Evidence heard in Public

Questions 91 - 153



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


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Oral Evidence

Taken before the Joint Committee

on Monday 17 December 2012

Members present:

Lord Lawson of Blaby (Chair)

Mr Andrew Love

Lord McFall of Alcluith

Examination of Witness

Witness: Carol Sergeant, CBE, former Chief Risk Officer, Lloyds Banking Group (2004-11); former Managing Director, Financial Services Authority (1998-2003), examined.

Q91 Chair: Thank you very much indeed for coming to see us to answer our questions. As you know, this is a public hearing and, although there are not vast numbers of the public in the room, anything you say you are saying publicly.

If I may, I would like to begin by asking you a straightforward question, although the answer may be less straightforward. You were a managing director of the FSA from 1998 to 2003. You have obviously reflected on that experience. What, in your considered judgment, went wrong? I am not talking about what went wrong with banking-all sorts of things went wrong with banking. What went wrong with the regulation by the FSA?

Carol Sergeant: In the more recent period? I think-

Chair: If you think it was all fine between 1998 and 2003 and that it then went wrong subsequently, you are perfectly free to say that.

Carol Sergeant: I don’t think that you can ever say that everything is all fine all of the time. What has gone wrong recently is a mixture of inadequate individual bank supervision as well as systemic issues. There is quite a lot of talk about all the international difficulties and so on, which are issues that I will perhaps come back to, but there were some very basic local difficulties. Northern Rock, Bradford & Bingley, HBOS were not complicated banks. They had no overseas exposures. Even at the micro level, they were inadequately regulated.

In addition, at the systemic level, there was-this is not just me; I think it is received wisdom-insufficient monitoring of the consequences. Whatever you do, there is always going to be a side effect and there will always be unintended consequences. One of the challenges is actually to monitor for those. Whatever you do in regulation, it is ultimately about national welfare. There is always a trade-off. Some of the much more explicit debate that is happening now, which is very healthy, is around the trade-off between an extremely safe financial system and economic growth, for example. There will always be trade-offs. Whatever you put in place, it is not something you can just set up and leave. You are always going to have to monitor for it. For example, Basel I, which I was involved in, was actually set up because, previously, all the banks really had was a leverage ratio, and people gamed that ratio. Basel I was brought in to make some amendment to that, but maybe other things were not adequately monitored as that progressed. I don’t think you can come up with a solution and then think that will last for ever. You have to keep monitoring for the consequences, both in terms of the economy and the effect on consumers, as well as where it might start unravelling.

Q92 Chair: I was not asking so much about the setting up of the system, but rather the carrying out of the policy of supervision, which clearly needs to be done. You began by talking about the supervision of the individual banks being inadequately carried out. That is the responsibility of the supervisory authority. It is not the responsibility of the supervisory authority, as it were, to balance out sound banking and economic growth; it is the responsibility of the supervisory authority to carry out effective supervision. You said that as far as individual banks were concerned, this was not done adequately. Can you say a little more about why that happened and what you think the remedies are?

Carol Sergeant: There are several things you need to do. You need to understand the strategy and business model of the individual bank, and that is something the regulators are now much more focused on. You need to monitor several different things. You cannot just look at one metric. Classically, there will be a couple of liquidity issues you should look at. You should look at leverage, absolutely, but that is not adequate-you also need to look at risk-rated assets. Finally, you need to go in and test, "Is this working as planned?"

I don’t think you need battalions of people like you have in the US but you do need to test. Certainly, after I had left the FSA and was working for Lloyds TSB, I was very concerned because people were not coming in just looking at the basics, for example, of how our credit risk was run or how our liquidity was managed-so much so, in fact, that after I had been in Lloyds for a couple of years, I got in touch with colleagues at the FSA and said, "You are sending in junior technicians who are having a jolly interesting intellectual debate about what is going on in the bottom left-hand corner of a model, but nobody is coming in and taking a thoroughly good view of how we are managing credit," including looking at a sample of loan files, because then you can actually see how the whole thing is processed.

I think it is a judicious mix of understanding the strategy and challenging senior management on that, including the kind of return on equity targets and so on that are being set. Are they realistic? Are they driving people to take dangerous risks? In addition, it is then about seeing how all of that is actually executed by going round and doing a bit of testing.

Q93Chair: And there was not enough testing done.

Carol Sergeant: Not in my experience. There was not, and I think people were becoming very focused on some of the more technical aspects of modelling, which are quite important. I would say as an aside that I think one of the biggest mistakes that was made-which, I have to say, continues a little bit with Basel III, although there are moves afoot to address it-was to allow banks to use their own internal models. There were several problems with that. First, it made it extremely difficult for the regulators to do their job properly, because each bank calibrates their book in a different way, so each bank will divide their corporate book up differently, for example. So it is extremely difficult to compare across banks and understand what is really going on in there, and that is difficult for regulators and for investors, who now have no confidence in what is going on in terms of risk-rating. It is also frankly difficult for non-executives and for the people who manage the bank.

It is a classic case of, "Be very careful what you wish for in how you incentivise people", because the motivation behind it was to encourage banks to develop more sophisticated internal models. So if you used your internal model to derive the capital requirement, you typically ended up with a lower level of capital, so there was an enormous incentive, then that just took off mightily. You can see from the aggregate statistics that the amount of capital held in the banking system, relative to the volumes of business written and the risk-taking, just got smaller and smaller. I think that was a really big issue and somehow we have to get back. You cannot go right back to Basel I-that was far too primitive for this day and age-but you do need to get back to something that is more standardised, because banks will do their own modelling for commercial purposes anyway. There is no stopping them. There are all kinds of models that regulators do not even look at, like marketing models, consumer models and all the rest of it. They are going to be doing that anyway. What the regulator has to worry about is how the actual capital is calculated, and that it is in a way that is understandable as well as transparent, and comparable over time between organisations. That was a really big issue indeed, and it made it very difficult for the regulators to do their job properly.

Q94 Chair: I have just two further questions before I hand over to my colleagues. What you have said is that there was something seriously wrong with the Basel system, but that the way in which the supervisors carried out the task was also inadequate. So there were failings on both fronts, as I understand it from what you are saying-both the system and the way it was implemented. So far as the system is concerned, what you have suggested latterly about models applies, of course, pre-eminently to risk-weighted assets. This seems to be a theme in a lot of the evidence we have been receiving, so would you agree that, of the three main things-there are obviously others-that supervisors or regulators are meant to look at, namely liquidity, leverage and risk-weighted assets, that, for the reasons you have given, risk-weighted assets are probably the least useful and the most gamed of the three, partly because banks are allowed to use their own internal models, and that one should maybe rest more weight on leverage and liquidity, which cannot be gamed in quite the same way? Would you agree with that?

Carol Sergeant: I would suggest that you really have to look at several different metrics; if you only look at one, you are going to end up in a bad place. My suggestion would be that there is a role for risk-weighted assets. If you only look at leverage, that also enables people to game, because they can then put more and more risky assets just into that leverage ratio and do all kinds of interesting things off balance sheet. My recommendation would be that the risk-weighted asset approach is simplified: that, in the extreme version, banks are not permitted to use their internal models and there is a more straightforward, standardised approach; or, if that is not acceptable, that at least there’s some baseline for each asset category and that banks are not allowed to use less than a certain level of weighting. That is the place that some of the regulatory discussions are going now.

