To be published as HC 1057




Treasury Committee

appointment of andrew bailey as deputy governor

of the bank of england

Wednesday 13 March 2013

andrew bailey

Evidence heard in Public Questions 1 - 51


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

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

Oral Evidence

Taken before the Treasury Committee

on Wednesday 13 March 2013

Members present:

Mr Andrew Tyrie (Chair)

Mark Garnier

Stewart Hosie

Andrea Leadsom

Mr Andy Love

Mr Pat McFadden

Jesse Norman

Teresa Pearce


Examination of Witness

Witness: Andrew Bailey, Deputy Governor-Designate, Prudential Regulation, Bank of England, gave evidence.

Q1 Chair: Thank you for coming to give evidence to us this afternoon, Mr Bailey. You are pretty new to insurance regulation. Do you know how to do the job?

Andrew Bailey: I am very new to insurance regulation; that is true. As you know, the Bank of England does not have a background in insurance regulation. Over the last two years, since I moved to the FSA, I have been immersing myself as best I can in insurance regulation, which is very interesting. We have obviously an inherited stock of insurance supervisors. As you may know, we want to raise the level of experience of our supervisors. It is fair to say, and it is a point the industry makes to me, that, for reasons I am not entirely clear about, we- interestingly-have the lowest level of experience in insurance, lower than the banks. So that is a clear task, but we have some good senior staff. We have increased our engagement with boards and senior management, as we have with banks. I have seen the chairmen and the chief executives quite often and we are getting to grips with what I think are some of the quite big issues the industry faces. Solvency II tends always to dominate any discussion we have with the insurance industry.

One of the things you realise when you start dealing with the insurance industry is that it is not one industry. There is a Life industry and a General industry and a few of the firms cross over, and then within the General industry there is also the Lloyd’s market. However, one of the interesting issues that does cross over-it affects the two parts in slightly different ways-is the impact of sustained low interest rates, which is quite marked because of the nature of the industry, the long-term contracts they write, and the guarantees built into those contracts and the pricing of liabilities.

Interestingly, one of the advantages of having insurance regulation inside the Bank of England is that we have already seen a better understanding between the monetary policy side of the Bank of England and the insurance supervisors about some of the common issues they face and the transmission of monetary policy through the insurance industry. So that is quite encouraging.

Q2 Chair: Do you think it was luck or judgment that kept our insurance industry out of the financial crisis?

Andrew Bailey: I am not sure. My impression is it has been a bit differential. There are one or two areas and one or two companies that got themselves highly leveraged in the run-up to the financial crisis. That is not a function of the fact that they were insurance companies, but of falling into the same sort of process as quite a lot of non-financial companies. There is nothing secret about this. Some quite well-publicised debt restructuring has had to go on.

For the mainstream insurers, I am not sure whether it is pure luck or pure judgment. They were somewhat distant from it. Of course, some of them had had a worse scare 10 to 12 years ago in the bursting of the dotcom bubble. We had also had the Equitable effect. That has been in the Life sector. They have had some experiences in that period when the banks were not having experiences.

Q3 Chair: Fortunately we had had a couple of medium-sized crises that had purged them of complacency?

Andrew Bailey: Yes. Interestingly, it did cause the FSA to introduce a new framework of insurance supervision in that period, the so-called ICAS framework, which is the one there today and we are modifying in the context of the delay to Solvency II. You can point to the fact that some actions were taken in the wake of those two experiences that were certainly beneficial.

Q4 Stewart Hosie: I want to stay on insurance because it is important and particularly Solvency II because it is fiendishly complicated. It seems to be taking forever to get any kind of certainty at the end, but you have said that the costs of Solvency II on insurance companies are indefensible. Why are the costs so high and what makes them indefensible?

Andrew Bailey: Solvency II has been going on now in various states for not far off 10 years, I think, as a process that is grinding through the European process. As I said in the points that I submitted to you, in all honesty, we do not know today when and in what form it will be completed. This is more of an issue for the Life sector than the General sector. There are no big outstanding issues for the General insurance industry, but for the Life insurance industry there are because there are some very highly charged issues in the European debates where, frankly, quite big national interests are at stake in that sector and those are nowhere near settled and are going nowhere at the moment.

Q5 Stewart Hosie: In terms of the European debate, clearly, if there is a massive delay or further delays or uncertainty with Solvency II, how will that affect the three-pillared approach Europe has taken if the insurance bit is not fixed? Does that add extra risk to the management of financial risk generally?

Andrew Bailey: It is. It obviously depends on how what I might call "systemic" you think the insurance industry is. What you have, therefore, is different national insurance industries at very different points in terms of the regulatory framework that they operate under, but bear in mind, of course, that that is not unusual. If you go to the US, it is still state-level insurance regulation. It is a very different industry from banking.

Are there risks? There are risks in the sense that you have quite different approaches and standards of insurance supervision. You have cross-border activities. Just finishing off your first question, I said it is indefensible because the industry was encouraged, kind of pushed, to start off on a very detailed approach to preparation for Solvency II. For reasons that it is possible to explain, more of the UK industry has gone down the models route than the standardised route. The reason for that is not particularly out of a love of models. It is because the standardised route does not fit two important areas of the industry that the UK has a relatively large component of: one is the Lloyd’s market and the second is the annuities and with-profits areas. The consequence is that more UK insurers are going down the models route than happens in other countries. The way in which Solvency II has been set up has snowballed the costs.

We got to last summer with the clear sense that Solvency II was going nowhere in terms of completion. There was incremental creep, whereby every six months it was clear that it was not going to be implemented for another six months, and so it got rolled out six months, and everyone went on preparing as if something had happened when, in fact, nothing had happened. The costs of doing that are very substantial. I was staggered when I got to the FSA to find the FSA themselves had budgeted between £100 million and £150 million to implement Solvency II. Whether I should be staggered or not is a matter of judgment. I could tell you the Bank of England has never spent anything like that amount of money on anything.

Q6 Stewart Hosie: I am glad I asked that. We may come back to the specific costs another time because that is extraordinary.

Chair: Except QE.

Andrew Bailey: Except QE. That is slightly different.

Stewart Hosie: In terms of what you said about the snowballing costs and the constant delays, there is the impact on policyholders in terms of costs of insurance.

Andrew Bailey: Yes.

Stewart Hosie: Can you measure that?

Andrew Bailey: You have to add up, particularly, obviously, the costs in the industry because the FSA’s costs, while they look big as a number-and, indeed, they are big as a number-they are quite small relative to the costs of the industry. People in the industry will tell you they think it is several billion pounds. If you talk to the Chief Executive of Legal & General, he says it is twice the cost of Crossrail. I have not gone out and tried to prove that, but that is what he says.

Chair: We do not know the cost of that yet.

Andrew Bailey: It has taken longer.

Q7 Stewart Hosie: People in the industry are suggesting that there might be an internal bill passed on to policyholders approaching £40 billion, if it is twice the cost of Crossrail?

Andrew Bailey: You have a higher cost for Crossrail than he does. It is several billion pounds, put it that way.

