SIR CALLUM MCCARTHY, MR HECTOR SANTS AND MS MARGARET COLE

6 MAY 2008

  Q80  John Thurso: What is the process going to be? I have the same goal that you have, which is that everybody who has been involved in this needs to put what they think they have learned and we need to work through so we get the best outcome for everybody. What I am worried about is that actually, as sometimes happens with legislation, it disappears into the departmental black hole and what comes out is what we are stuck with. What is going to be the process by which you and the other institutions will ensure that best endeavours are made to get the best legislation?

  Sir Callum McCarthy: There are extensive and intensive discussions going on between the Treasury, who are in the lead of this because it is legislation, the Bank and the FSA on all aspects of the proposed legislation. I think the proposal is that there should be a further consultation paper that will come out some time during the summer and then legislation later in the year.

  Q81  John Thurso: Would it be worthwhile publishing the legislation in draft or possibly even having pre-legislative scrutiny?

  Sir Callum McCarthy: It is not my decision. I think these issues are complex and important, and I am all in favour for giving as much clarity as early as possible so that discussion can take place on the detail as well.

  Q82  John Thurso: So you favour legislation?

  Sir Callum McCarthy: I favour trying to put out into the public domain the legislative approach. If that is through draft clauses, I think that would be an admirable way of doing that.

  Q83  John Thurso: That would be something for this committee to have a good look at, would it not? Let us move on. The Governor of the Bank of England when he was with us suggested that there was not much merit in the fact that he sits on your board and you sit on his and that, indeed, it had distracted us from really understanding the proper relationship that took place at a different level. How useful have you found your membership of the Court?

  Sir Callum McCarthy: I think that there are benefits in having—. Actually it is the Deputy Governor who sits on the FSA Board. I see very significant advantages in improving the understanding of the FSA's Board about the approach of the Bank and also, I think, if you talk to most of the non-executive members of the Court you would find that they find there is advantage in having a representative of the FSA on the Court.

  Q84  John Thurso: So you disagree with the Governor on that point?

  Sir Callum McCarthy: It is possible for reasonable people to have different views.

  Q85  John Thurso: That is nice to know. If the Bank of England is given a statutory responsibility for financial stability, as opposed to the more generic responsibility that it has at present, how would that interface and where would be the possible points of friction in regard to your responsibilities in this area? Maybe, Hector, you want to have a go at that?

  Sir Callum McCarthy: Can I make one point before Hector replies. I would not want it thought that at the moment the Bank is, as it were, indifferent to a wide range of issues affecting financial stability. The Bank sits on the Basel Committee and has played a major part in drafting and forming the proposals on capital that are Basel II. The Bank, as the Governor made clear, actually Nigel Jenkinson, an Executive Director of the Bank, chairs the present Basel I committee on liquidity, so in all sorts of ways there is an existing interaction which should not be underestimated.

  Mr Sants: As I mentioned earlier, I think that being clear about the importance of the Bank focusing on financial stability matters is the way into resolving the question you posed earlier in terms of achieving a degree of four-eyes creative tension, a positive engagement with this important topic from two institutions, and so we support the importance of the Bank having a statutory role with regard to financial stability. As Callum says, I cannot underestimate the point, I think it is important to reiterate the point that we do work well at the working level. We worked well at a working level in the summer of last year, and the Bank was involved right from the beginning, as you are aware from the chronology, in terms of being properly informed of the issues in the market place, including the specifics of Northern Rock. So we do work well together and we should intensify that relationship and a clearer mandate, I think, would help encourage the Bank to be more pro-active in that area, and we would welcome that.

  Q86  John Thurso: Let me put to you what worries me in this. It is the difference between the duty and responsibility towards the system as a whole as opposed to the specific regulation of an institution. We talked earlier on about the trigger, for example, that might be used with regard to a special resolution system for a bank. It is possible to imagine a situation where the Bank of England, with its overall new statutory duty with regard to financial stability, took one view with regard to a potentially failing institution, whereas the FSA, as the regulator of the particular institution with, as you have said, high regard for the consumer, might take a different view as to whether or not the trigger should be pulled. Is it possible therefore, if you are the single figure on the trigger, that you might not wish to pull it at a time when the Bank would want to see it pulled and how would that situation be dealt with?

