CORRECTED TRANSCRIPT OF ORAL EVIDENCE To be published as HC 821-i

HOUSE OF COMMONS

ORAL EVIDENCE

TAKEN BEFORE THE

PARLIAMENTARY COMMISSION ON BANKING STANDARDS

SUB-COMMITTEE E-PANEL ON REGULATORY APPROACH

REGULATORY APPROACH

TUESDAY 11 DECEMBER 2012

MICHAEL COHRS

MICHAEL FOOT and DR THOMAS HUERTAS

USE OF THE TRANSCRIPT

Oral Evidence

Taken before the Joint Committee

on Tuesday 11 December 2012

Members present:

Lord Lawson of Blaby (Chair)

Mark Garnier

Mr Andrew Love

Examination of Witness

Witness: Michael Cohrs, Member of Financial Policy Committee, Bank of England, examined.

Q1 Chair: Welcome, Mr Cohrs. I’m sorry you were kept waiting for a little while, but I hope it didn’t put you out. We are very pleased indeed to have you before us as the first witness at the first meeting of this panel. As you probably know, "panel" is our name for a sub-committee. As the Commission on Banking Standards, we have so much work to do, and to enable us to do more we have split into a number of panels or sub-committees; this one is on regulation. This is our first meeting and you are our first witness, as is right and proper.

Before asking whether you would like to make a general statement before we ask questions of you, I would like to explain and to have it on the record that we have invited you here in a personal capacity because of your great experience over a wide range of relevant posts, and because we know that you have thought about the subject a great deal. You are not invited here as a representative of the Bank of England’s Financial Policy Committee. You are your own man, and you should say whatever you think. Would you like to make a statement before we put questions to you?

Michael Cohrs: Thank you very much for having me here. I have met privately members of your Commission to do bilaterals, and we have covered a lot of ground there, so I am delighted to be here with the cameras rolling, as it were.

I understand the point about the Bank of England. It knows that I am doing this. I made it aware that I had been asked to do this in a personal capacity, and the views that I give you today will be mine. Sometimes, my colleagues on the Financial Policy Committee agree with them, and sometimes they don’t.

I am also a member of the court of the Bank of England, and sometimes I stray-although perhaps not so much during this session-into governance issues concerning the Bank, but again my views will be mine in a personal capacity.

I will make a very brief statement, and then allow you to ask questions. Your work is important. Not only are we suffering from the effects of the crisis which, to be fair, no one in the world predicted-we could go through reasons for that-but we then had the more recent scandals, which I found shocking because they showed that we face a whole host of cultural issues.

I have been very strong at the Bank of England on the concept of culture. My colleagues tend to be economists, and speak a different language from me. Sometimes, we find it hard to connect when I am talking about culture and they are talking about economic concepts. Culture is a big part of what has gone wrong. Your Commission has seen that in some of the evidence you have heard already from different people. There is no easy solution. In my life now as a regulator, I can see things from the other side of the fence. It is very difficult to regulate such entities, and we should not think that any type of regulation that we put in place will necessarily stop financial crises or the ups and downs that we have seen in the financial sector. We would be fooling ourselves if we thought that we really put in place something that would catch everything.

It is important that, whatever we put in place-and we are moving in the right direction-we have a healthy scepticism about it. We need to keep things very simple. It is a not a simple topic, but the rules have to be kept very simple if they are to be effective. One of the big issues that we face on the regulatory side is the complexity of the regulatory system not just in this country, but the way we connect into the international community, which is quite complex. I was surprised initially at how there seemed to be not much communication between the various regulators. As I have gotten deeper into this, I realise that a fair amount of conversations go on, but there is still a lot of work to do.

Q2 Chair: Thank you very much. Your take may not go down naturally with a number of economists you are obliged to mix with, but it certainly chimes very much with the view of Parliament and why Parliament set up this Commission. We are a Commission looking not so much into banking, but into banking standards. That is our name, and it is addressed directly to culture.

There are other issues we will want to follow up, such as the complexity of regulation, but I should like to start with the cultural point. I was struck by something you said in a speech that you gave in March 2012, when you said, "Ultimately it is the culture within individual banks and the incentive systems that drive risk taking which need to be changed. The good news is that I see evidence that banks are changing incentive systems and this will lead to a different culture within the banks which society will prefer."

We would all agree with you that the rather difficult issue of culture has to be addressed first and foremost, not exclusively, through the nature of incentives. You say you see signs that the banks are changing incentive systems, so I should like to begin by asking you a double-barrelled question: first, are they? What evidence do you see that banks are changing incentive systems? I shall ally to that, before I go on to the second half of the double-barrelled question, what can we do to ensure that, if there are any changes-you must tell us what they are, as I’m not particularly aware of them-they are not ephemeral, and will not go back to the bad old ways? What can we do about that?

The second, broader question is, accepting what you say that at the heart of the problem is culture and the incentives connected with it, what part does the design of regulation or supervision have to play in trying to change the culture or change the incentives?

Michael Cohrs: On the first point on remuneration and the signs that it is changing, if you go back a decade the average banker would have been paid a bonus, which was typically cash, which they would put in the bank and go on their merry way. Today, that is not the case, and this is the change that I have seen. Today, the average banker is paid a bonus that typically pays out over three to five years, and it is now typically paid in shares in the company for which the person works. There has been a structural change in how remuneration is granted to most bankers. This has been driven by the Financial Services Authority. They mandated this. Back when I was a practitioner, they were the first regulator to approach us as a bank and demand that we change our remuneration schedule systems.

So there is some change, and this is very important because it starts to get away from the culture of trying to take as much risk as possible. In the old world, the worst that could happen was that you would be fired, and if you were lucky or smart or both, you might become wealthy in a single year. It was a one-way trade. When I used to be a manager of people who took risk, I hated the system whereby the employee had, effectively, a one-way trade. We have changed the structure of remuneration, and that is quite important. We would like to change even further. Rather than pay employees in shares, for instance, we are recommending-this is an idea of the Financial Policy Committee, among others-that employees get paid in subordinated debt of their organisation, which would give them different incentives around the creditworthiness of that institution. We believe that banks should not use ROE as extensively as they do today. ROEs are part of the remuneration system at most banks.

Q3 Chair: ROEs?

Michael Cohrs: Return on equity. The problem with return on equity is that most banks bought back equity and made themselves not very stable to increase their ROE. That was typically tied to a remuneration contract. Most of that has been changed as well, so I think there is good evidence that the remuneration system is changing. In terms of changing culture, I am not optimistic that you can change the culture of an institution through regulation. Try as we might, as regulators, all we can do is create the right incentives and hope. To some extent we can also at the senior levels of an organisation approve or not approve the types of individuals who might run those places, but we would be mistaken if we thought that the regulators can go into an organisation and impose a culture that they would like. The organisations themselves are going to have to do it, and we have to use incentive tools to create the right outcomes.

Q4 Chair: And those incentive tools-incentive requirements and remuneration requirements-should be mandated by the authorities?

Michael Cohrs: Yes.

Q5 Chair: What change would you like to see mandated?

Michael Cohrs: I would go a bit further. A typical business cycle is around seven years, so I might lock up remuneration for 10 years to make sure we have gone through a business cycle before people are paid out. So I would extend the length of these pieces of paper that people get at the bonus time, maybe out to seven to 10 years. I would make sure that the employee is getting paid, as I said, in subordinated debt of the organisation. That aligns them with the creditors, which I think is a good thing. These should be mandated, and they need to be mandated globally, because if we do not, the banks will create HR centres in countries where regulation perhaps is not quite as rigorous. We must be mindful of that. We have shut down a lot of regulatory arbitrage that used to exist, but we have not shut it all down. Getting these remuneration standards more global and getting agreement with our fellow regulators is quite important.

Q6 Chair: Supposing we try to get this global agreement but it proves impossible-maybe we can get it with some other regulators, but not globally-what do we do then?

Michael Cohrs: We just make sure that the people who work in our banks in our country have to follow our rules. In other words, if we know that somebody is running a desk in London but they are being remunerated in Singapore, we have to not allow that, basically. We have to be very tough on things like that.

Q7 Chair: One last question before I hand over to my colleagues, or perhaps two if they will be indulgent; we are slightly short-handed at the moment because two members of this sub-committee have been unable to attend this session, for different reasons. First, there has been a lot of discussion-and in fact you homed in on it in your initial remarks-about regulation having become far too complex and the need for it to be simpler. Can you say whether that would be desirable in itself, which may well be the case, or will it maybe assist in having a healthier culture because there will be less focus on box-ticking and gaming the complex system of regulation-it may be better if it is based on simple principles?

Secondly, even if there is not that game, there may be others that come from having a simpler rather than more complex form of regulation or supervision. In that context, what would you like to see, and what is your view on Basel III, which is an incredibly complex system that goes completely against the spirit of what you were saying?

Michael Cohrs: In terms of culture, I am not sure that I think the complexity of regulation has much impact. Ultimately-this is very simplistic, so I apologise, but I really believe it-we want people in finance who understand right and wrong, because it’s actually pretty simple. It’s not all that complex: you can either do things the right way or the wrong way. To hide behind complex rules to pretend you are doing it right when you are not is where culture starts to go in the wrong direction. So I am not sure that the complexity of regulation ultimately matters that much, as long as an individual understands right and wrong.

In terms of the complexity of regulation, we divide ourselves at the Bank into different categories-some people are capital people, some are liquidity people, I am a leverage ratio person.

Q8 Chair: Andy Haldane.

Michael Cohrs: Leverage ratio-total assets divided by equity, that is how I would regulate the banking system. It is the only indicator. Before almost every crisis we have had in that last 200 years, one of the things that happened was that leverage went up in the financial sector. If you measure it in a very simple way-assets by equity-it gives you a pretty good indicator. I don’t buy the argument that by doing that we push banks into only buying risky assets, because that comes back to my first principle, which was that these people understand right and wrong, and the person who understands right and wrong does not go off and simply buy all the riskiest assets. So that is how I would come at financial regulation; I would rely heavily on simple leverage ratios.

Basel III is, as you said, very complex. There must be a question as to whether it is going to be implemented. Basel II was never really fully implemented. That creates a problem, because that creates uneven playing fields, which the bankers are very sensitive to. I believe that, if the banks all think that they have effectively the same rules, even if those rules are very tough, as long as the banks think they are being applied to all of them on the same playing field, they accept them. What they don’t like is when they have a feeling that in some countries the rules are applied in different ways, and then they start to think about how they can arbitrage that by starting to shop for regulators who may be easy on them. Level playing fields are very important. My colleagues will have a much better feel than I will, but I am not sure where Basel III really is, or whether it will be implemented. I have my doubts, from what I am hearing, about whether it will be implemented.

There is a very important simple test. You may know that the FSA sent out a portfolio to its constituents and asked them to risk-weight it. It was pretty simple. I think the expectation was that there would be a very narrow spread among the banks when they came back with this relatively simple portfolio. Lo and behold, it came back and there was a massive spread between the bank that was most conservative and the bank that was most aggressive. Risk-weighted assets are at the heart of the Basel ratio system. Therefore, you just throw your hands up. You start from there and say, "It doesn’t really work."