Q8 Stewart Hosie: One final question then. How much of your time do you intend to spend on insurance given what you have just said in your opening questions?

Andrew Bailey: I am very clear, and we have been very clear with the insurance industry, that we are, of course, very aware, going back to the point the Chairman mentioned, that they thought they were second-class citizens in the Bank of England’s pecking order. Of course, the other problem with that is that the banks, for well known reasons, take up and have taken up a very large proportion of the regulators’ time. We have gone out of our way- and I have gone out of my way to say-they are not second-class citizens. I say to them quite honestly that when the Bank of England is asked to do something, we do it seriously. We have done that. The feedback I get is that they understand that, and they have seen the evidence that we are paying a lot more attention to them.

What we did on Solvency II, in this particular case, was last autumn, I said to the chief executives, "Look, we are very clear this is not settled. We think it is not going to be implemented until at least 2016. Therefore, we are going to stop this incremental approach, whereby you just spend the same amount of money per day for longer, which is just racking up costs, and re-plan it". We have scaled the costs back. In the next year, because the FSA imposes a special levy on the industry to fund its Solvency II costs, the additional special levy will be only about £100,000, whereas last year it was getting on for about £20 million. We saved about half of that special levy last year to fund future costs. That £100 million to £150 million that I mentioned, I am hoping to get back to somewhere around £80 million. Bear in mind that something around £60 million has already been spent, so I cannot do much about that. We agreed what we call the "ICAS plus" regime with them, which was to say, "Let us take the useful bits of Solvency II that you have already prepared and bring them into our current regime and produce a sensible interim regime", and that has been a good outcome with the industry that we are now taking forward.

We are giving them attention. I keep saying to them, "If I could spend less time on the banks and more time with insurers, that would be good news all round".

Stewart Hosie: Thank you.

Q9 Andrea Leadsom: Good afternoon, Mr Bailey. Do you think that the financial sector is too reliant on credit ratings still?

Andrew Bailey: Some of the bolder statements that happened at the height of the crisis and immediately afterwards that we were going to get rid of the credit rating agencies have not been realised, and I think those were frankly rather optimistic.

I am very clear that some of the worst practices in terms of credit ratings and their use were what I call business models in banks that, in effect, hardwired credit ratings into their whole structure. The classic example is Northern Rock. Northern Rock was using the so-called originate-and-distribute model. It had a balance sheet, when it failed, of about £110 billion of which £60 billion was securitisation and covered bonds. The effect of that was that you had this big animal out there that had to be fed mortgages, so they had to keep generating mortgages.

The interesting fact is that Northern Rock had about an 8% or 9% share of the stock of UK mortgages, but when it failed, in the six months previous to that, it had 20% share of net mortgage because it had to keep doing volume. The problem was you had hard-rating triggers in there under securitisation vehicles. One of the things that became very apparent, certainly when I got involved in it from a resolution point of view, was that the cash that was coming out of the securitisation vehicles by virtue of people paying their mortgages, basically, was being re-deposited into the bank. This £50 billion legacy bank had about £7 billion or £8 billion of cash that was coming out of the securitisation vehicles, but the problem was that there was a hard-rating trigger on them. The minute they got their rating downgraded, that cash could go out of the door. At that point, the whole thing just comes down like a pack of cards and that is the sort of hard-rating trigger we are determined to get rid of.

Q10 Andrea Leadsom: Will you be requiring financial institutions to do their own analysis, for example, of complex financial transactions rather than relying on credit rating agencies?

Andrew Bailey: Yes. They should have the capacity to do internal analysis. Whether they decide also to use external sources as a check and an input to that, I am not so fussed about, but an institution that has no capacity to assess risk and depends on an outside party- again, you are hardwiring a dependence in there.

Q11 Andrea Leadsom: Do you think that Britain’s loss of the AAA status has had an impact on Britain’s ability to borrow and do you think it matters what the credit ratings agencies think?

Andrew Bailey: Interestingly, if you look at the evidence so far in terms of financial markets, you would conclude that it has not had much of an impact. Now, there may be all sorts of reasons for that. Of course, the key thing there will be to what extent financial markets were expecting that to happen, so the news content of the actual announcement was not so great. It may also be that two of the three main rating agencies still have the UK rated AAA and, insofar as people are looking at the two out of three, then it has not had the full impact, in which case you can say there will be more shoes to drop. It may also be state contingent, in the sense that the impact depends on what the state of the world is when you make that announcement, but I think you would have to conclude so far that the impact on financial markets has not been very great.

Q12 Andrea Leadsom: Does that suggest that the power of credit ratings agencies is not as strong as it used to be?

Andrew Bailey: I think probably to a degree it does. I have certainly heard people in the markets say that they use a range of indicators, and that using that range of indicators in the case of the UK sovereign credit rating has mitigated that impact. The other point, of course, is that Moody’s downgraded but then put the rating on stable; so in a sense they did not cast a future uncertainty, which they have done in some other cases.

Q13 Andrea Leadsom: Yes. Just to change the subject slightly, do you think that the new EU-proposed restrictions on bonuses will be good or bad for the industry and, specifically, do you think that there is a risk that, since, as we know, bonuses tend to fall when banks perform worse, it is likely that banks will be under pressure to pay higher salaries and, therefore, be unable to reduce their costs when their performance worsens?

Andrew Bailey: I could just simply say "yes". I am very concerned about it. What we have managed to do over the last two or three years is bring a number of disciplines into the remuneration structure. I do have to preface this with the point I made to the Parliamentary Commission last week that, of course, it is an odd world where you promise bankers egregiously large amounts of money so that you can threaten to take it away from them and somehow thereby incentivise them. What has happened is that less cash is going out of the door, so more remuneration is in the form of equity. There is much more deferral and there is real application of what in the lingo is called "malus", i.e. when an event happens, as has happened in the past, that crystallises a cost, then for the unvested deferred part of remuneration that can, in fact, be cancelled.

I was adding up an interesting statistic. If you take the major UK banks this year and you add up the reduction in bonus pools as a result of reducing those to reflect the cost of things like LIBOR and so on, and the malus element, which is again the reduction of unvested deferred remuneration, the sum of those two things this year comes to £2.5 billion, which is not a small number.

Andrea Leadsom: No.

Andrew Bailey: I say that because if the EU directive has, firstly, the effect of increasing fixed remuneration as a way to get out of the ratio bind, that is cash out of the door to start with. Secondly, of course, fixed remuneration is not deferred; so it reduces the power to use that incentivising mechanism. That is a concern, quite frankly, in the sense that it will reduce the discipline in the structure, but it will not obviously have the effect of reducing overall remuneration because the concern is that that employed will push up fixed remuneration for the code staff.

Again, I did a back-of-the-envelope calculation for the major UK banks and said, "What if, for the code staff"-I think there are about 1,300 code staff in the major UK banks-"on average you re-set the ratio to 1:2, so you assume the shareholders approve it, that is an increase in fixed remuneration of around £500 million a year".

Q14 Andrea Leadsom: Gosh. Do you think, if it is imposed, it could have a detrimental effect on the future location of senior bankers? In other words, could it drive business away from London and the rest of the EU?

