House of Commons - The FSA's report into the failure of RBS

The FSA's report into the failure of RBS - Treasury Contents

2 The future of prudential regulation

Regulatory and supervisory failure

10. The FSA's Report into the failure of RBS includes a blow by blow account of failures at FSA as well as of those at RBS. It describes an "inadequate regulatory framework", asset quality being "subject to little fundamental analysis by the FSA", the FSA's supervisory approach underestimating possible losses on structured credit products, "poor capital and liquidity regulation", and "a flawed supervisory approach" that "provided insufficient challenge".[17]

11. Mr Sants stated that "the general approach to supervision, and the policy framework that accompanied it that was in place in the FSA before the crisis [...] in relation to overseeing [...] UK banks, was inadequate" and that it was "grossly inadequate; totally unacceptable to me."[18] He described the FSA as operating in silos, with the result that the Executive Committee "did not discuss major supervisory issues."[19] He further noted that the Executive Committee were "not encouraged to question or debate the management approach across the silos."[20]

12. One example of this was that RBS was entirely regulated by the Retail Markets Division of the FSA, which was separate from the Wholesale and Institutional Markets Division, despite the fact that RBS had a very large and rapidly expanding investment banking operation. This division of responsibilities meant that Mr Sants, as Managing Director of the Wholesale and Institutional Markets Division until mid-2007, had no supervisory responsibility for any part of RBS.[21] Furthermore, Mr Sants noted, staff in the Wholesale and Institutional Markets division "had considerable expertise in investment banking activities and they were not able to share their expertise easily with the supervisors in the UK Banks Department."[22]

13. We asked Mr Sants whether he had attempted to work across the institutional silos in the FSA or to complain about the way the institution was organised; he stated that he had indeed complained, but that his offer to oversee some aspects of the regulation of RBS was "not taken up".[23] He said that he had raised his concerns about silos in his regular meetings with John Tiner, the then Chief Executive, and the question of the general quality of management in that area, informally, in the margins in a number of the executive meetings.[24] No record apparently exists of these complaints by Mr Sants. Nor did Mr Sants seek to ensure that his concerns were formally minuted.[25]

14. While acknowledging at many points the multitude of flaws in the FSA's overarching approach to supervision and regulation, the Report argues that the FSA's supervision team for RBS was "largely doing what was expected of it, according to the priorities, processes, practices and approach set by FSA senior management, and working within the constraints of the resources allocated to it."[26] Mr Knight concurred with this assessment, arguing that "by and large, [FSA] officials were doing what was expected of them. It was what was expected of them that was wrong and, therefore, the responsibility has to lie at the top of the FSA."[27]

15. The culpability of senior FSA management for the flawed regulatory framework is explicitly acknowledged in the Report, which states:

The fact that the Supervision Team was largely doing what was expected of it but was following a deficient supervisory approach, in turn clearly implies however, that the senior management of the FSA who determined those resources, processes and practices must have made design decisions which were, in retrospect, seriously mistaken.[28]

16. This acknowledgement of the culpability of senior FSA management is mitigated, however, by the argument that a good deal of blame for the failure of regulation should be put at the door of the prevailing global regulatory framework, ideological assumptions about the efficiency of markets, and political pressures placed on the FSA. The Report argues that FSA senior management and the Board that oversaw them "made [...] decisions within the context of a widely held, but erroneous, view about the inherent stability of the global financial system, and of political pressure to maintain a 'light touch' regulatory regime to support the competitiveness of the UK financial sector."[29]

17. On 9 February 2010, the FSA announced that Hector Sants would leave the organisation that summer.[30] However, the Chancellor stated in his Mansion House speech on 16 June 2010 that:

I have asked Hector Sants to remain at the FSA to oversee the transition and become the first new deputy governor and chief executive of the new prudential regulator.

