SIR CALLUM MCCARTHY, MR HECTOR SANTS AND MS MARGARET COLE

6 MAY 2008

  Q40  Mark Todd: I take that as an answer saying, yes, systemic failure is a reasonable criticism. To give an example, the poor recordkeeping which was revealed, which I think to an outsider was startling, where rather important meetings were not minuted in any way so you could not get a proper picture of what had actually happened; was that unique to the Northern Rock team?

  Mr Sants: I think a degree of failure to keep records, on the basis of the analysis that we have done was unique. Certainly there is a key aspect in respect of Northern Rock, without getting too much into the technical details, concerning the fact that the team did not keep up-to-date the necessary risk database where the key issues should have been recorded. As the data shows with regard to the high impact firms, that was a unique failure and that was a major contributor to the problem here, so I think you can say based on that analysis that, yes, there was a high degree of specificity here.

  Q41  Mark Todd: And the revelation of rather poor challenge mechanisms so that those at a more senior level actually discussed issues raised within an individual firm and challenged the team directly—because I think we all recognise that those closely engaged may not necessarily have the most objective perspective and require challenge—is the picture that you are presenting to us that management discipline was in place elsewhere in the FSA but was not in place in this particular instance?

  Mr Sants: Yes, correct. I am confident, as you would expect, that that is not to be found across the whole of the FSA. That was not found in some of the other divisions.

  Q42  Mark Todd: Some of the other divisions?

  Mr Sants: To be specific to your question, that was not found in the wholesale business unit but it would have been found to a degree elsewhere in the retail area. Given there was more than one firm in that retail area responsible to the relevant senior managers, clearly if they were not challenging with regard to Northern Rock it would be a reasonable deduction to assume that the challenge was also not necessarily found across the board.

  Q43  Mark Todd: That has been rectified since?

  Mr Sants: That has absolutely been rectified already.

  Q44  Mark Todd: It really follows through on the Chairman's line of questioning that a reading of this report, which I think you described Sir Callum as "painfully candid" or something like that—

  Sir Callum McCarthy: I think the words I used were "brutally honest".

  Q45  Mark Todd: Okay, pretty similar, but people reading this would certainly have considerable doubts about the functionality of the FSA and its ability to perform its duties. I must admit I am mildly surprised that I have not had correspondence from little IFAs saying, "They are all over us like a rash and look at what happens when they are looking at much higher risk institutions." I think I have only had one of those. Can you see the damage that has been done to your organisation in a corporate sense?

  Sir Callum McCarthy: I absolutely recognise that what has happened has been damaging both to financial services and to the FSA. Could I just make one point however that throughout the world in relation to the present problems there have been regulatory failures, but the only institution which has set out in detail what went wrong and has set out a programme very determinedly to change those and to put them right is the FSA.

  Q46  Mark Todd: It is an unusual document, I agree. It has been mentioned how infrequent the visits were to Northern Rock. Has that anything to do with the fact that they are way out of London up in the North East? It is a startling statistic, the relatively low frequency of visits to the company. Has anyone asked why it seemed to be so infrequently visited?

  Sir Callum McCarthy: We look after a range of institutions and it includes for example HBOS which is headquartered out of London and it includes people who are headquartered around the world. This was not because it involved people getting on a train or an aeroplane; it was because we did not do the job properly, full stop.

  Q47  Chairman: Sir Callum, we are looking to the future here and you mentioned about regulatory failure but we are the only country where there has been a retail run on a bank. To add to Mark's point here, in terms of your table—and I agree it is a very honest appraisal but we are looking for reassurance for the future—the average number of visits to the major retail banks in the period 1 January to 9 August was 22 and the average number of visits of the FSA to the five largest retail banks was 43; yet for Northern Rock there were seven visits and of those seven visits five were held in the one day, two were by telephone, and none of which had minutes. I suggest to you that if you were the secretary of your local community sports chub you would be thrown out on your neck for that. Here we have a high impact firm, one of the 37, with five meetings in one day and no minutes. Can we get reassurance that there is a fundamental culture change taking place in the FSA to ensure that that never happens again?

