SIR CALLUM MCCARTHY, MR HECTOR SANTS AND MS MARGARET COLE

6 MAY 2008

  Q60  Ms Keeble: I wanted to ask specifically about some of the issues around liquidity of financial institutions. What have you learned out of the last crisis, the Northern Rock crisis, and will that need international action or do you think there are measures you can take to improve the situation?

  Sir Callum McCarthy: You know that we have already started the process of taking action on a UK basis. The history of international agreement on liquidity is not a good history. When the Governor gave evidence to you last week, he was pointing out that when the Basel II process began, there was an attempt by the Bank of England to try and make sure that liquidity came higher up the agenda and that attempt failed. One of the things that concerns us is that, because it is likely that there will be slow process in the Basel Committee in relation to liquidity, it is essential that we take action in the UK. We have already started that with the discussion paper that we published at the end of last year and I think we will be coming forward, indeed we will be coming forward this year, with other proposals on liquidity. It would be ideal if we could get agreement internationally but I am sceptical about the practicality.

  Q61  Ms Keeble: In the memo you sent to us you said that in your new programme there would be more focus on liquidity particularly in the supervision of high impact firms. Are those some of the changes that you are proposing? One of the key issues here was that Northern Rock did not actually breach the rules so how are you going to improve and sharpen the focus, particularly on the risks factors, and how are you going to assess them given that the rules are quite lax?

  Mr Sants: We come back here to the point we have made a number of times before. The primary focus, in our view, with regard to liquidity management should be on scenario planning, on stress testing. We do believe that you need to have some prescriptive and detailed rules. As we said before, we do not believe that liquidity regimes should be solely principles-based and, yes, there should be some rules and we will reassess where those rules are pitched and also, critically, the definitions in terms of eligible collateral and definitions of securities which are relevant to those specific rules, but the main focus has to be on ensuring that boards and executives and non-executives are properly focused on giving clear consideration to the various stress-test scenarios, stress scenarios that could develop and that they properly satisfy themselves that they have adequate liquidity to deal with those types of eventualities. As we said before, that is not what happened here with regard to Northern Rock. It had not properly considered all eventualities with regard to the various scenarios that might develop. It had not made a judgment as to whether it thought those risks were acceptable for its board to bear. We as supervisors, however, had equally not properly engaged with them to ensure that that was happening.

  Q62  Ms Keeble: Mr Sants, I wondered if I saw some sort of changing of the position around principles-based regulation, because you mention in your memo that you are an outcomes-based regulator. I know we can all sort of dance on a pinhead when it comes to words, but it would seem that outcomes-based regulation, and it is quite specific in your memo, where you look at the results of actions, is different from the principles-based which would look more at the processes that are put in hand, and I wonder if this is a shift. What do you mean by this what seems to be a difference of approach?

  Mr Sants: I think we have always stated, and certainly when we re-launched our regulatory proposition with our document back June of last year, that we were a more principles-based regulator rather than solely a principles-based regulator, a point I think I have covered with the Committee before. We are not in any way suggesting we could operate solely on 11 principles, there are undoubtedly occasions when rules are necessary, but in that document we also talked about outcomes—judging firms on the outcomes of their actions. I think you are right in saying, however, that in trying to communicate our message in a way that firms and, critically, of course, the management of firms can understand, I do myself find it more helpful to focus on the word "outcome" rather than necessarily that we are more principles-based. More principles-based, if you will, is a framework that we are using and focusing on outcomes is what we want the management of firms to do. I think it is more helpful in the communication process and in the messaging process to stress the point that people have to think about the consequences of what they do. That, surely, is the most important point here. Are people giving proper consideration as to the consequences of what they do? The framework under which we judge whether they are giving proper consideration sits behind that, but I think the main message should be about you, the management of the firms who are the people responsible for running firms, not the regulator, we do not run firms, and you need to think about the consequences of your actions.

  Q63  Ms Keeble: There has been a lot of critical questioning from colleagues here about the management structures and the reliance on junior staff and the messaging sent out, and so on, and it would seem to me that, if the regulation is to be improved, there has to be clarity of focus, and it would seem (and again I do not want to dance on a pinhead) that there is a difference in approach between rules-based, principles-based and outcomes-based, and if people are asked to do all three things at once it is a muddle. What is the focus of your regulation, moving forward, given that you need real clarity to deal with financial institutions in a difficult climate?