Andrew Bailey: Yes, it is possible. Of course, it will also institute an unhelpful culture of banks spending their time finding ways around the rules-

Andrea Leadsom: Yes.

Andrew Bailey: -with some sort of, in the loosest sense of the word, sanction because we all think it is a bad thing, and that is not a good place to be either. When you had the people from UBS before you, they put up a pretty bad performance and did not give the impression they were managing the institution. One of the things we have done across the board with the major foreign banks operating in the UK-I know the point was made in the hearings of the Parliamentary Commission-is say, "If you are running a large operation in London, it has to be run by somebody who is in the senior management of your institution globally. It is not being run by a country manager, who may get around London a lot, but is not in the risk management framework of the institution". We have been pretty successful in this. My worry is that these people will suddenly say, "I am in New York from now on. I am still, in some sense, running the business in London, but I am running it from New York". From a risk management and control point of view, that is not a good place to be.

Q15 Andrea Leadsom: My very final, very short question is do you therefore think that this has been driven by some desire for retribution rather than common sense in how to reform the financial services sector?

Andrew Bailey: I can understand it. I think it has been driven by popular anti-banker sentiment. A lot of people are saying that the UK Government failed in this sense. I do not think the UK Government failed. I think, given what they were facing, any Government was finding it very difficult to go along and say, "It is not sensible to do this", and by making that argument appearing to defend bankers’ remuneration.

Q16 Chair: What you are saying is public pressure has inadvertently put us in a worse place than we were before we started?

Andrew Bailey: I think that is right.

Q17 Jesse Norman: Mr Bailey, you previously worked for Eddie George when he was Governor of the Bank of England.

Andrew Bailey: I did.

Q18 Jesse Norman: You have said in your Q&A that you were able to see the structural and other failings of the tripartite system. Could you dilate in detail on that?

Andrew Bailey: I was present with Eddie George when he was told that the FSA was being created. I was his private secretary at the time, in 1997. This is all well documented. It was not a good moment. I think the reason that is significant for me is that it got the tripartite system off on a very bad footing, because, in essence, you then had a state of conflict going on at the point when the foundations of the tripartite system were being laid down. The famous tripartite MoU was constructed in very difficult circumstances when relations were very difficult and the FSA did not exist.

What is the long-run consequence of that? The responsibilities were not very well defined because it had something of the characteristic of a peace treaty between parties that are not really at peace. What then happened was that there was a very long period of peace because nothing happened in the financial system for about 10 years-no event of any significance. I think that some of the structural failings that got built in early never got tested, so never really got found out until things got very bad. I hold to that.

Q19 Jesse Norman: How do you write a MoU when one party feels completely betrayed and one of the other parties does not exist?

Andrew Bailey: The approach that was taken, certainly by Eddie George, was quite defensive. He felt that he had been put in a very difficult position. By the way, this was not about the substance. It was about the process. I can tell you that he always took the view about banking supervision being in the Bank of England and, bear in mind, as you will remember, this was not a glorious history of banking supervision in the Bank of England before 1997. I will say to people, "We are not going back to those days", because those of us who were involved and remember it remember that the bank was pilloried for BCCI and Barings and so on. However, he always took the view that he could argue both sides of, "Should it be in the Bank or should it not" with almost equal force and he probably preferred it to be in the Bank because he did not want to shake the Bank up. Although, it was not the substance; it was the process that was very difficult.

Q20 Jesse Norman: Do you think the new structure is also flawed?

Andrew Bailey: First, the Twin Peaks system is a clear improvement on integrated regulation. It has been very interesting for me because I spent two years in the FSA. I had worked very closely with the FSA as Head of Resolution before that, but from the perspective of being an outsider looking in. The thing that struck me in the first year I was in the FSA, which was basically up to a year ago-and a year ago, we did the internal split-but the first year when I was responsible for integrated regulation of banks, was how difficult it was and obviously had been, looking at the history, to balance conduct and prudential when they were being done together. My assessment of it was that the FSA had never managed to balance the two in a stable equilibrium. One had always been on top of the other but it was not the same way round. Before the crisis, I think it is pretty clear that conduct took precedence over prudential. Clearly once the crisis happened, the machine switched around, but what you get from that was it was not a stable balance.

The other thing that became very apparent was that it was very difficult for senior management to balance the competing demands on their time when you have conduct and prudential. There is an interesting test of this. You will be familiar with something called Key Data. If you go into the Bank of England, they do not deal with Key Data because it is a consumer issue. It is a conduct of business issue. It is a very bad conduct of business issue, but it is clearly a conduct issue. If you are in the FSA, you are trying to balance dealing with that against dealing with failing banks and I think that was very hard for them to do in the end.

Twin Peaks, for me, helps. We have seen in the last year a much stronger articulation of what I call prudential and conduct arguments where they butt up against each other, but Martin Wheatley and I are also very clear that it is not good enough just to have elegant arguments about issues in which points are put better, you have to resolve things. We have to prove we can do that.

Q21 Jesse Norman: Let us talk for a second about the culture of the FSA. Could you describe that candidly as was and as it is now?

Chair: Is it the word "candid" that is causing the pause?

Andrew Bailey: Actually two things. It is quite hard to define the culture of the FSA today because it has gone two different ways. It is legally still the FSA and obviously functions in that sense but for the last year, it is quite interesting, as we split it, that the supervisors went quite clearly to their different points.

What struck me overall about the approach, particularly the approach to prudential supervision in the FSA, was that they had clearly changed it in the wake of the crisis. Whether they used the term "light touch" about themselves I do not know, but clearly that was the effect and it goes back to my point about prudential being subordinated to conduct. They moved to what they called intensive and intrusive supervision. The problem with intensive and intrusive is that there is no end to it. Unless you focus it, there is no end to it because how many drains do you want to rip up? That struck me as the problem. There was a lack of clear focus on what the objectives of supervision were. That is what we are correcting in the PRA and, by the way, that goes back to your first question, which is having very clear statutory objectives and very clear objectives underneath that, which I do not think the 1997 reforms achieved. It was this question of lack of clear focus and what the end objective was that struck me, certainly about prudential supervision, and that is what we are changing.

Q22 Jesse Norman: Spaghetti junctions, stove pipes, competing fiefdoms, lack of clear responsibility, under-lap, none of those things. I do not see you testifying against that.

Andrew Bailey: The lack of clarity certainly shows up in the shifting pattern of what is the focus of attention, which was this question about balancing conduct.

Jesse Norman: However, some of those words would not be inappropriate?

Andrew Bailey: Sorry?

Jesse Norman: Some of those words would not be inappropriate?

Andrew Bailey: No, not in that sense.

Q23 Jesse Norman: When the PRA comes into the bank it is going to have 1,000-odd people or increase the size of the bank by 50%?

Andrew Bailey: Yes.

Jesse Norman: I do not think there has been anything remotely in the bank’s recent history that is a comparable change.

Andrew Bailey: No.

Q24 Jesse Norman: What are the issues that are going to arise for the Bank of England out of such a colossal act of absorption?

