TUESDAY 11 DECEMBER 2007

SIR CALLUM MCCARTHY, MR HECTOR SANTS AND MS LORETTA MINGHELLA

  Q1460  Chairman: What a fine answer, Sir Callum! I am asking you, is it 100% credible? Would those very words have come out of your mouth, if you were in that position, in other words?

  Sir Callum McCarthy: I should make clear that the only person who can make that guarantee of 100% of deposits is the Chancellor, and that has always been the case.

  Q1461  Chairman: We understand that, but I am asking you, Sir Callum, is it credible?

  Sir Callum McCarthy: I think it is.

  Q1462  Chairman: 100% credible?

  Sir Callum McCarthy: Yes.

  Q1463  Chairman: What factors might make a financial institution less deserving of a 100% guarantee than the Government assessed Northern Rock to be?

  Sir Callum McCarthy: Sorry, Chairman, I am not sure I am qualified to answer the question.

  Q1464  Chairman: But you understand the question?

  Sir Callum McCarthy: I understand it. If I were the Chancellor I might have addressed my mind to it but since I am not the Chancellor I have never addressed my mind to the question.

  Q1465  Chairman: You are a lucky man, you are not the Chancellor. On the issue of financial stability, Sir Callum, what are the financial stability implications of the shift we have seen towards an "originate and distribute" business model, and is that irreversible?

  Sir Callum McCarthy: I think they have very substantial implications and they do not all go in the same direction. First of all, the "originate and distribute" model, as the shorthand suggests, it distributes risk much more widely, and that in itself is attractive because it stops risk being concentrated in highly geared banks. The questions that go the other way, which we have always been conscious of, as have other regulators around the world, is it makes it much more difficult to identify where risk lies. There are also two major questions that the "origination and distribute" model has to address more clearly than has been addressed: the first is the standards of underwriting by the originator, where failures in those standards have been one of the fundamental causes of the sub prime problems, and, secondly, it is important that those who invest, those to whom the risk is distributed, understand what they are investing in. It is clear that there has been a degree of complexity of product which has been distributed, and not everybody who has bought those products properly understood them.

  Mr Sants: Just to add, if I may, and to develop that theme a bit further, what we are thinking is clearly the structure of the market place will change as reflected in your question, and that those complex structures which were previously part of that distribute model are not going to find favour with investors going forward because of the issues we have seen. So we see a disappearance, or certainly a significant diminution in the use of complex structures, but not necessarily a disappearance altogether of a distribute model. It is more that the banks will have to think about distributing through clearer and simpler processes, so we see the model evolving but not disappearing entirely. But, of course, these are all crystal ball forecasts and it could go in other directions.

  Q1466  Chairman: So the idea of dispersing risk which would increase the resilience of the financial system to shocks still holds, but it needs one or two adjustments?

  Sir Callum McCarthy: I think it holds but we have always been concerned to make sure that the distribution of risk is real rather than apparent, and one of the things that is difficult is to make sure we can identify the channels by which that distributed risk may become reconcentrated.

  Mr Sants: The other aspect that we have talked here about before is that when you are dealing with this distributed risk model: almost by definition you will not know where all the risk has gone. The focus of the regulatory community is clearly on the major transmission mechanisms to make sure they are in good health, namely the core banks, and therefore it is important going forward that those core banks are operating in a very transparent way. We have, of course, had this slightly opaque proposition in place with regard to the conduits and the SIVs which needs to be addressed, so that the core transmission mechanisms are able to work in a transparent way.

  Q1467  Chairman: I notice that Josef Ackermann, Chairman of Deutsche Bank, as a member of the Institute of International Finance made the point that a number of structural problems need to be addressed and included in that: improved risk management, review of the role of off-balance sheet conduits and special investment vehicles, the valuation of complex products, the examination of credit agencies, and improved transparency. I do not want you to go through every one of them, but is that a reasonably comprehensive list to you?

  Sir Callum McCarthy: Those are the major items.

  Q1468  Chairman: And you would agree with those?

  Sir Callum McCarthy: Yes.

  Chairman: Good.

  Q1469  Mr Mudie: Would you please tell me what the core transmission method means?

  Mr Sants: One of the key issues here is, if we are having disruptions in the financial system, is that going to then affect the real economy, your constituents, the man in the street. From the regulatory perspective one of the key ways of managing and assessing that risk is through making sure that the mainstream banks which, as it were, sit on the interface between the financial system and the consumers, are in good health. The transmission mechanism is another way of describing the large banks.

  Q1470  Mr Mudie: I suppose that answer deals with the bigger question of stability, but what about investor protection? What we have are securities that were contaminated. I think some of the bankers did not know what the hell were in them, and they more or less said: "We were selling them, they were buying them, nobody was worried because we were all making money from them". Did you at the Financial Services Authority ever flag up, ever analyse, the various securities with a view to saying whether you should be warning investors about the possible risk? It is one thing to look at the wider stability but I am just thinking why were these allowed to pass through for such a length of time without anybody in the Financial Services Authority—well, perhaps you did. Did you?

