CORRECTED TRANSCRIPT OF ORAL EVIDENCE To be published as HC 606-i

HOUSE OF COMMONS

ORAL EVIDENCE

TAKEN BEFORE THE

PARLIAMENTARY COMMISSION ON BANKING STANDARDS

JOINT COMMITTEE

BANKING STANDARDS

WEDNESDAY 12 SEPTEMBER 2012

SIR DAVID WALKER

USE OF THE TRANSCRIPT

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

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

Oral Evidence

Taken before the Parliamentary Commission on Banking Standards

Joint Committee

on Wednesday 12 September 2012

Members present:

Mr Andrew Tyrie (Chair)

The Lord Bishop of Durham

Mark Garnier

Baroness Kramer

Mr Andrew Love

Mr Pat McFadden

Lord McFall of Alcluith

John Thurso

Lord Turnbull

Examination of Witness

Witness: Sir David Walker gave evidence.

Q1 Chair: Sir David, may I welcome you to the first hearing of the Banking Commission? We are all very grateful to you for coming to give evidence this morning. I think that I should mention that you come here in your capacity as one of the country’s leading experts on corporate governance and, until very recently, a specialist adviser to the Treasury Select Committee. You are not here in your Barclays capacity, which you took up only on Monday, I think, and you will not be taking up your formal position as Chairman until November. It is against that background that we would be grateful for your answers, which means, of course, that I hope you feel less restrained than you otherwise would. This is perhaps your last opportunity to be unrestrained, or less restrained.

You have seen a lot in the City and in financial services over many decades, so can I ask you to start by giving us a sense of just how bad the standards problem is?

Sir David Walker: I think it is very serious. Standards have slipped in a grave way, and I would be very happy to talk about the way in which they have slipped and why they have slipped. I want to give some perspective, which I think is important, to all the remarks that I anticipate making. One thing I would do, if I may, in the presence of this Commission is give a sense of historical perspective.

I noticed in some remarks made in the City the other day that there was a yearning for the "good old days" when standards were impliedly higher. My proposition is that standards are not what they ought to be now, but I don’t say at the same time that I think standards were satisfactory in the past, because in many respects they were not. If you go back 25 or 30 years, banking was inefficient in a huge array of ways. The whole City was-I think I would use the word-tainted by what we would now regard as clear malpractice. Before the Companies Act in 1985, insider trading was quite widespread and there were preferred syndicates and so-called baby syndicates in the Lloyd’s insurance market. By the standards of today, there was effectively no real regulation of the City.

What is particularly important is that the array of services provided by banks-I will focus on banks back then-was extremely small and limited compared with what it is now. A consequence of the wide array of services provided by banks now-which is almost certainly as wide as those provided to retail and SME customers by any banking system anywhere in the world-is that the points of contact between the banks and their customers are hugely increased. The array of interface is much larger, so the possibility of, and potential for, dissatisfaction or problems is greatly increased.

I just want to make one other observation about history, because it is very relevant to the capability and readiness of banks to provide credit, which is of great concern now. In the years after the North sea oil exploration began, the banks, without exception, were extremely reluctant to provide credit for that major new area of economic activity for this country. It was only on the basis of an intervention which was done discreetly, confidentially, but very effectively by the Bank of England-by the then deputy governor-that the banks were brought into the North sea business at all. There was much wrong with banking 25 or 30 years ago.

One other observation I would like to make, which is relevant both to the past and the present, is that while there is much to be repaired, it is really important to be clinical and forensic about what is wrong-about the diagnosis. The things that are really striking-I will give two examples-are the unintended consequences of measures that are taken. Of course, some unintended consequences can be very positive, but some can be very negative.

I will give two examples of negative unintended consequences of measures which, at the time, seemed eminently sensible and desirable. The first-I think, Chairman, I have mentioned it to you in the past; I attach very great importance to it as an element in what has gone wrong in the last few years-is the abolition in 1985 of a thing called the maximum commissions agreement, which most people, perhaps even those on your Commission, won’t remember or know about. When the maximum commissions agreement was abolished-there were good reasons for not having administered prices: it was illiberal, and all those objections-it was open season to sell bad products on the basis of unregulated commissions. If you had a bad product, all you had to do to distribute it was to increase the rate of commission up front and the rate of trail commission. That happened over a very long period of time. In a way, we are only now getting rid of the problem of inappropriate incentivisation for the sale of bad products.

Q2 Chair: Through RDR?

Sir David Walker: Through the RDR, which, no doubt, we will come to later.

The other example-which is, in a way, more extreme-which has a lot to answer for and has infected retail and certainly investment banking, is something I imagine many members of the Commission would have thought was a very good initiative. I certainly took that view at the time, because it was under the rubric of transparency. It was that we should have more reporting of company, including bank, performance on a quarterly basis. The introduction of those detailed obligations for quarterly earnings announcements has been a very powerful influence on behaviour in a direction which I think is quite inconsistent with the sort of sustainable medium to long-term behaviours that we want to see.

Q3Chair: That is a point that Professor Kay makes in his very interesting reports on equity markets.

Sir David Walker: I think what has gone wrong is serious. I would just like to say, before I come to listing my observations, that I have looked back at my 2009 report on corporate governance and I am struck-not embarrassed, but certainly struck-that I didn’t talk much about culture or reputation. Those are the issues that are of most prominent concern now. The reason that I didn’t talk about reputation, culture and conduct at that time was because the biggest issue then was the survival of banks-how they stayed out of taxpayer support or how they survived at all, in some cases. That is why my recommendation focuses in particular, but not only, on approaches to market, credit and counterparty risk, and hardly talked at all about reputation risk or culture. It is obviously the case that as those issues in relation to market, credit and liquidity risk are being addressed-whether satisfactorily, you may wish to discuss, but they are being very fully, comprehensively addressed-attention is now focused on these other issues, which were overshadowed by the problem of financial stability. These other issues are, as I said at the beginning, and as the Commission would expect, very serious.

If I could identify three strands that I think have been very negative, I think that the inducement given to sales of inappropriate products by the growth of this commission culture has been very damaging. If I could fast-forward to the present, I think it is very important that we see change in remuneration practices that gets away from remuneration of individuals being tied to revenue performance or sales, and the RDR is one way in which that is being done.

Secondly, in the very-perhaps I could call it go-go atmosphere before 2007-09, when everything seemed to be going up, and Governments and central banks, which were being expansive, as well as boards, employees and shareholders, were all supportive of the seemingly unending phase of good times, I think that there developed a quite irresponsible approach to increasing business performance by improving market share. One of the things that happened was that banks which wanted to improve their market share in particular areas of business were able to do so. I cannot speak for other retail businesses, but certainly in banking it is very easy to improve your market share if that is your objective: all you have to do is to forget to price risk into the charges you apply. If you don’t price properly, with an appropriate risk adjustment, you can achieve a very substantial increase in your market share in a short period of time. That is the story of at least one, but probably several, of the British banks that got into the most severe trouble between 2007 and 2009.

There was inadequate regulation throughout this period. It is true, and really was the case, that the FSA placed a huge amount of attention on treating customers fairly. My own sense of that is that they were much more concerned with the financial stability issues of capital and liquidity, particularly as the crisis broke, and some of the "treating customers fairly" stuff failed to get adequately to the heart of the problem. We have talked about the RDR, and my observation about it-I feel very supportive of it, though when implemented, it generates unintended consequences-and my main criticism of it is that it came 15 or 20 years too late.

The last thing I would want to say, in talking about these failures in banking and the decline in standards, is that we had, alongside the go-go phase that I described, enormous advances in technology. Among other things, and coupled in particular with the short-term horizons that became pervasive, partly because of the quarterly earnings but partly also for many other reasons, we had a sense not only that everything could be done much more rapidly, but that response times needed to be shortened. I think we had a phase-this is perhaps a way of characterising the last 10 or 15 years-when ingenuity, speed of response with new products, and innovation, all of which are a "Good Thing", rather overtook concern about integrity. I am not saying here that there emerged a new phase of greed or avarice or selfishness, but I think that, on the scale of priorities for banks, making quick returns on the basis of what was facilitated by rapid technological change-keeping abreast of your competitors-rather overtook the rather old-fashioned concerns about standards. That is the story.

Absolutely lastly, but I am then very happy to enlarge: you did not ask the question, Chairman, but it is one that I will want to address-are these failures of culture and conduct reparable? My answer is affirmative.

Q4 Chair: That amounts to an extremely interesting opening statement. We are very grateful to you for it, and I know that colleagues will be picking up on a number of points. Before they do that, I just want to ask you about one area that you did not discuss, or scarcely touched on, which was the free-in-credit model that retail banking has operated on. Do you think that that model has had its day, and is it responsible for some of the poor standards?

Sir David Walker: I do think that it is responsible for some of the poor standards; whether it has had its day, I am unsure. But perhaps I can say first why I think it is responsible for some of the ills that afflict us. I think it is unattractive for several reasons. One, it involves concealment-there is a lack of transparency in free-in-credit banking, because of course customers of banks pay for the banking services that they utilise, but they do not know how they are paying, so there is a lack of transparency about the way in which these services are being paid for.

There is unfairness, because actually, these services are being paid for quite often not by the people who are in credit, but by the people who are borrowing from the banks, who probably-it is very hard to be absolutely certain about this-are paying more for their indebtedness-the credit that they have been extended by the bank-as a consequence of those who are in credit not paying for the services that they are achieving. So there is a lack of transparency and a lack of fairness.