I do think there is a role for risk-weighted assets. I think that because of the internal models approach, and because of the complexity of the models that are now deployed, it is very difficult to get anything meaningful out of the way it is done at the moment, but it would be useful if it was done not in a simplistic but in a more simplified way. That would be a good counterpoint, then, to the leverage ratio; by the way, I think that the leverage ratio the regulator is proposing is still actually quite generous. I would not rule out risk-weighted assets at all, but I think it has to be looked at very differently.

Q95 Chair: In your last point, a moment ago, you said that in Basel III, the leverage that is permitted is, in your judgment, too great.

Carol Sergeant: I think it is still, yes. There is a case for tightening that up.

Q96 Chair: Which indeed Vickers recommended. You would agree?

Carol Sergeant: Yes. I would agree with that.

Q97 Chair: My last question at this juncture is this: when you were the managing director of the FSA, did you, in conjunction with your colleagues, give any consideration to the question of the remuneration of bankers? I am not talking about the quantum of remuneration; I am talking about the structure. Did you consider at any time that the way remuneration packages and bonuses were constructed gave an incentive to behaviour that was contrary to the interests of bank stability?

Carol Sergeant: We did consider it, but I would say that we probably did not do enough about it. The way people are remunerated is hugely important. That was one of the things I learnt when I joined the private sector with Lloyd’s TSB. I am obviously personally not that motivated by money, or I would not have spent 30 years in the public sector. Until I actually worked with colleagues, I did not completely understand how motivated they were, not necessarily for money per se; money is almost a measurement of how successful you are. Remuneration is incredibly important-how you motivate people in general. Almost by definition, if you are offering somebody a bonus, you are offering them a bonus to make more money.

That applies not only at the very top of the organisation but right at the bottom. I found that a lot of banks come out with statements that are factually correct but completely irrelevant, particularly in the retail space, such as that the amount of commission staff earn there is quite small. That is by and large, in my experience, true. It is typically not more than about 5% to 10% of their income, but because it is the only part of their income that they can influence directly-almost with an automatic formula-it becomes disproportionately important. That is very, very important, and I think that in the work that is being done at the moment to look at remuneration much more closely, it is not just about the metrics; what is really important is how that is implemented. Latterly, the regulators are doing a good job there, because they are not only setting rules but coming in and seeing how that actually works in an organisation, and how people take decisions on remuneration. As well as the theory of the case, they look at the practice, which I think is really good.

Q98 Chair: Do you have any practical proposals in this area that you would like to see implemented?

Carol Sergeant: I personally think that bonuses per se are a bit of a problem. In fact, they have more or less disappeared, because in the UK regime they are, by and large, paid in shares and deferred for a very long time. They have become more or less like long-term incentive plans, which I think is an appropriate way of dealing with the issue. I think the way the UK is going about it is, by and large, correct, but everybody needs to continue to look at how it is actually implemented, because that is crucial. As you have seen in quite a number of the retail banks, either they have already stopped or they are considering stopping commission for their retail sellers, and they have much more rigorous approaches to senior management. I do not have a particular issue with the way it is being proposed here in the UK at the moment, although I would urge people to watch very carefully how it is being implemented in practice and not just look at it as a theoretical exercise.

In practice, most banks have what they call balanced scorecards, where they look at a number of aspects of somebody’s performance. They will look, obviously, at how much profit they have generated; they will look at franchise development; they will look at how they have managed risk; and they will look at how they have developed their staff. There will be a whole load of metrics. In practice, however, it is quite hard to get a balance in this balanced scorecard and it is quite hard to ensure that the amount of money generated is in its right place and does not dominate. That is difficult in practice, and I think it needs to be watched very carefully.

Q99 Lord McFall of Alcluith: Carol, is it not the case that regulation just creates the opportunities for regulatory arbitrage? The tighter and more plentiful you make regulation, the more innovative ways there are for the many accountants and lawyers to get round it, so regulators are always chasing their tail, at the end of the day, irrespective of how bright and engaged they are.

Carol Sergeant: If you make the regulatory system too complicated, which is absolutely what has happened with risk-weighted assets, it is an invitation for clever people to game it. If you do that, and particularly if you only or mainly focus on one measure, you are inviting that. By definition, whatever you put in place, people are either consciously or unconsciously going to try to game it. The trick is to have something understandable in place where you are monitoring several dials, so you have a more straightforward, understandable approach to risk-weighted assets. At the moment, I do not think anybody, in the aggregate, fully understands the models, at either institutional or system level. You have a sensible approach to risk-rated assets, but you also have leverage, you have liquidity requirements, you monitor the governance, and then you put all that stuff aside, go in and kick the tyres, and say to yourself, "Does this look sensible?" It is a bit like flying a Jumbo jet; you are not going to be looking at just one dial, you are going to be looking at several dials to see what they add up to. You need to be very conscious about how that can be gamed. You need to put aggregate measures in place both systemically and at individual institutional level, because it will be gamed. It is just human nature. I am sure that if there were banks in the caveman age we would have had exactly the same.

One of the things I have observed in the general debates that are going on is a kind of nostalgia for the past, where you had branch managers, and bankers were all terribly, wonderfully good people. I do not think that we have ever been in that place. I do not think that anybody is necessarily any more or less wicked than they ever were. It always has the potential to be gamed. Leverage ratios were gamed and Basel I was gamed. You just have to be very conscious of that, and you have to create a system where, if people do game it, it is more easy to spot.

The regulators lumbered themselves with the internal models and the complexity of the risk-rated asset systems. They made it very difficult for themselves to see the wood for the trees. They also used up a huge amount of their energy and capacity dealing with all these models, and I suspect that they did not have enough time left over to go and do the common sense tyre-kicking. There is nothing like some very straightforward questions and some common sense tyre-kicking to make sure that all these dials you are watching are actually adding up to something sensible.

Q100 Lord McFall of Alcluith: I am thinking of William McChesney Martin’s comment about the regulator taking away the punch bowl, which goes back to the 1920s and the Federal Reserve. The regulator certainly did not take away the punch bowl in the last crisis here-is there a reason why? You referred in a speech to the regulator being seen as a party pooper. At the end of the day, does the regulator always feel inferior to the politicians, and will we therefore never get regulators standing up to the plate on an issue such as that? Are we kidding ourselves?

Carol Sergeant: It is very tough, because, at the margins, are you being a party pooper or not? That is why I absolutely agree with Lord Lawson that there is the individual regulation of the individual institution, but there is also this constant trade-off between how safe you want the financial system to be and how much potential you want for economic growth.

It is quite interesting at the moment with funding for lending. For me, funding for lending is almost like a back-door way of providing cheap liquidity to the banking system, and then, as I understand it, banks are not actually being charged capital on the extra lending. That is probably quite sensible, but if you stand back from the detail, that means that the authorities have said to themselves, "The regulatory system we have at the moment, with the current capital and liquidity requirements, is actually too tough for economic growth." That is a really good development, because until the last few years I have not actually heard that debate being had quite so openly as it is now.

That is where I think that the macro-prudential stuff is very important. There do need to be explicit debates about the trade-off between the safety of the financial system and economic growth. I am not sure how transparent the debate around funding for lending has been, but that is a very important debate to be had, because there is no point having a financial system that is utterly safe, which is not possible, and then having no lending going on and no economic growth. There is an absolute trade-off there all the time. What has happened from time to time is that it has swung too far one way or the other. Pre-crisis, it had obviously swung too far in terms of taking more risks than people probably realised with the financial system and financial stability in order to continue the economic growth we had, and the punch bowl, as you describe it.