I am delighted that he has agreed. [31]

The Committee notes that before this decision, made within a few weeks of his becoming Chancellor, he did not put in place the arrangements he has subsequently put in place for the appointment of the Governor of the Bank of England. We would expect such an appointment in future to be made in a transparent manner. On 16 March 2012 the FSA announced that Hector Sants would not be assuming the role of Chief Executive of the PRA and Deputy Governor of the Bank of England with responsibility for Prudential Regulation, as had previously been announced. Instead, the FSA said that Mr Sants would be leaving the organisation at the end of June 2012, "having completed the fundamental design and delivery of the changes needed to achieve the Government's plan to separate prudential and conduct financial regulation in the UK".[32]

18. The Report gives a number of examples of the pressure that the FSA came under from Government to avoid an intrusive supervisory approach. One such example cited by the FSA refers to a Treasury press release dated 24 May 2005, at the launch of the Better Regulation Action Plan. In the press release, the then Chancellor Gordon Brown is quoted as saying "… the new model we propose is quite different. In a risk based approach there is no inspection without justification, no form filling without justification, and no information requirements without justification. Not just a light touch but a limited touch".[33] Another example, used in the FSA Report, refers to a speech on 14 June 2006 by the then Economic Secretary to the Treasury, Rt Hon Ed Balls MP. In the speech Mr Balls said "[...] we must keep the UK's regulatory system at the cutting edge—the best in the world [...] at all times we will apply a principled system of risk-based regulation, without unnecessary administration burdens [...] nothing should be done to put at risk a light-touch, risk-based regulatory regime".[34]

19. The Report further highlights that the FSA management and Board were operating in a context which entailed:

global regulatory standards which were severely deficient but believed to be appropriate and sophisticated;
a consensus, among practitioners and policy-makers, which confidently asserted that financial innovation and complexity had made the financial system more stable;
a regulatory structure which made the FSA responsible for the entire range of financial regulation issues—from the prudential soundness of major systemically important banks to the conduct of some 25,000 financial intermediaries; and
a strong focus on the importance of the 'competitiveness' of the UK financial services sector and so of avoiding 'unnecessary' regulation.[35]

20. The FSA Report argues that, within this context, "it is likely that, if the FSA had proposed before the first signs of the crisis (i.e. before summer 2007) the measures that in retrospect appear appropriate, such proposals would have been met by extensive complaints that the FSA was pursuing a heavy-handed, gold-plating and unnecessary approach."[36]

21. The assessment that the global environment provides considerable mitigation for the FSA's approach was supported by Sir David Walker. He noted that "the policy environment globally was massively inadequate", and that the FSA "operated well within that very unsatisfactory environment."[37]

22. The FSA Report paints a picture of a regulator that was severely unbalanced and with an insufficient focus on prudential issues. The prevailing assumptions about decreased risk in the financial markets, and political pressure, have been cited in mitigation of the regulatory and supervisory failures of the FSA. However, statutory independence was accorded to the FSA to enable it both to offer constructive challenge to established dogma and to resist political pressure. The FSA Report describes failures and inadequacies in the regulation and supervision of capital, liquidity, asset quality and a failure appropriately to analyse the risks relating to the ABN AMRO acquisition. This is a serious indictment of both the senior management and leadership, and in particular the Chairman and Chief Executive, in place at the time, and their predecessors, regardless of the prevailing assumptions and political pressures.

The FSA as shadow directors

23. Although the FSA does acknowledge its own inadequacies in respect of supervision and the regulatory framework, Lord Turner argues in the foreword to the Report that the decisions that led to RBS's failure were "decisions for whose commercial consequences RBS executives and Board were ultimately responsible."[38] The Report elsewhere highlights that "ultimate responsibility for poor decisions must lie with the firm."[39] In defending the FSA's decision not to intervene more actively in the running of RBS, and in particular not to intervene in RBS's acquisition of parts of ABN AMRO, Mr Sants said:

The general principle that still prevails, and was certainly prevailing at that point, was that boards take responsibility for running their own firms, and that ultimately the decision for running the firms well rests with the boards and their executive. For the FSA to act as shadow directors, and second-guess the judgements that executives and boards have made, was absolutely not the philosophy prevailing at the time.[40]

24. Sir David supported this, stating that "the deep tradition of supervision and regulation of financial institutions—not just here in the UK but widely—was for the regulator not to become shadow directors on matters of strategy, but to leave these matters to the judgment of the board."[41]

25. In describing changes in the supervisory framework since the crisis, the FSA Report notes that "Supervision of high impact firms now places much greater emphasis on the FSA reaching its own judgement, through detailed investigation, of the risk in firms' strategies and business models, governance (including the size and composition of the board and the challenge it provides), risk management, capital and liquidity."[42]

26. Mr Sants has maintained that for the FSA to have interfered with the running of banks would have risked acting as a shadow director. We agree that were this to transpire, boards of banks would be less accountable. Boards might attempt to deploy the argument that the regulator had become a shadow director as a defence in any subsequent enforcement action against them. The PRA's use of judgement-based regulation in the future may, at times, also lead to the appearance that the PRA is acting as a shadow director. A similar risk is run by the FCA in undertaking product intervention. We expect both the PRA and the FCA to examine how they will minimise the risk of appearing to act as shadow directors under their new approaches to regulation, and publish their findings.