  Mr Sants: It seems to me difficult to envisage the scenario you are suggesting, I have to say. It is easier when one talks about concrete examples, and I am not sure if I can specifically envisage that. I would go back here to maybe looking at it from a slightly different perspective which may help eliminate this key question, which is that the basic role of a supervisor with regard to institutions—there are other things the FSA does, of course—is already to determine whether or not it meets threshold conditions. That is our job, and I am back to my earlier point. Either we are doing our job or we are not. It is obviously up to this committee and Parliament to determine whether we are not.

  Q87  John Thurso: May ask you to address this distinction? Banks can fail without having an affect on the system overall. Johnson Matthey, Barings, a variety of institutions have in the past gone bust and it has been judged that the overall system was not at risk. A judgment was made with regard to Northern Rock that the system overall was at risk. So you have a duty to regulate an institution. It is perfectly possible for you either not to or to pull the trigger looking at one institution. The Bank of England have a specific duty to the overall financial system. What I am saying is the two are not always matched. How does that get dealt with?

  Mr Sants: That would be addressed in a different way. I think that is a different question. There is an interesting question as to whether or not all banks and building societies should be eligible for going into a special regime or not, and if it was chosen that not all banks would be able to enter a special regime but only those who are deemed to be systemically important, then that judgment as to whether or not they were systemically important could well be one reached jointly or in different ways and is a separate determination from the decision as to whether or not they have met thresholds and conditions. The point, we are saying, is it should be a necessary criterion that you have not met our trigger with regard to the deliberation of whether you go into a special regime. There may well be other criteria for going into the special regime which are separate and apart from the determination of whether or not the FSA's trigger has been breached. By the way, in passing, we would take the view that one of the key lessons to be learnt from Northern Rock is the importance of having an effective depositor protection scheme that does protect all depositors. So we certainly would like to see a regime which covers all depositors and does not discriminate between those depositors in smaller institutions and larger institutions, but that is a separate question and that determination would be addressed separately from the specific of have you met your regulatory threshold and conditions? What we are not wanting to see is somebody who can pre-empt that initial judgment. The initial judgment should be: have you met your threshold conditions? Subsequently other determinations could be made.

  Sir Callum McCarthy: Can I make one point. I absolutely follow the line of questioning in terms of institutions versus the system, but to some extent it neglects the fact that there are important things that we do which are aimed at the system. If I can give one example: there has been a rather successful pincer movement between the New York Fed and the FSA designed to ensure that a backlog of credit risk derivative execution was dealt with, and it was something which no individual broker, dealer, bank had an incentive to deal with as it was a collective action problem. That is something which, by action between the FSA and the New York Fed, we substantially improved. That was not about any one institution, but was something which was designed to improve the system as a whole.

  Q88  John Thurso: My concern is to ensure that going forward the lesson we have learnt is that there is clarity of responsibility?

  Mr Sants: We would like our clause to be the necessary but not necessarily sufficient i.e. it does not have to be the sole clause.

  Q89  Chairman: To take up John's point about draft legislation and pre-legislative scrutiny, that is one of the points that I will be including in my letter to the Chancellor as well as market abuse, because this committee has produced a report, Sir Callum, which was unanimous, which reflects the feeling across the whole House, and it is important that this committee is to be assured that we have confidence in this future legislation as the House has, because if we do not, then we are off to a bad start on that issue. So pre-legislative scrutiny is extremely important on a bill which you are saying, with which I agree, is one of the most complex bills that we will have before us in the coming months. Do you agree on that?

  Sir Callum McCarthy: I think I agree with every word you have said, Chairman.

  Q90  Chairman: Good. Mr Sants, you mentioned that all depositors should be protected. Do you include wholesale?

  Mr Sants: No. Thank you, Chairman, for making that point? I just observe that on balance we would favour a regime that did look after all retail depositors.