Q101 Lord McFall of Alcluith: Is there a case for regulators, if you like, educating politicians and bringing them face to face with reality? Thinking about John Kay’s point and his article on narrow banking when he said that supervision involves a form of shadow management that will always be to the disadvantage of those who are not real management: for those of us who have been on boards, local authorities or whatever, you cannot really know what the executive are up to. Even on a board of, say, eight or 10 people, there is a chemistry in that board that is very important. Here you as a regulator are on the outside, educating politicians to say, "Look at the position we are in. The institutions themselves should be responsible here. Therefore there is a limited amount that we can do", instead of coming back and ending up in the dock before the Treasury Committee. or whatever else and saying, "Regulation is duff." It will always be duff, given the present system. Is that a bit harsh?

Carol Sergeant: I think that is a bit harsh and a bit pessimistic. It is difficult. I don’t underestimate it, having been on both sides of the fence. In a way a chief risk officer in a bank is doing exactly the same thing. You are pulling the punch bowl away just as everyone is getting into the swing of a party. It is a tough thing to do. I am not sure what the alternative is. I agree with you completely. Ultimately management are accountable for how they run that particular organisation. What they are not that accountable for though is that they cannot know necessarily about the systemic consequences of what the system in aggregate adds up to. What individual firms should do more-and I say this to them quite happily and openly-is that what has tended to happen is that when the regulators or the politicians have come out with any proposals, firms have looked at them very narrowly and said, "Is this good for me?", but I think they should look at them more broadly and say, "Is this good for the system?"

Lloyds TSB, where I was chief risk officer, was a triple A bank. We were very, very boring. We were pretty prudent. I have reflected a lot on what we could have done differently. Well, a few things, but frankly they would all have been marginal. At the end of the day if you are part of a financial system and the whole thing gets completely out of control, it is extremely difficult to protect yourself. Therefore each individual bank has also to think not only what is good for them as a bank but what is good for the whole system. In the end you cannot protect yourself. The best you can do is be last man standing. It is a bit pessimistic. But I think a more explicit conversation around where those trade-offs are and how they should be managed-it may be possible to have something in the regulatory sphere with the right kind of metrics. It is a little bit like monetary policy where you have targets. I would suggest more than one, actually. Just having one target is always going to be very dangerous. There are a set of targets and if you decide to change them or rebalance then there has to be very open conversation and explanation as to why that is happening.

Q102 Lord McFall of Alcluith: To sum it up, are you saying that the regulators and politicians do not understand the force of competition sufficiently because when competition is ratcheted up then the possibility of good behaviour recedes even further back?

Carol Sergeant: Not necessarily. On the whole competition is a good thing but there is good competition and bad competition. One of the things-

Q103 Lord McFall of Alcluith: Well I’ll talk about bad competition.

Carol Sergeant: In the crisis it was bad competition. Certain banks were running around offering 125% mortgages to first-time buyers. That completely wrecked the mortgage market, by the way. We came out of it and got excoriated by the analysts. That is not good competition. There will always be a drive. In some ways that is good. We have authorities that make sure there is adequate competition and so I think having competition is not necessarily a bad thing as long as it is balanced.

Q104 Chair: I would like to pick you up, if I may, on something you said in answer to Lord McFall which astonished me. You implied that part of the regulatory problem-it was a disaster-was this trade-off between regulation and economic growth. You are not seriously suggesting, are you, that the regulators or supervisors fell down on the job because they felt that if they were too tough with the banks that would be inimical to economic growth? That wasn’t a factor was it?

Carol Sergeant: I am not sure. It probably was not an explicit factor, but if you are taking the punch bowl away, if you increase capital, if you toughen liquidity requirements as happened now, you are reducing the capacity, deliberately and rightly, of the banking system to lend. So I would dare say it is probably not an explicit consideration, but I suspect it was an implicit consideration. You are having to stand up and stop people doing things which are supporting the continued growth in lending-not necessarily very good lending-but at some points that was pretty much all that was keeping the economy going.

Q105 Chair: But that was not the job of the FSA. That is the job of the Bank of England, the Governor of the Bank of England, the Chancellor of the Exchequer and the Treasury. It is not the job of supervisors and regulators. It is not the job of the FSA or its successor to be balancing that and to be holding back in case it was bad for growth. Or was that what the banks said to you: that you must hold back?

Carol Sergeant: No, they did not say that to me and I am not distinguishing between the different parts of our structure and what they do. That can be recalibrated. Actually I spent most of my life in the Bank of England and in that organisation we had both the actual day-to-day delivery of regulation, but then also the more strategic elements about what we should be doing and what was the balance. So I am not having a point of view about exactly which part should be doing what, but I do think there is a strategic decision to be taken.

Q106 Chair: But not by the supervisors?

Carol Sergeant: Not by somebody who is individually supervising a bank, but it has to be taken somewhere in the system and quite possibly the Bank of England would be a jolly good place to take it.

Q107 Chair: Before I hand over to Andy Love, I have one other question. I asked you right at the beginning what you thought were the lessons of this supervisory failure. Do you think that one of the lessons is that the supervisors themselves were not of sufficiently high calibre?

Carol Sergeant: I think they were very mixed, it would be fair to say. When I was at Lloyds TSB, I was at the receiving end, particularly latterly I have to say, of some very good regulators but I was also at the receiving end of extremely inexperienced people who should not have been put in that position. The other experience I had was that, in the lead-up to the crisis, we were being dealt with by very junior people. The senior management at the FSA never really darkened our door and, frankly, only when we actually asked them to come. So we would have an extraordinarily junior person who would come and present to the board and who really could not cope with the kind of challenges and questions that came from the board. I have to say, again, that has changed very significantly. The likes of Andrew Bailey and Clive Adamson do now go round, have a much better dialogue with the senior management of the banks, present at board level, and have a much more strategic and experienced approach. I would not blame the individuals because I think they were put in an impossible position, but we were certainly at the receiving end of some very junior and inexperienced people.

Q108 Chair: What were the senior people doing then?

Carol Sergeant: I have no idea.

Q109 Mr Love: There is a challenge for members of the regulatory profession to leave and go into the private sector. Just taking your comments about the difficulties at the FSA, there is some concern that the better regulators will gravitate to the PRA, the prudential regulator, and leave the FCA in a somewhat difficult position in getting the best staff. Do you recognise that and would you think that that is a concern?

Carol Sergeant: They are both very different types and styles of regulation; I would have thought they would have different appeals to different people. I think it is a very different style of regulation in both. I have to say this, though: there has been a lot of talk about pay and so on. When I was in the FSA-even in the Bank of England-with a final salary pension, I considered myself to be one of the best paid public servants in this country. I thought I was pretty well paid for doing what was a fantastic job.

I don’t think it is much of an issue. A lot of it is about motivating and managing people, and I still think that, working for the FSA or the FCA or the PRA, there are extremely interesting jobs that are, actually, jolly well paid. I certainly did not leave for the money, I can assure you. I felt very well paid there, and very well respected.

Q110 Mr Love: Can I come on to the review of Simple Financial Products, which you are undertaking at present? It strikes me that we may have been here before with stakeholder pensions, so I get your take on the differences, but we are really interested in the focus on the regulator, the FCA, which has an expanded role from previously. What role do you think the FCA can play in making products that are simple, effective?

Carol Sergeant: My own view is that the industry has to want to do this. There are a vast number of people-nearly 30 million-who have inadequate savings at the moment; if you define that on OECD and so on, that means less than three months’ expenditure saved up. It is an important issue for the industry to address and I also believe that if they go about it in the right way, it could be a profitable proposition. One of the problems with some of the previous initiatives was that they were price-capped.