I believe that as regulators we are fixated with capital and yet the amounts of capital we are talking about are really tiny. Does it really matter if a bank has 8.5% or 10%? In 2007-08 it didn’t make any difference. They would have had to have had three times that much to have survived. I don’t think we are going to go to three times as much, nor do I think we should. We have to think about capital, liquidity, leverage together. We should always talk about those three concepts together, never as one or the other. One of the concepts has to be quite simple, such as a simple leverage ratio. The other ones can be complex, as long as they are looked at with the other ingredients. The mantra from the regulator should not be capital. The mantra should be "leverage, liquidity, capital", seen as a whole.

If you give us those three tools and we set the appropriate benchmarks we can have a financial sector that is functioning and taking risk-which we want it to do-and we can have a relatively safe financial sector.

Q9 Chair: To adapt the words of the Bible, you are saying that the greatest of these is leverage.

Michael Cohrs: Yes.

Q10 Chair: Before I go to my final question before opening it up, you said that you want a level playing field. I think we would all agree that a level playing field is highly desirable. Supposing it is difficult to get a level playing field or the discussions go on and on. What do we do then?

Michael Cohrs: We err on the side of being tough with our banks. We don’t take excuses. The excuse, "We are going to move headquarters"-rubbish. The excuse, "We can’t lend money"-rubbish. We call the banks out on these various blusters they have been putting up. We err on the side of being tough.

Q11 Chair: This is the last question I have at this stage. I was very struck in your excellent "Broken Glass" speech that you suggested that it would be a good thing to break up the big banks. Can you say what you had in mind and what you think the benefits would be from that?

Michael Cohrs: I think what I said was that, absent an explanation of why banks should be global and big-and I don’t see a good explanation-they should be smaller. I know we can’t solve the big issue. The big elephant in the room is "too big to fail". As long as we don’t solve "too big to fail" we haven’t made much progress. We haven’t solved the "too big to fail" argument. That means that the public is still at risk. Until we fix that, we haven’t moved very far from where we were.

I come at it from an ability to resolve a failed financial institution. The way I think about it is: if you had advised the Chancellor of the day in 2008 on individual banks, I think your advice would have been very short: "Chancellor, you have only one option, which is that the state has to buy into this bank. Otherwise, we will have a catastrophe."

I want to get to a position where the adviser to the Chancellor of the day can say, "You have two options. The state can buy the bank and prop it up, or you can let the bank go bust, and here will be the consequences but it is a viable option". Today we do not have that second option. Until we get there, we should expect that we will get some bad behaviour from the banks, because they know it is a one-way trade. We should expect that society will be really unhappy with banks and bankers, because they know that ultimately they are the backstop. Until we get there, we have not moved very far. We are not there yet. I think that any of my colleagues would sit here and say to you, "If we look at the world’s really big banks, we can’t put them through a resolution regime right now that works." Therefore I think they are too big.

Q12 Chair: So what would you do precisely?

Michael Cohrs: I grew up thinking that Glass-Steagall was written by a bunch of dumb old men. That is what I was taught. I have changed my views on that, but it is hard to go back to the investment banks being partnerships, which is what you want them to be, and the commercial banks caring about clients, with lots of regional offices, and with a relationship manager and a credit officer in a region where they know their clients. That is the world that we want. Getting back to that is really hard to do.

In the first instance, I do not care so much about structure and whether an investment bank is in a commercial bank. The structure, to me, is not that important. Every type of structure has failed at some point in the last 100 years. Anything that we have devised has shown that they can take too much risk, so structure is not terribly important to me. What is important is to have the confidence that we can put a financial institution through resolution, which we cannot today. To me, it is about size. So I would not focus so much on the structure as I simply would on size.

At some point, banks and financial institutions become hard to put through resolution for two reasons. One is just pure size; the second is geography. They operate in so many places and you have to have so much co-operation among regulators that you cannot resolve them, so in my view you attack size and geography. I want to understand why banks think that they need to be global and think that they need to be big. I have not heard good explanations as to why the owners should want that.

Q13 Chair: I understand entirely your explanation. What I am not entirely clear about is precisely what you are proposing.

Michael Cohrs: Lord Lawson, I said in my speech that maybe we should think about attacks on size, which would give banks an economic incentive to not be so big. If they want to have a trillion euro balance sheet, they can, but they will pay a price, and that money will go into the resolution fund that we use to resolve banks. This, by the way, in my humble view, would be on top of all the other things we have already done. The banks will be moaning, because we have already done a lot of things to them, but this size thing is a big issue. I would think about creating economic incentives or disincentives, depending on how you look at it, to not be really large and to not be too global.

A bank ultimately has a licence to operate that is fundamentally based on deposits. The minute you start taking in deposits, we as society care about your activities. To me, where you take deposits is quite important. A bank should operate in the geographical area where it takes deposits. If banks want to operate outside that geographical area, I pause and wonder what good it does us and how we regulate that, because it is not easy. In my very simplistic-I apologise, it is very simplistic-world, I believe banks have to be more regional and this concept of deposits is how I think about it.

I also think about a bank manager having a catchment area that is about a two-hour drive in his or her car. That is the area that they can cover. That is the way in which banks used to be set up. We do not have banks like that in this country any more, and a lot of the problems that we are trying to solve with very complicated schemes come back to the basic structure of banking, which is wrong.

So, I want to see smaller banks. I want to have incentives for banks to be small. I would also like to see banks that are not as global as today’s banks are.

Q14 Chair: That is the tradition in the United States. We have a different tradition in this country. We have a tradition of big banks on the retail deposit-taking side. The tradition used to be that the so-called merchant banks were quite separate from the so-called clearing banks. I do not want to put words in your mouth, but are you suggesting that if you load sufficient incentives, as you call them, in terms of a differential tax regime on larger, more global banks-you may not be saying this, but I want to explore it-there might be shareholder pressure for them to unbundle because they might be worth more separated than together?

Michael Cohrs: Look, it is clear that banks today trade at a fraction of their book value, so the owners-the shareholders-and the market are telling us that something is fundamentally wrong with how banks are valued. We have clear evidence that even the banks that we consider to be the best run in the world have had embarrassing incidents in the last six months. That shows that they are too big to be managed. Almost anyway you cut this and as much as I do not want to sit here and say publicly I think we should be trying to shrink banks-this all sounds like neanderthal stuff-there is a lot of evidence that the banks are too big to be resolved, too big to manage, and they are not providing the basic services we want them to provide in Bristol, Taunton or wherever they are because they do not have offices there any more. They have forgotten how to do the type of banking that produces the loans that we so much want them to produce.

Try as we might, we will not change much with the current structure. You can have a big bank-I am not necessarily against banks with big market share-but I am against banks that are London-centric, and using models in London to make loan decisions in a different place. Having run loan books, I know that that does not work.

Q15 Chair: When you express these views at meetings of the Financial Policy Committee, does anyone agree with you?

Michael Cohrs: No.

Q16 Mr Love: You said the British banking system is London-centric and does not respond to the needs of Bristol or Manchester. Let me press you a little, because we are interested in how to deal with size. If we assume we want a smaller banking system, we must come up with some solutions. The two suggestions that come immediately to mind are that the Government should break up particularly those in which they have a major shareholding, or that we should use competition policy and the concentration of personal current accounts and small business banking in a number of institutions as a way of achieving that. Are you sympathetic to any of those?

Michael Cohrs: I do not think either of those work, sadly, because 30 years from now, when our children are running this hearing, the banks will have got back together. In America, we have an interesting law, which I have made my colleagues aware of, and some have picked up on it. It is that no bank in America can, through acquisition, acquire more than 10% of the deposits in a given state. That rule applied only to merger and acquisition activity, but it has been generally applied by the regulators as a rule of thumb. That is interesting when you think about it, because it is not about capital and so on, it is about deposits-your share of deposits-and because of that the country has a very spread-out banking system. Every year, the FDIC puts hundreds of banks through administration, and you do not even know about it. I have had the FDIC over here working with the special resolution unit at the Bank because they are the pros. On Friday night, a bank is closed; on Monday morning you are up and running with customers and a new bank. It all works.

How do you apply that to this country? I have spent a year thinking with colleagues at HMT about how that might apply. I thought about a county basis, but counties are not legal entities. The neat thing in America is that a state is a legal entity with elected representatives, so it is a nifty way of building some regulation. I have even sat with colleagues at HMT, and drawn the United Kingdom up into sections to think about whether we could come up with something that might work. Unless you have some type of concentration rule-I would probably use deposits as the test-those other things will probably fail. You will put them in place, you will break up a bank and, guess what, it will just put itself back together. Ultimately, you have to legislate for competition based on percent of deposits that an institution has in a geographic area.

Q17 Mr Love: You will get me on to the subject of regional government, which I know my colleagues will baulk at.

Michael Cohrs: I will try to stay away from that.

Q18 Mr Love: We are on standards and culture. One of the issues you raised in your introductory statement was a concern about conversations, or the lack of them, between regulators. That undoubtedly was a major contributor to the difficulties that the regulators got into. However, some of the evidence that we are receiving is that with the FCA and the PRA we may have exactly the opposite-they will be competing with each other; there will be perhaps too many conversations. Is that a concern that you share?

Michael Cohrs: I don’t have a concern within the country. My observation for the entities where I travel-the Bank, the PRA, the FCA, HMT and, to some extent, parliamentarians-is there seems to be a reasonable amount of communication between those entities. The Governor speaks to his counterpart at other central banks on a regular basis. The deputy governors travel a lot; they meet people. I get more concerned about the working level, where there is not as much communication as I thought there might be. Of course, when it is time to put a bank into resolution, it is not the governor who does the resolving, it is the working-level people who have to do the work. I would love to ask Andrew Bailey, who is one of the world’s experts in resolution, whether he thinks that if one of these huge banks had a problem today the people in the bank would, from a communication perspective, understand who they talk to at the Bank of Japan, the Bank of China, the Federal Reserve or whatever. I don’t know the answer to that. My suspicion is that there is not as much interaction as I thought there might be at that level.

Q19 Mr Love: Do you think that this is bedevilled by differences in structures? The European system of regulation is quite different from the one that we are introducing. Some people have suggested that that makes the communication you are talking about more difficult. Do you have any sympathy with that view?

Michael Cohrs: There is certainly competition between all these entities. They all want to be seen as being clever. I have learned that, within the regulatory world, being seen as clever is quite important. It is almost as important as a bonus is to a banker. So there is some competition around such things as thought leadership and making sure that the idea was invented here first. I suspect that part of what might hinder some co-operation is people wanting to make sure that their speech is the first speech to recognise a given issue or come up with a solution to a problem.

Q20 Mr Love: Can I come on to the setting up of the PRA and the FCA? It was done to much hooray, particularly about judgment-based regulation; rules-based and tick-box was now out. We received in evidence suggestions that, when the FSA was set up, it was formulated on the basis that it would be judgment-based. First, do you agree with that and do you think that there are real dangers that somewhere down the line the PRA and the FCA will fall into bad habits?