I think there is, very specifically, an inducement to the banks to recoup what they are not getting through fees for banking services very directly-from the in-credit customer who is perhaps not using other services-by devising ancillary products, which are an alternative means of generating fee income. That is very important in a low-interest environment, where interest income is much harder to achieve at the rate that was achievable 10, 15, 20 years ago, when we had higher inflation and higher interest rates.

So the lack of transparency, the lack of fairness, and the incentive given to the banks to find ancillary products, some of which pressure explains some of these unattractive products, which unjustifiably-but I have given you an explanation-were introduced by the banks-such as PPI, and, earlier, the inappropriate selling of life assurance, endowment policies, and so on-that will persist. The reason I hedged in response to your question, "Has it had its day?" is that it is very difficult to see how the banking system "gets out of it." To make one very clear observation, it is not possible for the banks to talk to one another about this, because that would fall foul, our general counsels advise, of the competition rules.

Chair: Well, the Commission might be able to help on that, and maybe we will find a way.

Sir David Walker: There is a problem there.

Q5 Chair: Does the bank account portability model offer something?

Sir David Walker: Can I come to that in a moment and just say a little more about free-in-credit banking? It is not only difficult for the banks to talk to one another about it; it is, of course, improbable-extremely unlikely-that any individual bank, however strong its feelings about this, is going to incur first mover disadvantage. My own view is that it is hard to address the problem of free-in-credit banking from within the private sector. I think, for the Commission or the public sector, there needs to be some policy initiative to address it. Perhaps the work that is in train under the OFT is a way of completing the inquiry on all that.

Q6 Lord Turnbull: I think you have answered the questions that I was going to give you, Sir David. On the question of the endowment effect, I can remember that in my days in the Treasury we used to say, "If interest rates fell below 5%, how on earth would banks run their branch networks?" They have been stuck in this low interest rate environment for some time, so even if you dealt with the free-in-credit problem, you would still have the problem of the lack of endowment and low interest rates.

Sir David Walker: Yes.

Q7 Lord Turnbull: I think that prompts another question, which is that, somehow or other, the politicians, who have rigorously defended free-in-credit banking, have to give a licence to people to start talking about an alternative.

Sir David Walker: Yes. I want to be clear that, while I feel that these concerns about free-in-credit banking are serious, I equally recognise that the man in the street-the customer who is enjoying free-in-credit banking-does not want to pay for it; he does not want to lose free-in-credit banking. This is very much like the RDR problem, which we may come to, Chairman, where, as a result of what has now been done, advice of a high standard will only be available to individuals if they are ready to pay a fee for it. Of course, that is a problem because most people are probably not ready, in the short term, to pay a fee for advice. So we have the problem Lord Turnbull identifies, that the banks will continue to be under pressure to find alternatives to what used to be fat interest-margin income by generating new forms of fee income. That leads away from the free-in-credit banking question to the question of how we, as bankers, regulators and society, are to be satisfied that the ancillary products, as I think Adair Turner called them, are suitable for people. That is a large question, from which other considerations arise.

Going back to unintended consequences, Lord Turnbull, I would say that most good things that happen, like the fall in inflation, and the fall in interest rates that was concomitant, or consequent, to it, do have consequences, not all of which are benign.

Chair: If we are not careful, we are going to run short of time. I implore colleagues to be brief in their questions, and if you can, Sir David, find a way of saying the same things-even though they are extremely interesting-in slightly fewer words, we would be extremely grateful.

Q8 Mark Garnier: If I may turn to the role of shareholders in corporate governance, is it not fair to say that the most effective way shareholders have of being involved in corporate governance is that if they don’t like the management of the company, they simply sell their shares?

Sir David Walker: That is a way in which shareholders can signal their dissatisfaction. If the question is a normative rather than a positive one-is this a good response, in a wider, societal sense?-my answer is negative.

Q9 Mark Garnier: But the reality is that there are huge incentives for shareholders to get performance for the funds that they are running. At the end of the day, with the short-termism we have been having in the stock market, and given that the only way that investment managers get funds under management is by short-term performance, the entire system seems to be set up in a way that is completely opposite to what you need in terms of shareholder involvement.

Sir David Walker: Mr Garnier, I very substantially agree with you. The John Kay report does address this issue. There are one or two things that I would pick out of that and attach particular importance to. I do think that, in many ways, the shareholders-we need to be clear who we are talking about, but I will come to that-are, for the very reason you say, quite an important part of the problem, and were a source of some of the problem before 2007 and 2008. Shareholders liked short-term performance, and of course were responsible in many cases for encouraging banks to leverage up and manage their balance sheets efficiently, which was catastrophic in some cases.

The specific suggestion that may be helpful in this area, which builds on what John Kay proposed, is that we need to go behind the people to whom you refer-the fund managers who manage most shareholder money-to the shareholders, the ultimate beneficial owner. A proposal that I would submit to the Commission as worthwhile, particularly in relation to banks, although one could not perhaps confine it to banks when one is talking about how shareholders view responsible stewardship, is to create a greater sense of obligation about stewardship not in the fund managers, but in the ultimate owners. Best practice for ultimate owners-pension fund trustees, for example, are very important and there are many other significant beneficial owners-is to set standards for the way in which they want their fund managers to behave. I will give one instance of this.

If I were a beneficial owner now, I would say that best practice for me is to say that I would not put money with a fund manager who did not have a capable and dedicated corporate governance capability, by which I mean a capability with which the chairman of a bank or the chairman of any board can have a conversation without being impaired by the insider problem-someone who is a buffer between the investee company board and the beneficial owner. Not enough, even significant fund managers, have a corporate governance capability. It costs money.

Q10 Mark Garnier: It sounds like an interesting concept. Clearly, where you have a large financial institution the collective fund manager may own a significant stake of an institution, but spread across the sub-funds then each one is fairly small. You have different fund managers so you have a disjointed approach. Indeed, within those funds you may also have a disjointed approach. You may have a short-term investment trust seeking short-term returns, which owns the same shares in a company as a pension fund manager within the same institution, who is looking at the much longer term. I appreciate your point that you could then draw together a corporate view for the institution to do that. But as you so rightly point out, this will inflate costs on to the fund manager, which have to be passed on to the consumer. Do you think that is an acceptable cost?

Sir David Walker: Fund managers are very attentive to costs. I don’t think the costs here are necessarily very high. But I just want to revert to my proposition. It is for the beneficial owner to determine what the institution wants. If you are a beneficial owner and your interest-perhaps I could move away from pension funds to someone like a sovereign wealth fund. One of the problems we have is that so much of the UK-the FTSE 100 companies are now owned abroad by foreign beneficial owners. If your horizons are naturally long term, then I think it is incumbent on you to ensure that you choose a fund manager who works to your horizons and is not a short-term switcher. You don’t put money, for example, with a high frequency trader. That is pretty obvious.

Q11 Mark Garnier: Sure. You made a speech in May last year to a forum of sovereign wealth funds talking about this point and asking whether they would play an enhanced stewardship role. How well do you think that speech was taken? Have you seen any evidence that they have heeded your words?

Sir David Walker: Some. But not enough. It is a long slow process. I think, Mr Garnier, if I may say so, it is perhaps wider than your Commission would wish to be involved in. There is a wide discussion which I think is really important about how to get sovereign wealth funds, which now have 14% or 15% of UK equity, more engaged in sustainable investment, as distinct from short-term switching. I think the focus should be on our UK entities.

Q12 Mark Garnier: But who do you think from the UK should be engaging with the sovereign wealth funds in order to build on that?

Sir David Walker: It is a difficult question to answer because most of them are extremely resistant to public policy pressure or influence because, after all, in the UK and above all in the United States they were under a lot of pressure when they were building up, not to be seen as arms of their sovereign Governments. You will remember the Dubai Ports affair and so on. So many of them are extremely sensitive to being commercial and not subject to sovereign pressure either at home or in the host country where they are investing. So my answer to the question, which is tentative, preliminary and cautious, is that I think it would be really salutary to boost the engagement of the Financial Reporting Council, which has done a lot of work on stewardship. I think this tallies with the views of Baroness Hogg, who is trying to work in that area. The more encouragement they can be given to work on sustainable investment horizons-that is an important means of tackling this pervasive problem of myopia.

Q13 Mark Garnier: If I may briefly turn to the so-called shareholder spring that we saw earlier this year, interestingly, although we corporately here in Westminster welcome the fact that shareholders were taking an active interest in the management of companies, what seemed to be going wrong was that it was always focusing very much on the remuneration element of that. There are two things, scratching below the surface. The first is that it highlighted the fact that people are very fed up with the remuneration packages; we will come to that later in this evidence session and that particular point will be picked up. Secondly, when it came to talking about financial institutions, it demonstrated that the utter complexity of these organisations is such that it is far easier for shareholders to pick up on something relatively simple to identify rather than getting into the really complex elements of a financial institution, which is actually where you really need the shareholder intervention.

Sir David Walker: I agree with that observation. There are just two very quick things, bearing in mind the Chairman’s admonition. One is that in the remuneration space in banks, the problem that I think has been most serious is not so much levels of remuneration as the gearing of remuneration to revenue. I gave the instance in the retail bank of this preoccupation with bonuses linked to sales. That has almost disappeared now, but perhaps we can talk about that later. The preoccupation with short-term revenue performance in the investment banks has been, in my view, hugely damaging, and we are moving away from that.