I have a view, though, on the Financial Conduct Authority, and we are seeing this happen already. We have the retail distribution review and also the objectives that are being proposed for the FCA. At the moment, there is a risk that a smaller and smaller cohort of richer and richer people will receive very good advice, and the rest of the population will receive none. That is because, for good or ill-I would not be defending many of the things that the industry has done, absolutely not-the net effect is that most retail banks have withdrawn substantially from providing advice on financial services to consumers; they provide it only for their wealthy clients. The reason for that is they perceive it to be a very high-risk activity for which very high standards are set, and they are not prepared to take that risk. Indeed, they cannot make it commercial or affordable. One of the propositions for my Simple Products is that they have to be able to be sold without advice, because if they came with advice from the industry, they would be unaffordable, uncommercial or, more likely, both.

I think there is a really big issue. In general, both for individuals in firms and for regulators, my advice is to be very careful on the objectives you set them, because if they are ambitious people, they will focus on those objectives. If you look at the purpose of regulation, which, ultimately, is to increase social welfare, with us having got to the situation we are in now for very good reasons, I am not sure that the outcome of less and less people having access to financial advice is necessarily good. The Money Advice Service will have to be awfully, awfully good at producing its generic advice to make up for that shortfall.

Q111 Mr Love: You tempt me to get into the retail distribution review and the Money Advice Service-two minefields for the Treasury Committee, I have to tell you, but I listened carefully to what you said. The FCA decided that it will not give products pre-approval but it will intervene to stop things like PPI occurring. You have set up an accreditation board. Does the regulator have a role? I know that you suggest that it should attend, but does it have a role in accreditation?

Carol Sergeant: My aim is to get something done and to live in the real world. I think the FCA have said, very clearly, that they are not going to pre-endorse any products. At the moment, they are being very constructive and helpful. I have a very senior observer on my steering committee in Sheila Nicoll. She’s one of Martin Wheatley’s deputies and is very diligent. She attends the steering committee and is extremely helpful.

I am hopeful with this particular project that, when I set up the final accreditation board-I am on the way to working out how we can do that-the FCA will continue to be an observer on it. In any event, the process of designing this product will be so transparent, as it has been already in the consultations we have had and the public consultations we have had, that the FCA will have every opportunity it possibly could have to intervene at an early stage. That is extremely important for the industry, because they, quite rightly, see that they will not make a huge amount of money out of these projects-certainly not to start off with. If that then comes with a risk of retrospective action from the Financial Conduct Authority, the thing is dead in the water.

I respect the FCA for saying they do not want to do pre-product approval and, again, one needs to think of steps two and three. If they did do pre-product approval, even for the Simple Products, as some of the industry has suggested, where could that end up? Would we necessarily be in a better place if the regulator pre-approved every new product? I am not sure we would be. Where we are now, where they look very hard at products coming to market and have the powers to intervene at an early stage, is not a bad place to be.

With PPI, they could have intervened. It is dreadful what many in the industry have done with PPI, but it is also a massive regulatory failure. It did not creep up on anybody. You cannot hide the fact that huge numbers of those policies have been sold. The FSA has been investigating it in firms for years and years. There is that power to intervene, but all of this takes courageous people. It is a little bit to do with Lord McFall’s point about taking the punchbowl away. You have to be courageous to come in and say, "I am going to stop that product. I don’t like it." It really does need that. In principle, if that happens, that is not a bad place to have ended up, but you have to see how it will work in practice.

Q112 Chair: I absolutely agree that we need courageous regulators or courageous supervisors, and that was partly what lay behind my question about having a better calibre of people in the supervisory regulatory role. It is not only those people, however, who need to be courageous. Possibly even more courage is needed from the risk management people within banks. It has been put to us, in particular by Michael Cohrs, that the risk management people within the banks were not properly integrated in the banks. They deliberately were not taken seriously. They were thought to be on the side of the regulator and not on the side of the banks.

Obviously, it is inherently difficult to be a gamekeeper in a society of poachers, but do you think there is anything that can be done along the lines, for example, of the encouragement that is given to whistleblowers in the United States? Or do you think, looking at the United States, that that does not help much? Would you like to see any move along those lines and, if so, what? If not that, is there anything else that can be done to enhance the risk management function within banks? I don’t think it should be the main bulwark, but it could be a useful additional one. You would be in a position to know, because you were a chief risk officer of a bank yourself, at one time. What is your take on all that?

Carol Sergeant: I am also currently chairman of the whistleblowing charity Public Concern at Work, so perhaps I can deal with that. We have not published yet, but there is no harm in telling you that we have two pieces of work in train at the moment. One is to do a review of whistleblowing, specifically in the financial services sector, which is about to kick off, and the other piece of work is broader, because we care about whistleblowing all over the place. We are very interested in the Savile case and the care homes and so on. The Public Interest Disclosure Act 1998, which protects whistleblowers, came into force in 1999, because of some eminent predecessors of mine. It is time for a review both of the legislation and how it is working, so we are setting up a commission in January to look at that. That will consider, among other things, what I think is the very thorny issue of rewards for whistleblowing. I have a completely open mind. I can see the pros; I can see the cons. There are pros: if it encourages people to speak up then it has to be a good thing. Some of the cons are that some of the things you would want people to speak up about don’t generate a financial benefit necessarily directly. We are worried about things like people being abused in care homes. We are worried about-

Q113 Chair: I don’t want to cut you short and suggest for a moment that that is not important, but that does not come within the terms of reference of this Commission.

Carol Sergeant: No, but I think the other issue that would concern me-as I say, we need to look at this and we need to see what the experience has been in the US and what we can learn from it. But if you have a financial incentive as they have in the US, which is tied to a percentage of the amount of money disgorged, for example, to the tax authorities, it doesn’t encourage people to raise issues at an early stage before there is a big financial detriment to have a big percentage of. What we are concerned about in the whistleblowing charity is creating cultures where people can speak out. The whistleblowing is a back-stop. Whistleblowing is an important part of overall good governance. It is a back-stop to cultures where people can speak out. I think it is incredibly important; otherwise, I would not be chairing the charity. In a lot of things I’ve seen that have gone wrong, both when I’ve looked at them as a regulator but also when I’ve looked at them in individual firms, people have spoken out and for a whole range of reasons-not all of them malevolent-they’ve not been listened to. We need to find a way of not only encouraging people to speak out but making sure they get listened to. Very often it has been quite junior, brave people who have spoken up and then, for various reasons, have not been listened to. I think an open culture where people can speak out about their concerns and where, if they are not being listened to, there is protection for them to, if you like, whistleblow, is one significant ingredient in the kind of culture that leads to good ethics and good behaviour. I wouldn’t go so far as to say it is the be-all and end-all, but it is very important.

Q114 Chair: But in many cases speaking out is bound to be ineffective. Take, for example, the case in the United States where someone was very concerned-I can’t remember whether it was Fannie or Freddie; I think it was Fannie but it was one of them-and he voiced his concerns to his bosses. That was unlikely in all cases to achieve the desired result. What a whistleblower has to do, probably, and I am interested in the study that you are undertaking, is to alert the authorities, isn’t it?

Carol Sergeant: The Public Interest Disclosure Act in the United Kingdom, which was pretty much the first in the world to go on the statute book, is still considered world leading, although I think we can make it better.

Q115 Chair: How many cases have there been of that Act being used?