  Mr Sants: I would make the point that we would hope that sophisticated banking staff can focus on three things at one, but notwithstanding that, I take the point and, just to be clear, we are asking people to focus on the consequences, the outcomes of what they do. The other comments are about describing the framework that we will use to judge whether those outcomes are reasonable. What we are asking management to do, what we are asking people to do to protect depositors and savers is to focus on outcomes, and I think the message is straightforward and simple and should be easily understandable. It is actually a lot more understandable than, say, adhering to an 8,000-page rule book.

  Q64  Ms Keeble: What more do you think that financial institutions could have done to overcome the current difficulties?

  Sir Callum McCarthy: I think that there are a wide range of things that have gone wrong in the risk management within banks and other financial institutions—that is undoubtedly the case—and that is one of the fundamental things. If you look at the origin of the present problems, there have been problems in the origination of mortgages in the US which represent a series of failures, including what I think the US regulatory authorities would recognise as things that they have not appropriately controlled. There are a wide range of things. If you ask what can now be done, I think the particularly important question is to ensure that financial institutions improve their disclosure so that counter parties can make a proper, informed assessment of the position of those institutions, and that is something that we are pursuing.

  Q65  Ms Keeble: Do you agree with the Governor that the incentive structures in the City of London presently are partly to blame for market turmoil?

  Sir Callum McCarthy: I think there are some very difficult questions about incentive structures. I think it is a very complex area. I am very mindful of the fact, for example, that if you take Bear Stearns, about a third of the stock of Bear Stearns was actually owned by the employees, but that did not prevent Bear Stearns materialising as an acute problem. I think there are some very interesting and important questions about incentives which are very difficult to deal with.

  Q66  Ms Keeble: I want to ask one further question, which is about the Special Liquidity Regime. I wondered if you had been consulted on it as one of the tripartite authorities. Given that you think that there should be credible deterrents for financial institutions who do not adopt sound lending policies, as is also set out in your memo, do you think that the prospect, as the public would see it, of a 50,000 bail-out is a credible deterrent?

  Sir Callum McCarthy: Yes, indeed. We were involved, extensively involved, in the discussions of the development of the Special Liquidity Regime. Second, I do not believe that the existence of this is going to impede credible deterrence because the essential—

  Q67  Ms Keeble: It is going to impede it?

  Sir Callum McCarthy: It is not going to impede it, and the reason why is that the credit risk lies with the banks and remains with the banks, and that is essential to the scheme.

  Q68  Mr Fallon: The medium-sized and smaller building societies were excluded from the scheme, presumably because they could access funding indirectly. Has that worked? Are you aware that capital liquidity pressures on the smaller building societies have been eased or not?

  Sir Callum McCarthy: I think the answer is the capital and liquidity pressures on the smaller building societies have eased for a number of reasons. I think it is not principally, at the moment, because of the very early stages of the Special Liquidity Regime. I am confident that there will be a transmission mechanism from those who can access the scheme, which include about half the building societies, to the residual half who cannot.

  Q69  Mr Fallon: So there are not any smaller societies at risk?

  Sir Callum McCarthy: Could I just make clear that I do not comment on any institution, but I am very confident that the scheme will work in a way that the smaller building societies will actually get access to it, not directly but indirectly.

  Q70  Chairman: In fact, there was a radio report last evening as I was coming down talking about Nationwide, which services a number of very small building societies, but that facility had been withdrawn. I am suggesting it is just a radio report, but it highlights the issue of the very small societies having access. Is it something that you can look at and come back to?

  Sir Callum McCarthy: Chairman, I would simply say that we have been very conscious, as the Bank, of this issue from the very beginning of the scheme, and I remain confident that there will be a transmission mechanism to ensure that the small building societies indirectly get access to it.

  Q71  Chairman: Mr Sants, in regard to the Special Resolution Regime, you said to me that the role of the FSA was to protect consumers and not shareholders?

  Mr Sants: As a general point, yes.

  Q72  Chairman: If you believe so, why do you regard yourselves as the best qualified to close a bank when the best way to protect consumers would be to keep a bank open?

  Mr Sants: Basically the special regime would not necessarily involve closure. It depends on the circumstances. It depends on the option, the resolution option, then selected as to whether or not that would lead to an orderly wind down or not. Reaching a determination that the current framework under which a given bank was operating was not a sustainable one, or likely not to be a sustainable one, does not also require reaching a determination as to what resolution option would then be selected. Just in passing, however, it would be clearly ill-advisable to reach that determination if you had not already worked out with the person or the organisation who would be responsible for running the resolution regime as to what the likely option was to be selected. That would clearly not be a good idea and that is why a high level of co-ordination is absolutely required between the organisation that runs the special regime and the regulator. There is no suggestion that this should not be a wholly co-ordinated process. I think some of this discussion somehow suggests that we would not be talking to each other. We obviously have to have a wholly co-ordinated approach, but determining that the current business model runs at risk of failure does not also require you to determine what would happen next.