Michael Cohrs: Let me make three comments. First, going back to my original statement, we need bankers who understand right from wrong. That is an important ingredient. It doesn’t really matter what-

Q21 Chair: How do you get that?

Michael Cohrs: You have to have bank managers who reward good behaviour and punish bad behaviour. In the past 20 years in the banks, good behaviour was defined by making money. Those are the people who generally succeeded in the bank and became senior. That was one of the only criteria. You have to go back to a system where good behaviour is rewarded, and part of that good behaviour has to be seen in client satisfaction: as a banker or as a financial professional, you must put the interest of the client first, and you must ensure that there are no conflicts, so even the whiff of a conflict ruins your reputation. We have to get back to that kind of world, and we are a long way from that. Ultimately, you need both rules and judgment. You can’t have only judgment regulation, because there have to be some rules that we can all work from. It is very clear that the rules themselves should be simple, and judgment has to be applied to them, but then the sector itself has to have individuals who understand right and wrong, and are not as fixated on what the year’s bonus pot is going to be.

Q22 Mr Love: What would you say to some regulator who said that rules are black and white, and you either pass the rule or you don’t-they are a bit tick-box-whereas judgment is very grey, so there is some security in rules-based regulation that you perhaps do not get otherwise?

Michael Cohrs: Mr Love, I think I can take any rule and, given enough time, there would be a way around it, or I could show you how banks, in the past, have gotten around it. It does not matter how simple the rule is. You have been hearing a lot of evidence about the lobbying power of the banks and how good banks are at tunnelling under the fence or going over the ring fence-whatever we are calling it now. They are bright people, and if the incentive is, as it is today, just to make a lot of money, and we don’t care about customer satisfaction, then you will continue to have that kind of behaviour.

You need to have simple rules. Judgment needs to be applied to them. The banks themselves have to be assessed, in part, on the service that they provide to their clients. I can’t emphasise this enough, this concept of a client: whether it is an investing client on the trading side or the corporate client or government client on the corporate finance side, that basic relationship broke down in the last couple of decades. The banks became competitors to those clients, to a large extent, and they had one goal, which was to make a lot of money, as defined by return equity.

Q23 Mr Love: You mentioned assessment then. There has been a lot of discussion about how to do assessments. You want prudent management and the culture that backs that up, but how do you assess the culture of an organisation, and whether it is working in tandem with what it is that the regulator is trying to achieve overall?

Michael Cohrs: First, you go in and look at how much time the management spend even thinking about those types of problems. A good management team will have set up review systems that assess the employees, so you look to see how the employees are being assessed: is it based purely on money and on market share, or is there some assessment of how happy the client is? Have they surveyed the client? Is the client giving feedback, and if so, what is that feedback? Client satisfaction is an important part of how you should assess your employees if you are the management of one of these institutions. In many cases, I think you would find today that that client satisfaction piece dropped out of how bankers were assessed or only had lip service paid to it. We need to put that piece back, front and centre.

Q24 Mark Garnier: I am quite keen to continue with the business culture. You have said on a couple of occasions that what you want is people in finance who understand the difference between right and wrong. That is absolutely core to this whole issue, and it is something that I don’t think that we can even begin to address in regulation. But Ali Parsa said something that struck me. You may have worked with him at Goldman Sachs, way back when; he is now the chief executive of Circle group, which runs Hinchingbrooke hospital. We asked him to talk to one of our panels about alternative management methods, and he told us something which struck me as being absolutely crucial to this whole thing: when he was first at Goldman Sachs, he did a deal, and his boss took him in and said, "Ali, well done on doing that deal, but you have charged too much, so phone your customer and tell him you are giving him some money back, because you’ve got it wrong."

The fact that he mentioned that when he came before us two or three weeks ago was the most important thing, because that was something that he had taken right from the very start of his career in banking, and it is what happens when you first start. It is what happens when you are first taken on as a graduate trainee or a blue button on the floor of the stock exchange, as I was. It is the person who is mentoring you, and it is that person who instils in you those very first thoughts about what type of person you are going to be in your professional life. I do not know how we get to this. Obviously, the whole point of the Banking Commission is to try and answer those questions, and one of the things I have been struck by is the sincerity of the people who run these organisations-that they want to drive good standards. But the inescapable conclusion seems to be that no matter how enthusiastic you are at the top of the business, in terms of getting that down to the front line-to the hot-blooded traders on the dealing desk or to the customer-facing bankers in Bristol-these organisations are too complex. Have you any thoughts on that statement?

Michael Cohrs: It is interesting that you say that, because as much as people malign Goldman Sachs, I was trained that way there, and when I went to S.G. Warburg-the old S.G. Warburg-whatever Goldman did vis-à-vis clients was 2x at S.G. Warburg and Company. They were totally client-focused. It was quite extraordinary.

I think that we are not going to get there, to answer your question, in part because we are still focused on a bonus culture that rewards people for making lots of money. The fact is that serving clients is hard work and it is not terribly profitable. One of the big secrets of banking is that retail banking, capital markets activity, and M and A advice-it’s just not very profitable. It is so much easier to have 10 traders on a trading floor doing the carry trade and making a lot of money, so, of course, over 20 years the smart people gravitated to that type of activity. That activity, to some extent, competed with the client because you were using client flows-not in an illegal way, but you had so much information that you could trade extremely well and you had a funding cost that was very low because we have banks that are too big to fail, so as long as we have a bank that is too big to fail, it will have a funding cost that allows it to fund. You buy a risky asset, and you buy a hedge for that risky asset, and there is enough left over to do the carry trade. Why do hard work like serving clients when you can do that?

Until we eliminate the implied subsidy to our banking sector, which exists today because people think that we will bail them out when they get into trouble, it will be pretty hard to get to this nirvana that we are sitting here talking about, because it will continue to be very profitable to run trading operations-one of my colleagues has wondered whether that is a socially useful activity, and I think that that is an interesting idea.

Q25 Mark Garnier: If you look at the pre-big bang City-I pay deference to the Chancellor of the Exchequer at the time, who took through big bang-and certainly at the stock exchange, where I spent my formative years, you had a very different set of cultures. You had the stockbrokers who were not allowed to take principal positions and who absolutely had to dedicate-on the basis of minimum commissions-their competition on the excellence of the service they gave to their customers, whereas the market-makers who were at risk were not allowed at any point to have any contact with the so-called outside world. I slightly hesitate to say that it was a better system, because it had its problems then as well, and we often look back at these things with rose-tinted spectacles, but it did seem, in that small micro-world of the stock exchange, to be a system that worked quite well. Do you think a type of separation is right, where what is very much customer-focusing is identified and should be on one side of a ring fence or whatever-or as some business-and then you have complete separation from that risk business, which is about turnover, cash flow and all the rest of it? Do you think that is core to this debate?

Michael Cohrs: I think it is core to it, but I would make an even bolder statement, which is that if a bank is allowed to do proprietary trading, or proprietary investments, you will not have a culture that you like, because de facto, you are then competing with the client, and it is a heck of a lot easier to do proprietary work than it is to do client service. The best and the brightest within the institution will gravitate to the proprietary activity and we will end up where we have ended up, which is with bankers who sometimes do not understand right from wrong, or at least a pool of them. I think that Volcker was on to something. I am not necessarily happy with how it has been implemented, but this concept that proprietary activity exists within a client-serving organisation is false.

Q26 Mark Garnier: Almost cancerous.

Michael Cohrs: Yes.

Q27 Chair: So you may have your reservations about the particular implementation in Dodd-Frank, but do you think we would do well-I am inferring, so this is a question and I may be wrong-to introduce legislation to impose a Volcker rule in this country?

Michael Cohrs: Yes, Lord Lawson, I do. I fear what will happen to me when I leave this room and see all my friends, but I think if we really want to get to a culture that we like, we have to be quite radical. I do not see anything on the table today that gets us there on the cultural side. We have clearly moved the ball and I do not want to leave the impression that I think we are wasting our time, because we are not. We have made a lot of improvements for all but the largest banks, and we could put them through resolution at this point. We are making progress, but we just have not made enough progress in my view. I still wonder, even with the smaller institutions, about the culture. I believe that, until we are absolutely confident that the adviser can tell the Chancellor of the day, "You have two options", and mean it, and until society believes it and until we have taken away the subsidy, we are in a bad place, because people should not like bankers, which they do not, and bankers will do perverse things, because we have given them incentives to do perverse things.

Q28 Mark Garnier: Can I ask about you something slightly different, which is the supervisors and the regulators? I do not just mean the PRA and FCA; I also mean the internal risk people and the compliance departments. How do we motivate them to ensure that these issues are compliant and to drive these cultural standards?

Michael Cohrs: That is a great question and I do not have a good answer to that. I was at Deutsche Bank for a couple of decades and the risk system in Germany is different. The risk division of a German bank reports directly to the board of directors; it does not report to the chief executive. I would love to sit here and say one of the reasons why Deutsche got through the crisis relatively well was because of that different risk system, but if you pointed me to two or three other German banks, we could prove that that system did not work so well with all of them. It was an interesting system. I was an internal board member, and one of my colleagues was head of risk, but once his division has taken a view, to get them to change their view it had to go to the board of directors. That was a hard thing to do, so they were very independent. In my experience, it worked quite well. Something like that may be worth exploring, but it is not easy and the bankers will say to you, "If you do this, we will stop lending", which is what they say to just about everything.

Q29 Mark Garnier: They have to lend, because that is what they do.

Michael Cohrs: My observation is that if you look at the average British bank, roughly a quarter of its balance sheet is not lending-related items. People forget that our banks no longer see lending as a core business. In fact, for many of our banks, only 40% of their balance sheet relates to lending. There is this concept of forcing a bank to de-lever-sorry, this is going off to a slightly different topic, but I am passionate about it-but there are plenty of ways for a bank to de-lever without touching their ability to lend money.

When it comes to risk management, it is an important issue. Historically, the compliance and risk management people were not well integrated into the organisations. In fact, sometimes there was a feeling that they were more on the side of the regulator than they were on the side of colleagues within the bank, which was not a good place, because you want them to be integral to the team and you need a team culture. A concept like the Germans use is worth thinking about because the notion of a risk unit reporting directly to a board gives them the independence they need.

Q30 Mark Garnier: You talk about being part of the team. Are you suggesting that you almost get to the stage where if you are setting up, say, a French equities sales trading team, within that team you have a guy who just sits there as a risk guy? He is part of that team and goes out and has a beer with them after work.

Michael Cohrs: Absolutely. But in my world the boss is also somebody who cares about risk. So in the world that I grew up in, the boss was not a big risk taker. The boss was typically Mr or Ms No, always challenging the team as to why you should do a piece of business, and not trying to put the piece of business on the book immediately. In that world, the team is trying to come to the best risk decision they can. When I worked in partnerships, it was pretty easy because your money was on the line and your mind was totally focused. That is clearly the best system. There is no doubt about that.