My second observation concerns the shareholder spring. Like other springs that have happened, one could ask, "Why did it take them so long?" and one possible explanation or excuse is that they were not provided with the right sort of information. In my 2009 report I made it clear that I thought it was unsatisfactory, and in some ways a perverse incentive, that the only regular statutory requirement for information about remuneration was for executive board members. Certainly in the investment banks, many of the executive board members were commonly paid much less than the traders, which is why I would recommend-I hope that we will soon have progress on this; it is one of my recommendations that has not been implemented-that there should be made available to shareholders bands of remuneration of the top 50, 100 or whatever. The detail can be worked out, but that is something that I think requires a significant, clear public policy push.

Mark Garnier: May I ask one final question?

Chair: A quick question and a quick reply.

Q14 Mark Garnier: You hinted earlier at the perverse incentives that you may have with shareholders intervening, where they can get the wrong thing. I would use the example of Lloyds bank, which prior to the crisis was deemed to be an extraordinarily dull company because it was not revving up its balance sheet and it was not being very aggressive. As the chairman of an investment committee we held positions at Lloyds and the other banks, and we were incredibly disappointed with Lloyds bank. Clearly, however, Lloyds bank was the good manager right up until the point when they bought HBOS. The fact is that there was a lot of City intervention coming in and asking, "Why are you not revving up your balance sheet?"-as it turned out, the question was, "Why are you not running your company badly?"

That is always going to be the case, isn’t it? Even if you have something as simple as a property company, in a rising property market you want to have a highly leveraged balance sheet and in a declining market you want to have no leverage at all. The shareholders will always be encouraging the companies they invest in to be taking advantage of the cycle, which is not necessarily the same thing as prudent management.

Chair: That was not a model quick question. Let’s see whether we can have a model quick reply.

Sir David Walker: I share your concern. The problem of myopia is massive and pervasive, and we have to do all we can to tackle it at every point. There is no silver bullet. One thing, if I can presumptuously exhort the Commission to do this, is to talk in the battle against this about sustainability, because that is part of the problem of banking. We have great focus on sustainability in relation to the environment, carbon emissions, forests and green belts, but we need to talk about sustainability in these respects.

Q15 Lord McFall: Sir David, good morning. My first question is about the integrity of the banking system itself. I have reflected on the companies that did not take state aid a few years ago, such as Standard Chartered, HSBC and Barclays, which have now got into terrible problems. I just wonder whether this is an endemic problem for all big banks. How far do you think it is possible for the board and chairman to know what is going on in these massive organisations? After speaking to people at the top, I felt that they were trying to do a good and decent job, but we now find a mess underneath the system.

Secondly, how deep do you think we need to go in terms of the layers of management to get the right kind of cultural change that you and others are advocating?

Sir David Walker: I’ll deal with the first question as fast as I can. The second one requires a longer response. The question about the capability of boards to get hold of this stuff-to use a simple term-is partly a question of the quality of the individuals who sit on the board. Non-executive directors have to be up to the job. If the question is whether there are non-executive directors who are capable of doing it, my answer is affirmative, but non-executive directors are not capable of doing this unless they get much better support from within. It should not just be management information thrown at them in a telephone directory, but guidance, access to independent advice and so on, and spending more time as independent directors than has been widely the case in the past. I think these bodies need to involve much more challenge in the boardroom than has often been the case in the past.

There is a rather British thing that sees challenges as discourteous or perhaps not the way that you should behave. I should perhaps not be saying this in a parliamentary setting, where challenge is much more common and frequent, but a boardroom that does not have challenge is unlikely to get to the right answers, so we need a much more challenging boardroom environment. It is not easy, but I think it can be done and there are instances where it is clearly being demonstrated. There has been a great improvement in awareness of the issues and what it is that boards need to address.

Turning to culture, I have been-I hesitate to use the word schizophrenic-two-minded about this. At one level, changing culture is a profound thing from the top to the bottom of the organisation, because if you don’t change it at the bottom of the organisation, it is hard to say that the culture has really changed. Cultural changes can tend to happen over a long period of time. However, in the present environment, there is an important question about reparability. Can the present cultural changes be accomplished rapidly? My pretty confident answer is, "Yes, and of course they have to be." The reason my answer is confident is that, in the recent past, boards of banks have just not been focused on culture. As I said, I did not focus on culture. In 2008-09, they focused on survival or how to avoid taxpayer support or whatever. Now, because of all the things that have bubbled up to the surface-perhaps they were always there, but are now much more evident focuses of concern-there is a new focus on culture.

What needs to be done first is that in the boardroom-where you started, Lord McFall-there needs to be a clear statement of values. Most banks actually have them, but the problem is not with the values but how they are embedded from top to bottom. A clear statement of values is relatively straightforward to accomplish, but what needs to be and can be done pretty briskly is to have a mandate, an edict, a fiat that says to the whole organisation, "If any one of the 150,000 people"-I instance the organisation to which I have recently moved, Barclays-"feels in any decision that he or she is taking in relation to client or any other matter that there is a choice between short-term profit and reputation or conduct, it is very clear where priority should be given." So we need to say that very strongly at the top, and to say that reputation, culture, conduct, is to be the driver and profit comes second in any choice. Of course, these are ideally complementary.

What specifically needs to be done? I would start with changing the remuneration structure. Inappropriate incentivisation is accountable for a lot of what’s gone wrong. I do want to say here, Chairman, that it is very unfortunate and very unfair that the large majority of cashiers on the front line in the retail branches of retail banks are branded as tainted or unsatisfactory or having inadequate culture, when in the case of most of them, that is palpably not so. They were responding to a totally inappropriate incentivisation. People down the line, if they are incentivised to sell a £10,000 loan rather than a £5,000 loan, and they get a bigger bonus if they do a lot of them-don’t be surprised if they do that. People do respond to incentives. We need a performance evaluation system that pays much more attention to people’s behaviours. Just as behaviours matter much more in the boardroom, they need to matter all the way down the organisation. We need disciplinary processes in place that are seen to be effective, complemented by good whistleblowing arrangements.

Can all that be done, and quickly? My answer is a resounding affirmative. If I may say so, if I didn’t have confidence about that, I think I would have been very unwise to take on the role I have in one of the major banks.

Q16 Lord McFall: On the question of the role of chairman or chief executive-or, indeed, of supervisors-how confident would you be that nothing untoward is going on in a part of an organisation? Given the huge banking edifice, it is very hard for one individual to know that, but we have seen these nasty surprises coming up in the past few months.

Sir David Walker: If the question is, could there be nasty surprises in future, I am afraid the answer is yes. It is very hard to devise a total failsafe arrangement. We’d reduce banking, which is a hugely important commercial activity in this country, to a barren desert. What one has to do is not have situations like one I was told about-not in the organisation to which I have gone-where a particular misfeasance and failure of conduct and culture was drawn to the attention of a middle level compliance officer, and he was sat upon by the business unit head, who said, "No, no, we have to go on doing this, because otherwise-it’s our P and L target". It is open to the board to change those attitudes and behaviours. Whether you do it universally, all the time, to everybody-perhaps not. But you can do a lot.

Q17 Lord McFall: The G30 paper, "Towards Effective Governance of Financial Institutions"-you were the vice-chair-included the following statement: "Management needs to strengthen the fabric of checks and balances in the organization. It must deepen its respect for the vital roles of the board and supervisors and help them to do their jobs well. It must reinforce the values that drive good behaviour through the organization and build a culture that respects risk while encouraging innovation." How would you anticipate boards putting that wise recommendation into practice?

Sir David Walker: I come back to a word that has caused disturbance to some, which is, "challenge". Boardrooms have been too reactive and passive. Boards, driven in many cases by a concern about short-term P and L and the quarterly earnings announcement, have in my view been too passive and accepting of what was proposed by the executive. This doesn’t mean that the executive is necessarily wrong; the executive has a responsibility for proposing a strategy. But I hope that in the future-and there has been huge change already-more boardrooms will be much readier to challenge what executives propose against yardsticks like, "What is this doing not only for our market risk, our credit risk, our operational risk, but for our reputational risk, as well as for the P and L?" It is not hyperbolic exaggeration to say that that atmosphere is now much more pervasive, highly desirably, than was the case as little as five years ago.

Q18 Lord McFall: On the point you made about culture, reputational risk and ethics, do you think there is much work to be done on that issue yet?

Sir David Walker: Oh yes. It is relatively straightforward, but very important, for there to be values at the top of the organisation and emphasis given to them, as we all obviously know. How they are embedded from the top to the bottom of the organisation is the challenge. This was very evident in another place where I think standards have been very greatly improved. I am not close to it now, but on the Woolf inquiry into the defence industry, in which I was involved along with the former Lord Chief Justice, it was quite difficult to decide what the standards ought to be. The embedding of them was really difficult. I think the chairman and board of BAE Systems would now say they had accomplished it. They set a target of a very short period of time in which to do so.

Interestingly, I heard an observation at a social dinner event very recently. Someone who had been closely involved in that company said to me, "You have done a great deal to undermine the profitability of this great British company." Of course, what he was actually saying was that now that great British company had appropriately high standards and had got the balance right, and I felt rather gratified, frankly.

Q19 Baroness Kramer: May I follow up on the issue of culture and reputation? As you rightly highlighted, it is at the crux of a great deal of what we are looking at in banking standards. I am interested in your comments about the way boards are redirecting themselves to tackle the problem of taking on unreasonable risk and avoiding abuse; but to the public at large the underlying role of banks is providing credit to the real economy.