  Q91  Nick Ainger: Sir Callum, the Governor told us last week that this crisis, meaning the credit crunch, came right out of the design of instruments traded among the most sophisticated financial institutions where they did not spend enough time thinking deeply enough about the incentive structure of those instruments. Before Northern Rock were you looking at the risks that all financial institutions were exposing themselves to because of their involvement in the trading of these instruments?

  Sir Callum McCarthy: Yes. Before Northern Rock, we, the Bank of England and other comparable institutions around the world, had been drawing people's attention to a fundamental mis-pricing of risk which had many aspects associated with it. One aspect of it, and something which I think has had less attention than it should have had, as most of the attention at the moment is on the sale side, i.e. those who originate or distribute products, is I think that one of the central questions arises on the buy side: why did people buy instruments that they did not understand on the basis of a simple rating?

  Q92  Nick Ainger: Bearing that in mind, if you were giving warnings, as the Bank was as well, about the risks that some of the institutions were exposing themselves to, those warnings were not heeded, and we have now got a situation where banks are still not lending each other money, we have got the credit crunch, people's mortgages are being directly affected and possibly the wider economy. Is it now time to consider a regulatory regime of those financial instruments so it is brought home very clearly and starkly to these financial institutions that they should not expose themselves recklessly, as they clearly have done, to these risks?

  Sir Callum McCarthy: I very strongly believe that people should not expose themselves recklessly; and one of the points I think I made earlier is that one of the things that absolutely is required is improvement in the risk management practices within firms. I am not in favour of a regulatory regime which actually attempts to regulate individual products—to say you cannot produce this sort of product, you cannot invest in that sort of product—because I think that that has disadvantages which would outweigh the advantages.

  Q93  Nick Ainger: But if we are all agreed that these financial institutions have, despite warnings, exposed themselves recklessly in the last few years and this has resulted in the first major global banking crisis for many years, and we all accept that, but you are saying that we would carry on with this light touch, while the Governor says that he feels that in the next five or ten years hopefully those managers within the financial institutions will have learnt this particular lesson, but do we not run the risk that new instruments not yet dreamt up by financial whiz-kids will end up doing exactly the same thing that the CDOs, and so on, have done this time? Is there not a risk of that and should we not really be trying to define the exposure of these institutions to the risks that they run rather than leaving it to them to make those decisions, because clearly we left it to them before and this is the mess that we have got ourselves into?

  Sir Callum McCarthy: I should make clear that I do not believe that either present and certainly not the future should be described as light touch. I do believe that there is a need for a series of changes affecting capital, affecting liquidity, affecting valuation, affecting aspects of credit rating agencies, affecting aspects of origination where we need specific actions, absolutely, and I think that that complete programme is something that we very badly need. There is determination not only in the UK but in other major capital market centres to implement that.

  Mr Sants: Also could I make the observation, one of the lessons which we would learn from the last year or so is that market behaviour is not just a function of numbers, it is not amenable solely to arithmetical modelling; one of the key issues here has been a loss in confidence which then affected liquidity. So I think to set ourselves a goal that somehow or other we can create this model which we, the regulator, could then set parameters within which banks would have to operate, I am afraid, whilst it may sound attractive, it just is not possible. Markets are a function of both human behaviour as well as maths, and it is not possible for us to design a model that will anticipate everything that will happen in financial markets.

  Q94  Nick Ainger: But one of the failings that you have identified in your report on Northern Rock was a lack of intensity by the FSA in ensuring that all available risk information was properly utilised to inform its supervisory actions. Given you have admitted that is a failing, the failure to assess the risk that the institution was under because of its business model, how does that fit in with what you have just said?

  Mr Sants: Northern Rock's business model, as I have reflected a number of times, was not that complicated, and we do believe in this particular case it was reasonable for the Board, as non-executives, and the supervisor to have better anticipated the risks it was potentially running and to have put in place a better risk mitigation programme than they had. The comment I was making was a reflection of your consideration of the wider issues that have occurred in financial markets over the last 12 months. Northern Rock was, as it were, a victim, in the sense that liquidity disappeared in its main financing instrument, of these wider issues. What I was pointing out was that modelling the entirety of the financial system and all the risks that any individual financial institution is therefore running is not a realistic proposition.