Carol Sergeant: People tend to use it in employment tribunals when they are up for being sacked because they have blown the whistle.

Q116 Chair: Sorry, I should have made myself clear. I meant in this banking area.

Carol Sergeant: In the banking area. Well, what the whistleblowing enables you to do is have your employment rights protected if you go outside the organisation, ultimately to the media or wherever, to raise an issue. So if you’ve tried to raise it with your boss and you’ve been ignored, or if you don’t even feel you can raise it within the organisation because of the personal jeopardy you would be in, provided that you have a reasonable case, you can report it to a regulator, to a politician, to anybody you like-ultimately, to the media-and if you have a good reason for doing that then your employment rights are protected. So the whistleblowing is, if you like, the back-stop if you are unable to raise something within your own organisation in the way you hope a good organisation would encourage you to do. But whistleblowing only works if it is properly dealt with. I can only quote from what I have read in the newspapers, but it seems as though in the case of the UBS trader who was sentenced, one of his colleagues did raise concerns but nothing happened and, what is even worse, the gentleman who has now been sentenced became aware of it and gave his colleague a hard time. In giving evidence, the individual was asked, "This all happened again, so why did you not raise it again?" Well, of course he didn’t, because nobody had done anything about it and he had suffered as a result.

Good organisations need to encourage people to speak out, support them and do something about it. If they don’t do that, you have always got this outlet that you can go outside. One of the things we need to look at, and why we are setting up the commission, is not only how good the legislation is-I think it can be improved; somebody raised that in a debate in the House of Lords recently-but what more we can do at a practical level to make this work and get people to speak out. That is where we need to look at the whole issue of incentives and payments very carefully, to make sure that we understand it and its implications, and maybe there is a case for offering people incentives. We need to work out how to make it work better.

Q117 Chair: But what is your provisional answer to that question? What is your provisional conclusion? In what way is your mind moving on this, always accepting that your final conclusions are some way off?

Carol Sergeant: We haven’t announced them yet. I have just set up a genuinely independent commission, which will be chaired by a retired Appeal Court judge and has some very powerful, independent people, including-following your example-a very senior member of the Church. I want to keep an open mind, because I really don’t know what the right answer is. We need to think about it very carefully and listen to a lot of people. Then we need to begin to look at the US, which I think is the only authority that pays compensation, and talk to the people there and see how they feel about it. I think it is a very tough issue. I am not sure I would even want to say now what my thoughts are; I want to keep my mind open and listen hard.

Q118 Mr Love: Just picking up on the points you have made, is it not the case that the cutting-edge legislation that you indicated we have in this country has broadly failed to bring forward whistleblowers, and where they have come forward they have almost entirely been ignored or vilified for what they have tried to do, whereas in America they seem to have more success, at least financially? I am frustrated that you are only beginning your inquiry, because we could have done with the evidence that you would have amassed from it in our deliberations. This, as you have already indicated, is a central part of what we are looking at. We need whistleblowers to be effective if we are to find out what is actually going on in some of the financial institutions.

Carol Sergeant: Whistleblowers are incredibly brave people. One of the reasons why we are looking specifically at financial services is that that’s an area in which there probably hasn’t been sufficient whistleblowing. Very interestingly, however, the amount of whistleblowing going on to the FSA has gone up by a factor over the past year or two, since the crisis-I cannot remember the precise statistics, but it is a multiple of what it used to be. At least people are whistleblowing to the FSA, and hopefully the FSA is doing something about it. But there are other sectors where whistleblowing has brought about significant changes, for example in care homes, in the national health service and in local authorities, where people have whistleblown about fraud and maltreatment of patients. There have been changes, but I would say not enough.

Q119 Mr Love: I understand that other sectors are different, but we are focusing entirely on financial services. It would be interesting if you wished to make any submission to us, because this is an issue we will deliberate on and try to take a view on.

Carol Sergeant: My charity, the whistleblowing charity Public Concern at Work, has already made a submission to the Commission, but we can go away and see whether we can amend it.

Q120 Chair: If in the new year you have anything to add to that, please do so.

Carol Sergeant: Yes, of course.

Q121 Mr Love: Can I come back to Simple Products again? I was interested to discover that you were a member of the board of Secure Trust, which has a basic bank account. However, it is not a basic bank account; it is just called a basic bank account. When you are looking at various products for your final report, will you be looking at the basic bank account and seeing what changes could be made to engender greater trust and confidence in the basic bank account, not only from the customer, but also from banks, which seem to be hightailing it out of basic bank accounts at present?

Carol Sergeant: Just briefly, my understanding of basic banks accounts-I have not been in a large bank for nearly two years, so you would have to ask the banks-is that they are extremely unprofitable as currently constructed. Therefore, it is probably not surprising if the banks are hightailing it out of them. In terms of Simple Products, we are trying to do two things. One is to get the concept going. Phase one-we hope there will be many more phases-is more about financial protection. It is to make people more financially resilient. We now have auto-enrolment pensions. This is to try and deal in phase one with all the stuff that happens to you between getting your first job and ending up with your auto-enrolment pension. We decided at an early stage to focus on things such as life cover, basic savings products and basic income replacement. The products that are likely to go out in phase one will be Simple life cover and Simple savings products. The idea is that if this concept takes off-ultimately, the industry has to decide whether it is prepared to do it, because the Minister who commissioned this made it very clear that there will be no compulsion-there will then be other phases.

Certainly, some of the feedback that we have received has suggested that basic bank accounts should be one of the things to go in the next few phases, so that will absolutely be considered.

Q122 Mr Love: Finally, we have been investigating a variety of issues, one of which has been treating customers fairly. The FSA rules failed comprehensively, as you can see from PPI and various other things. One of the areas that we are looking at is whether a duty of care, which has been suggested to us by a number of organisations, would be an appropriate alternative to try to ensure proper conduct standards. Do you have a view on that?

Carol Sergeant: To be honest, I am not quite sure what a duty of care means that is different from treating customers fairly. I don’t really understand that.

Mr Love: I thought you might be able to tell us.

Carol Sergeant: One of the things that I would put to you is that, yes, people must be treated fairly, but if you make the test too onerous, you are going to find that people will not be providing advice, which is happening at the moment in the financial services industry, and they may not even be providing product. There is a balance there. Of course, people must be treated fairly. There is no question about that. However, what standards do you hold people to and what error rates do you find acceptable? At the moment, the industry is scared stiff-to use a colloquial term-of anything in that space. They are withdrawing like you have never seen them before from providing advice to anyone other than very wealthy clients, where they can justify the cost of providing that advice.

Personally, I think it is a really big issue. People are talking about the advice, but I am not at all sure what they are doing about it. My concern would be that unless the Financial Conduct Authority is given some additional objective or constraint or something about ensuring-I do not know how you would draft it as I am not a parliamentary draftsman-access and availability of financial product to consumers as part of their overall objective, you could be making it very difficult for them to make risk trade-offs, which will maybe take a bit of risk with how customers are treated, but also ensure that there is still product and advice available.

Q123 Mr Love: Let me just ask one final question. The Money Advice Service, even if it does its job 100%, provides generic financial advice. It then goes to the private sector, and this is where the gap occurs. The well-off will always have advice. How do we fill that gap?

Carol Sergeant: That is a very interesting challenge. At the moment, I think that the industry, rightly or wrongly-I am not defending anyone here, I am just describing a fact-is concerned, and it has withdrawn from giving advice, by and large, other than to the wealthy.