To what extent is that embedded or part of the culture, as you now look at the banking system in the context of so many small businesses declaring that they are finding it impossible or very difficult to access credit? The Government have gone through programmes such as Project Merlin, guarantees, and now funding for lending, and essentially we find that the banks are quite capable of gaming that, rather than achieving the goal of putting money out to small businesses and others in the real economy. How does culture change work with that? Or are we just naive in expecting this to be part of the culture?

Sir David Walker: I am not sure how far it ought to be part of the culture. I say this because there are two separate strands. One was the sense that if I approach this from the standpoint of Main street, which is the retail customer-the SME you refer to-they were justifiably massively critical of the failure of the banks to know how to run their own business. That was the financial stability problem. They made massive errors in mispricing risk, having inadequate liquidity, and in some cases almost negative tier 1 capital in 2008-09.

Those problems are being addressed, but what are the consequences of those problems? I am thinking of competence within the banks, but in particular Basel III and CRD IV-the regulatory stuff that is improving liquidity ratios, quality of capital, capital ratios and reducing leverage. All that is happening, but a consequence of it is that the banks are having to think much more critically about their balance sheet, the size of the balance sheet and the quality of the balance sheet.

The banks are now being much more demanding before they take on any new credit exposure. In a way, this is rather an unkind way of putting it. You cannot have it both ways. We are trying to do two things simultaneously: improve the quality of bank balance sheets, which almost certainly needs to be accompanied by a shrinkage in bank balance sheets, and at the same time we wish to see a revival in the economy, for which there is no recipe that does not involve more credit. I think the answer is that where SMEs, for example, have a good track record and a good business plan, they are able to get credit, but many of them do not meet those tests. That is tough.

Q20 Baroness Kramer: This is probably a discussion for another day, but I think you will find a lot of question marks about that final statement you made. I am interested to know the extent to which the banking culture from the top asks whether we should reorganise or change the way we function so that we are more capable of recognising bankable propositions as they come to us. But let’s park that for a minute.

Sir David Walker: May I just comment on that? It is not the case that all or perhaps much of the squeeze on balance sheets is being focused on lending to SMEs. That is not the case. All I was observing is that the standards that are being applied are necessarily high in this new regulatory environment. Businesses that are being cut out, particularly in the universal bank, are businesses like the commitment of capital, which can be very high and is very high in the new environment, to activities like proprietary trading. They are being cut back very significantly, partly because proprietary trading is not going to be allowed, but partly also because the capital involved in what is allowed is very substantial. It is not the case that lending to SMEs or that type of credit to individual small businesses is bearing the brunt of these shrinkages in bank balance sheets or the reduction of leverage. That is not the case.

Q21 Baroness Kramer: I come to a few questions on board effectiveness. You raised yourself the issue of challenge. I think it is a very interesting one. Other than the British inhibition in raising a critical voice, are there other factors that you consider make challenge more difficult? Some have proposed, for example, that the incentive structure for non-executive directors does not encourage challenge. If you get a reputation for being difficult other opportunities such as picking up a similar role with other firms are unlikely to come your way. Again, the complexity of banking may make challenge extremely difficult for non-executives. I should be interested in your views on that.

Sir David Walker: To take the last point, banking is certainly a complex business. I have to say-you might have to aim off from my view-that a lot of the complexities are exaggerated. Whether it is much more complex than other businesses I am not totally sure. I am very clear, for example, that the exposure to criticism from Main street is very great in banking because the points of contact with Main street in this industry are much greater than those in most non-financial industries you can think of. As to the board, Baroness Kramer, there is no silver bullet. My sense is that there is much greater readiness to be challenging in the boardroom. Of course, it is not much use being challenging unless you are well informed in the sense of having a good question to put. You may not be an expert in the business. I would want to say here that a difficult issue is balancing the composition of a board between industry expertise and boardroom expertise. That balance is really the thing that helps to turn the trick. If you can get it right it is very important.

In the case of one entity that I can think of the conventional wisdom was that the chairmanship was inadequate because the individual was not a banker. I think it is arguable that the chairman was inadequate because he was not a good chairman; it had something to do with boardroom skills. So getting that balance right is very important. The only other observation I would make is that I think there needs to be almost a revolution-radical change-in the support of non-executive directors on boards. Non-executive directors need to give more time, certainly in banks but probably elsewhere, and to have access to outside advice if they feel they need it-alternative sources of advice, apart from the chief executive and the secretary within the entity.

Q22 Baroness Kramer: What about the recruitment pool? Many remark that boards all look virtually identical. There does not seem to be much diversity either by background, gender or ethnicity. Diversity itself creates an environment in which challenge is much more likely and groupthink becomes less likely.

Sir David Walker: I favour greater diversity. One wants diversity but one still wants high quality people. That is a challenge.

Q23 Mr McFadden: I want to continue on this question of boards. The commission is going to be interested in the corporate governance of banks, and that starts from the board. Bank boards have been guilty of a number of sins in recent years. Some of them have been sins of stupidity, such as approving mergers that banks could not afford. Some of them have been sins of negligence, such as allowing the growth of products like the packaging of sub-prime mortgages that turned out to be worthless. There is another sin that we see in Parliament quite a lot, which is that when something blows up or goes wrong in a bank the board attests to blissful ignorance of what was going on in the organisation. To paraphrase Her Majesty, why didn’t they see what was coming, and why are they always citing ignorance when things go wrong?

Sir David Walker: That is a really difficult question, Mr McFadden, and I am not sure that I have a confident answer. The pressures on executives in banks, who communicated the sense of these priorities to boards, to find ancillary products-we know how bad some of those ancillary products were, like PPI and some of the unsuitable interest rate swaps-have been very great in circumstances in which the interest margin has been so low and banks were concerned to generate P and L.

Should boards have known more about it? Absolutely. Will boards know more about it in future? For boards not to have learned from this recent experience, where the costs of putting right PPI and interest rate mis-selling are going to be as huge as is now in prospect-you just have to tot up the provisions that are publicly available of the major banks that have been engaged in this business-would be extraordinary. I think it would be extraordinary for boards not to have taken and hoist aboard the significance and importance of focusing on these things.

I would be very surprised if in board-level risk committees, or other committees that are concerned with customer satisfaction, there is not much more attention to reputation risk. Let us take the risk committee. Prominent in the questions that lead to concern about reputation risk is the new product approval process. Is this new product, which has a tremendous margin and which the business unit says will be very attractive for us, actually going to end us up in another PPI sort of problem? I am sure that every bank risk committee in the land is now asking that sort of question.

I cannot answer your question confidently about why they did not get there in the past. I think they were focused on survival and the short-term pressures on generating returns in the short term, which I do not excuse, but the factors are clear.

Q24 Mr McFadden: The banks have become much more complex, although you said a moment ago to Baroness Kramer that complexity was maybe overstated. We are sometimes told that chief executives are not even aware of what is on the balance sheet and everything that is going on in the banks. Is it, therefore, possible for a non-executive director, typically getting three or four days a month, to be across what is going on in the banks? Or is it really that non-executive directors serve for a period of three years and the best that they can hope for is to keep their fingers crossed that nothing blows up during their time in office?

Sir David Walker: I think it is really important to distinguish between the prudential side and the reputation and culture side. On the prudential side, it is important to give the history. Two thirds of major banks, including in the UK-it may be more than two thirds in the UK-did not have board-level risk committees before the crisis, but now they all have board-level risk committees. So there is a dedicated group of the board with a chief risk officer.

Does it always work as it should? Probably not, but is it getting better? Absolutely. We now have board-level risk committees that are focusing on risks in a way that did not previously happen. I think it is going to be much less likely-partly because of the much more intense regulatory regime-that we will get failures that were the consequence of inattentiveness to liquidity or leverage at levels that now seem, when we look back at them, almost unbelievable. So that is not going to happen in the future.

On the behavioural, cultural side, I submit that it is in part the answer I gave to Lord McFall. If the board has determined that we are going to have high standards of behaviour of individuals, and we are not going to sell to retail clients or indeed corporate clients, for example, products that are inappropriate that make a fast buck for the manufacturer but may leave the client or counter-party disadvantaged, my submission would be that most boards and board-level risk committees are focusing on those issues under the rubric of reputation.

Only time will tell, Mr McFadden, how effective a change has been accomplished. I don’t know what public policy initiatives could be taken to underline or accelerate the pace of this. One important area we have touched on is that advice to individuals to buy what might prove to be unsuitable or inferior products is now going to be much more difficult for banks to give. Most banks have withdrawn from purporting to give independent advice, except to private wealth-the affluent customers.

Q25 Mr McFadden: You asked whether public policy can influence this. John Kay in his review talked about greater use of fiduciary duties in terms of the selling of products and so on. What if we made bank directors more legally responsible for what the banks do?

One thing that greatly angers the public is that when something goes wrong the banks pay a corporate fine-in effect, a corporate parking ticket-but there seems to be a lack of individual responsibility from the people who did wrong in the first place and those at board level who were supposed to be governing their behaviour. Why don’t we give directors greater legal responsibility for what banks do?

Sir David Walker: The proposition would be, Mr McFadden-and I think it has been a subject of Treasury Committee discussion-the concept of strict liability. For the reasons you give, it certainly has its attraction; I understand the concern that leads people to be interested in it. I have profound misgivings about whether it can be made to work.

One problem is whether, in the event of a strict liability being imposed in the way you envisage, you would find any people willing to be directors of banks. Leaving that question aside, you would open the Pandora’s box of challenge, fairness and human rights, which would mean that the process involved a lot of litigation. That is not where one wants to take the boardrooms of banks. The process I advocate-to get higher standards of behaviour without criminal or strict liability sanctions-is the better course.