  Q95  Nick Ainger: So we are back to the position that we were in pre Northern Rock, in that we hope from the culture within these financial institutions that their risk management committees will start performing properly. Would you look at the performance of risk-management committees, for example, within these financial institutions, and what is the difference between what you were doing pre Northern Rock and post Northern Rock?

  Sir Callum McCarthy: If I may say so, the answer to that is yes and yes. One of the things that we have done, for example, alongside other supervisors, through something called the Senior Supervisors Group, is to look at the experience of the last nine months in relation to those firms which have succeeded in managing these problems and those firms which have exacerbated the problems to pull out exactly what is the difference in behaviour, to make sure that we ourselves in our supervision, the American supervisors and the German supervisors, and so on, go back to all these firms and say, "Are you actually doing the things that the best firms have done or are you simply doing the things which have led to these problems?" Absolutely, we will do that, and that is the line that we think is going to produce the best results.

  Mr Sants: We are just trying to tread a balance here between saying, "We can do more" and, "We can do a better job", and also making the point that we are not infallible. We are not a regulator that just comes along and checks, "Are the necessary safety barriers in place", we are a regulator who is trying to make a judgment about the consequences of people's actions, the outcomes of what they are doing. Outcomes occur in the future. It is not possible to predict the future. If we could predict the future, we would not be sitting in these jobs. I am just trying to draw the distinction between what we can do and what we cannot do and encourage the committee to recognise the complexity and challenges in the task, but that should not in any way deflect from the fact that we can do a better job.

  Q96  Mr Dunne: Just a couple of questions picking up on lessons to be learnt from Northern Rock before I follow up some of the Chairman's questions on market abuse. Now that we have the benefit of not only the hindsight of the way the Northern Rock crisis was handled but also the way the US authorities handled the Bear Stearns crisis, what lessons do you think the authorities here can learn from the way the Bear Stearns crisis was handled in the US?

  Sir Callum McCarthy: I think that it is clear that Bear Stearns, which I think was a very important set of actions by the US authorities, has had a significant effect on improving confidence. It is clear that the rescue of Bear Stearns would not have occurred without involvement from the US authorities and from the Federal Reserve Board in relation to the £29 billion that they underwrote, and I think that one of the things that one has to recognise is that there are circumstances in which that sort of involvement is necessary.

  Q97  Mr Dunne: Was there not a very close parallel with the situation with Northern Rock where there was a potential offer, or there was a major domestic bank seeking a central bank funded facility in precisely the same way as JP Morgan were, as you have just acknowledged was required for Bear Stearns? Were those circumstances not parallel to what was potentially available in the UK had the authorities, including yourselves, injected enough energy and speed of activity to encourage a similar situation to that which happened in the space of a weekend in September last year?

  Sir Callum McCarthy: I think there are not exact parallels, but I do believe there are comparisons between the two, yes.

  Q98  Mr Dunne: Would you have done it differently in the light of Bear Stearns. Would Bear Stearns provide the excuse or would Northern Rock provide the excuse to engineer a rescue within a weekend today which was not available last autumn?

  Sir Callum McCarthy: I think one of the things that people were very conscious about in relation to Bear Stearns was how much further through the developing crisis were Bear Stearns versus Northern Rock, and I think that you have to recognise the effect of that, which undoubtedly concentrated minds in the US.

  Q99  Mr Dunne: Turning to the accounting principles that apply to banks at present, given the difficulties in the securitisation markets of marking books to market, has that exacerbated the problems that there are at present in providing confidence to banks where risks and losses are likely to occur?

  Sir Callum McCarthy: I think there are very significant problems in valuation of complex instruments in illiquid market. It is because of that that we have been encouraging UK banks and UK institutions to increase their disclosure to enable counter-parties to form an informed view.

  Mr Sants: It is certainly very important that banks lay out fully all the necessary information that investors would need to reach their own views about the valuations of those positions, and that is something we are very much encouraging banks to do, but I would say, I think the main issue for the market place is not so much the issue of whether they are currently marked to market but rather investors' concerns and lack of knowledge as to what will happen in the future. So the bigger issue for investors has not been knowing what the next mark will be, not necessarily their concern as to whether the last mark was marked to the then market.