The Money Advice Service could be very effective, but I think there is a question about exactly how much advice people need. One of the challenges I have had with Simple Products is people have asked why not have a Simple investment product. I have said that, at the moment, people are getting used to going into auto-enrolment pensions, which will have quite a lot of investment risk. But I am talking about people who have no life cover-no savings or virtually no savings-having some basic protection, like a squirrel who has some nuts in the ground, rather than making shed loads of money out of investment. It will need very careful monitoring-will the generic advice that the Money Advice Service gives be enough, or not, for that cohort of people?

I also think that there is a bigger issue, which is awareness. On the Money Advice Service’s website, there is all kinds of jolly technical stuff-I am sure it will get better-about analysing your own financial position. The big thing that has come out of the research that we have done is that, actually, until somebody feels that they ought to be doing something to protect themselves financially, they are never going to go to that website. There is a huge awareness campaign, and huge awareness that just having an auto-enrolment pension but then no life cover and virtually no savings is not adequate; you need to be doing more, particularly as the welfare state withdraws more and more. It is not a political point; it is a fact of life, which has happened under several Governments, that people need to make more provision for themselves. As well as providing technical support to people, the Money Advice Service needs to get out there and try-almost literally-to emotionally engage with people because they need to be looking after their financial protection more then they perhaps are at the moment.

Chair: Thank you very much indeed. We have been asking you questions for quite some time, you have answered them and we are extremely grateful to you.

I should make one point in the interests of clarity. I do not know whether you are aware that the Commission will produce two reports. The first report, which will be produced very soon, concerns the pre-legislative scrutiny of the coming banking Bill. The matters which we have been discussing this afternoon are largely for the benefit of our second report, which will probably come out in March. When you see the first report, do not be surprised if there is not much about this because there is not meant to be.

Carol Sergeant: Thank you.

Examination of Witness

Witness: Christine Downton, Vice Chairman of Pareto Partners and Director at Atlantic Philanthropies USA Inc and Governor Emeritus of London School of Economics and a Member of External Investment Committee of Partners Capital Investment Group LLC, examined.

Q124 Chair: I am extremely grateful to you because I know that you have completely changed your transatlantic schedule-your trip from the new world to the old world-in order to appear before us today. We owe you a great debt of gratitude. Before we ask you any questions, is there anything that you would like to say to us, particularly because I know that you listened to the discussion we had with our first witness? If there are any thoughts that you would like to volunteer to us before we ask questions, please feel free to do so.

Christine Downton: I would like to add a couple of points arising from Carol’s testimony because it provoked thoughts in my mind. The one that really came to the forefront for me was whether or not we are thinking enough about the objectives of regulation in terms of are we aiming at the systemic risks to our financial system worldwide, or are we wanting to regulate and to monitor for some specific wrongdoing or for bad practices at the micro level within institutions? It seems to me that those are two not mutually exclusive, but rather different focuses. If you are looking at the systemic risks, you end up perhaps with the greater simplicity of some of the metrics that you think about. In the other aspects of the micro-behaviour, it is more of an audit function. The capacities of the people involved need to be very different.

Q125 Chair: So your practical suggestion is that they should be different people in different organisations, which to some extent they are under the new system.

Christine Downton: That is the case, but it just seemed to me that that needs reinforcing in the way that we think about the challenges. When you look at the systemic risks, they seem to be more identifiable, and the metrics are not so complicated. If you look at almost every financial crisis that has ever happened, you have some fairly similar things going on. They occur during a boom. That leads you back to the macro-prudential issues. During the boom, certain practices come into being, sometimes through the forces of competition, which is what Carol was saying and which one of your questions led to. When you are in those boom environments, the potential for excessive growth in certain parts of the financial system can really be identified. One of the most influential reports on a financial breakdown was the Comptroller of the Currency’s report on the Continental Illinois breakdown. It identified a number of factors: very rapid growth of business; very rapid growth of recruitment of people without strong backgrounds in the areas that they were going to be working in; high turnover of staff; and very rapid growth in particular lines of business. Those are the sort of flags that come up both at the systemic level and at the individual financial institution level. They are the sorts of metrics that regulators should be looking at and then drilling down into both at the systemic level and at the individual institutional level.

Q126 Chair: As you say, there have been repeated financial crises-there is a history of financial crises. They do seem to have a number of common factors. Why do you think it is then that the lessons of history were not learned?

Christine Downton: It partly comes back to history not being studied. The regulators should be trained more in the history of financial crises. We need to add to the training that regulators generally get. To have case studies of a range of financial crises would be an extremely useful addition to their training. That would be one thing that would be an enhancement to training. There is that tendency to think that this time it is different, but, at some level, it is different because institutions change and new institutions come into being. It is focusing on what is the same, what is different and what that means. Why does it happen? I think it is because there is also a march of history in that people who have been through financial crises have personally learned what it is like to be in a financial crisis, and the mistakes that they and others have made. Financial crises don’t often happen immediately one after the other: there tends to be a lag while those people who learnt lessons move out of the industry. I think we have seen that time and time again. It is not a particularly helpful thing to say about why it happens, but the only thing I can suggest is that people are required to have a greater grasp of the conditions in which financial crises occur.

I would go back, though, to the macro-prudential issue. It is extremely difficult for regulations to control excess risk taking if you are in an environment of boom that has been created by fiscal and monetary conditions. I think it goes back to good fiscal and monetary practices.

Q127 Chair: But that might not be enough, might it? You could still have excessive risk taking and all that is associated with it: if, for example, a particular financial institution wishes very aggressively to increase its market share, that can be done in any macro environment, can’t it?

Christine Downton: It can, but I think that becomes more of a risk to a particular institution than a systemic risk. That goes back to the question of how much you control the systemic risk or improve the regulation of systemic risk, and how much you want to focus on an individual institution. If an individual institution starts poor practice in a non-boom environment, they are more likely to get into trouble themselves, rather than that being a systemic event.

Q128 Chair: So they should just be allowed to fail?

Christine Downton: I think in that environment, yes.

Q129 Chair: You began-correct me if I am wrong-in this country, and are now based in New York, so you are in a particularly good position to compare and contrast the system of supervision and regulation in both countries. Are there any lessons, do you think, from this comparative study?

Christine Downton: One of the challenges that the US has is the multiplicity of regulatory authorities within the financial service industry. Within banking, there is the SEC, the futures regulatory authority and then you have the state authorities as well-

Q130 Chair: Is that a good thing or a bad thing?

Christine Downton: I personally think it is a bad thing, in that it means that you have not got that overarching systemic focus. There has been discussion in the US about putting in some overarching framework around that multiplicity of agencies, but there are tremendous differences of interest in all of those agencies, and there are conflicts and competition between those agencies, which I think really inhibits good regulation.

Q131 Chair: So you do not think that there is anything that we have to learn in this country from the United States?

Christine Downton: Well, I would never want to say that, any more than I would want to say that the US has nothing learn from here, but I think that is something that is a flaw in the US system; it has developed over many, many years and decades, and is an inhibitor of the good monitoring of systemic risk.

Q132 Chair: One last question from me at this stage: in your written evidence to us, for which we are extremely grateful, you gave some practical suggestions as to how, as it were, the calibre of supervision could be improved. Again, coming back to the comparative study, what is your view of the relative calibre of supervisors in this country compared with the fragmented system in the United States?

Christine Downton: It is a difficult one for me to give really solid feedback on.