Q26 Mr McFadden: Can I end by asking you this? These questions of complexity, and the fact that even within banks the risks seem to be unknown, have become reflected in the share prices of banks. Investors are less confident about what they own and what is lying beneath it. Leaving aside what regulators and Governments might do to the structures of banks, do you think there is a possibility that investors will lose confidence in the concept of the universal banks because they simply don’t know what they are buying anymore?

Sir David Walker: That could happen. My sense is that certainly the investors I know, with whom I have had wider discussion in the context of the Government’s exercise a couple of years ago, recognise that the universal banking model does have strengths as well as potential weaknesses.

The strengths that I expect shareholders who are interested in financial services-some are palpably not, and rule that out-to be interested in would be the diversity of revenue or P and L streams in an entity that has a retail bank and a corporate and investment banking capability. That is quite significant. They would also be interested in the synergies within a universal banking entity, between the flow of business that can be undertaken in the investment bank on the basis of the relationship established-

Q27 Mr McFadden: Why are some of them worth more dead than alive at the moment, in the sense that the sum of their parts is worth more than their book value?

Sir David Walker: It certainly is the case that the crisis of confidence, if I can describe it as that, has led the price-to-book of most banks to be significantly less than 1.

There is an atmosphere of suspended animation, doubt or whatever about how fast recovery is going to be. If your definition is that the part should be more valuable than the whole, given the way the whole strategy is being priced, that is manifest in the market at the moment.

I would sense that a lot of shareholders are holding on given that they do not want to crystallise their losses if they have been there for a long time. They are hopeful, with the new prudential regime that is being put in place, of which the main lines are the implications of stress testing, resolution and recovery, and with the prospect of ring-fenced banks for retail in the universal banking groups in the UK. There is also what is being said by a lot of chief executives and chairmen about their determination to deal with these cultural issues. There is a readiness to wait and see and be optimistic. That would be my read.

Q28 Baroness Kramer: I do not want to let go completely of the issue of board composition and the role of non-executive directors particularly. If I understood you correctly, it was a view that the risk committees will now manage to get the information together and ask the questions about risk, rather than the board at large.

You get some more capacity for advice, but essentially, the board composition-the sort of very part-time nature of the non-exec-remains pretty much as it is today, although the recruitment pool may expand at the margins. I wonder if you are saying that, or whether you are looking towards something where there is a fundamental difference as we go forward in the way that boards are structured, in their capacity and in the way that they view their responsibilities, and where there is detailed examination of organisations.

Sir David Walker: I am very much in the "looking for radical change". I think it is in process. How far are the banks down the track? I am not sure, but directionally, there is the right sort of movement.

Q29 Baroness Kramer: Away from part time?

Sir David Walker: I do not think that non-executive directors are going to be full time, but they will give more time, and I think they are giving more time.

On the point you made right at the beginning about the risk committee rather than the board, that is not my proposition at all. To address the sort of issues that Mr McFadden was raising, of, "How could you not know?", boards need to have board-level risk committees looking at risk. That is not an abdication of responsibility by the board.

Elsewhere, I have said that my preference, based on a large amount of behavioural psychology analysis done by people such as Tavistock and Harvard Business School, is for relatively small groups as boards. The consequence is that there is a problem of populating committees such as remuneration, risk and audit. I think increasingly in the future, the pattern will be one in which non-executive directors give more time, with most non-executive directors on most committees. The risk committee will perhaps have a large contingent of people who are also on the audit committee. But they are doing different jobs. One looks back and one looks forward.

Q30 The Lord Bishop of Durham: Going on with the questions about risk appetite and risk management in particular, and looking slightly more at the technicalities, as we all know, risk in complex organisations as systems are the most difficult to manage-not the individual risk, but the accumulation of risk and the long-tail issues, where one risk affects something else that you cannot adequately foresee. It is still the case, according to Andrew Haldane, that most banks are still using value at risk as one of their major tools for risk management.

You said just now that boards need board-level risk committees looking at risks. The assumption underlying VAR is that risks are manageable. There is a school of thought that says that they are not, because there is so much uncertainty, which you cannot measure or adequately foresee. Are there tools for boards adequately to manage risk, or are they simply based on false assumptions? You keep using words like "hopefully" and "optimistically", which are delightful but perhaps not reassuring.

Sir David Walker: Yes; I need to be admonished by my own precept at the beginning of being forensic about this.

The first proposition I would make is that a risk committee that is relying on the governance of risk in the bank or the setting of the risk and the calibration of risks that have been assumed on value-at-risk modelling is palpably inadequate. There is enough work to show that reliance on this track record of past performance vulnerability is inadequate in circumstances in which the system is vulnerable to a tsunami attack where the markets dry up, there is no liquidity and that sort of risk had not been foreseen.

Moving on from that, value at risk is certainly relevant, but to place total reliance on it would be negligent, imprudent, wrong and inadequate and I do not think that it is happening.

Other measures of risk are now being used. They are being reflected, in the first instance, in the attentiveness of the regulators to reducing the total potential risk profile of the organisation. There were financial entities, including those in this country, whose leverage was 40 times before the crisis. For many of those, the leverage is down to 25 times or lower and in many cases it is lower than 20 times, if you look at the United Kingdom and the United States.

When you look back to the situation of Northern Rock before the crisis, its over-dependence on liquidity from market sources was the critical factor that brought it down. Its dependence on a particular source for liquidity, in circumstances in which it did not generate deposits on anything like an adequate scale in relation to the lending to which it was committing, was quite extraordinary and that will not happen again.

We have leverage, we have liquidity provision and definitions of capital that are much tougher. The quasi-capital definitions that were accepted before the crisis, with ratios that were dramatically lower-a fifth or a sixth of the ratios to which we are now moving-mean that banks are being required by the regulators to achieve high standards of inherent robustness and financial integrity.

Your question might persist: are they still vulnerable to attack or some unexpected catastrophe, such as a rig disaster in the North sea, the Caribbean or the Gulf of Mexico? I could never say never, but the robustness of these organisations and what is being done alongside the improvement in their resilience to ensure that, if they hit a rock, there is a resolution and recovery mechanism that protects the taxpayer, but not the shareholder or the bondholder, gives us a great degree of assurance.

Q31 The Lord Bishop of Durham: Following on from that, the history of the past 30 years is that from time to time-for instance, after the Continental Illinois run in the early 1980s and so forth-banks increase their capital. When there is a disaster or something that gives them a real fright, they decrease their leverage and increase their capital.

Should this Commission be looking at recommendations that essentially isolate certain banks completely from particular activities unless they have vast amounts of capital? That is more along the lines of Volcker than Vickers. The question will always be one of confidence. You talk about banks being able to be resolved, yes, but the effect of a bank going into a resolution process will be that all the other banks will be seen as being much more dangerous.

Sir David Walker: To the extent that the question is about the possible retention of universal banking-that is, universal banking accepted as persuasive by John Vickers in his proposals with application of restraint such as that in the Volcker rule, which greatly inhibit proprietary trading-I should say that that is a model about which I seek to be strongly defensive.

As we have discussed, it is not the case that problems of culture all stem from the investment banking side of universal banking. Many problems of culture, and the ones that have interfaced most with people in Main street, come from the retail bank. The provisions now being put in place by the regulators effectively address some of the most problematic activities in the investment banks that led them to have high leverage on inadequate capital, like the assumption of big proprietary trading positions. To put it at its simplest, all that is last year’s war. It is over. There is not going to be much proprietary trading in the investment banks themselves or in the investment banks to be found in the investment bank arms within universal banks. To the extent that those proprietary trading desks have not been substantially eliminated, it is work far advanced.

To give other examples of the increased resilience and robustness of banking activities, which are not to do with capital in the conventional sense, one of the bigger crises, in particular in Lehman’s, was the build-up of exposures to derivative transactions of all kinds that were not cleared through a clearing mechanism.

One of the overdue developments-I spoke to the Select Committee about it five or six years ago-is now a requirement that over-the-counter derivatives should to the maximum extent possible be standardised and cleared through a central clearing mechanism. There is a double whammy incentive working there: where that is not happening and over-the-counter derivatives have been traded on an uncleared basis, the capital charge is hugely greater than in the case when they are centrally cleared.

If we had had much more central clearing of so-called over-the-counter derivatives before the crisis, there would have been much less of a crisis and, quite possibly, Lehman’s could not have happened. So I want to be reassuring about the underpinnings of resilience that are now being placed under the whole system.

Q32 The Lord Bishop of Durham: Turning to chief risk officers or equivalent posts in different banks, your 2009 review recommended that the CRO should, alongside the internal reporting line, also report to the chief executive or the chief financial officer and the board risk committee and have direct access to the chairman in the event of need, so that there were three separate reporting lines. Is that not likely to lead to a loss of accountability and should not there be simply a direct reporting line to the chairman and the senior non-executive director?

Sir David Walker: Basically, yes. You have perhaps read it more recently than I have. I do not think that I ever recommended that the chief risk officer should have a reporting line to the chief financial officer. One of the worst disasters we had-not in the UK, fortunately-was when the chief risk officer was the chief financial officer in one of the Dutch banks. That was a recipe for disaster-and the disaster befell.

There is a need for balance. Certainly, the chief risk officer has to be able to say no to the chief executive. He has to be able to say no, without fear that he will lose his job or that he will not get an adequate bonus. He has to have a direct line to the chairman of the risk committee or the chairman of the board. If that is not in place, that is being established. It is certainly in the institution to which I am going, and I think it has been for quite a long time.