Q31 Mark Garnier: That was going to be my last question. The concept of unlimited liability-I have always thought that the biggest measure of risk is waking up at 3 o’clock in the morning in a muck cold sweat that a decision you have made that afternoon will result in your son being thrown out of Eton for unpaid school fees and your daughter’s pony being repossessed at the gymkhana on Saturday. Do you agree that we should be aiming for that type of thing?

Michael Cohrs: Absolutely. But how we get back there is hard to imagine given how large our financial companies are. An interesting sidelight: many smart people thought that the hedge funds would all go pop during the financial crisis. They largely didn’t. They largely didn’t because they are mostly partnerships.

Q32 Chair: Earlier, you said that you weren’t too fussed about structure. Subsequently you came up with a structural reform, the Volcker rule, properly implemented. You gave a very good reason why you thought that this would be desirable. Going on to the culture thing, it seems to me that you could make a similar case for some modern form of Glass-Steagall-if you like, going further than the ring fence because of a number of things emanating directly from what you have been saying. First, the culture of commercial banking, lending to retail customers and SMEs, is rather different from the trading culture of investment banks, partly because it is easier to see the banks that are focused on lending because, as you pointed out, that is only a small part of when banks do the trading. They tend to be much more customer focused. They also historically-I agree there have been many lapses, but this is a relatively straightforward thing to supervise-have been more prudent, necessarily, than the rather more adventurous investment banks. Finally, when you say partnerships are the ideal form, it is much easier to envisage an investment bank as a partnership than it is to envisage a universal bank as a partnership. Do you think that there might be, for the reasons that you have advanced-so far there is always the danger that it will be aspirational, just motherhood and apple pie, which are delightful things to have, but the question is what are you going to do about it-some help, some sense, in moving in that direction?

Michael Cohrs: Yes. I liked your expression of a modern Glass-Steagall. That is sort of where we are headed. As I said, I am not completely pessimistic. I think that Vickers is a step in the right direction. To me, however, it is only a step in the journey because I think a modern Glass-Steagall will ultimately see total separation. I actually thought that John and his colleagues did what they did because they came to a view that total separation was not feasible. I gave evidence in front of the Treasury Committee and said that I had had a mandate as a banker to try to separate an investment bank from a commercial bank. I gave that mandate back to the client after two years because I couldn’t do it. I think that it is really hard to do total separation. I have quizzed a number of members of Vickers to say, "You guys wanted total separation, didn’t you; you just couldn’t figure out how to do it and that is why you have done ring-fencing?" and I have not gotten satisfactory answers.

I think that we are on a journey, and Vickers is a good path for us to follow. I like the concept of modern Glass-Steagall. I need to think about-and get some of the brain power at the bank thinking about-what that might encompass because it is not easy. People really do not understand just how big the top 10 banks in the world are-at Deutsche, we had a €3 trillion balance sheet-and it is hard for anybody really to get a grip around such large entities, which are not straightforward like an industrial company. So, modern Glass-Steagall is something that is worth thinking about. How we get there, and over what period of time we get there, we will have to think hard about. I quite like that.

Q33 Chair: One other point that I would like to pick you up on. I think that you made an important point when saying that, one the whole, the hedge funds performed much better during the financial meltdown-they suffered less-because they had performed rather less recklessly than the conventional banks. I think that that is important, and that lessons can be drawn from that, as you did. Hedge funds are a very important part of the shadow banking system as it has come to be called latterly. There are some people who feel that if you are at all tough in your regulation or supervision of the banks, you will shunt business away from the banks to the shadow banking system, which, it is said, would be appalling, the end of the world and so on. Do you lie awake at night worrying about that?

Michael Cohrs: I wish we had more of that because it would achieve my goal of making the big places smaller. I accept that shadow banking is an issue, and we do worry about it, but I am more worried about how large the largest banks are. To the extent that they hive off some of their activity and send it into shadow banking, the next generation of people who will do what I do can worry about that. In the meantime, I lie awake a lot more at night worrying about how big the big banks are.

Q34 Mr Love: I am interested in what changes you would make to shadow banking if there were to be that shift. I believe that some transparency is necessary so that we can understand what is going on in that sector, but I do not want to pursue that. I want to touch upon a comment you made earlier, which I felt was dismissing the attempt by some of our banks to suggest that if we introduced too onerous regulation, they may go somewhere else. I would like you to give a more comprehensive comment on what you think about that. I understand that that was an issue when you worked for Deutsche Bank, so I wonder if you could explain to us the rationale behind that and the final decision not to move.

Michael Cohrs: You may remember that, about a decade ago in Europe, the concept of being a European corporation was introduced. Allianz, the large German insurance company, went from being an AG to become a Euro company. We looked at that because it was modern and there may have been some benefits. In the case of Deutsche Bank, at least, before you even got to the emotional and cultural issues, which were very big-we were as German a bank as you could possibly be-just the complexity and, to be very blunt, the tax bill of leaving the country made the whole concept a non-starter.

I would suggest that, of our banks-one of our banks is different because it came here relatively recently. In that case, maybe that bank kept in place a structure that would allow it to move back to whence it came, although that bank has announced, I think quite helpfully, that they are not going to take any decisions on their jurisdiction until 2015, which is outside this Parliament. I thought that that was quite a clever thing for them to do. But generally speaking, it is really hard-just as it is really hard to separate a bank-for a bank to move its jurisdiction. That is before you get into the cultural issues, which, for a bank, should be very important. So I am dismissive of bankers when they tell me-I used to be one of them-"If you don’t give us a good regime, we will go elsewhere." It is rubbish.

Q35 Mark Garnier: Just to follow on from that point-because I think it is very important, this whole issue about the banks; I think it was HSBC you were referring to-what are the other reasons why they are here?

Michael Cohrs: You know the most important reason? Greenwich Mean Time. I had people in 77 countries, and I could always talk to somebody on a 24-hour basis who was in the office working. If you are running that kind of business, being in Greenwich Mean Time is ideal, because you can do one half of the world in the morning, you do your home market at lunch, and you can do the rest of the world in the evening. No other location has Greenwich Mean Time. Don’t underestimate how important that is to the way a bank operates. A lot of it is automated, but a lot of it is not; it is people talking to each other, and time zone is really important. That is one.

Two, language is critically important. The world has adopted our language; that is very important. Three, our legal system is very clear. It works. People want to litigate in this country. That is a big asset that we have. We should make this into an industry, as a country. We are probably not charging enough for people to come here and use our courts.

Q36 Chair: The lawyers know how to charge.

Michael Cohrs: That’s true. I am not worried about the country, but the Exchequer.

That is important. Finally, London is a pretty neat place to live. These people make a lot of money. They want to spend their money in a pleasant place, and London is a very pleasant place.

Q37 Mark Garnier: And each of those is unique. Put together, they come up with an unchallengeable edge.

Michael Cohrs: Greenwich Mean Time-

Q38 Chair: That’s not going to change, is it?

Michael Cohrs: It is unique in the sense that there is no other city in Europe that benefits from Greenwich Mean Time and has any of those other-I shouldn’t say that; you know what I mean.

Mr Love: So you are not expecting Beijing time to emerge some time in the next 30 years.

Q39 Chair: May I open up briefly on two other aspects that we haven’t yet discussed, before releasing you? First, the quality of supervisors is important. I am old-fashioned. When I had some responsibility for these things, we called it supervision rather than regulation. I think that was better. That is why in the Banking Act 1987, which I was responsible for, I set up a board of banking supervision. I think that is important.

The critical question I want to put to you is that you need able people. You have said that you don’t want to make this task unnecessarily difficult, but you also want able people. How are you going to do that when, if any supervisor is any good at all, he or she will be poached by one of the banks at a greatly increased salary? When I had some responsibility as Chancellor of the Exchequer, there was not a problem of having able people in the Bank of England-in those days the Bank of England was responsible for everything-on the monetary policy side. The problem was having and keeping really able people on the supervisory side. What is the solution?

Michael Cohrs: There are a number of solutions. First, I would strongly encourage you to listen to Mervyn King’s speech that he gives to graduates who come into the Bank or people who are thinking about what to do. He gives a very compelling speech about being in a career in bank regulation. He talks about a career, which is something, to be blunt, that you do not see financial institutions talking about. They talk about money, about a year or about two years, but Mervyn gives a very compelling speech about a career.

Secondly, the gap is closing, because the banks are-

Q40 Chair: Temporarily.

Michael Cohrs: Well, if we take away the subsidy, which fuelled a lot of the profits-the extraordinary profits that the banking sector made were because the public were writing them a free putt. If we take that away, you would expect that banking pay will normalise, so the gap will close.

Thirdly, in the public sector, if you have a career, you actually get a pension. That is unheard of in, frankly, most of the private sector, but it is certainly unheard of in the financial institutions. That is interesting, because if you had come to me when I was a young person starting out and talked with me about pensions, I would have struck you off my list of companies that I wanted to work for, because I thought that any company that would think about pensions was too dull to want to work for. In today’s world it is so difficult for young people to get jobs, and thinking about a career with one or two companies is almost gone. This concept about coming to work as a public servant and making a career of it, the reasons for doing that are quite compelling. Then, if you can get people into these places or interviewing with these places, you realise that they are really bright people. If you just replace money with being clever, it is a very interesting dynamic, and you could convince people to do it.

Q41 Chair: You could convince a child of yours to have a career as a supervisor?

Michael Cohrs: I’m working hard on that, but they want to have nothing to do with finance.

Q42 Chair: The other issue that would like briefly to mention is something that concerns me, which, again, I put into the 1987 Act, but it did not entirely work. I tried to ensure that there was a constant dialogue between the supervisors and the auditors of the bank. If they feel that their advice to their client is not being followed, do you see an advantage in auditors, who are obviously afraid to qualify the accounts of a bank because of the consequences, tipping off the supervisors about concerns they have about a bank? Equally, do you see an advantage in supervisors saying to the bank’s auditors-all this is in private-"We think you ought to look at this aspect of what your client is up to"? Do you see any advantage in that? Do you think it should be made mandatory?

Michael Cohrs: I don’t see an advantage in it, because typically, the auditors are the last ones to know.

Q43 Chair: Should they be?

Michael Cohrs: No, but that’s just the way that the world works. If we talk about complexity, I despair when I look at the accounting profession and the rules, because I used to work at a bank where every day I would have a P and L, and I would run the bank in a certain way. When I looked at how we presented our bank to the public, I virtually couldn’t understand it, and we were following all the proper rules. There is such a disconnect between the way a financial institution reports, according to the rules, and the way it’s run. So I don’t think that is that fruitful.

I do think it is important to have a relationship between the regulator and the senior management of a bank. It is a place where this country has not done a good job, because I had a feeling that if I went to my UK regulator with a problem or an issue-this is a personal opinion-it spiralled out of control. The next thing I knew, there were 20 guys from the regulator in, and it was on the front page of The Times. There were other regulators that I could have a chat with and say, "I am worried about this or that," and it stayed confidential. They helped me work it through. They might discreetly send somebody in to help, but it was discreet. That was not the case in this country, and it was a problem.