My observation from having worked in the Bank of England and the Fed, and being on the Investment Management Regulatory Organisation in the very early days of more detailed supervision here and in the UK, is that the calibre of senior people is high in this country. There is more temptation in the US to be recruited by the industry in general. That happens here too, but the pressures are even stronger in the US. Politics intervenes more in the US with intense lobbying. Whether that has an impact on the calibre of people who stick it out in the regulatory environment, I would have to look at the detailed data to be confident about that, but I suspect that it would be quite a burden on regulators at times.

In the Madoff scandal, for example, I wonder whether a potential whistleblower here would have been as persistent as the one in the US who for five years was writing reports to the SEC about the impossibility of the returns that Madoff was reporting, and whether that would have been picked up here. It was not picked up in the US because of the quality of people in the SEC who were dealing with those allegations, so I think the quality of people dealing with complaints is an issue, and I think there was some political pressure1.

Q133 Lord McFall of Alcluith: May I reinforce Lord Lawson’s comments about your paper? I thought it was excellent. I want to explore complexity and simplicity. Are we, in the Beatles’ phrase, starting over again? We are on a bandwagon of complexity with Basel II and Basel III. We had Michael Foot before us who said that Basel II was useless. Dodd-Frank in the US is approaching a few thousand pages, and your paper makes it clear that the propensity for regulatory arbitrage will increase. What can we do? Is it too late to do anything about this?

Christine Downton: If you have regulation, you will have regulatory arbitrage, and the tighter the regulations, the greater the incentives for regulatory arbitrage. The other danger of excess regulation is that it is an incentive for corruption as well. There is discussion about control of remuneration in the financial services industry. I just wonder whether, if you introduce those sorts of controls, you will increase incentives for other perks to come in which are even less attractive and less transparent, but that is a bit of an aside. I am sorry, I have lost my train of thought.

Q134 Lord McFall of Alcluith: In terms of complexity and simplicity in regulation starting over, perhaps you could incorporate into your answer what would make a good regulator. What should a good regulator be doing? Should they be looking at the business model? Should they engage in on-site visits? Should they lay down a list of simple rules? After all, if we can get by with the ten commandments for 3,000 years, what do we do with regulation?

Christine Downton: Interestingly enough, the report I mentioned on Continental Illinois was originally reported as 10 things you have to look out for. I went back and had a look at it, and I now find it more opaque than I did at the time, but there is a series of metrics. For example, where is growth in the industry happening? What are the instruments that are growing very rapidly? What is happening to staffing in those areas? What is happening to the quality of the staff in those areas? If you have those metrics, you can then start to dig into what is actually going on. There, I feel that-not necessarily the whistleblower-having regular interactions with senior people in the industry around those issues could be extremely helpful. An interview process like this, or as happens in the Committee system in the US, where you bring people in and say, "Look, this is what’s going on in your industry. How is that affecting how you are running your business? Do you have any concerns about the way your competitors are running their business in that environment?", might have the potential to flag those competitive forces that Carol was talking about and that you also picked up on, where the competitive forces in these very buoyant times lead to corners being cut, risks being underestimated and the whole panoply of poorer practices coming in.

Q135 Lord McFall of Alcluith: So what you are saying is, maybe we cannot do anything about the increasing complexity, given Basel II and Basel III, but maybe a regulator should have these overarching themes that can complement the regulation.

Christine Downton: That can insist on the interpretation of the data. That is something that should be done.

The other area that I feel is going to be a growing challenge generally is the capacity both to gather and to analyse data. If you look at what is happening in the industry-I don’t know it any more in detail-regarding the amount of data that are now being gathered on credit risk, for example, it has been going on for 20 or 30 years, but it is absolutely gaining momentum. This is going to be a very potent force. The information that is being picked up on every single individual, and the way it is being linked to consumer behaviour, borrowing behaviour and everything you can think about, is going to have implications and is a potential resource for regulators. I think regulators have to ensure that they are keeping up with those developments in data analysis and collection that are going on in the industry everywhere.

Q136 Lord McFall of Alcluith: Okay. Last one from me. How far away-this is a ballpark figure, if you like-are we from resolving the issues of too big to fail, too big to manage, too complex to manage, or too big to behave? It seems that we are not within grasping distance of those issues yet. You mentioned the shadow banking system possibly being the next financial crisis.

Christine Downton: The potential for picking up on some of these developments, if you can keep in touch with gathering enough data-I think part of the problem in the last boom was that data were not gathered and captured on a whole range of activities, particularly over-the-counter activities and the collateral that was or was not being required against all those transactions. Regulators need constantly to be pushing out the frontiers of what they are looking at. That is another sort of metric: what else is going on that is increasing the fragility or complexity of the system? When I talk about complexity, what I mean is being aware of where the weaknesses and cracks are and focusing on them. Maybe that is another requirement, to try to gather information on where those are.

Going back to your question about too big to fail, I think it is a bit like Zhou Enlai and the French revolution: it is too early to tell. I don’t know whether we know.

Q137 Lord McFall of Alcluith: That answer is enough for me. Lastly, I am a believer that it is not the architecture of a system that is the issue, it is the engagement of people. If you like, it is the interstitial areas where you can fall down, which is the point you made. Given that we have got the PRA and the FCA now, do you think there is the capacity for grey or interstitial areas to exist with the overlapping of responsibilities?

Christine Downton: I am not enough of an expert any more on the specifics of the regulatory organisations here. The one thing that I do think is important is to make sure that there is an effective bringing together of them in an environment that fosters co-operation, not competition. That is my only observation.

Q138 Mr Love: I cannot resist the temptation, since you now spend most of your time in New York, to come back to this question about the comparisons and the differences between our two regulatory systems. One of the things that our Commission has turned up is that, in terms of successful prosecutions for market abuse-insider trading in the main-the Americans seem to be doing better. You can describe that as a robust form of regulation, but some people would say that it is brutal and it coarsens the relationship between regulators, the criminal justice system and the financial services sector. Do you think we are getting it right in this country or is there something we can learn from the United States?

Christine Downton: I think that sanctions for bad practice need to be stronger here in some way. On the issue of whether it has to go through the courts, the disadvantages of the US system are not only the resources that are absorbed in all of this but the benefit that it gives to very wealthy institutions and individuals. One has to think quite carefully about whether what comes out of it is justice. However, I feel that there are not enough sanctions here for poor behaviour.

Q139 Mr Love: Martin Wheatley said to us, in answer to this question, that if the sanctions were harder there could be a proper process of negotiation so that people could turn Queen’s witness and the FSA would be able to extend its investigations. Do you sympathise with that view?

Christine Downton: I think I do, yes.

Q140 Mr Love: Let me move on. Our previous witness-I suspect you were here when she said this-was strongly of the view that remuneration for regulators, especially, I suspect, at the senior levels, is not an issue. Do you agree with that or do you think that remuneration is an issue that we need to look at carefully?

Christine Downton: I would really respect what she was saying. I am not sure that remuneration is the issue. I think that people are motivated more by a sense that they are able to do what they are supposed to do, and that they have the backing to do what they are supposed to do. It can be demotivating for regulators-I mentioned the incident at the SEC, but you could find many incidents of the same kind-if people raise an issue or identify a problem and they are not backed up in the political system or elsewhere in the regulatory system. I do not think that it is money. I think that the money needs to be good enough to keep really good people, but I do not think that is has to be of the scale that you are getting in the financial service industry itself in those boom times.

Q141 Mr Love: So what other things do you think we need to do to motivate regulators, if the money is good enough?

Christine Downton: I think that perhaps some of that comes back to sanctions. They should have the feeling that when they identify problems they are going to be pursued, and that people are going to face up to sanctions-being excluded from the industry or suspended from the industry for periods of time.