But banks do not need two chief risk officers. There is an executive risk process, which is run by the chief executive and the chief financial officer, so the chief risk officer will be involved in the executive risk process. Let us say that a new product is being introduced that, in the CRO’s view, has significant reputational risk that is being undervalued by the executive because the product generates a big margin and is therefore attractive. If the chief risk officer thinks that that is going too far, and beyond the risk appetite determined by risk committee and/or the board, it is his prerogative to say no to this new product proposal and to insist that it be looked at by the risk committee.

I think that is a really important governance building block that needs to be absolutely firmly in place, which is why, I think, the chief risk officer obviously needs to know the business-he needs to know his theology, or whatever it is-upside down, inside out and backwards. That is just a necessary condition. He probably needs to come from a business unit. He needs to be independent, in the sense we have just been talking about, but he also needs to be capable-and this comes back to some of Baroness Kramer’s questioning-of presenting the issues to the board in a thematic way.

Of course, it might occasionally need a deep-dive, granular examination, but if the chief risk officer can only deliver 25 pages of small print A4 to the risk committee, then he is not right for the job. He has got to be able to say, "This new product"-to come back to one of Mr McFadden’s questions-"is hedged about with risk, and if we can’t deal with it we really shouldn’t introduce it." He needs to be able to say that on a side of A4.

Chair: We are going to have to move on: a very quick last question-and a quick reply, please.

Q33 The Lord Bishop of Durham: You have mentioned risk appetite. Whose risk appetite are we talking about: the country’s, society’s, the central bank’s, or that of the shareholders of the institutions?

Sir David Walker: Chairman, I cannot give a quick answer to this question.

Chair: Give a quick answer now, and put something in writing for us later.

Sir David Walker: All I can say is that the first accountability in my view-though you have to look at the drafting of companies legislation, here-the principal accountability of the board is to the shareholder; but the shareholder’s interest is in sustainable performance, which will not be achieved if it is a quick buck and is inattentive to reputation.

Chair: If you want to elaborate on that, do, on paper, later, Sir David.

Q34 Mr Love: Perhaps you could give a quick answer to this. It is not my subject, but I was interested in your views about proprietary trading, and I wondered whether you would have any sympathy for the idea that alongside Vickers we should have a Volcker rule.

Sir David Walker: Effectively, Mr Love, we do not, here in the UK, have-and I don’t think we have in prospect-a Volcker rule; but it is going to work as if there were a Volcker rule, because in the United States the Volcker rule says "Thou shalt not do this sort of activity, save within very tight constraints". Paul Volcker was very clear about what he had in mind. What he had in mind has spawned, I think, 1,700 pages of small-print drafting, so the devil is in the detail; but here, and in Europe, something very similar to the effect of a Volcker rule will be achieved by the application of very tough capital requirements to proprietary positions in any bank. So I don’t think, at the end of the day, it will be very different.

Q35 Mr Love: Can I come on to the issue of executive remuneration-a very sensitive issue? To what extent have all of the reports-the work of the Financial Reporting Council, and your own two reports-contributed to holding down executive remuneration? Do you think there are other things we need to do?

Sir David Walker: I think it is important that executive remuneration be kept under the spotlight. One thing that I think needs to happen-this is unpopular with the banking community-is to implement the recommendation that I made that bands of remuneration should be published. I proposed bands of remuneration-I think I said £1 million, £2 million, £5 million: how many people were in those bands-not identifying the individuals, but saying how many in the entity were in those bands. It is very hard for one bank to do that in isolation, and I think it is a public policy matter to require that to happen; and I hope it will happen.

I recognise readily there are concerns about levels of remuneration in banking, but I would immediately react to your question by saying that I think what matters also is the structure of remuneration in banking. Too much of it gave incentives to inappropriate risk-taking and providing bonuses or rewards on the basis of revenue performance. I think we are now moving away from that very substantially. I think you will find in the packages for executives in most banks-not only here in the UK, but we are probably leading the world in the extent to which we are moving in these directions-much more performance relationship. The incentive is to the right sort of mix of behaviour-Six Sigma or whatever it is-that the board want to specify as their expected behaviour for an executive board member, the chief executive or a trader.

There is a much more broadly based set of criteria to judge performance. For example, deferment, so that if there is a bonus, you do not get it all in cash this year: there is a deferment so that you have an interest in the ongoing performance of the entity, and if the entity shows a weaker performance in the period ahead, to the extent that your bonus is in stock you will bear the pain or the cost of that deterioration of performance. That embeds your interest in that of the performance of the entity. There is now-I think, almost universally-provision for clawback, in the event that something goes wrong or that there was some misstatement of profit. All those are ingredients in a very healthy development in the structure and appropriateness of incentives in banks.

Q36 Mr Love: Can I pick up on two of those issues? The first is transparency. You mentioned earlier that your recommendation had not been implemented. There seems to be a broad section that suggests we ought to go further in terms of transparency, perhaps right through the whole organisation. I wondered how you would respond to that. There is another body of opinion that says that transparency has been a major contributor to the ratcheting up of executive pay. How would you respond to that? That is sort of contradictory, but how do you view transparency?

Sir David Walker: On the first proposition, my recommendation-31, I think it was-related to bands of remuneration in banks. The concerns in Main street in our country, to which we are all very attentive, focus in particular on banks, but the propositions from the fair pay commission and these other bodies from which the Treasury Committee has taken evidence are about remuneration generally. I think it would be hard to confine my recommendation to banks, so bands of remuneration might be relevant in oil, pharmaceutical companies, energy companies and so on. It would be a kind of generic proposition.

On the second question-if I understood it correctly, Mr Love, I think it was: would this sort of disclosure heighten public anguish, irritation or annoyance at these levels of pay?-this is really an argument about transparency. If it cannot stand the test of daylight and have an explanation to go with it, then there is something wrong in the model. I think that those who believe that if British business generally, which is globally competitive, as much of banking is, needs to pay high rates of pay to be able to recruit high-quality executives, then we have to be able to win that argument, and winning the argument is not going to be helped by being secretive about it.

Q37 Mr Love: The other issue to touch upon is deferment, which you mentioned. There is an argument that we should be going much further and that we should be retaining a significant proportion of the remuneration while waiting to see what the longer-term performance of the bank or financial organisation is. Do you have any sympathy with that?

Sir David Walker: Yes, I do have sympathy with that. I think my proposals talked about three to five years’ deferment. I think that if it were longer and, indeed, for executive board members and perhaps senior executives below the board, if there was a mandate that you hold on to some part of the stock that is given to you as part of your remuneration until the point of retirement, which is beyond the point of normal vesting, that is an attractive proposition.

I would make one observation here that is very important for the Commission Chairman, which is that some of the guidance and potential direction that is coming from Europe is wholly unhelpful in this respect, because there is a proposal to cap variable pay. The consequence of capping variable pay will be to increase basic pay and therefore the overheads of the banking industry, which is not a sensible development. It also undermines one of the principles to which I referred a moment ago: that in structuring remuneration so that it is related to the right sort of incentives, variable pay, properly constructed, precisely achieves that. If caps are put on variable pay, it will be hard to justify remunerations related to the right sort of performance. That proposition from the Commission is, in my view, very retrograde and to be resisted.

Chair: I am going to move this on in just a moment, so one very quick question.

Q38 Mr Love: I was going to ask you about the European Union, but you have touched on that. My final question is about the ratchet effect that many people talk about. The last time you came before the Treasury Committee, there was a great deal of discussion about the ratchet effect. A lot of people think that it primarily relates to remuneration committees, but perhaps it relates more to remuneration consultants, who almost compete with each other to ratchet up the pay of the executives. Is that something you recognise and is it an area we should look at more carefully?

Sir David Walker: It has undoubtedly been a problem and it deserves continuing attention. Apart from drawing attention to it as an issue, I am not quite sure what public policy initiative could be taken. I have two specific observations. One is that all FTSE 100-not just bank FTSE 100-remuneration committees are on notice that they are under the spotlight and that shareholders will be very attentive to what they put in their directors’ remuneration report about both remuneration policy and how it is implemented in relation to awards made to particular individuals. Given what has happened in the shareholder spring, which has particularly focused on remuneration, we will find a change in remuneration committee attitudes to this. A strong sense that I have from talking to confrères elsewhere in the industry is that it is extremely difficult to find non-executive board members ready to be chairmen of remuneration committees because they are in a very direct line of fire. That is a healthy place to be at this juncture.

On the remuneration consultants, I have some sympathy with the view that they were part of the problem. Let me repeat what has been said on other occasions. I have proposed to the main group of a dozen or so remuneration consultants that they should construct a code of how they would perform and how they would be objective and neutral. You could say that this is all somewhat aspirational, but they did produce a code. They do have an independent chairman who looks at the monitoring of the code, and there is a remuneration consultant, too. I think that it has helped a bit.

Q39 Chair: No doubt we will come back to the subject of consultants in a bit. I will bring in Andrew Turnbull in a second. You mentioned pharmaceuticals. On the basis of what you know, which is much more about one than the other, what do you think has higher standards-pharmaceuticals or banking?

Sir David Walker: They are chalk and cheese. I do not think that I can do that. Pharmaceutical companies will-and there has been experience of this-be very keen to get out new products on which they perhaps spent billions. Through toxicity tests, it may sometimes seem that corners were cut and damage is done to people.