Andrew Bailey: It is interesting. It is the first time the Bank of England has expanded in anybody’s working life in the Bank of England. It has always been a shrinking or static organisation because, over the years-I have been there nearly 28 years now-a number of functions have either come off or declined. It had getting on for about 5,000 staff when I joined and in the previous change it was down to about 1,700 or 1,800. We have obviously had to gear the machinery up to accommodate and adapt this, which, by the way, has mostly happened now. We are in our new building. We are technically in there obviously as the FSA. All staff are in the Moorgate building. They are being serviced largely by the Bank of England in terms of IT and what have you, so that has happened.

We are now working on what I might call the cultural integration because if we are going to make the system work from the point of view of the responsibilities of the Bank of England, which is the MPC macro-prudential and micro-prudential, they obviously have to work together. Interestingly, going back to the 1990s, this was not something that worked particularly effectively in the Bank of England in the days when it had larger responsibilities. This is not, as I say, going back to old territory. It is trying to make something work afresh, and I think we are making pretty good progress. I am always encouraged when we see a stronger bond between the financial stability and monetary policy sides of the Bank and the supervisors, which is beginning to happen, but we have a substantial way to go. Do not get me wrong.

Q25 Jesse Norman: Final question, could you comment on staff turnover and your ability to recruit? By staff turnover, I mean loss of good staff.

Andrew Bailey: Yes. The FSA has traditionally had higher staff turnover than the Bank of England, so as a rough metric it is probably double. With both organisations it is cyclical. It very much depends on the state of the outside market as to what the staff turnover rate is.

Jesse Norman: When you say roughly double, do you mean 15% to 20% a year?

Andrew Bailey: When I moved to the FSA two years ago, it was probably up in the higher teens and the Bank was probably around eight or something like that. Today both are lower, so probably the Bank is down to five and I think the FSA, certainly the prudential side, is probably down to about nine.

Obviously, that can be due to a number of reasons. The outside job market is obviously not good in the City at the moment, so that is the cyclical point. Obviously, we would like to think we are creating a better working environment and creating an environment where people want to work in a public policy institution for its own reasons. There is probably at least one reason why a supervisory authority will have a higher turnover, which is that one of the things you notice about supervisors is they have much more intensive contact with a small number of institutions.

Many of the Bank staff obviously meet people in the outside world, but they meet lots of people, whereas a supervisor, if you are supervising a major institution, you see them and, of course, the institutions know who the good ones are and who the less good ones are, and they do bid for them. That is fact of life, I am afraid. It has always been true and it is true in foreign supervisory institutions. I am pleased the rate of turnover has come down but the jury is out as to how successful we have been until we see where the cycle in the outside job market goes.

Q26 Jesse Norman: Are you able to grow or recruit attractively?

Andrew Bailey: Yes, we are. I think the Bank will be a big help here because the Bank has a very strong reputation in the recruitment market, particularly in the graduate recruitment market. I am optimistic that we are retaining good staff but, as I say, the jury is out as to how successful we are.

Jesse Norman: Thank you.

Q27 Teresa Pearce: Good afternoon. On the objectives of the PRA, one of them is to promote safety and soundness and not to make sure no firm fails but to make sure it does not have an impact on the wider economy. One of the threshold conditions for firms that come within this is that the firm’s business be conducted in a prudent manner-

Andrew Bailey: Prudent manner, yes.

Teresa Pearce: -and the firm be fit and proper and appropriately staffed. You are meant to assess firms against that standard. How will you do that?

Chair: Andrew, before you answer that question, I notice the sun was in your eyes. We do not deliberately do that.

Teresa Pearce: No, keep it on.

Andrew Bailey: You might not get sensible answers.

Chair: If you want to move one seat down.

Andrew Bailey: Let me have a go.

Teresa Pearce: It would be better.

Mr Love: Unfortunately it is the only day we have had the sun.

Teresa Pearce: Now I will have to get my torch out. Is that better?

Andrew Bailey: Yes.

Teresa Pearce: Hello.

Andrew Bailey: Hello. The threshold condition obviously of the prudent manner is absolutely the core threshold condition because that is the prudential standard of capital and liquidity.

Teresa Pearce: Nevertheless, how will you monitor?

Andrew Bailey: We do this on a continuous basis because firms have to meet the threshold conditions every day. We do that through continuous monitoring of their capital positions, their liquidity positions and their large exposure positions to counterparties. However, the key thing that I would emphasise here about what is changing is that it is becoming what I call much more forward looking. This is the judgmental element of supervision.

You can obviously do threshold condition on prudent manner on a-to use this terrible phrase-"tick box" basis. You can come to work and say, "What is the capital ratio today? Is it above X?" Tick. "What is the particular liquidity ratio?" There are quite a few of them you have to look at, "Does it meet it?" However, of course, that does not answer the question. What answers the question is how robust is it, given its starting position, to the threats that you can conceivably see coming ahead. That is what we have to do more of and that is what we do more of.

Q28 Teresa Pearce: Given that we all know that there were issues with Barclays and that they were meant to be gaming the FSA, how will your supervision differ so that it will find when someone is gaming? It was not seen at all, was it, in the past?

Andrew Bailey: First, the key thing there is, to go back to what I said earlier about being focused on the key risks that this firm poses to our objectives and not to be covering a huge landscape of what I might call compliance issues. That is for the firm to do. The second thing then is to be prepared, through that focus, to "call it" and say, "Look, we have observed patterns of behaviour that lead us to conclude that you are the wrong side of the line in terms of the risks you pose".

The third thing that follows from that-and this in many ways, for me, is the major lesson from the Barclays issue-is being close enough to understand the practice and substance of governance as opposed to the form of governance; to be able to understand why these things are happening-in essence, do we understand which buttons we press on the board to get some response? We have to do all those things.

Views differ on this. I am not a supporter of supervisors sitting in the back row at boards observing them at work, largely for the reason that if I was in that position I would behave differently if a supervisor was in the room and if they were not.

Teresa Pearce: The culture is how you behave when no one is watching.

Andrew Bailey: I am a strong supporter, as you know, of us going to boards and talking to boards and saying, "You need to know these are the key things that we are focused on".

Q29 Teresa Pearce: Given that your objective is to avoid adverse effect on the stability of the UK but there is no objective for having regard to growth, do you think that is an issue? Do you think that is a missed opportunity?

Andrew Bailey: The Financial Policy Committee does have, as you know, what I might call the hierarchical objective. Much like the Monetary Policy Committee, it has the hierarchical objective. It has the financial stability objective and then, subject to that, the very similar objective that the MPC has. I think that is a very important piece of the architecture. We do take that very seriously and we should take that very seriously. In the context of the interface between the FPC and the Prudential Supervisory Authority, I strongly believe that you have to have a stable, well-capitalised financial system to support lending and to support growth but we obviously have to get that balance correct. That does feed through into the PRA because the FPC will give us recommendations on that front.