Q142 Mr Love: Our terms of reference as a Commission are to look at standards and culture and, as the Chairman has indicated, that is what we are focusing on in the second part of our inquiry. Recently, the former chief executive of the FSA, who left some months ago, took up a job in the private sector. That interchange seems a regular feature, and lots of people would describe it as a sensible and pragmatic approach that delivers benefits to both sides, while others see standards and cultural issues involved in that. How do you look on it?

Christine Downton: I think knowledge is always good. If people move backwards and forwards between the two sectors they will be building their knowledge. I think that is good.

Q143 Mr Love: Do you think that any conditions should be applied to that? People could perhaps be in sensitive positions and may have knowledge that would obviously be of great benefit on either side.

Christine Downton: I think cooling-down periods are always good; gaps between taking up one kind of job versus another can be useful.

Q144 Chair: May I follow up on some of the interesting answers you have given to my colleagues? Starting with sanctions, just for the sake of clarification if nothing else, what you are talking about, as I understand it-and correct me if I am wrong-is not sanctions against a bank that has done something wrong, but sanctions against individuals.

Christine Downton: That was certainly the tone of my response, but I’m not sure that is the only thing.

Q145 Chair: There is no silver bullet for anything.

Christine Downton: No, so I wouldn’t want to restrict it to that. I think perhaps-and again I am probably not enough of a regulator to give a really good answer on this-that fines on institutions are a useful a weapon. Having said that, the fines are usually relatively small, relative to the profitability of the activities. I think it is a very interesting area to think more closely about.

Q146 Chair: But the fine on the bank can, and probably will be, considered just a cost of business. It will be reflected either in the margins they charge or, if there is any loss, it is the shareholders who lose out. So it doesn’t really hit where the culpability lies. You are mainly talking about sanctions against individuals, whether it is fines, whether it is being struck off the list of fit and proper persons or, even in the last resort, a term of imprisonment. You are talking about that sort of thing, are you?

Christine Downton: I am. Institutions are, after all, made up of all the individuals involved. If an institutional culture is poor, you are going to find individuals who are contributing to that. The only thing that I think fines do regarding sanctions at the institutional level is that reputational risk is much more serious for institutions than fines are likely to be. But the process of fining an institution and everything that goes into that process of fining then creates a reputational risk. I think reputational risk is a sanction.

Q147 Chair: But again, reputation is something that is much more acute for an individual, isn’t it, than for an institution?

Christine Downton: I think as far as an institution is concerned it does have implications for their business. Maybe not for a long enough period but perhaps for a certain period, it does create some bias against that institution in terms of who does business with it.

Q148 Chair: To take one example, and I don’t want to pick on them particularly, not long ago Goldman Sachs were found guilty of a wrongdoing and were fined. Do you think that has damaged them in any way in the amount of business they can do?

Christine Downton: Well, their share price has certainly gone down quite a lot. I am not quite sure whether that causal relationship is strong. I suspect it gave them pause, but in terms of its absolute position in the industry, then no. The fines themselves, reputationally-I think there was a period of time when there were some question marks, but from customers, about Goldman Sachs. On how much that impacted on them, you would have to look at the specifics.

Q149 Chair: Since we are talking about Goldman Sachs, you referred in one of your answers earlier to whistleblowing. Do you think we have anything to learn from the United States, which has a totally different system when it comes to whistleblowing? Do you think we should encourage whistleblowing, as they give financial encouragement to; or do you think it is counter-productive; or could we learn the lessons of where they’ve gone wrong and have a better whistleblowing system? If so, what would it be? Where do you stand on whistleblowing?

Christine Downton: Where do I stand on whistleblowing? I certainly think that whistleblowers need to be protected; that’s extremely important. There is a history on both sides of the Atlantic of whistleblowers not being protected. I have almost a visceral reaction against financial incentives. At the same time, I think one simply has to observe whether they’ve been effective or not and whether they have encouraged people to come forward. In the US, there are indications that they have encouraged people to come forward, but have they encouraged people to come forward without real cause, which is obviously one of the concerns about whistleblowing, or is it grudge-related?

Q150 Chair: I don’t need to tell you that there is nothing in life which is all advantage or all disadvantage. Policy makers have to weigh up and see where the balance lies. That is the question I was putting to you.

Lord McFall of Alcluith: The moral maze.

Christine Downton: I find it a very difficult question to answer, because as I said, I really believe whistleblowing should be encouraged, and financial incentives work. I suppose I would probably say I would be for them in a spirit of experimentation, and close monitoring of what it actually produces.

Q151 Chair: This is the last question from me. Lord McFall alluded to the problem of "too big to fail" and "too big to manage" and all that.

Christine Downton: Which I did not really deal with properly.

Chair: One of our witnesses, Michael Cohrs, whom you no doubt know, in effect said to us that he thought that big banks had become too big and that the advantages of size and scale had come to a point where they were outweighed by the disadvantages of scale, and therefore they should be broken up. Would you favour that?

Christine Downton: No. I will quickly go back to the "too big to fail" issue. I think that progress is being made on that-the work that has been done on the process of how to manage "too big to fail", and on letting an organisation fail and unwinding it in an orderly manner, which in turn could lead to the breaking up of large institutions that get into trouble-but I don’t favour that as a regulatory intervention or a legal intervention. That is because I believe that people would find ways around it, and you would be back into that world of regulatory arbitrage, so there are disadvantages to forcing those kinds of regulatory distinctions.

Chair: Thank you. A final question from Andy Love.

Q152 Mr Love: I apologise; I should have asked this earlier. In many ways, it relates to many of the comments you have made. Every other witness we have had was involved with the regulators at the time when difficult decisions were being taken up to 2008. In your very good paper, you mentioned regulatory failure in 2008. Will you give us your view of what they failed on at that time?

Christine Downton: I would have to go back up the regulatory ladder, if I could put it that way. I think the environment was a lax one from a fiscal perspective, and that made it extremely difficult for monetary policy to be as tight as it should be, which in turn created the environment for the laxness of the regulators. [Interruption.]

Chair: I am sorry to interrupt you, but as you can see and maybe hear, there is a Division in the House of Commons, which affects one of our members.

Mr Love: I shall listen for a few more seconds, and then I shall excuse myself, but you should continue rather than stop.

Christine Downton: Sorry-I got off a plane this morning, so jet lag is a bit of an issue. Just remind me of the specific question.

Mr Love: I just wanted you to comment in more detail specifically about the regulatory failure in 2008.

Christine Downton: Again, focus on those areas that were growing almost exponentially-I would say that even more in the US than here-in that there was insufficient attention on those areas. Such things as the over-the-counter market just seem to me to have got completely out of control, and the off-balance-sheet activities of the financial institutions were not being paid attention to. Somehow, we have to try to figure out a way of getting regulators constantly to look at what is happening outside their ring fences and outside the areas that they are regulating within the institutions they are responsible for.

Q153 Chair: The box-ticking approach is disastrous.

Christine Downton: Absolutely disastrous.

Chair: Thank you very much indeed. I am sorry we have kept you for so long. It is heroic of you both to have changed your flight schedule to accommodate us, and to have agreed to come and give evidence having just stepped off a transatlantic flight. We are extremely grateful. Thank you very much.

Christine Downton: Not at all. Thank you.

[1] Witness comment: I believe such constant whistle blowing by one informed individual would not have been ignored in the UK as it was by the SEC.

Prepared 4th January 2013