  Sir Callum McCarthy: Chairman, we have repeatedly made—

  Q48  Chairman: In terms of minutes and visits, give us an idea of what is going to happen now?

  Mr Sants: The answer is, yes, there is a fundamental change. The staff are abundantly clear to the fact that if these standards were repeated those employees would not remain with the FSA. I do not believe that they will be repeated. I am confident they have the message loud and clear. We completely agree with you.

  Q49  Chairman: Just to assure us that it is not going to be repeated, can you give us a flavour of what you are going to do in the future to effect that change in senior management?

  Mr Sants: Most certainly, yes, we have a significant programme but at the end of the day I think personally you can have as many programmes as you like; the most important thing is to deliver a message loud and clear. The message is the one that you have just articulated and we have already delivered it. I have delivered it personally, I shall be repeating it, and I shall be holding managers to account and you can hold me to account.[2]

  Q50 Chairman: There will never be a visit undertaken in the future without minutes?

  Mr Sants: It would be a rash person who says that there will never be human infallibility of an organisation but what we can say is if we discover such things there will be resolute management action taken.

  Chairman: You reassure us.

  Q51  Mr Brady: One of the other issues that was highlighted in the internal audit was the excessive reliance on junior members of staff in regulating Northern Rock. What measures do you propose to deal with that?

  Mr Sants: From our point of view, as I say, I believe we have set out a comprehensive programme. We do recognise that we need to make changes across the organisation and not just with regard to specific issues identified in Northern Rock. We will be addressing it through improved training, with clear standards and competency levels which will be assessed; through having extra resource; through having far greater focus applied by the senior management with regard to the supervisory process; by clearer accountability to those senior managers to delivering and then, critically, going forward, we are going to set up a unit which will in addition to our internal audit organisation, constantly review that process and ensure that our procedures, as we have just touched on, are being adhered to. That will be a regular, rolling programme with experienced supervisory resource, constantly reviewing the effectiveness of our supervisory regime. We would apply that to all the high impact firms over—and we will work through the details—something of the order of about an 18-month time period, so in addition to internal audit and in addition to increased and determined focus by senior management, there will be a quality assurance group providing regular review as well as regular help and assistance when tricky situations are encountered.

  Q52  Mr Brady: There is general acceptance that you had a difficulty because of the sector you are regulating that it is difficult to recruit and to retain good people. To what extent, in your view, does that lie behind the problem?

  Mr Sants: As we said before, it is a challenge obviously to recruit good people, particularly from industry, given the compensation differentials, and that is an established fact that everybody recognises. I would note however two points: (i) industry conditions of late have moved somewhat in our favour; and (ii) I do believe that with thoughtful and imaginative packaging of our employment propositions that we can hire. We have demonstrated of late in particular that you can hire senior people particularly if you offer them a mix of advisory roles, maybe part-time roles. You can bring in senior people with a lot of experience. We have demonstrated that of late by bringing in five or so very experienced and senior individuals to help us in a variety of different roles on the advisory side, so hiring at the top end to bring market experience into the organisation is absolutely doable. I would say in the last six months we have proved and demonstrated that so that we now have a strong team at the senior level. We have a strong and effective graduate programme where we are able to offer an overview of financial services. This is an excellent starting opportunity to market to bright, young graduates. There is an issue in the middle around retention, reflected primarily in the compensation proposition and that will always be a challenge for us. The expectation that this is an organisation where people come and stay for 20 or 30 years would be the wrong model to be pursuing. What we want to pursue is a model which has fluidity in the interchange between us and the industry and overall gives us a good blend of experience at all times. I think that is achievable and I would say over the last six months there is good evidence that we are on the right track and we have made significant progress already.

  Q53  Mr Brady: Would you be able to give me any kind of sense of what proportion of the fees that you charge to Northern Rock would actually have been spent on regulating Northern Rock or perhaps more generally for the big, major institutions?