The culture within our regulator-the PRA-needs some work. Andrew Bailey, the acting head, has the right culture. I think he will make a lot of progress, but I would much rather see a trusted-"trusted" is the wrong word; I don’t want regulatory capture. But I do want the concept that a senior banker could sit with the regulator and-look, if certain lines have been crossed, the regulator has an obligation to bring in 20 people and do an investigation, but there has to be a step in between, based on judgment, whereby the regulator could sit down with the banker in question and think through the issues. It may be that it has to become public, but my experience was in this country that the minute you opened your mouth to the regulator, it was public.

Q44 Chair: That’s obviously undesirable. You’re talking about the FSA, presumably?

Michael Cohrs: Yes.

Chair: You’ve been extremely patient with us. You’ve been here for well over an hour. Thank you very much. We know what the solution is to our problem-it’s simple: that all bankers should be like you. What we don’t know is how to achieve that. But you’ve given us plenty to think about. Thank you very much.

Michael Cohrs: My pleasure.

Examination of Witnesses

Witnesses: Michael Foot, Global Vice Chairman, Promontory Financial Group (UK) Ltd, and Dr Thomas Huertas, Partner in the Financial Services Risk Practice, Ernst and Young LLP, examined.

Q45 Chair: Mr Foot and Dr Huertas, welcome to this session of the Commission on Banking Standards, which is looking at regulatory issues. I do not need to do much of a preamble-you know what the Commission is looking into, and I believe you heard our questioning of the previous witness, or at least part of it. I would like to reiterate that, although we are interested in the specifics, our chief concern is anything that can be done to improve the standards in banking culture, because that is right at the heart of what the Commission has been set up to look at. With that reminder, may I invite either or both of you to make any opening statement you wish to make before we ask you one or two questions?

Michael Foot: I’ll go first, Lord Lawson. It is a pleasure to be here. I shall be approaching this from the point of view of a grizzled old supervisor. I was an economist for many years before I became a supervisor, but basically I worked at the Bank of England in the last few years of banking supervision’s time there, took 450 banking regulators over to the FSA and helped them to create the new FSA. I was there until 2004. I then went to the Bahamas to run the banking regulation out there. Since then I have been working as a consultant. Although my consultancy experience undoubtedly will have some impact on what I have seen and how I view it, I think that the best value for you is if I dwell on the things I have seen as a regulator here and in other countries.

Q46 Chair: Please do. Is there anything further you want to say at this stage?

Michael Foot: No, not at the moment.

Q47 Chair: Dr Huertas, may I invite you to make an opening statement?

Dr Huertas: By way of introduction, I was a banker for many years at Citibank in North America and Europe, including here in the UK. I joined the FSA as the director of wholesale firms in 2004, and remained at the FSA until 2011. At the beginning of 2012 I joined Ernst and Young as a partner in its risk practice.

Q48 Chair: Thank you. I will ask questions without directing them to one or other of you; please, both of you feel free to answer them. Indeed, I encourage you to do that.

Mr Foot, I was struck by your evidence to the Commission panel on HBOS, in which you said, among other things, that because of its crazy complexity and how demanding it was of resources, Basel II was a complete waste of time. There is certainly a problem on the regulatory front, there are no two ways about it. Do you think that that lesson has been learnt? To the outsider looking at Basel III, it would seem that it has not. If it has not, what precisely do you think we should do about it? Finally, do you think that, if we went back to a simpler system of regulation/supervision, it might not merely make supervision and regulation more effective, but even be beneficial for the culture of banking? Or do you think that it is neither here nor there?

Michael Foot: Right, it is a major question. I have to say that I think Basel III is somewhat better than Basel II, but I don’t for a minute think that the regulators have learnt the lesson. Solvency II would be the example I would cite, where we are going down just the same route of endless complexity, endless guidance papers, years and years of work and development internationally, and delay after delay in implementation. That is a more striking thing. To me, it seems that there is really a sort of triangle or quadrangle, but there are about three things that really matter to me. One thing the regulator has always said they wanted is for the people who run the business to incorporate the rules they are operating, and run with them-the front line of the business, the management. For example, under solvency II, the board of the insurance company have to basically absorb thousands of pages of paper and make that part of their daily life, and similarly with the banks. I do not think a complex system can remotely do that. Even bright front-line managers struggle hugely with anything other than relatively simple concepts they can get their minds round.

The second thing I would say is that there has to be certainty. We are constantly in a world where, because of the international perspective, things are being pushed back, made more complicated, reviewed because one or other aspect of the level market problem has not been addressed. I would much rather have-it is a question of building the Ford rather than the Rolls-Royce-80% of it done much faster, and live with the fact that 20% is unsatisfactory.

The last thing is that I have always been against, and am still amazed by, the emphasis on treating all firms in Europe the same, no matter what their size. In their approach to Basel III, the American regulators said basically that only the largest internationally active banks will be subject to the full rigours of Basel III and I think that is the way to go. I understand why we got into the problem in the single market. Everyone wanted certainty that there would be even treatment. What we have seen is that there is still not even treatment, and there is endless delay and complexity. Many of the smaller banks and insurance companies are burdened with an impossible set of rules that they have to live with.

Q49 Chair: Do you want to add anything, Dr Huertas?

Dr Huertas: Basel III is a distinct improvement. It significantly reduces the risk that banks will fail. It improves the quality of capital, increases the amount of capital, and introduces a back-up leverage ratio that supplements the risk-based ratio. It is the braces that go with the belt of a risk-based capital ratio. We tried a belt-only approach in Basel I, and that was seen not to work. We tried a belt-only approach in Basel II, and that was seen not to work. The belt and braces approach in Basel III is in my opinion the right approach for capital.

Importantly, Basel III also introduces for the first time a global liquidity standard, and puts in place requirements that banks monitor, measure and report their liquidity risk and take precautions in the form of a liquidity buffer against those liquidity risks. These are distinct improvements. Banking is a complex business, and as Bagehot once said, simplicity can be overdone, and simplicity for a complex problem is not necessarily the right solution.

Q50 Chair: I detect a slight difference in emphasis between the two of you. As I understand it, Mr Foot was saying that whereas Basel II is not as bad as Basel III-

Michael Foot: The other way round.

Q51 Chair: Sorry, Basel III is not as bad as Basel II was, but it is nevertheless not the right answer, and he wants a Ford. Could you tell us the design of your Ford?

Michael Foot: I want something that is a good deal simpler, and applies only to the five or so banks in the UK that really matter from a systemic point of view. If their culture were right, and their types of operation were right, the rest of the UK sector would largely fall in.

I take Tom’s point about some improvement in the quality of capital, although I suspect that the banks will be at it again very quickly with their CoCos and so on. They will be chipping away because it is expensive. On liquidity, I took part in the first discussion of liquidity, which was only in sterling, that the Bank of England had in 1980. We have been arguing about this for over 30 years, and in the meantime the level of liquid assets in the banking system in the developed world has fallen hugely. It is now rising back up again, but it is nowhere near where it was. Again, it depends what the central bank in the location will lend against as to what liquidity is. I do not for a minute think when we come to real pressure that necessarily the local lender of last resort will read their global standards and say, "That is all we are going to do."

Although I accept that there are significant improvements in Basel III, the other thing that worries me is the continuing difference demonstrated by the FSA in its review of risk-weighted assets, which the previous speaker was talking about. I found that all staggering. Basically, internally approved models can produce wildly different capital numbers for the same portfolio. As a supervisor, that makes me feel very uncomfortable, because you almost certainly know that the ones who produce the lowest probabilities of default will be the ones who are pushing the envelope.

Q52 Chair: So you would, like Mr Cohrs, place much less weight on risk-weighted assets and much more on, for example, leverage.

Michael Foot: Like him, I have changed my mind about leverage in the past seven or eight years. I was very dismissive of it because I thought risk-weighted assets gave us a better measure. I no longer feel that. If it were possible to produce some greater standardisation from the supervisor in how risk-weighted assets are treated, that would be better than what is currently the case.

Q53 Chair: You also indicated in your remarks a moment ago that the desire, which is very understandable and rational, to get a global, international agreement tended certainly to lead to delays and probably added to complexity. Do you think, therefore, that we would be better advised, in the light of that and in the light of the banking meltdown and disaster, to go ahead and do whatever we in this country-we are a major financial and banking centre-think is the right thing to do? In the light of the great wisdom of the Bank of England, the wisdom of the Independent Commission on Banking-the Vickers Commission-and, of course, the great wisdom of the Treasury, and maybe even in the light of what this Commission produces, do you think we would be well advised to go ahead with what we think is right, trying to get others to agree with us but still going ahead if they do not? Or do you think that that would lead to British banks leaving this country and going somewhere where they think they can game it better-what they call regulatory arbitrage?

Michael Foot: I think I agree with the previous witness as to the risks. There are risks, the longer the time horizon you have, of British banks leaving. The one he mentioned that only came recently, in historical terms-I can see that possibly happening, but I do not worry too much about that. In terms of harmonisation and additional standards, I would just say two things. I am strongly against any move within the EU to force complete harmonisation and not allow a country to have higher standards if it wishes. In terms of whether we should be just pushing ahead on our own, the UK is very well equipped, partly thanks to people like Tom and the many people who are still at the FSA. The UK has such a major input into what is going on that their ability generally to pick their way through this and find things that will meet UK needs but not seriously disrupt international relations by the UK appearing to get a flyer, for example-in nearly everything we do at the moment we are wanting to be tougher rather than softer-I think they could well succeed in doing that.

You made the point about delay. There has been obvious delay in policy development in areas like Basel III and Solvency II. There have been some things that have been worked on, such as the living wills and the RRPs and the kind of cross-border work that has been done, where a great deal has been achieved really quite quickly. In that case, particularly with the RRPs, it has been understood that the 80:20 model should apply. This first round of RRPs is not perfect, but it is a darn sight better than what we had before, which was almost nothing. That is the kind of intellectual model that I would like to see.

Q54 Chair: On the subject of HSBC, I do not know whether you are aware that in the 1980s Michael Sandberg, who was then the chairman of the Hongkong and Shanghai Banking Corporation, as it was known, came to see me and said that he would like to move the headquarters of the bank from Hong Kong to London. I thought that that was probably quite a good thing. I took the view of both the Bank of England and the Treasury at the time, and neither of them could care a damn one way or the other. The only body that had any strong feelings about it was the Foreign Office, who thought that it would be disastrous for Anglo-Chinese relations. At that time, nothing was done, but they came along later. At the time, neither the Bank nor the Treasury thought it mattered one way or the other to us whether they were based in Hong Kong or here.

Did you want to add anything Dr Huertas?

