This can’t go on and there are risks", and they were people that were huge in their professional integrity, competence, and all the rest, who should have banged the drum louder. So, if I have criticism, perhaps the Bank did not make enough noise about its concerns. Of course, the architecture then is not what the architecture is about to become with an FBC and all that.

Q78 Chair: Before I ask the next question, I just want to clarify that you are acting under the protection of full parliamentary privilege in answering it. You will have seen the earlier drafts of this report, prior to this report having been sent to Sir Fred Goodwin’s lawyers and, therefore, you will have seen the "Maxwellisation" process in action on this report. Is the fact that there is no censure of Sir Fred in this report in any way related to what you saw of the Maxwellisation process?

Bill Knight: It is true that the references to Sir Fred were changed following Maxwellisation, but in my judgment actually that was a fair change.

Q79 Chair: What was the change?

Bill Knight: The change was that there was a suggestion that he lacked the experience to run an international bank. The point being made against that was that was, in truth, an attack on his competence and that there was no evidence of incompetence. I felt that that was a fair point, actually, and was subsumed into the point about delegation, which Sir David has mentioned. So yes, there was a change but I felt that the point was fair because there was no evidence of lack of competence, in terms of the experience of running an international bank.

Chair: Is there anything you want to add, Sir David? There is another area I want to explore.

Sir David Walker: No, I don’t think so.

Q80 Chair: No. We are all agreed that bad decisions were made at RBS and that they were bad decisions even in the context of the time. Can I take you to what I think is a key passage in this very full report, which is paragraphs 427 to 429. I will give you a moment to look that up, but I suspect you have looked at this carefully.

Sir David Walker: Yes.

Chair: This says, basically, that the FSA could have stopped the ABN AMRO deal but decided not to, and the question I want to ask you is whether, even by the standards of the time, that was a poor judgment?

Sir David Walker: I think it was. I hesitate and pause, but I think it was.

Chair: If I may say so, I am slightly surprised you are hesitating because this must have been right at the heart of what you were thinking about.

Sir David Walker: It is not an equivocation, I hesitate because the deep tradition of supervision and regulation of financial institutions-not just here in the UK but widely-was for the regulator not to become shadow directors on matters of strategy, but to leave these matters to the judgment of the board. So this would have been a first. An intervention to stop this, where there wasn’t a doubt about the integrity, and at the time not much doubt about the liquidity or capital capability of the entity to make this acquisition, would have been very exceptional and they did not have the formal power. Nonetheless, on balance, I would think that they should have intervened before all of this. I think after the shareholder vote it became very difficult to intervene without destabilising RBS in a way that would have had its own consequences. They could have done it earlier in a way that would not have been, they could have been saying to the chairman, "We are not sure about this, but if you want to do it we are going to raise the capital requirements very substantially".

Chair: It is something we will go into in more detail but it is very helpful to have your advice on that key point.

Bill Knight: Paragraph 420 puts the point very frankly, I think. They say the FSA’s supervisory approach to the acquisition of ABN AMRO did not entail adequate assessment of the risks that RBS were taking-three bullets-clearly this was a significant mistake.

Chair: Yes, but what I was asking was whether I should put this on a par with, and sitting alongside, the kind of judgments that were being made at the time, and your assessment of those bad judgments being made at the time, in RBS. Paragraph 420 does not make it clear whether that is a judgment with the benefit of hindsight or a judgment at the time.

Bill Knight: They are not praying hindsight in aid. They are not saying "in hindsight"-

Chair: It is unclear, which is why I decided I wanted to clarify your view-

Bill Knight: I think they are quite clear about it.

Chair: -and we are now getting your view. Jesse Norman wanted to come in with one final rejoinder.

Q81 Jesse Norman: Yes. It is just to recap the situation very quickly. The ABN AMRO was a transaction whose total value was €71 billion. The following year, RBS, having raised its dividend, had a loss of £40 billion, and I just want to briefly focus on an area that hasn’t been touched at all, which is the role of the advisors. Obviously the board did not review liquidity issues. We have just discussed this. First of all, could you remind me who the advisors were?

Sir David Walker: Principally Merrill Lynch.

Q82 Jesse Norman: Merrill Lynch, who have something of a reputation for getting these things wrong and I believe did the same thing in HBOS one might notice. How much were they paid, do you think, on a €71 billion transaction?

Sir David Walker: I don’t know the precise amount but it was a very substantial sum.

Jesse Norman: North of €100 million or €200 million?