Ability of the FSA to take action on acquisitions

27. The clearest failing of the FSA that becomes apparent in reading the FSA's Report is the failure to intervene to stop the bank's disastrous acquisition of ABN AMRO. RBS decided to bid for ABN AMRO as the head of a consortium involving Santander and Fortis in March 2007. It announced the terms of its bid in July 2007, and 94.5% of shareholders voted in favour of the acquisition in August. The acquisition was completed on 17 October 2007. The FSA's Report describes the acquisition of ABN AMRO as "a misjudgement with catastrophic consequences."[43] It states:

The acquisition of ABN AMRO by a consortium led by RBS greatly increased RBS's vulnerability. The decision to fund the acquisition primarily with debt, the majority of which was short-term, rather than equity eroded RBS's capital adequacy and increased its reliance on short-term wholesale funding. The acquisition significantly increased RBS's exposure to structured credit and other asset classes on which large losses were subsequently taken.[44]

28. Sir David Walker highlighted that the largest failure of the FSA was:

Failing to see that the proposed ABN AMRO acquisition, despite the fact that they had no formal power to stop it, was wholly special and posed questions for capital, liquidity, leverage and risk assessment of a dimension that justified putting a taskforce on to it, which they palpably failed to do.[45]

29. The FSA Report supports this, noting that "the FSA was not sufficiently engaged from April 2007 [...] in testing in detail the potential capital and liquidity implications of the acquisition. Nor did it challenge sufficiently the adequacy of RBS's due diligence."[46] The FSA Report also questioned the judgement of the FSA management in not setting up a review team to examine the risks around the acquisition.[47]

30. As Box 2 shows, RBS announced its decision to bid for ABN AMRO on 27 March 2007. At that stage, Mr Sants sat on the FSA Board as well as the Executive Committee.[48] After his appointment as CEO on 20 July 2007, Mr Sants continued to sit on both bodies through the period of the takeover deal. Mr Sants confirmed the extraordinary fact that within the FSA at the Executive Committee and Board level "there was no discussion, and the then Chief Executive did not convene any discussion, on the merits of the deal. [...] there was no formal consideration of it in the Executive Committee or the Board".[49] This reflects a grave weakness in the corporate governance of the FSA.

31. The question remains as to whether, despite the lack of a specific power to halt the acquisition, the FSA could or should have intervened, and if so, when. The FSA Chairman (at that time, Sir Callum McCarthy) and CEO (Mr Sants) considered intervention in September/October 2007, in the early stages of the financial crisis. Mr Sants noted repeatedly in evidence to us that the FSA had no regulatory basis to intervene in the acquisition. He argued that:

The only basis under which we could have intervened would be if we had concluded that the bank, on completion of the transaction, would not meet threshold conditions. I am absolutely clear [...] that there was no regulatory basis for an intervention. So no, on the information available at that time, it was not possible to intervene at that point after the offer document was published. I did not have the power to intervene.[50]

Mr Knight largely supported the conclusion that the FSA did not have a specific basis on which to intervene in September/October 2007, saying: "They were advised in memoranda, which I have seen, that the capital and liquidity requirements—the legal requirements—would be met following the takeover. So they didn't actually have anything to go on at that point."[51]

32. However, Lord Turner in his foreword to the Report, says that "Arguably the FSA, if really determined, could have blocked the takeover by other less direct means."[52] Sir David Walker also said that the FSA could have intervened indirectly. He argued that:

One of the indirect things they could have done would have been to set capital buffers, to have set an individual capital guidance level for the combined entity that would have made the transaction commercially unattractive. That was an option that they could have followed.[53]