Dr Huertas: It is important to remember that the Basel accords are a harmonisation of minimum standards. Under the Basel arrangement, it is envisaged that each country has the opportunity to do things above the minimum. As Mr Foot has rightly pointed out, it is only a European Union consideration to impose a maximum-that the minimum also be the maximum. It has long been the position of the UK, quite rightly, that one should only harmonise the minimum. The UK, as Michael has pointed out, has a good tradition of acting quite quickly and in the forefront. Living wills are an example. The increase in effective capital requirements imposed in 2008 is another example. The early implementation of liquidity requirements is yet another example, as is the improvement in corporate governance.

Q55 Chair: I have one last point before I hand over to my colleagues. As you know, and as I indicated at the beginning, we are particularly focused on banking standards. We were set up in the wake of a great scandal and because of banking culture, which many feel is at the root of what went wrong. That was certainly the view of our last witness, as you know. Could you expand on whether you think there is any difference between regulation and supervision and how we should address the relative importance of these two concepts? They are clearly important in themselves, but do you think they have any bearing at all on the question of banking standards and banking culture?

Michael Foot: I will have the first shot. That is a difficult and interesting question. The main distinction that I see between regulation and supervision is over the implicit requirement that supervision has to exercise judgment. I am very comfortable with what Andrew Bailey has said about how the PRA will try to operate this, but we all have to realise-I am sure that he realises-that the kind of skill sets you require to exercise that judgment are hard to find. We all know that regulators here are quite difficult to keep. Although they are quite well paid, there are other things on the downside that tend to encourage them to move on.

I would also say that there are very different roles for the rules-based and judgment supervision in the different areas of the business. On the prudential side, for example, there is an awful lot of judgment that is required. In some of the areas like conduct of business or maybe anti-money laundering, the role for rules is significantly greater.

When it comes to how you can influence the industry itself, I think that there are basically two groups of people. There are those in the industry who are trying to do what is right, and the regulator can point the way quite often-as the FSA has done, for example-through guidance notes, letters to CEOs and the rest of it. I would encourage the PRA and the FCA to do that because it helps to make these things concrete. You can do something with the remuneration codes and the rest of it, though I think that when it comes down to it, when there is a tension between meeting an FSA-style remuneration code and your key trader walking out, the key trader wins every time. That is unfortunate, but it will be very difficult to change that-there is a limit to what they can do there.

As far as the other group is concerned-those individuals who do not care in the sense that they put a higher priority on short-term success and are prepared to walk the line or run the risk of punishment-all I can say is that the regulator has very few carrots so the sticks have to be as large as possible. These people tend not to care about the size of the fine on the firm; they care only about fines on them and serious damage to their capacity to earn money and maintain their reputation going forward. That is where the thing will have to focus as best it can.

The FSA has gone a long way, in areas such as market conduct, since I was there to improve that balance and to make people realise that there are serious risks. I think that we have probably got a long way further to go, and some of the current investigations-including LIBOR, for example-may help push that further. People have got to realise that the chance of being caught is higher than it was, and that when they are caught, nasty things happen. That is the only language that this second group really understand.

Q56 Chair: That language has been missing in this country- perhaps Dr Huertas can answer this-but it is a language that is spoken in the United States. Yet, is it the case that standards and culture on Wall street are any better than in the City of London?

Dr Huertas: Arguably not. The process is quite different in the United States; certainly, the use of consent decrees is a way for a firm to reach a settlement with the authorities without having to admit guilt. The fines are very much larger but the admission of guilt does not occur. In this country, when an enforcement action is taken, guilt is assigned to the firm but the fines are lower. They are different systems, and one can argue with respect to which system has more deterrence.

Q57 Chair: But I infer-correct me if I am wrong-that both of you are of the opinion that because the carrots are so large, there has to be a bigger stick than there is at present and that stick should be applied to the backside of the individual rather than simply to the firm. Could you both spell out, in a little more detail, what sort of regime you have in mind?

Dr Huertas: Certainly, there has been a great deal of progress in this regard with respect to introducing criminal penalties for market abuse; the FSA has made steps in that direction. The possibility of indictment and criminal punishment is a considerable additional deterrent, and the arrest of three people in connection with LIBOR is perhaps a further indication that this is working. How much more needs to be done is an open question, but certainly there has been progress in this area. I agree that the penalty has to be on the individuals who do wrong, as well as on the firm. If the penalty were only monetary and only on the firm, the great danger is that the firm will simply see this as a cost of doing business. There is no more insidious element from a supervisory standpoint than trying to deal with a firm when it has a view that bad behaviour is something that can simply be-

Chair: Priced in.

Dr Huertas: Priced in.

Michael Foot: I absolutely agree with that. If you look at the history of the development of the conduct of business fining in this country, we started out with relatively small fines not thinking that reputational damage would appear so great now. As Tom says, typically firms or many firms have priced that in as the price for doing certain types of retail business. I entirely agree with him.

Q58 Mark Garnier: Mr Foot, earlier you said that Basel III should apply to the big systemic banks only. I really want to dig a bit further into your approach to the smaller banks. Obviously, we have five big banks in this country, but around 49 smaller banks. A complaint that we have had from smaller banks is, for example, about risk-weighted assets in the sense that the bigger banks can look at risk-weighted assets and apportion a possibly questionable risk weighting to them, while, of course, the smaller banks cannot necessarily do that. Do you think that we have a fundamental problem with the way in which we are trying to bundle all these banks in together and regulate them in the same sort of way or do you think that the way we are doing is okay?

Michael Foot: Their complaint about RWAs is not unreasonable. The other thing that is a much more difficult, wider political-with a small "p"-issue is the risks that we all want to take with failure of smaller banks. Regulators are very risk-averse. The events of recent years have made them not surprisingly even more risk-averse, so it is fairly common knowledge that any new banking application, for example, at the moment has to work extraordinarily hard. A small number have succeeded.

From a competition and culture point of view, I am not sure that that is right, because, if you have a smaller operation that sets up, it may be offering something that is technologically new, such as new forms of lending or whatever it may be. If one or two of those fail, that should actually be beneficial for the system. I fear that the regulators now may be in the situation where they regard any failure of the tiniest mutual or the tiniest bank as being something they want to avoid. You must do anything you can to encourage them to take a slightly wider view because, in the longer run, if that kind of anti-risk attitude persists for too long, I honestly think that competition and innovation will be damaged.

Q59 Mark Garnier: It is very interesting you say that, because we have had a number of regulators coming before us. On a repeated basis, they keep saying that banks will fail and that we have to make sure that the resolution works properly.

Is it definitely your sense that, despite that rhetoric that is coming out of the top, actually below the surface-even if it were at a managerial level-there is still the fear that an individual does not want put their name to a bank that might subsequently fail in the future?

Michael Foot: From what I have seen, the regulation of existing small banks is generally tougher than I would have thought necessary. For new banking licences, it is one thing to allow a bank that you have already authorised to continue-even under intense review-but it is another to authorise a new bank, which then embarrassingly goes belly-up three years later.

Again, Andrew Bailey has made some positive remarks about his attitude to the small banking sector, and I hope he delivers on that. As for where the FSA has got to, I offer no blame or criticism of the individuals concerned because, if I had been on the receiving end of what they had to face in 2007 to 2009, I would have probably done exactly the same.

Q60 Mark Garnier: You raise quite an interesting point about incentives within regulation. It is one of those sorts of things where you save a goal, if you have done your job properly; you let a goal in and you are a failure. The incentives are perverse for regulators inasmuch as they can only get things wrong. Do you think we are giving the wrong incentives to regulators? Do you think there is a better way that we can incentivise regulators?

Michael Foot: I certainly don’t think financial incentives are the way to go because the public sector can’t compete.

Q61 Mark Garnier: Do you think that gives us a worse level or lower quality regulation than perhaps we could otherwise have?

Michael Foot: The way I used to put it, certainly in my Bank of England days when Wimbledon were in what was then the premier league, was that I played with a team like Wimbledon that had been put together out of people who nobody else would look at. I didn’t have any money to buy star players. When we went into Barings in 1995, I was incredibly proud of the people who went in there, because they were being paid probably 10% of what the people in Barings were getting. It is a management challenge and one can live with that.

I know Tom discusses these terms but I think we would both feel that intellectual challenge is one of the most exciting things you can offer people in the regulatory sphere. Unfortunately, being part of a working party in Basel or wherever tends to have more intellectual appeal to it than trying to sort out the plumbing in RBS’s IT problems, for example. That is unfortunate. However, that intellectual appeal and approval within the narrow circle of regulators are the things on which you can build a career.

In my time in the Bank of England and as a regulator there and at the FSA I went to places and did things that I could never have done in the private sector. That made a huge difference and compensated me enormously for any financial loss there might have been.

The Bank of England will try a slightly different model. They will try to revert back to the model that they operated in the 1990s. The private sector employment situation might fade. At the moment good risk and compliance people are like gold dust. That is serious because that is where FSA-type staff, PRA staff are most naturally at home. It would be helpful if private sector employment faded a bit, but I don’t think there is much choice.

Chair: That is a good reason, incidentally, for making the system much simpler, isn’t it, because there won’t be so much demand for these people from banks?

Q62 Mark Garnier: It is quite interesting. There is this ongoing debate about regulators flowing backwards and forwards from the regulator to the regulated, in terms of working at the compliance department and the risk department. I take your point that there is a cross-flow and there can potentially be a starvation of skill at the regulator. Equally so, what it can do is generate quite interesting networks of contacts between two organisations that might actually make supervision that much easier because of that close contact.

Within the organisations being regulated you also have a slightly more challenging environment, where you quite often see the internal regulators-the compliance and risk people-as being the "Department of stopping business", as opposed to being helpful. Where do you think the challenges are within the banks, within the regulated organisations, in terms of how they resolve that conflict?

Dr Huertas: Banks make money because they take risks. That is a fundamental law of banking. In terms of making the money, the risk organisation has to work to ensure that the risks are correctly priced and controlled.

Q63 Chair: Which did not happen.

Dr Huertas: It did not happen in many institutions; it did happen in others. From a supervisory perspective, this is one of the important judgments a supervisor has to try to make. Is the culture of the organisation one where risks are controlled and risk has a real voice in determining what business gets done and, more importantly, what business does not get done; or is risk off on the outside being solely a reporting mechanism, an after-the-fact control mechanism? In the institutions where that is the case that is where, from a supervisory perspective, you would see problems. In institutions where risk is part of the real culture and business model, they are very much better controlled organisations. It is akin to Michael’s analogy of autos. Cars can drive much faster if they have a good braking system and the driver knows how to use that braking system. It is very much the same in a banking organisation. A banking organisation that ignores the risk aspect and views it as a cost as opposed to an integral part of the business is one that is headed for trouble.

Q64 Mark Garnier: And that presumably is what a regulator is looking at to see how they assess that.

Dr Huertas: That is part of the supervisory judgment about the culture of the institution that needs to be taken. In my view it is helpful to have at the supervisory authority people who have had experience in banks and in industry, who understand the way that banks work and can help reach that type of judgment.