Q30 Teresa Pearce: Just one last question. Pension funds are extremely important to all of us and the whole country. One of the issues that concerns me at the moment is that we are moving to a low-carbon economy and there are, I think, 100 listed coal companies and the top 100 listed oil companies, listed in the UK, which currently have more carbon in them than they can possibly burn, and there is this carbon bubble in the way that they are valued. Obviously that is not something you want to discuss at the moment but is it something you would take away and consider about the valuation-

Andrew Bailey: I am happy to do so, but it is a question for Martin Wheatley because he is responsible for markets regulation for the UK Listing Authority.

Q31 Teresa Pearce: However, you have an insurance role. What I am trying to say is this is a risk to the market that surely all of you, in all branches coming under the Bank of England and MPC, would consider going forward because you have spoken-

Andrew Bailey: I am happy to consider it in this case. If it is possible that there will be some major correction in this area that would have an impact on the financial system-

Teresa Pearce: Particularly pension funds.

Andrew Bailey: -then yes. I think we ought to discuss that also with Martin because a lot of that is-

Teresa Pearce: The reason I raised it with you is because you were saying when you are looking at firms, rather than what they benchmarked for the past, you will be looking at the future-

Andrew Bailey: Yes.

Teresa Pearce: -and it is something that would be of consideration. So, just to keep it in your head.

Andrew Bailey: I know we have had some correspondence from others on this subject and we have done some assessment of it. I think, for the most part, we thought it probably fell into Martin’s area but we will take it away.

Teresa Pearce: I shall write to him, with the Chair’s permission.

Andrew Bailey: He will thank me for that one.

Q32 Mr Love: Good afternoon, Mr Bailey.

Andrew Bailey: Good afternoon.

Mr Love: In November the Financial Policy Committee asked the FSA to look at whether banks and building societies needed to strengthen their capital base. What can you tell us about the results you have come across so far?

Andrew Bailey: I can tell you that the FPC is now into the round of looking at the assessment that has been done. I am honestly not going to tell you what is in the substance of that, and the reason I am not going to tell you the substance of that is because I think that the FPC has to perform its function and then be accountable to you for what it does. We are in the midst of that process. I read Mr Peston’s blog before I came here and he seems to know what we are doing. I can’t tell you whether that is true or not. However, we are in the middle of that and we will announce the outcome on 27 March, if I remember rightly. Then you should hold us accountable for it.

Mr Love: Absolutely.

Andrew Bailey: You will.

Mr Love: We were just trying to get in early.

Andrew Bailey: I know you were just trying to get in early. Nice try.

Q33 Mr Love: You can confirm to us that there is a need to strengthen the capital position and perhaps you can say just a little bit about whether the order of magnitude that has been suggested is somewhere between £20 billion and £50 billion. Can you say a little bit about whether we are in the right ballpark?

Andrew Bailey: I can tell you that I agree with the part of the consensus view on the FPC that there is a need to strengthen the capital position but I am not going to get into where the number is.

Q34 Mr Love: I want to go on and ask you about restructuring, but in the response to the Banking Commission on this particular issue, you drew a distinction between different institutions and you suggested that where an institution did not have a fully sustainable business model, they would have to look at restructuring before they went to their capital markets.

Andrew Bailey: Yes.

Mr Love: Did you have any institutions in mind when you said that?

Andrew Bailey: I think that it fits with the issue of how the state-owned institutions come out of state ownership. Many universal banks are shrinking their investment banking activities, and that is sensible and reflects the fact that there has been a change in the terms of trade of doing investment banking. The relative capital requirements on investment banking have increased. That is a point that is relevant, whether they are state owned or privately owned. That is one restructuring point, but the second one, particularly, is that it is sensible to undertake any necessary restructuring measures as a precursor to being able to raise capital, and as a precursor to what I think everybody wants to see, which is to get these institutions back into the private sector.

Q35 Mr Love: There has been a lot of discussion about the issue of core assets and non-core assets, particularly in RBS. In your estimation or in the FSA’s estimation, are these institutions going fast enough? There is a lot of debate and controversy around about how fast they are realising their non-core assets.

Andrew Bailey: Yes. If you take the case of RBS it is very interesting. Since the end of 2008, RBS has reduced its total balance sheet by around about £900 billion and it has reduced its funded assets-the bit that strips derivatives out-by about £400 billion. That is a major change and I think the management of RBS deserves the credit for doing that. It has run very much on plan and in some areas it has probably run ahead of plan. The numbers are smaller because it is a different institution but Lloyds too has been aggressive in running down the non-core assets and that is sensible. That gives you the platform then to say, "So, how do we take it from there to get the thing back into private ownership?" That is a good outcome.

Q36 Mr Love: I have taken RBS as an example. They have recently announced they are thinking along the lines of having an IPO for their American subsidiary, Citizens Bank. The suggestion is that Citizens would be more prepared for an IPO in a year or two years’ time but the pressure is now on. Is the pressure from the regulator leading to them considering this now?

Andrew Bailey: It is quite well known that I have spoken to them about this but you must realise that ultimately those are decisions that the board of RBS took. The board of RBS, essentially, as I read it, has said three things. It has said that it is going to, as you say, get Citizens into a position where there is either an IPO or a trade sale. It has announced that it is going to restructure and reduce the size of its investment bank. I think that is sensible because, again, what they should be looking at and are looking at is an investment banking operation that effectively fits an institution that would be a major corporate and retail bank with a UK focus. It will not just be in the UK, but it will have a much greater UK focus in the future than it has in the past. The third thing that led from that was the board saying that, in their view, that put them in the position to contemplate starting to sell the Government shareholding and that is the right thing to do. I entirely welcome the fact that they have done that. Have we had conversations on those subjects? Yes, we have.

Q37 Mr Love: One final question. There has been a lot of talk about whether the Government would put fresh capital into either RBS or Lloyds. There is a concern out there that if the sale of assets does not raise as much as has been hoped, if those institutions have difficulty in going to the markets and raising enough capital, the Government may be forced into providing capital to strengthen their balance sheets. Is that a concern for the regulator?

Andrew Bailey: I have not asked the Government to put capital into RBS or Lloyds. You would have to understand what our position and our responsibility is. If and when plans are put in place to take the institutions back into the private sector then, going back to the earlier question, of course the state in which they go back into the private sector has to be one in which they meet the threshold conditions. That is our responsibility. They have to meet the prudent manner threshold conditions. We would obviously look very closely at the capital and funding position and so on of the entity that was being take back into the private sector, but I can assure you I have not asked the Government to put money in at this point.

Q38 Mark Garnier: May I turn to real estate, mortgages and loans, and the thorny issue of forbearance? The November 2012 Financial Stability Report was talking about around a third of British commercial real estate loans being now subject to forbearance. First, how long has the FSA been aware of this? Did they only just spot it in November? Secondly, and possibly more importantly, how does this compare with previous slow-downs?

Andrew Bailey: We did what I might call, a real drains-up on forbearance last year. It is as broad a definition of forbearance as we could come up with. There is not a precise definition. It is when something has happened to the terms of the contract that changes the terms of the contract. The devil is in the detail with defining forbearance. I found this out in my early days dealing with Northern Rock when it took us ages to find out what they had been up to.