Chair: What you are acknowledging is that it is a tough question. It is not an easy one. So, there are problems in other industries, too.

Q40 Lord Turnbull: I speak as a mad fool who is chairman of two remuneration committees. On your recommendation about banding, ironically if you have a Hong Kong listing, you end up having to do it. Other jurisdictions do not seem to think that it is such a difficult thing. Simply saying that six or seven individuals earn twice as much as a chief executive is not really going to be enough. You would need to say in the narrative something about the structure of how these guys earn that amount of money. Are they on the profits or the revenues of some sub-unit or whatever? Do you think that you have to go a bit further and provide an explanation of the methodologies?

Sir David Walker: Yes. My recommendation in 2009 was, I now think, incomplete. It was right-I stand by my position then-to require these bands of remuneration to be published. I agree, and this is part of it, that there needs to be a narrative. If it is the traders who are in this high remuneration category, what is being used to assess their performance and justify these high rates of pay? I think the narrative point is very important, more widely than remuneration. If one is allowed a wish here, I wish annual reports had much more narrative about what is going on and where the group or the board aspires to be, and less of this hugely granular, detailed reporting for which no one asked and for which very little use is made of the 200 or 300 pages that are put out. I am a strong supporter of narrative commentary.

Q41 Lord Turnbull: Mention has been made of a ratchet. You were also pointed to a world in which £1 billion of capital is going to sustain possibly half the amount of business profit-making activity that it used to. Surely, that means that in the banking world, the profits out of which bankers are paid will be much less per unit of capital, so to speak, than they were in the past. Therefore, in the natural order of things, bank remuneration ought to be coming down quite significantly to adjust to that. The question is, is there some ratchet that is going to prevent that happening?

Sir David Walker: I think the answer to that is no. I share the sense of the proposition you put. Returns on equity are going to fall, and it is quite interesting to observe how banks have been talking, having been attached for quite long periods to a very macho proposition about, "We’re going to get 25%"-to take one non-British bank, currently-about lowering that return on equity, which was a very high target, to some lower level that might be sustainable. Returns on equity will fall, which will not only put pressure on how much is available to pay out in pre-comp PBT-I am talking about remuneration-but will put pressure on what is available to pay dividends and plough back into the business.

I say that because this comes back to a wider part of the shareholder spring that I think we must expect. Shareholders will start to be much more attentive, as in my view they should be-less to the precise composition of remuneration packages-to this headline ratio of pre-comp PBT to total PBT. What is the carve-out between employees and shareholders? That, plainly, has moved strongly to the disadvantage of shareholders over this recent period, and I think that there will be a rebalancing. If there will be resistances to it, Lord Turnbull-people will say, "But we’re going to lose our best people and we’ll lose the ability to flourish"-

Q42 Lord Turnbull: It should not be a relevant argument, because this reduction in leverage is across the sector.

Sir David Walker: Yes. I subscribe to that view and think there will be anguish, pain and grief, but I am confident that it will happen.

Q43 Lord Turnbull: I have a very general question. You have clearly positioned yourself as someone who is very candid about the shortcomings of the banking sector and as being "radical"-I think you used that word. Are you a lone figure in this? Are you at one end of this spectrum? How far, as you talk to your confrères-as you describe them-is this pretty much a consensus view?

Sir David Walker: I think that there is a consensus view that, notwithstanding these awful problems of culture and conduct that have afflicted both the substance and the perception of British banking, it is a great British industry. If I focus on those parts of British banking that are internationally engaged, and doing significant cross-border business of all kinds, this is a very considerable British success story. I welcome the opportunity to say to the Commission, if I may, that although it is extremely important that banking-the banking industry and the regulators-gets to grips with these issues as soon as possible, it is also highly desirable that the knocking of the industry is brought to an end and that the areas of focus are narrowed down to things where urgent action is needed.

Let me take one area that is a legitimate cause of concern for what I call Main street; I acknowledge that that is an Americanism, but it captures it. We have these claims management companies, which are in a way seen to be pouring fuel on the flames of the Main street irritation, annoyance and anger about bankers’ behaviour. Claims in relation to payment protection insurance and interest rate swaps that are substantively justified need to be dealt with probably more expeditiously than the banks are currently doing, although they are all committed to dealing with them expeditiously. That is going to be very expensive and will take quite a time.

However, there is an interesting point that I do not think the Chairman fully recognised in his introduction. I do not want to talk about Barclays, but I will produce one statistic and say that 50% of the CMC claims that have come to Barclays relate to claims from people who have no relationship with Barclays. And so there is an enormous amount of ramping up of annoyance and irritation, and a build-up of expectations from CMCs that frequently seek advance payments before anything is delivered, that have no obligations about the holding of client money if an award is made and that are not subject to any sort of regulations. So there are areas of concern that I think are quite serious for the image of UK banking, which I hope we can get through quite fast.

Q44 Lord Turnbull: One final question. You have suggested that product design ought to be within the purview of a risk committee, but I have a feeling that that would be considering, "Is there some guarantee in this product that will cause us problems?" In other words, it would still be looking at it from the view of the impact on the profitability of the company.

One of the things that I have argued is that someone periodically needs to come along and say, "It is not just about how much profit we are making from this line of business, but what kind of deal does it represent for the people that are buying it?" I have a feeling that the automotive industry, for example, would have a lot more statistics about the record of the car, how often it breaks down, costs of repairs and customer satisfaction. I am not sure that the financial sector pays as much attention to, "Are we providing a good return for our customers that is commensurate with the return that we are making?" I don’t know whether, looking at your experience, you know if other companies do that better, or whether it is actually a general failing.

Sir David Walker: I partly agree and I partly disagree. I agree that that sort of testing of the suitability of a product for the customer-I mean, is it, to use Adair Turner’s language, which I think was in some way exaggerated in the way that it was interpreted but in another sense was very much on the point, "socially useful"? That is a very good question.

There is a huge amount of testing in retail banks of consumer reactions to particular propositions. I know from my time on the board of Legal and General that that was done in the life industry, which is very much concerned with distribution of retail products-as you know from your own experience-and savings products and protection products.

No new product proposition will come to a board risk committee, or whatever agent or authority within a bank is looking at the new product approval process, unless the executive thinks that that new product is going to do something positive for the profit and loss. So entities are driven by a commercial concern to deliver a return to their shareholders. That is the point at which the test needs to be applied.

Q45 Lord Turnbull: It could be rank bad value for the person that is buying it, or that is adduced to buy it.

Sir David Walker: Can I complete? Of course that has to be the test, that this product will not generate P and L on the basis that we would all want to see, which is on a sustainable basis, unless it provides something that the client wants to buy. So, if you are producing a product that generates a huge margin in the short term but the client, having bought it, will never want to do business with you again, that is not sustainable. So I think that these product approval processes have to be perhaps much broader in their scope than they have been in the past and should ask the sorts of questions that you are raising. I think they will and now do.

I think there is an issue in the new world of pulling back from products that are very hard to distribute other than on an advised basis for which Main street is not ready to pay a fee, so I think we have a gap or a lacuna in terms of quality of product, which can only be filled in part for the time being by the introduction of standard or perhaps kitemarked products of the kind that are being examined by Carol Sergeant for the Treasury. That may be an important part of the response to the retail distribution review, at any rate in the short term until we reach, I don’t know, a golden age where customers are as ready to pay banks or distributors for services-the sale of advice and products on which they are being advised-as they are ready to pay the dentist, the architect, the surveyor or anyone else to whom they make fee payments.

Chair: I call John Thurso, and then there are a couple of colleagues who want to come back with quick rejoinders and then we must close.

Q46 John Thurso: I have two questions on regulation, but I would like quickly, if I may, to come back to the remuneration question and where we left off when you appeared before the Treasury Committee when, if you remember, I asked why anybody is worth more than £1 million a year. All of the stuff that you recommended and all of what we have discussed has behind it an assumption that high pay for high-quality executives is the way of the world. It does not address the question of why the gap between average salary and executive salary in publicly owned companies of all kinds has been growing inexorably for 30 years. Who in society authorised executives to pay themselves more and more and why should society accept it?

Sir David Walker: The accountability, as I said in answer to an earlier question, is in the first instance not to society but to the shareholders. If you want to, one can have a philosophical discussion about whether to change that model, but that is the capitalist model. It can be modified at the edges, but at its heart is accountability to shareholders. On the whole-with bad bumps recently-shareholders have been satisfied with the performance that has been generated. This is relevant to the question about the, as you describe it, inexorable rise between the top and the bottom, and I absolutely understand the thrust of the question.

I think that what has happened, particularly over the last 25 years, is that a combination of globalisation and technology has made it not only possible but necessary for organisations to grow if they wish to be globally competitive, because their competitors are global. If you have a waterfront that is narrowly domestic, you are not going to be in the game, so to speak. Such organisations need to be able to respond much more quickly to opportunities and to challenges. The responsibility of steering an IBM, an Exxon, a Citi, a Barclays, a Shell, or a BP is now hugely more complex than it was 25 years ago. Myopia is relevant in this, but I do not want to talk more about that. The impact of IT, which requires much quicker responses than was the case as little as 20 or 25 years ago, has been very powerful indeed. The consequence is that if you are on the bridge of one of these organisations, you are managing a much-I don’t know if the analogy is perfect-larger vessel with much greater capacity for good or for failure than was the case 25 years ago, whereas down the line the guy in the engine room is still working on motors or engines or whatever it is that was there 25 years ago. I think there has been a big escalation in the relative responsibility of the chief executive and of the board.