  Mr Sants: Just to remind ourselves, of course, the buyers of these complex instruments are institutions, not the consumer in the street. The consequences, however, of that development of the financial market has ultimately been to cause disruption to the consumer in the street—

  Q1471  Mr Mudie: But, Hector, just stopping you, we had the pension funds in here and it was an interesting session. What you are saying is: "Well, I blame the buyers", but one of the things that I would take comfort from as a buyer is you. After all, the industry is paying a lot of money—not to you personally but to the Financial Services Authority—to give that regulatory structure and comfort. Now, your answer seems to be: "Well, you should know better".

  Mr Sants: It is a two-part answer, actually, and that was the first part. It is the case, nevertheless, I think we should remind ourselves, that institutions are meant to be sophisticated enough to make good judgments, but having said that the Financial Services Authority and the Bank of England as well, have repeatedly over the previous few years warned of the risks of the evolution and the development of the credit derivative and related complex securities market, and a variety of our publications have highlighted those risks to the institutional investors—

  Q1472  Mr Mudie: Let me take your latest one—we have a later one but it is less relevant—of January this year, a whole paragraph that will cover you in terms of warning, but in the middle of it: "Financial markets have been increasingly complex since the last financial stability crisis". Nothing about the individual securities. If you were regulating in a parallel industry: say supplying blood, I would want you to assure me if I were in hospital facing a transfusion, that the regulation was working and that the blood supply was not contaminated. This is what is happening in terms of these securities. These securities were coming in bundled up to avoid people seeing the real risk and the real original basis of the loan, and you were letting them come into the market, traded, with people making money from them. Now, it is not that we are looking for you to say you made a mistake: we are looking for some comfort for the future. Did you think, first of all, you recognised the dangers and, if you did, did you adequately tell the market about the dangers?

  Mr Sants: I think this takes us back a bit to the comments I made to the Committee earlier, that we absolutely acknowledged and made clear in our last appearance that we did not foresee, and nor do we think any other market commentators or regulators foresaw, the precise set of circumstances which have arisen since, and that includes the liquidity crisis.

  Q1473  Mr Mudie: I understand that, and we can all be wise after the event. I am just asking, as somebody in the street might ask, as a pension fund might ask, and maybe a pension fund with no great resources because we heard last week about how deep the analysis would have to be, how deep you would have to go in to see the make-up of these things, and a lot of purchasers—even if they are not individual and are institutions—are not going to have those resources so they are depending on you, amongst others. What comfort can you give us in the future?

  Mr Sants: I think we were clear in our advice as to the risks inherent in complex derivative products, and we have made clear in a variety of our publications, the complexity and potential liquidity risks that accrue to credit derivatives. What obviously is the case is that on top of that, in addition to the liquidity point I have made, we have seen a failure with regard to the income stream accruing from the US sub-prime marketplace which has then led to those securities falling significantly in value. If you are asking whether we are placing ourselves in a position where we would be looking to make all the commercial judgments that we think mainstream institutional investors should be making, no, we are not seeking to put ourselves into that position, but I do think in terms of a structural observation on the market we were clear on the risks that the increased complexity in the marketplace was creating for institutional investors, but we placed the onus on them then to draw the conclusions from that process, otherwise effectively we would be running the market which I do not think is desirable in terms of the overall process here and the type of marketplace that the community is looking for.

  Q1474  Mr Mudie: So, to bring that all together, a pension fund that finds itself losing money and looking to you will find on record the clear warning: "Be careful about these products".

  Mr Sants: About the inherent liquidity and complexity that these products—credit derivatives or related products—carry.

  Q1475  Mr Mudie: It is all about transparency. Did you feel these products were transparent enough?

  Mr Sants: I think I have said before here—

  Q1476  Mr Mudie: Yes or no. Did you think these products were transparent enough?

  Mr Sants: I think they are transparent enough to those who have the right level of competence and the time and the resource to look at them. I think there is a risk that because they are highly complex not all institutions have devoted the necessary time and resources, and have chosen to make assumptions, be over dependent on the rating agencies, which has proved to be unwarranted and inappropriate and not wise in the circumstances, but in principle, if you choose to and you take the time and you have the expertise, you can unpick these structures.

  Q1477  Mr Mudie: Are you intending, are you working on, are you investigating, any fresh approach to these securities? Or are you lying in the sand? Is that your industry? Are the Financial Services Authority doing anything further to give comfort that this sort of thing will not happen again?

  Mr Sants: Well, of course, as we mentioned before, the market place will itself adjust as it does in the event of circumstances—

  Q1478  Mr Mudie: I am asking about the FSA, though, Hector.

  Mr Sants: —but I think on top of that there are a variety of initiatives that the worldwide regulatory community—

  Q1479  Mr Mudie: No, Hector. Again, "worldwide". I would be very interested, because I think it is key, that the Financial Services Authority should be operating worldwide, but what are you doing as the Financial Services Authority? Anything?

  Mr Sants: Yes, indeed, and I was telling you that. I was just making the point that as the Financial Services Authority on our own we would not generally be able to solve these problems as a national regulator. Having said that, we will take the lead in and be fully active in looking at a number of the issues which includes the credit rating agency point which has already been mentioned, which is an important aspect of providing the right information and a clear understanding of how those organisations operate; we certainly do have our initiative with our institutional community to encourage them to give consideration to the lessons they can learn and the actions they should take; and we will also be obviously looking carefully around the issue of transparency, which is a point mentioned earlier by the Chairman, around these special purpose vehicles and related points. All those initiatives are part of the list that was mentioned earlier, and we will pursue those nationally and internationally with vigour.