I think then the question is this. There is clearly sensible forbearance from the point of view of borrowers when it is in the best interests of the borrower and the lender that there is a change to the terms of the contract, if you like. Our position is that I am entirely supportive of banks doing that. We do, however-and this comes back to the question of recognising provisions-want to ensure that when they do that they understand the impact on the valuation of the asset and recognise it.

The point you make about how does this compare with past times is interesting. This is a very different pattern of recession from the ones that we have had in the past. The recessions of the past, of course, have been far more ones where the interest rates were higher and, therefore, debt servicing costs were higher. If you go back to the experience of the early 1990s, for instance, the rate of arrears and repossessions was much higher than it has been. We know why, because obviously the effect of low interest rates means that borrowers can service the debt. The consequence of that is that the pattern of behaviour, I think, has been quite different during this recession and that is fine. One of the things that we have to watch quite carefully, and this comes back to the issue of models the banks use, is how they weight the various patterns of behaviour, in terms of calculating the amount of capital they require.

Most banks’ mortgage models work off the early 1990s, so most of them assess the realised rate of loss in the early 1990s on mortgages and use that as a benchmark for what the capital requirement is. That may not be silly. We look at it quite carefully and sometimes put add-ons in. The question then becomes very much: how long is this pattern of interest rates going to last, and what would be the effects, given the amount of forbearance that has built up, on a change in interest rates? That is the important question in terms of assessing the pattern of losses. Certainly, if you look at it straightforwardly at the moment, you would think this is a very benign experience for a system, but we know why. It is down to, quite deliberately, the impact of very low interest rates.

Q39 Mark Garnier: Quite. Of course, this raises a huge number of further questions. The first thing is I completely accept your point that if you have a very genuine reason, the bank would want to help their customers through the cycle, and that is quite understandable and a normal business approach. Nevertheless, what is slightly worrying, of course, is how many of those banks are helping the so-called "zombie" companies, not necessarily through a cycle but just trying to kick this problem further down the road. The second point is low interest rates. It is obviously that much cheaper for a bank to exercise forbearance than it would have been in a higher interest rate environment and, therefore, there are fewer day-to-day problems for them.

Andrew Bailey: Yes.

Mark Garnier: However that, of course, comes up with the even bigger risk, which is when interest rates inevitably start to go up at some point in the future. I have made this point in the past: we are in a super-low interest rate environment. If we return to a normal period of low interest rate environment we can see a doubling and a tripling of the cost of capital for these things. Do you not have serious worries about what is going to happen when interest rates start to pick up?

Andrew Bailey: Obviously, that is why it is important to apply what tends to be, in the jargon, called the "through the cycle" approach, because, you are right-and I think history tends to bear this out and certainly if you talk to the old bankers they will tell you this-the highest rates of company failures tend to be as you are coming out of the recession, as the forbearance ends and, as you say, as interest rate conditions tend to return, particularly in this environment, to their more normal pattern. It is quite interesting. I was involved, back in my previous role in the Bank, in the so-called London Approach that the Bank of England has done for ages, which is knocking heads together when companies get into difficulties with organising debt refinancing.

The banks all have this thing about good companies do not fail. They restructure them, but some business models just run out. They will tell you that it has not been particularly because of the debt side of the contract; it is that the rationale for the business model has run out. I go back to your question. We are very focused on the risks of a return, obviously, of the interest rate level and also, I should say, the way in which that happens. If you go back to 1994, I think it was, where you had a very sudden spike up in the slope of the yield curve, that was a quite difficult experience and going back to the earlier question, this is also relevant for the insurance industry. What happens over the long run when interest rates return to normal? That is one issue. If there is a sudden shift in the yield curve, what does that do? That is another issue.

Mark Garnier: It could easily happen.

Andrew Bailey: It could happen, obviously.

Mark Garnier: The other key point, of course, is we have been having this forbearance, potentially now, for five years and that in itself is pretty unprecedented as well.

Andrew Bailey: Yes.

Q40 Mark Garnier: Can I just turn this slightly from commercial real estate to residential real estate, which is also quite important. We have £1.2 trillion worth of household mortgage debt and £1.6 trillion worth of aggregate household debt, including mortgage debt, which, again, is pretty unprecedented, is it not?

Andrew Bailey: Yes.

Mark Garnier: They are very high levels. I understand that 40% of residential mortgages are now interest only and do not necessarily have a repayment plan alongside them. Twenty-five years ago, I suppose, in halcyon days when money was a bit tighter, a mortgage on a property was a savings scheme, ultimately. Now, 40% of people who own homes are not saving, effectively, because they are not going to pay off their mortgages. The first part of my question is what happens, when interest rates go up, to households, given that, to a certain extent, forbearance could be self-imposed by people going to interest-only mortgages, but, again, we may now have people who will be kicking that can even further down the road? Are we not just building up enormous problems for ourselves that we are not tackling today, and we are going to have to deal with them either when interest rates start going up or, probably just as importantly, when people start having to pay back these loans?

Andrew Bailey: I have a lot of sympathy with the point you make. One of the fascinating but, as you say, quite disturbing elements of this entire story is what I call the long-term intergenerational transfers that are going on and the effects of this. When I talk to new graduates at the Bank of England I say, "Look, I have bad news for you. You are going to be working for a lot longer than your predecessors." It is very interesting how-

Mark Garnier: That is an easy answer to the question.

Andrew Bailey: It is true, but it is a trite answer. What you are also going to see, as you say, is a pattern of indebtedness that is going to go on far more through people’s lifetimes and cause more problems for people than they did expect. That is one of the things that has been built in in the system.

Mark Garnier: Do you think we have a crisis facing us?

Andrew Bailey: I do not think we have a crisis today, but I think we have a very different pattern of behaviour and outlook from that we thought we had probably 10 years ago.

Q41 Mark Garnier: My last question. Do you think politicians are being chicken in terms of dealing with this potential crisis?

Andrew Bailey: This one?

Mark Garnier: Yes, the accumulation of debt.

Andrew Bailey: It would be trite and I would have to run out of the room quickly if I said you all have very short-term outlooks. You know this better than I do. I think, for all of us, it is always easier and more pressing to concentrate on the problem that is going to hit us next week than the one that is going to hit us in 10 years’ time.

Mark Garnier: However, if we do not think about what is going to happen in 10 years’ time, the problem then will be 10 times as big.

Andrew Bailey: Yes. It would be worth all of us spending more time on these issues to try and work out what we are going to face and what we are going to do about it.

Mark Garnier: Will this be part of your job?

Andrew Bailey: Yes.

Q42 Mr McFadden: We sent you some questions when you were asked to the session and you have written some very full replies. I would like to ask you a few questions about the document that you sent back.

Andrew Bailey: Certainly. I have a copy in front of me.

Mr McFadden: The second question was about your previous experience. At the bottom of the first page of the document you say you have experience in resolving failing banks and, "There are few better learning opportunities than to be responsible for resolving failing banks." In your experience in doing this, what are the main one or two things that stand out in terms of the lessons that resolving failing banks have taught you?