  Mr Sants: It is an interesting question as to what you mean by "regulating". What you can say is, including the specialists who support the supervisory process, something of the order of 60% or 65% of the FSA's people are involved in the supervisory process. Lots of other bits of the FSA are involved in other things such as financial capability and so on and we are not a regulator that only does supervision of individual institutions and, as you rightly point out, we do seek through the fee block mechanism to relate the fees to the amount of supervisory engagement and that is particularly important of course for the smaller firms. However, if you are asking what was the exact cost of regulation for the large firms, or for Northern Rock, over the last 12 months, I would have to do that analysis and come back to you.[3]

  Q54 Mr Brady: I would be interested to see that, thank you, in particular as a percentage of what the fees coming in from that institution were. If I can just move on to the question of capital requirements, it is also noted that you were aware that Northern Rock was in breach of its capital requirements and yet there was no risk mitigation programme. Why not?

  Mr Sants: There should have been a risk mitigation programme in my opinion and, back to the analysis shown in the report, I think the failure to fill out the necessary risk data and have a risk mitigation programme were probably two of the most important reasons why we did not do a good job in this case. I do not think the particular issue of the breach of the regulatory capital requirement has at the end of the day had any impact on the events that transpired in the summer because it was a breach of only some 0.2% and it was rectified by the time the summer was reached. I do not think that particular breach has influenced the events that transpired from the end of July onwards. Should there have been a risk mitigation programme? In my opinion, yes, and that was one of the failings that led to an unacceptable performance in supervision.

  Q55  Mr Brady: On average, how often do firms breach their capital requirements?

  Mr Sants: If I were to give you a precise answer I would have to come back to you in writing and I am not sure whether we can actually do that for legal reasons. We might be able to give you the aggregate data but we do need to be aware of the confidentiality of individual firms' data. I think I would have to take an opinion as to whether we could release that information. However it does happen and it is not that unusual an occurrence. The question is how you respond to that and what happens next.

  Sir Callum McCarthy: Could I make one supplementary point to what Hector has said. A breach should not be thought of as a necessarily irrevocable event. The important thing is if there is a breach what is the action that the bank or insurance company or whatever it may be is going to take to put it right. If you take the instance of Northern Rock there was a programme that put that right, so I am not even sure if the number of breaches quite gives you a flavour of the reality of the situation.

  Mr Sants: You do not want to confuse breaching a regulatory capital requirement with failing threshold conditions so some idea that just because you breach the regulatory capital requirement you cannot continue as a viable institution would be a serious misunderstanding; they are not the same.[4]

  Q56 Mr Brady: Why did Northern Rock not have to disclose it to the market then?

  Mr Sants: In certain circumstances it can be a disclosable event. It depends on the circumstances surrounding the breach. If it was of material importance to shareholders and likely to remain so it would then be a disclosable event.

  Q57  Mr Brady: So is it your view that this particular breach was too small and insignificant to be disclosable?

  Mr Sants: It is not necessarily just the quantum, it is also back to the issue around disclosure. If you are likely to be rectifying it within a short period of time then you do not necessarily have to disclose, so it also depends on the existence of a set of mitigating actions. In this particular case, as you know, Northern Rock was able to swiftly mitigate the problem through the disposal of the loan book.

  Q58  Mr Brady: So there was no need for disclosure in this instance?

  Mr Sants: I do not believe so but if you would like a more detailed explanation on this I would have to come back to you. These are matters in the past prior to my taking on the Chief Executive role, so if you want a detailed explanation I will come back to you.[5]

  Q59 Ms Keeble: I wanted to ask a bit more about the overall banking regulation. First of all, do you think that it would be possible for the FSA or the Bank of England to encourage a contra-cyclical break of some sort—this was Charles Goodhart's approach—so that during the good times if patterns end it did not trigger the next crisis?

  Sir Callum McCarthy: I think this is one of the questions that we and other regulators around the world absolutely have to develop answers to over the next 12 to 18 months because what one does not want to do is to find that you tighten requirements at the wrong time in the cycle and relax them at the wrong time in the cycle. In some respects, Basel II will help in this. There are other aspects of Basel II where we need to improve aspects of the capital requirements and that is going to be worked on. It is one of the things that the Financial Stability Forum report identified but the wider question that Charles Goodhart was raising is something that we will have to come back to and follow up on.

3   Ev 61 Back

4   Ev 62 Back

5   Ev 62 Back