Q65 Mark Garnier: It is quite interesting-having been doing this Commission now for four months, and having a number of panels on the sub-board level of governance actually looking at how they try to deliver this; and looking at the first line of defence in the business end, the business-facing people being the first line of defence-trying to work out how this actually operates in practice. Correct me if I am wrong, but it seems that if you have a good compliance department-good in terms of appearing to be good with lots of box-ticking-what you are actually doing is lessening that first line of defence, because those business generators are just not thinking about the risk. They are just thinking about the box-ticking for the compliance department.

Trying to get this culture of understanding what the risk is into the first line of defence is much more complex. From the point of view of being a regulator, how do you assess this or supervise it? How do you actually get on to a dealing floor and work out whether these hot-blooded traders are doing it right?

Dr Huertas: There are certain litmus tests. If a trader breaks a limit, what type of penalty does the trader incur, particularly when the trader has made a lot of money when breaking the limit? Is that a slap on the wrist? What type of influence does it have on bonus and career? Those are the types of signals that one would look for. If there is a tolerance for breaking limits of whatever sort, be it quantitative limits or conduct limits, that is the wrong signal for the culture. There are attempts by supervisors to engage in what we call deep dives to try to get to the bottom of that. They can look at the way in which individuals have been disciplined. They can look at the control procedures. That is all part and parcel of the supervisory mandate. It goes much beyond rule observation.

Q66 Mark Garnier: Pushing back slightly on that, Mr Foot, you talked about Barings and the collapse in the early ’90s. At the time, we who were in the City looked at this with absolute shock, horror and amazement. We thought how on earth could that happen and surely it will never happen again. But I think it was quite quick that it happened again in New York with the Shanghai International Trust and Investment Company, where they had a rogue commodities trader. It then happened again with SocGen at the beginning of the crisis. I think that was €5 billion.

Then we have had the UBS one, where the chap has just gone to prison. To me, what that states is not that it is being repeated once or twice, but that there is every possibility that this is being repeated time and again. It is just that the bloke got it right in the end, and it has not been noticed. We possibly do not know quite how much this is going on. There is a fundamental problem that if you don’t blow the bank up and you manage to resolve the problem, or you make an acceptable amount of money-clearly, if you make too much money, that should flag up signals as well-and you get through this, the systems do not pick it up. Only when things go catastrophically wrong do the systems pick them up.

Michael Foot: My reaction to that is that it is an entirely reasonable point. Risk and compliance have their roles to play. Being a risk officer in any reasonably complex role is an extraordinarily challenging thing. The difficulty and danger, as I implied earlier on, is that the people who really matter are the front-line business managers. When it comes down to the big credit decisions and the rest of it, the risk people will be there; they will, I hope, be making challenges; they will have a way of aggregating data and passing those back; but it is then, again, a question for the board. I have been staggered-and I am not talking about UK firms at all, because I have done quite a lot of work in other parts of the Union in the last four years-at the failure of boards to provide proper direction in areas like risk appetite. Most large firms have a risk appetite; much of it, frankly, is written by the senior executives.

Q67 Mark Garnier: Is it because they don’t understand it?

Michael Foot: They find it difficult to make it real, in these sorts of terms: if there is a large loan application being dealt with by a particular credit committee two layers down, how does it apply and what sort of reporting up and challenge up is there is going to be for it? What worries me is that the hardest part is to get the front-line business managers to breathe enough of the same air that the risk people breathe, so they are talking sensibly to each other. In the kind of firms that Tom talks about, which get this right, it is nearly always, I find, the CEO, or very occasionally a strong member of the board-usually the chairman of the risk committee-who has to do that; if the CEO shows that they breathe the same air there is a good prospect.

Q68 Chair: This is pretty depressing. You are saying that you have to rely on the board. Obviously the board is your line of last resort, but what you are implying is that senior management are either incompetent or corrupt, because it should be dealt with at that level, before you get to board level, shouldn’t it?

Michael Foot: The board should set the general tone of the organisation. For example, it is a matter of public record that I worked extensively with one of the Irish banks after the problems; it was the board there that endorsed executive forecasts of very rapid growth in assets and earnings and then, basically, kept up the pressure on the executives to deliver that when other firms in the industry in Ireland were doing even more lending. So, if you like, the board was complicit, in a general way, with what was a general problem elsewhere.

I have come across other boards, which, in early 2008, issued instructions to their executives that the budget forecast for the year was to be torn up, the growth of assets was to be rapidly cut and the dependence on wholesale funding was to be reduced much more quickly. Boards can lead like that.

Q69 Chair: My point is that what you are suggesting is that the only safeguard against reckless behaviour-whether it is lending, or trading, or whatever-is the board, and that you cannot rely on senior management.

Michael Foot: I certainly didn’t mean to say that. What I was trying to say was that that management itself has to breathe it and believe it, because, in day-to-day terms, if the trader is going over his limits or if there is some particularly aggressive piece of proprietary trading that the floor wants to do, it is the manager there on the spot who is the key person. By the time the information has been collected by risk, aggregated and put up to the board, the chances are that the thing is long gone, and maybe has blown up.

Coming back to Mr Garnier’s point about how you monitor this, one of the things that I always encourage even non-executives to do is to go and look. I have been converted, I have to say, even since my time at the FSA, to believing that on-site inspection in certain areas-not every area-is extraordinarily useful. If you go and look at the large credit files of even a quite complex lender, it frankly does not take very many files for you to work out whether this firm is in control or not: is the stuff that ought to be in the file there? Has it been regularly reviewed? Has there been a clear challenge process? You don’t have to do that much, frankly.

Q70 Chair: I don’t want to go into too much detail, but are you talking about unannounced on-site inspection?

Michael Foot: In a case like that I am talking about the risk director, for example, actually going and having a look at some of those. But yes, it would be the sort of thing that internal audit would do within the firm but if the regulator has any real doubts, getting someone external to do that review would be beneficial. What I wonder about is whether the current practice by which the firm pays for all of that is the correct one. I think I would be intellectually happier if every time the supervisor asked for an external piece of work, it was the supervisor that paid, not the firm. Otherwise it creates-both our firms are involved in this kind of issue-a potentially very awkward conflict.

Q71 Mr Love: Mr Foot, you, I believe, led supervision from the Bank of England into the new FSA. Do you have any reflections on returning supervision from the FSA to the Bank of England?

Michael Foot: Well, what goes around comes around. Hopefully they can learn some lessons from what happened to us. We did what was at the time, and I think still is, the most complex merger there has ever been. Nobody has ever taken eight organisations to create one new one with the promise, at the same time, that not one single culture would dominate and that we would create a new culture. You get two firms. One takes over the other. Typically one wins: their systems come in; their people come in and the rest of it. We tried to create something very different and we faced a number of problems which now the PRA and the FCA will face the other way. We had conduct of business and prudential people in the same building arguing like cat and dog because they had never been together before and whether it was mortgage endowments or whatever the issue was, there was a prudential aspect and a conduct of business aspect.

At least the people who are now going into the two new bodies have considerable experience of that and they ought to know that they are going to have to resolve these things. The things still need resolving whether you have two bodies or one. It just has to be done in a different way and in a fully transparent way and done quickly. In terms of culture, we learnt a lot as we went through. I get the impression that the FCA and the PRA have understood that very well and that a lot of what they are going to have to do in the early times is to show their staff, "This is what we are here for. This is how things get done around here now." That culture should be somewhat different, obviously, in the FCA and the PRA because they are doing somewhat different things. But hopefully, they will both draw on what the FSA has achieved, which over time, and it is many years since I was inside, seems to have hit quite a few of the bells.

Q72 Mr Love: I want to come on to Dr Huertas about the FSA in a second but let me just pursue you briefly. There has been quite a lot of comment about whether the structures inside the Bank of England, which I suspect you will know well, because I don’t think they will have changed very much from your time up until very recently, are appropriate for the significant responsibilities they are now taking on.

Michael Foot: The significantly new thing is the activity of the Financial Policy Committee. It is really vital that that Committee has very heavyweight outsiders on it who throw they weight around. The Monetary Policy Committee in many ways did that in a rather more subtle way when it first started. The FPC in a way is more important. If you look at macro-prudential work around the world, in the IMF, the Financial Stability Board in Europe and elsewhere, typically it is group-think. The people who are appointed to those things were the people who have been involved in the issues all the way down the line. The FPC, the external members of it, really are not in that position. The second thing I would say is that in any organisation, one of the things that matters more than anything is else is when there is a problem, how quickly are the communication lines operated and how quickly do decisions get taken.

Typically, regulators, when they are deciding whether or not to intervene, take too long. All the incentive is to wait for more information and the possibility that capital will come in from wherever. But once the crisis has actually hit, the speed of those decision lines is absolutely critical. There is nothing in theory about the way the PRA will be organised within the Bank of England that would prevent those working properly, but it is something that needs to be tested and gamed as quickly as possible, because it really matters.

Q73 Mr Love: Briefly, is the Court fit for purpose? I would hate to put you on the spot, but it is an issue that bubbles to the surface regularly in Commission meetings.

Michael Foot: I haven’t sat on the Court since 1998. I am sorry. I just can’t answer that.

Q74 Mr Love: Let me move on to Dr Huertas. You left the FSA in 2011-

Dr Huertas: That’s right.

Q75 Mr Love: A rather appropriate time. Do you have any reflections on the difficulties the FSA experienced? It certainly took quite a lot of the blame for what happened. As someone who went through all of that period, do you have any reflections on what went right and what went wrong in the FSA?

Dr Huertas: In terms of what went wrong, the FSA did, as you mentioned, a study in particular with respect to Northern Rock and, on the basis of that study, put many things right. In my view, the FSA did a number of things from the end of 2007 through to 2011 that very much improved the stability of the financial system. As I mentioned earlier, they have put in place higher effective capital requirements. In 2008, they were not enough to withstand the crisis that erupted after Lehman’s, but significant capital raising by the major UK banks in early 2008 was a direct response to FSA intervention. The FSA improved liquidity regulation. The FSA was in the forefront of recovery and resolution planning, and they introduced strengthening corporate governance. Those, in my view, were quite a lot that was done correctly.

There was also, in my view, a strong co-operation at working level among the members of the tripartite in terms of working in advance with respect to specific institutions and their problems, so that as they approached the point at which intervention was necessary, the authorities had agreed a common course of action and agreed when those institutions would be put into resolution. In my view, the October 2008 recapitalisation of the UK banking system-to have done all of that over a weekend is a very considerable accomplishment.

Q76 Chair: If everything was so great, what went wrong?

Dr Huertas: Two things went wrong. In terms of Northern Rock, as the FSA itself indicated, there were mistakes made in the supervision of that particular institution and more broadly. What went wrong more broadly was the overall economic environment, in particular developments in the United States.

Q77 Chair: So nothing really went wrong here?

Dr Huertas: There are a number of things that did go wrong here, but it would have been a much different outcome, in my view, had the developments in the United States been other than what they were.

Q78 Chair: What is your answer to that question, Mr Foot?

Michael Foot: I observed from the outside.