Andrew Bailey: As well as the obvious problems with banks that become under-capitalised and reliant on short-term funding, I think what you also see when you do resolution, because you have to get into the guts of institutions, one of the other things that I am afraid I think is a problem that is in the system-and this goes back to the long term problems and I am not singling any one of them out now because this is across the board-is that these are very big institutions with very complicated infrastructures. Broadly, they keep going from day to day and, of course, a lot of them have grown by acquisition-not all of them, but quite a lot of them-which has involved bolting things together. When you get into resolution you have to face, "Do we have to cut these things up? How do we deal with them? How do we keep things going when the institution is failing?" You realise the sheer complexity of dealing with these institutions and I think there is a legacy problem in there, there is no question about it, but you do learn a lot doing that. You learn a lot about how the basic infrastructure of these institutions works or does not work.

Q43 Mr McFadden: In the various reforms that have been put in place, ring-fencing, new capital rules, new resolution mechanisms and so on, do you think there is a danger of the public’s misunderstanding that these are about making sure banks cannot fail in the future. You stressed in the note that people should be wary of this misunderstanding and that the point of all this reform activity is not to make failure not an option, but eventually to make it an orderly option. Can you say a bit more about that?

Andrew Bailey: Yes. I think there is a potential to get a wrong message across-not that I think, by the way, the Commission has done this-that the ring-fenced bank is somehow risk-free and all the risk has been put outside the ring-fence because that is where you want all the risk. Of course, that is not the case. There are different risks. The whole point about it is having different risks inside and outside the ring-fence and being able to deal with and manage those risks separately, and potentially to be able to resolve things at the institution separately by virtue of having the split. Although, the history of UK banking tells us-as some of the critics of ring-fencing sometimes point out although I do not think it is a criticism of ring-fencing, they use it in a slightly self-serving fashion-that, of course, more of the failures in this country have come from failures of what ought to be fairly straightforward mortgage banks, for instance, than of complex trading books.

Q44 Mr McFadden: That is a communication challenge, definitely, and you refer to other communications challenges in this note as well. In question 7 on page 7 you talk about the interim FPC and we have had some questions this afternoon about the bank balance sheets and more capital for them, and so on. What do you mean when you say, "The FPC will need to consider its style of communication and invest heavily in building an understanding among the public"?

Andrew Bailey: I think that one of the successes of the MPC right from day one was to invest very heavily in explaining to the public what the objective was, what the MPC did, what it did not do, and to do this very rigorously. It was one of the reasons why both Eddie George and Mervyn King put so much emphasis on going around the country doing it and not just sitting in London doing it. There was a very determined campaign, which has gone on, to explain the objectives, the framework, the tools, and so on. Interestingly, first, I think the FPC has to do that. It is more complicated for the FPC. It is very interesting to compare the two.

Monetary policy is an analytically complex activity, but it does lead to a single decision. Obviously, at the moment it is a single decision on a different variable. It is a different lever from that used than in normal times, but it is still a single decision on an outcome. Sitting in the FPC is quite interesting because you have a lot of levers. There is a whole array of levers in the FPC that you can pull and you can pull them in combination. I think that is perfectly sensible. That is right, but communicating what we are doing, what we are trying to do, and why we are doing it, first, less of it has been done but, secondly, it is more complicated.

Mr McFadden: This is true of this alphabet soup in general, is it not? We have the PRA, the FPC, the FCA. You would have to be a pretty interested member of the public to follow what all these are and what they are for.

Andrew Bailey: Yes.

Mr McFadden: Do you think that is a problem?

Andrew Bailey: I am off to Belfast for the next two days to have a go, so I will tell you. I think it is a challenge, do not get me wrong, but I think it is a challenge we have to take on.

Q45 Mr McFadden: Jumping around a little bit, later in the document you talk about judgment-led supervision and so on. I am looking particularly, if you want to look at it, at question 12 on page 11. You talk about your experience with Barclays and about how there was, in what has become quite a well-known quote from you, "a culture of gaming the FSA" at Barclays.

Andrew Bailey: Yes.

Mr McFadden: Were they the only ones? Have you found other banks that had the same culture of gaming the system, of gaming you as a regulator?

Andrew Bailey: I think that they were furthest out, by some way, along the curve. I want to be careful what I say because I do not want to tar others with that sort of accusation. However, it is in the culture of a detailed rules system-and it goes back to the point I was making about remuneration earlier on-that you can get almost an orthodoxy of culture built up that if you can find a way around a rule, it is okay. I will give you an example. The first end year I was at the FSA was 2011. Bear in mind, the banks have end-of-years that are the end of the calendar year, and many of them have a sort of a capital ratio in mind that they want to sort of report to the world. What happened as we got towards Christmas, the model-change requests started coming in. I think I mentioned this last week. I am not going to use the word "outrageous gaming". If you create that sort of rules-based system and you do not apply an overlay of judgment, of course, all the incentives are stacked up to do that sort of thing.

Q46 Mr McFadden: You say this throughout the document. You talk about Europe having this huge harvest of data. Do you think there is a potential big mistake that regulators are going to make in the wake of the crisis, which is that, to cover their backs partly, they ask for more and more data and then, drowning in the data, they squeeze out the judgment or the governor’s eyebrows if you want to call it that. They squeeze out the essential smell test.

Andrew Bailey: To be honest with you, one of the biggest threats we face in what we are trying to do-I will be careful, because this point can come across as very anti-European-is there is a different sort of trajectory among many involved in the EU processes who want to create more and more rules, because they see that as the way to sort of-

Mr McFadden: Is it only the EU?

Andrew Bailey: In my experience, it is probably most extreme there because they are, in a sense, dealing with a different problem.

Mr McFadden: There is nobody in the UK asking for more and more data?

Andrew Bailey: I was meaning rules. The EU data requirements for banks in quite a few areas are 10 times our data requirements.

Mr McFadden: That is what you said.

Andrew Bailey: Yes. However, they are trying to solve a different problem, which is how you standardise across 27 countries. They are trying to discipline a process across countries. Frankly, I am deeply sceptical of whether you can do that by more and more rule-making.

Q47 Mr McFadden: I think we are coming to the end, but if I can just finish on this. You have heard a lot of discussions between other operations, the Banking Commission and so on, recently about new entrants and the desire for competition and the concerns over the concentration of the UK banking system. You made quite a pointed remark on this. It is at the bottom of page 14 and top of page 15, where you talk about greater competition, but it must be based on robust and sustainable institutions: "I want to see a more diverse banking system, but not at any cost." Are you saying there is a danger that, in our desire to see more players in this market, we allow weak institutions who will increase risk in the system to-

Andrew Bailey: The point I made there is an illustration from history. If you go back before the crisis, there were two things-in a sense, the UK has had a concentrated banking system for a long time- that led to an increase in competition in the UK banking system. One was the demutualisation of building societies and the other was the entry of some banks from other countries. Today no demutualised building society exists as an independent entity and most of them had a bad end. That was a model of competition that failed, so I do not want to repeat that model.

Mr McFadden: None of them survived.