Sir David Walker: North of €100 million, certainly.

Q83 Jesse Norman: Yes, thank you. Did you see the report from the advisors that they would have given to the directors?

Sir David Walker: There was certainly one major report. At the time when the board were first considering the ABN AMRO acquisition possibility, which was probably about February/March-I don’t know the precise date and my recollection is not clear-there was a report, the thrust of which was supportive of this being an attractive opportunity, something like that.

Q84 Jesse Norman: That report would have modelled the financial effects of the takeover?

Sir David Walker: No, I don’t think it did. I don’t think that question had been posed. I think the question that was posed was, "Here is an opportunity. Is it interesting for us?" It was at a fairly high level I recollect.

Jesse Norman: But there must have been some projection of the financial benefits. The board must have had some advice as to what the financial implications of buying an institution worth €71 billion were, for its own balance sheet, for its own liquidity, for the status of its own operations.

Bill Knight: I am sure they did. You should bear in mind, of course, that €71 billion was the total price. RBS’s share of that was 38%.

Jesse Norman: Yes, it was about €27 billion.

Bill Knight: Yes, that is right, so it was actually much smaller.

Jesse Norman: But the board was, nevertheless, buying into a transaction of the larger size and one would have expected that the portions it was buying would have been in substance modelled pro forma into its own P&L, into its own financial statements, into its own capital requirements.

Sir David Walker: My belief is that although they had that advice at the beginning, which was generic, rather high level advice-saying, "This is an interesting opportunity to pursue"-most of the arithmetic, the pro forma stuff of the kind you refer to, was done within RBS in the ensuing period, and the focus of the advisor was in the execution of the transaction, not advice on the way it could be done.

Q85 Jesse Norman: Does that mean that the advisor never actually gave the advice that what you might call a traditional financial advisor would give, "Is this a good transaction for you"?

Sir David Walker: It depends what you mean by "traditional financial advisor". I think the error of omission there, and it is what leads us to make a specific policy proposition, is that in situations of this kind if it were to happen again it should be the norm that independent advice is taken, which is not remunerated on the basis of success with the transaction.

Jesse Norman: That is what I am trying to get at.

Sir David Walker: Yes.

Q86 Jesse Norman: A final question: how would you assess the quality of-

Chair: A very quick question and a very brief answer.

Jesse Norman: Very quickly, but it is rather germane. Did you have a chance to assess of the quality of due diligence that would have been given on the purchase by the advisors?

Sir David Walker: No.

Jesse Norman: Or indirectly come to a judgment on it?

Bill Knight: The due diligence done by RBS was inadequate.

Chair: Was?

Bill Knight: Inadequate. There is no doubt about that.

Jesse Norman: Could you just describe it a little bit more so we can get a sense, don’t forget we haven’t seen any of it and we would like to know just how inadequate it is, the kinds of things it covered or did not cover.

Bill Knight: It was famously, in April at least, two lever-arch files and a CD. That is what is referred to in the-a very minimal amount of information was given, so it was largely based on published information, the reports to the board. The PWC report, summarised in part 3, clearly concludes that this was inadequate.

Q87 Jesse Norman: So the punch line is that the transaction of €27 billion was made by the board without independent financial advice on the back of thoroughly inadequate due diligence by Merrill Lynch for which they, and other advisors, would have been paid well north of €100 million or €200 million. That is the punch line of what you are saying?

Bill Knight: To give the complete picture, though, this was a contested takeover bid in which due diligence, in the sense of information volunteered by the target, was not available. That is the situation.

Sir David Walker: The conclusion to which it leads me is not only the importance of independent advice-this is a kind of rhetorical question and the Chairman may want to end here-but whether in large financial services entities a contested takeover is ever acceptable. Because it is not possible in the framework of contested takeovers to do the sort of due diligence that is necessary, and whether the advisors failed or the board failed or the regulator failed is of second order importance. They all failed because it was not available, and I think the inference is irresistible for me that contested takeovers in financial services are doubtfully permissible in future.

Jesse Norman: Thank you very much.

Chair: That is an extremely interesting final remark, and of course we have the HBOS deal where virtually no due diligence was done at all, and we have that on public record already.

Sir David Walker: But things can go wrong without it being contested.

Chair: That is the point that I was making. Thank you very much indeed for coming this morning to give evidence. Thank you, much more particularly, for the huge amount of work you have done on this and for exercising your judgment. The Committee very much appreciates it. Thank you again.

Prepared 30th January 2012