Q79 Chair: That is a good perspective to have. What went wrong? What lesson do you think is the most important we should learn from these dreadful experiences-the single most important lesson?

Michael Foot: First of all, undoubtedly, communication between the senior people, I entirely agree with. From the outside, I did not observe a level of communication between the top members of the tripartite committee in August and September 2007, which would have helped minimise the crisis. That is purely from the outside.

I was involved in the first 15 months of the creation of the tripartite. There were many good things about it, but I don’t think that that worked well. As Tom says, by the time we got on to the later parts of the crisis, that lesson had been learned very quickly.

I do think that the sort of supervisory weaknesses that were identified in the internal audit report on Northern Rock and the rest of it were to blame, but the fundamental issue was the failure to conceive the possibility that an entire market-the wholesale market-could freeze up in the way it did. Whatever stress testing and so on had been done before, that kind of stress had just never been envisaged.

Again, by the time you got to the end of 2008, I suspect that the stress testing that the FSA were requiring of their firms pretty well included the end of the universe, which was good, but before that they were not doing so. They were in a paradigm that said, "We have all this value-at-risk data and we have this experience of this, that and the other; let’s stress the housing market by watching prices fall by 20% or whatever." Actually, when things went wrong, they went wrong in a much worse way, partly because everybody-regulators included-underestimated the extent to which asset classes were correlated. Once you had a problem in area A, the people who came under pressure were selling assets in completely different markets to try to raise liquidity, and liquidity was probably the ultimate issue in that. I don’t think that anyone, including the regulators, had allowed sufficiently for that.

Q80 Mark Garnier: Is it not the case that the point is repeatedly made that nobody saw it coming, yet a year or two before this happened, a number of hedge funds were actually staking positions anticipating exactly this? Wasn’t that, in itself, quite a significant signal that there was a crisis ahead?

Michael Foot: That is a perfectly fair argument. If you have 100 hedge funds and four of them take a position against the proposition, clearly 96 did not, and you would expect a degree of deviation. To me-for a time I was a foreign exchange trader at the Bank, and I have worked with the industry as well-it is also about the risk return ratio. Had those bets been wrong, the private equity firm would no doubt have lost some money, but I suspect that the size of the losses would not have been that great. If the bet went well, as it did, the returns were huge.

That is just something about the way markets are structured. In the same way, every time the authorities anywhere try to protect a given exchange rate, once you are down at that exchange rate and there is downward pressure, the risk if you short the currency is not that great, because if it bounces it will bounce only a small way; the benefit, if you get it right, is huge.

Q81 Chair: What lessons do you draw from that?

Michael Foot: I think that that is just a feature of markets. The authority just needs to not get itself into that situation. By all means, with the way the FPC is now structured, you would hope that they are the sort of people who would be talking to some of these hedge funds about what they are currently doing and what they see as the risks. It is the judgments of that very small group of people that will determine whether or not they pick up the right kind of signals. In a way, my best hope for the FPC is that it picks up more thunderclouds than actually burst, and certainly that it does not miss one thundercloud that actually drenches the lot of us.

Q82 Mr Love: One of the reasons for forming the FPC was to bring the people who were not talking before together to talk. One of the challenges, which I think you indicated, in the origins of the FSA was that the prudential and the conduct people were, in some senses, talking at cross purposes and with different priorities. Is there a danger that having them in two separate organisations will cause some competition between the two?

Michael Foot: I would hope not. They are there to do two different functions. The senior people on both sides have a very great responsibility. In the same way, when we created the FSA the senior people who came together had a great responsibility to show their staff that this was for real and that this was how it was going to work; that needs to be done. Those tensions have always existed, whether they were dealt with inside the FSA or outside. In terms of competition-the kind of staff they are wanting, for example-the degree of competition should not be terribly great. One would hope that senior members of each support the other. Whenever there is fighting, they both need to be in the trench, firing the same way.

Q83 Mr Love: May I press you again on your experience? In a previous session-you mentioned this in one of your answers-Andrew Bailey made it very clear that judgment-based regulation is what he is hoping to achieve with the PRA. But we were told, when the FSA was originally formed, that it was very strongly in favour of judgment-based regulation, yet one of the implications of the failures was that it had evolved over time into a tick-box, rules-based organisation. Do you think that there is any danger that the PRA and FCA might go along similar lines?

Michael Foot: What you say is probably fair comment about the FSA, and as I was there for the first six years-

Q84 Mr Love: You were there, so no doubt you made the speeches.

Michael Foot: It certainly wasn’t voluntary. I suppose I would say, going back to what I said earlier, that the growing complexity of supervision and regulatory rules around the world tended to push you in that direction. The great trouble that Andrew Bailey or somebody like him will face is this. He will have a relationship manager, just as the FSA has had, for a major group, and that individual has a number of people working for them. They have access to credit experts, trading experts and operational risk people and to one or more "grey panthers", who provide the external view. That group of people have to come up with a judgment that is basically sound about the risks and the opportunities, and then the senior people have to take that and form the right judgments. That is exactly what the FSA tried to do. It is a difficult process. I suspect and hope that Andrew and his senior people will spend more time facing towards the industry, talking to them and being involved in this, but because of the sheer scale of the operations, there has to be a very clever process for bringing this together.

We created ARROW, and ARROW will no doubt go on developing. The FSA has done a lot of work developing business model analysis, which is one of the things, like corporate governance, that I would say has been a big plus from the FSA in recent years, because if you ask questions about the business model-"What are the real assumptions you’re making?"-that helps to focus everybody, management and regulator, on what really matters.

Q85 Mr Love: Dr Huertas, you left in 2011. You must have been there at the beginning of the process of separating those that would go into the PRA and those that would go into the FCA. What discussions were there around the issue of judgment-based regulation and rules-based regulation? You must have seen that evolving process while the FSA was still in business. What lessons did you learn that you have put into practice?

Dr Huertas: The lesson is that judgment is an inherent part of supervision, and, as Hector Sants said, a large part of supervision is making judgments about the judgments that business executives are making. Supervision is about how the bank or financial institution will evolve in the future-taking a view as to whether it will evolve in the right way and then, if you come to the conclusion that it is not going to evolve in the right way, developing action steps that the firm needs to take to correct matters. In my view, the philosophy of the PRA represents a reasonable evolution of what the FSA had already been undertaking. I do not see the great distinction that has sometimes been drawn between the new PRA and the old FSA.

Chair: One distinction, in my experience, is that the conduct of business regulation requires a totally different set of skills and a totally different kind of person from prudential supervision; and therefore putting them together was probably a big mistake. Anyhow, that is all water under the bridge.

Q86 Mr Love: I want to come back to the issue of criminal penalties. We seem to be getting ourselves into a situation where the Serious Fraud Office has certain responsibilities for financial crime, but the FCA is developing responsibilities. Do you have any views about how we could ensure the maximum impact on financial crime by restructuring who is responsible for what? Should it all go to the FCA? Should it go to the SFO? Should we set up a separate organisation? Do you have any views?

Michael Foot: All I would say is that it is about where the expertise lies to pursue the problem. In the case of insider trading, for example, the FSA and now the FCA will have an unparalleled level of practical experience. They undoubtedly ought to be in the lead on that sort of thing. That is the sort of question you have to ask in each case. What is important is that there are hits every year-that there are successful cases-and the message gets out clearly, as I said earlier, that you are more likely to get caught and when you get caught, nasty things will happen.

Q87 Mr Love: Let me ask you a question, Dr Huertas, just to press you on this. The reality is that a lot of evidence on which the SFO would take a case for fraud has to come from the FCA or the regulator. Does it make sense to do that, or should we be rationalising how criminal action charges are made against individuals involved in a market abuse and other crimes?

Dr Huertas: I am going to say on this question that I agree with Michael’s comments. It is a question of expertise. The important aspect is that we build up what the FSA called credible deterrence and an expectation that if you do something wrong, you will get caught, and if you are caught, you will be punished and you will be punished quite severely.

Q88 Chair: Before we close, may I just open one other topic, which emerged from the evidence that Mr Foot gave to the Commission panel on HBOS? You said that the reason why the regulators were a soft touch-I am summarising-was that the banks would say, "If you don’t give us further concessions, the shadow banking sector will take even more of our business than it is already doing. You wouldn’t want that, would you?" I ask you two questions: first, was that an empty threat? Secondly, to the extent that it might actually have happened, would it have mattered? You were in the room when you heard our previous witness say that on balance it might be a good thing. His view was that the size of the "too big to fail" banks was so great that if they did lose some business to the shadow banking sector, that would probably do more good than harm. When you were saying that, you were saying that in the context of the liquidity ratio, as an example, but you were using it, as I understand it, as an example of a more general phenomenon.

Michael Foot: Yes, indeed. As I think I made clear at the time, I wasn’t talking about HBOS in particular.

Chair: Right; you were talking more generally.

Michael Foot: I was talking about an international trend that had been going on ever since the 1980s. The banks always had an excellent set of examples. They would just pull their treasury function together again. They had done this, they had got this new model, and they had demonstrated that they could access funds in 15 different markets and the rest of it. That was the constant pressure on the FSA. The Bank of England had been, and the FSA was, with the Fed and all the other international regulators, facing the same thing.

With the aid of hindsight, the thing I perhaps did not get close enough to early on was that if the alternative was to lend to these shadow bankers, that should have attracted as much capital requirement and regulatory concern as had the money gone directly to where it was going. There was an awful lot of false liquidity created in the 1990s and early 2000s, which, by 2007, turned out to be the sort of market that is fine in a fair wind but not otherwise. I can’t help feeling that if the regulators hadn’t given way in the way they did, part of the consequence would have been that the pressure would have been elsewhere. I am not sure the outcome would have been much better. Maybe it had to take a crisis of the kind that we had in 2007 to make everyone realise that this was a case where the pendulum had swung considerably too far.

Q89 Chair: It is a little depressing that it takes a crisis of that magnitude to achieve anything in terms of improved regulation and supervision. I am still not clear about your answer. Do you think that, faced with this threat, the banks will say to the supervisors/regulators, "If you are too tough with us, all that will happen is that business will leave us and go to the shadow banking sector"? When they are told that, should they back off or not? What you are saying is that they did.

Michael Foot: I guess the pressure was probably strongest in the United States. Tom might have a view on that. We try to retreat in good order across the globe-certainly in my time of doing this. With hindsight, you are very likely to be right that we should have stood firmer earlier, but we didn’t. At the time, there was a very rational debate about the pace of withdrawal and the pace at which we would allow this to happen. Again, we did believe and accept collectively-and so did the Fed, the OCC and the others-that the arguments that the banks were putting forward had considerable merits.

Q90 Chair: Well, it isn’t surprising, and I don’t mean that in any way disparagingly. It is the same with regulatory authorities across the globe. It is the very essence of the bureaucratic mindset to be particularly concerned about that sort of thing.

Michael Foot: Yes.

Chair: Thank you both very much indeed. I am most grateful to you. Together you have an enormous amount of regulatory and supervisory experience, which has been extremely helpful to us.