  Q73  Chairman: But you do not see any conflict of interest between your duty to protect the consumer and the protection of financial institutions?

  Mr Sants: Undoubtedly, if you give an organisation a task—in our case, as the regulator, our task is to determine whether or not the institutions we supervise meet threshold conditions and we set a set of criteria for so doing—if people stop meeting those threshold conditions, people will hold us accountable to that fact along with the fact that we, of course, would be holding the bank management accountable, but that is the case in all cases. If you give people authority and responsibility, you make people accountable for the event. I do not in itself see it as a conflict, I see it as a natural fact of giving us a job which we would have to do well.

  Q74  Chairman: Given the fact that the FSA's meeting was not minuted, you can imagine someone like ourselves saying, "Wait a minute, there could be a situation here whereby the potential regulation requirement on the supervisor means that they could hush up what is happening there." That information is not put back to the senior management of the FSA. Indeed, there are no minutes of that. So, at the end of the day, the interests of the consumer are not protected 100% here.

  Mr Sants: If we do not do a good job, then the interests of the consumer are at risk. There is an obligation on us to do a good job, and Parliament has to believe that we will do our job well, and the purpose of setting out the programme we have set out and all the comments we have been making today and in our earlier appearances is to persuade you, what I truly believe that going forward we will do a good job.

  Q75  Chairman: So you have got to persuade us that we have absolute trust in you?

  Mr Sants: You always have to believe that an institution to whom you give responsibility and authority is going to do a good job; otherwise, obviously, you should not do that. We have set out what we believe we have to do, we believe we can do it and we make the point that I think the Chairman has already made that we have gone through a very painful learning process. We will be a better institution for having been brave enough and courageous enough to go through a learning process, lay out what we have to do and acknowledge our mistakes. That is the basis for a really strong institution in the future. Acknowledging your mistakes and learning is, I believe, a key component of a successful organisation.

  Sir Callum McCarthy: Could I say, Chairman, I have no doubt that this Committee would be properly critical of the FSA, and I mean that, and I also think that that is good for us, but you should be in no doubt about the determination of the Board, the executive team, to actually learn from what has gone wrong and put it right.

  Q76  Chairman: Sir Callum, but we do not want to be critical of the FSA after the event. We want to make sure that this legislation is fit for purpose, and that is the issue here.

  Sir Callum McCarthy: Absolutely.

  Q77  Chairman: I have met quite a number of brave people who just hit their head against the wall. We want bravery combined with intelligence and judgment.

  Mr Sants: I would ask you not to set it up in a way that we cannot do our job. I am saying I truly believe, if it becomes a complex overlapping process with double supervision, that neither of those supervisors will do a good job and we will be back here with same type of conversation.

  Q78  Chairman: I do not want to take too much time up, but the report of the Committee in terms of the deputy governor role was made because we need to inject creative tension and grit into the system, and that creative tension, I am suggesting, Sir Callum, was not there. That is why all of you, with equanimity, could come along to the Committee and tell us you did your job.

  Sir Callum McCarthy: Chairman, I simply repeat what the Governor said. I am all in favour of creative tension so long as it is creative; and the points that Hector has made are ones which seriously worry us in terms of duplication, lack of clarity and lack of responsibility.

  Mr Sants: We are all in favour of the Bank having a clear mandate with regard to financial stability and the Bank fully involving itself in discharging that mandate, and fully involving itself in discharging that mandate includes being involved in supervision of firms particularly when there is a risk that they will need to turn to the Bank for liquidity assistance, but being involved in the supervision is not being a parallel supervisor causing confusion.

  Chairman: I do not think the Governor was suggesting that.

  Q79  John Thurso: Regarding the legislation, the Government have proposed that it should be enacted during this session. In the consultation document the Government also said it would be consulting with the FSA and other parties. What progress has been made?

  Sir Callum McCarthy: The initial period for consultation has just closed. There have been very extensive comments, I am glad to say, because I regard this as probably the most important initiative affecting British banking for a decade and is going to shape British banking for decades in terms of the suitability and attractiveness of the UK as a place to do banking business. It is essential that we now digest properly the comments that have been made.