Q47 John Thurso: I think that can be challenged, because your core assumption that the shareholders have that influence is possibly faulty. I will go on to other questions, but I would suggest that one of the things that has happened-I would like to flesh this out in the evidence process over the next couple of months-is that companies have become so big that the shareholders as individuals have become so irrelevant that they cannot function and exercise the same control as a traditional shareholder who held a sufficient piece of the company to matter. In the absence of that power, the executive now forms a power of its own within the corporation. I will leave that there for you to contemplate and move to the question of regulation.

Looking backwards at the deficiencies of the past and the old tripartite system, there is one view that says the architecture was wrong and you can solve the issue if you put the architecture right. There is another view that says the problems were much deeper than the architecture and were with the basic assumptions of both regulators and operators about the models that were being used. To what extent do you believe that the outgoing regulatory regime failed because of architecture and basic assumptions across the piece?

Sir David Walker: I am less critical of the architecture than is the conventional wisdom. Most people are critical of the architecture, but I defended the architecture because I thought it was extremely important that the Bank of England’s credibility, which at the beginning of the process was not very high in financial markets, should not be damaged in its fight against inflation by failures or problems on the regulatory front. I still hold that view to some degree, so I worry about the new architecture that is to be put in place.

Moving from the architecture to the content of the regulatory process, much was wrong but two things above all were deficient, and I hope they will now start to be corrected. The two things are not really features of the architecture, and they could have been got right under the old architecture. The first was that the content of regulation itself was inadequate. The regulators failed to keep up with what was happening in these businesses. This is not unrelated to your previous point. Financial services business was expanding and growing in ways that was extremely hard for the regulators to keep up with. At any rate, they did not. The consequence was that in 2007-08 we had a Basel regime-globally, not just here in the UK; the regime was international-that was palpably inadequate. That was one failure.

More subtle, but very important, was the sense that the job to be done involved box-ticking regulation: if you do this, this and this, we can tick a box and all will be fine and dandy. As you know, Mr Thurso, there is now a lot of evidence that there should be much more focus on behaviours, as distinct from, "Do you have the right numbers to put in this box?" and, "Is this what you did at a particular point in time?"

The processes that are in place will not work effectively unless behaviours are right, and it is the behaviours that lead to the challenge. Is this something we really want to do? Is this socially useful? We will make a quick buck next year, but we are not going to be able to look our customers in the eye and go on with it for very long because we will get rumbled.

As we talked about in the Group of Thirty report, the really important thing for the next phase, and I believe the Bank and those moving from the FSA at the senior level have this in their minds, is building new relationships of mutual trust and respect between supervisor-there is a difference between supervisor and regulator-and board, which is the chairman, the SID and the chief executive. That prize is mightily worth striving for. If we have that, we would have, for example, a much greater readiness in the banks to say, "We have been doing something here, and we are getting worried about it," or, "We observe that another bank is doing this, and we would be under a lot of competitive pressure to match it unless it is brought to an end." There would also be much greater readiness for the supervisor to a bank, "I don’t have hard evidence, but I am worried about what you are doing in this area." As a chairman, prospectively, if I received a message of that sort from the head of the PRA, rest assured I would be extremely attentive to it.

Q48 John Thurso: That takes me neatly on to Andrew Haldane’s recent speech, which I read very recently. It has at its heart the concept that complex regulation and assessment of risk and models complicates supervision hugely, and that human beings need to develop simple rules. One of his comments was that "catching crises relies on a lengthy sample of past experience. Good supervision means developing well-honed rules of thumb", and he talks about five commandments. Do we need to move to a regulatory and supervisory regime that sets aside the attempt to find everything that might go wrong and measure it in infinite complexity, and go back to saying, "Here are the five commandments of banking. Do these and the chances of a crisis diminish exponentially"?

Sir David Walker: Yes. When I was chairman of SIB, which was the precursor to the FSA, I effectively tore up the rule book and we had 10 principles. Unfortunately, my successors replaced them with rules. Coming more seriously to Andy Haldane’s proposition, I do think that responding to complexity in banking with more complex rules, without having them clearly principles-based, has been a mistake, and we need to be much more attentive to the principles or ground rules. I like to use the word "principles" to demarcate them from rules.

One example of the disadvantage of focusing on rules is that people in investment banking and elsewhere are pretty clever, and if you set out a rule these people are very good at devising ways around it. This has happened lamentably in relation to something that is not financial regulation but tax regulation. We have a tax system that is vastly too complicated and therefore created open season for clever bankers to devise tax avoidance schemes of a kind that are now increasingly being eliminated. I do not defend them, but I observed that they were a consequence because they were possible to get round and create really quite lucrative structures.

Q49 John Thurso: One very quick point. I was struck by a programme on television last night that made the accusation that British-based banks-not British banks-had been selling derivative products to Italian cities, which is why they are going bankrupt. That is a very rapid encapsulation of what the whole thing was about. You talked earlier about British banking being a great positive to the economy. What if we keep finding, after we lift every rock, a derivative that should never have been sold to Milan because it was linked to a default in Greece, or a LIBOR scandal or whatever, and we find that the whole thing has not been hugely good but actually has been rather bad, and we come back to the Haldane approach, which is not one of "Thou shalt, but you must look after all these things," but simply says, "Thou shalt not"? That is going to alter banking and alter the profitability and returns on banking. How will the industry respond to that approach?

Sir David Walker: If I may say so, Mr Thurso, you underestimate the extent of change that is currently in process. I would make just one other observation about principles. We do have an enemy. We might, in this room and in your great commission, agree that it would be good to go back to principles-based supervision, if I can use that word, and I am very strongly for it. One of the reasons why it will work only partially-Andy Haldane knows this very well-is because that is not the American way. The American way is precisely the opposite; they want a bible. In my own experience in the firm where I was previously, Morgan Stanley, all the time I had an argument with the American lawyers, who were extremely good people, and the American compliance people. All the time, they wanted great specificity about what we could or could not do, and I had great difficulty in saying, "The first question is: is this the right thing? Is this where we want to be?" They were much less interested in that. A consequence of that focus on rules is that there is less attention to these principles, which most of us would think were more to do with culture and, "Is this a situation we want to occupy?"

Q50 Lord Turnbull: Some of the evidence we have received makes a distinction between professionalisation, which is people having more expertise in the technology, the new shape of products, derivatives, this whole world of high finance, and professionalism, in other words belonging to a profession with a set of ethics and values. There is talk of creating an enlarged institute of banking, with something like a code and the prospect of disciplinary proceedings: you could be struck off. First, can you make this work or would it become a kind or Press Complaints Commission which is too internal? Secondly, the striking off always ends up involving the regulator. How can this body carve out a space for itself where it exerts discipline which is not getting caught up with what the regulator is doing?

Sir David Walker: Lord Turnbull, Chairman, there is, as you know, and I should say now that I had no part in it, in the Barclays submission to the commission a proposal for the exploration of an initiative along those lines. It was submitted before I arrived. I think it is very interesting. We have at the moment an approved persons regime in the FSA. It is a good regime but it is in my view inadequate and I would think that that would be the view of it that the FSA takes. To enlarge it, to create, if I could use the word and not being as fine and subtle as the way you were putting it, the sense of a profession of banking to which everyone who plied for hire as a banker had to subscribe-had to be a member like a member of the Law Society to solicit or an architect to provide architectural services-is a really interesting question. I would submit, Chairman, that that particular proposition is worth quite close investigation by some group that the commission might want to consider appointing.

The difficulty that I see with it is that it won’t do any good in the context of the discussion we have been having this morning unless there is a good disciplinary process. I would be sanguine-optimistic-that it is available for people to make fair judgments and reach a view that this individual did something that was egregiously wrong and should therefore be struck off or, to take a more generous view, perhaps he needs a first warning and that if he does it again he should be struck off. The thing will only work in improving the performance of this profession-I think it is highly desirable that it should become that to a much greater extent than hitherto and we have all sorts of fragmented initiatives in this space-if there is found a way to deal with the human rights tribunal hearings process, which creates the opportunity for challenge for anyone whose name goes on the register as someone who has been struck off. Someone who has been struck off ought to be unemployable in this industry. Surely that is precisely the object, and what we would want to achieve if we are to have this as part of raising standards.

Chair: Certainly that is something we will be taking forward. That is very helpful.

Sir David Walker: It is a very interesting area but it requires a lot of work.

Chair: You have given us a very interesting set of preliminary thoughts there. Andy Love, a quick last question and a quick response, please.

Q51 Mr Love: Very quickly, whistleblowers have a pretty meagre time in this country. How can we encourage more whistleblowers to come forward and do their duty?

Sir David Walker: I agree with your observation. It is a matter for the board to say that whistleblowers are guaranteed a free passage, so to speak, and that if you whistleblow you will not be disadvantaged. I am afraid that has not always been the case in the past. We are much closer to that now.

Q52 Mr Love: America has much more success than us. There seem to be more whistleblowers because they incentivise whistleblowing. Do you think there is any merit in going down that road?

Sir David Walker: I was shocked to read that someone today was being given something like $65 million for something that sounded like whistleblowing. My quick answer, which is all that I am allowed to give, is that that cannot be right.

Chair: Thank you very much, Sir David, for coming before us this morning. It is the beginning of our evidence-gathering process which is going to be very intense over the next few months. I expect that we will want to hear more from you in the weeks and months ahead, probably with your Barclays hat on. You have certainly given us a very good early steer and we are very grateful.