Andrew Bailey: None of them survives today. There is no independent demutualised building society in this country today. Some of the foreign banks have obviously stayed, but we saw the Icelandic experience.

Q48 Chair: Just on the Europe point that you were making a moment ago, in your evidence on page 12 you make clear it is not just in the bonuses field that they are getting it wrong. You say, "I see a pressure to create more binding rules at an ever more detailed level and to use the so-called maximum harmonisation approach, which means that the rules set both the minimum and the maximum standards". You clearly do not like that. You then go on to say-you are pretty robust-"I do not see ever more detailed rule-making as a sustainable solution to the identified problems"-that is, the problems of banking and supervision, and the next part of the sentence is even more telling-"nor is it necessary to achieve the free trade objectives of the single market". You are basically saying, are you not, the EU should get out of some of this territory?

Andrew Bailey: We are trying to apply what I call judgment against a framework of rules. There have to be rules because clearly our actions have to be, firstly, defensible and, secondly, predictable, but there is judgment in there. I think the danger of going down the "ever more rules" approach is that it does not work in the end. It falls over under its own weight. There is a huge pressure at the moment in Europe on this. It is quite interesting that a lot of the debate on the banking union in this country is about the UK position vis-à-vis the banking union.

I am on the management board of the European Banking Authority. When you sit there what you see is a different debate, which is what I call the pressure from the single market institutions and the European Commission to make rules to hold the single market together against authorities involved in supervision like ourselves-and maybe as the ECB will become when it is the single supervisor in the mechanism-who are trying to use judgmental supervision to achieve financial stability. That is a real tension. That is the biggest tension I observe at the moment, not the tension between us and the ECB. There is not a tension between us and the ECB. It is the scope of rule-making, and the reason I say this, I do not think the problems that beset the single market are banking supervision problems. They are, at root, macroeconomic problems.

I do not think you can use rule-making and banking supervision to solve those problems. You have to solve those problems through other actions. There is no question that the single market is fraying. There is absolutely no question. I hold my hand up. We are doing it and others are doing it. We have to take certain defensive actions to protect our statutory objectives and to protect the users of the banking system in this country. That tension over rule-making is a big one.

Q49 Chair: It is a very interesting point. You are also making the point, are you not, that they are going beyond what is required to complete the single market?

Andrew Bailey: Yes.

Chair: You might be reluctant to do this, but it might be helpful if you would be prepared to set down on a piece of paper what you think the minimum necessary areas of EU activity are for completion of their objectives. Then, maybe alongside, you could list the things that you think fall outside that are currently being undertaken.

Andrew Bailey: Yes. It is also how far you drill down through all this. It is not necessarily, "Do you have that thing in or out?" It is also how far you make the rules themselves drill down. I will have a go.

Q50 Chair: Thank you. If we turn to page 14 of your evidence, just a bit higher up from the point at which Pat McFadden was asking you questions, you discussed the PRA veto of SCA activity. This is what you describe as an entirely hypothetical scenario. I presume that is put in because you want to make sure people do not mistake it to apply to PPI?

Andrew Bailey: Absolutely.

Chair: Do you not think that this power, when exercised by the Bank of England, whoever it may be in the Bank, is going to be seen as a criticism of the FCA and, therefore, weaken the FCA as an institution?

Andrew Bailey: No. I will give you an example that could have happened in the past. I can see a situation where the FCA say, "Look, this is what our statutory objectives tell us we should do". It is interesting about your role in this. Rather than have some sort of smoke filled room deal between me and Martin Wheatley that we then sort of do not reveal to you or only partially reveal to you, it may well be better for both the FCA and the PRA if at that point the veto is used transparently. I do not think that would be a failing of the FCA because I think the FCA would be saying, "Our statutory objective leads us to this conclusion", and the PRA says, "Our statutory objective, I am afraid, leads us to have to say we cannot do that". The case I am-

Chair: I am sorry to interrupt. In that case we would need some kind of requirement on both institutions, should there be pressure that they consider amounts to serious consideration of the veto, for that to be raised with the Treasury Committee.

Andrew Bailey: Yes, we should be completely transparent to you.

Chair: You think that would be appropriate?

Andrew Bailey: Yes.

Chair: We would need that prior to the moment at which the veto is exercised.

Andrew Bailey: I do not know. I would have to think about that. That is an interesting question. Let us assume this regime was in place at the time, which it was not, if you remember the legal action on overdraft charges that was back in 2008, I think. I am not revealing anything that is not in the public domain. Had it gone the other way, that could have led to a bill, in terms of the cost to the banking system, that was, in some estimates, sufficiently large that it would have raised a financial stability and prudential issue; particularly, of course, given the state of the system at that time. Had that all come to pass and had we had that regime in place, I think that is an occasion in which the veto could have been used. The interesting question in that is, what would be the effect of using the veto? It may well be to say, "Look, we understand there is this amount of redress. We are going to have to deal with this over some period of time because, otherwise, we are going to have adverse consequences for the stability of the system that are too large to manage in the alternative way".

Chair: This is an interesting example because it is an industry-wide example.

Andrew Bailey: Yes.

Q51 Chair: Do you not think that in judgments about the whole industry, and indeed generally, the better place for the judgment to be made is the FPC rather than the PRA? Have you not just made the case yourself, by drawing an example for the whole industry rather than an individual institution?

Andrew Bailey: Yes, I think that is a case in which the FPC would have had to consider that in the context of its statutory objectives.

Chair: We have proposed this, as you know, and the Government have batted it away. It will be interesting to see what you think about it.

Andrew Bailey: I am trying to think at the moment, if we had this current system-it is an interesting question. The PRA on its own has the mechanisms for dealing with it, so you might say it does not need the FPC to intervene because it would draw the conclusion anyway. The FPC, however, in its consideration of risks to the system, had it been-I am not saying its institutional architecture was in place then and of course, it was known in advance that there was the risk because obviously, the court case was going on. I do not think you need to change anything in the current institutional setup for the FPC to be able to consider that.

Chair: The question is: where does the authority lie for the exercise of the veto?

Andrew Bailey: It lies with the PRA.

Chair: I know, but I am asking you whether you think it should lie with the FPC.

Andrew Bailey: I do not think that is a problem. I do not think the FPC, in the current environment, could give the PRA a recommendation or a directive to use the veto.

Chair: No. I am asking you whether the veto, if there is to be one, should lie with the FPC.

Andrew Bailey: I do not think it has to, no. I think the PRA can use the veto-

Chair: Might preferably lie with the FPC.

Andrew Bailey: I think that is a bit difficult because I think that you have to combine both a sort of system-wide impact and an individual institution impact. Yes, maybe this is coming at the same issue from two different sides. I would be quite happy-this is how the system works-for the FPC to give a system-wide view to the PRA and say, "You should be very concerned about this." What the FPC cannot do is say, "And you should be concerned about institution X because that is outside the FPC’s remit".

Chair: Thank you very much for your typically frank and thoughtful evidence, like the written responses to our questionnaire. The Committee is very grateful.

Prepared 27th June 2013