33. The main tool that the FSA had to influence the level of capital held by firms was setting Individual Capital Ratios or, after 2007, Individual Capital Guidance (ICG).[54] There is however no indication that this was considered as a means of blocking the ABN AMRO acquisition. The Report also acknowledges that, more generally, the FSA did not make use of the ICG tool in 2007, illustrating "a supervisory approach which did not fully utilise the tools available."[55]

34. Sir David acknowledged that there were difficulties in a late intervention:

If there had been an intervention in August or early September, which would have been a time when technically it would have been possible, this would have destabilised RBS. There is no question that the time for intervention of the kind that we now all see would have been highly desirable, appropriate, necessary, would have been much earlier.[56]

35. He later noted:

It is important to recall that this [September] was relatively late in the process, after 95% plus of the shareholders had voted in favour of the transaction. So for a regulator without direct power to stop it, in the face of such strong shareholder support, would have required a very strong view that liquidity, capital and whatever were a problem. Of course they should have had that sense, but they didn't have it at the time.[57]

36. There was a large degree of consensus among our witnesses that early (before the consortium published its offer on 20 July), and preferably not public, intervention was the only option that would not have been destabilising. It appears that no consideration was given by the FSA to a later intervention, trading off some destabilisation to force reconsideration of what turned out to be a calamitous deal.

37. The regulatory scope for such intervention, although difficult, already existed under existing legislation. Mr Sants noted that even in the absence of changes to the regulatory framework, the FSA is already more proactive in intervening in acquisitions before the intention to acquire is made public:

When we have deals now notified to us in advance, we have now demonstrated, we have a visible track record, of intervening at a very early stage before offer documents are published, to minimise the risk or even sometimes try to dissuade management from acting. In those cases, it won't have been visible to the marketplace at all. That approach is one that we now take as part of the new proactive supervisory approach.[58]

The Report supports this, stating that: "Since the crisis, Supervision has fundamentally changed its approach to the assessment of major acquisitions, using existing powers far more aggressively."[59] As we have seen with the regulators' recent action to remove Bob Diamond as chief executive of Barclays, a regulator can act even when it does not have a specific power to do so.

38. Nonetheless, the FSA Report recommends "making it a formal requirement that banks obtain regulatory approval for major acquisitions (relative to the size of the acquiring bank)."[60] Mr Sants believed that it would be desirable for the regulator to have a concrete power to intervene in future acquisitions.[61] Mr Knight and Sir David Walker told us that it is "unsatisfactory that existing statutory provision does not require a UK bank of which the FSA is the lead regulator to obtain the specific agreement of the FSA for a proposed acquisition."[62] In oral evidence, Sir David supported the idea of the regulator having such a power which could be operated at the very outset of an acquisition process. He said that:

"the regulator should have control, clear control in black letter primary legislation, and the way that control should be operated is right at the front of the process before all this gets into the public domain."[63]

The written evidence from our specialist advisers argued that:

The existence of a specific statutory power would not only give the lead supervisor a clear locus in the process, facilitating probing and questioning to an extent that may not hitherto have been practicable, but should also promote greater discipline and challenge in the Board's own assessment of the proposed initiative.[64]

39. Mr Knight and Sir David put forward another suggestion with respect to what the process for regulation of acquisitions should entail:

We would recommend additionally that, as an aid to its own appraisal process of any major acquisition proposition, the supervisor should encourage a board to seek independent external advice. Such advice would be independent in the sense that its remuneration does not depend on completion of the proposed transaction and would be wholly separate from the banking advice and capital markets capability that is applied to and remunerated largely or wholly on completion of the proposed transaction.[65]

40. The FSA appears to support this recommendation; its Report states that "the FSA should consider whether and how the Board of a firm considering a major acquisition should obtain independent advice, from an adviser whose remuneration is not linked to successful completion of the transaction."[66]

41. One further question raised both by the FSA's Report and by Sir David Walker in evidence to the Committee is whether contested takeovers in financial services firms should be allowed at all.[67]The FSA Report suggests that the decision of RBS to "make a bid for ABN AMRO on the basis of due diligence which was inadequate in scope and depth" was "the inevitable consequence of making a contested takeover, where only limited due diligence is possible."[68] The Report further notes that:

The level of due diligence conducted was in line with market practice for contested bids. The regime for public contested bids did not (and does not now) make it possible for bidders to insist on more thorough due diligence than RBS conducted. And market practice for contested bids in the UK and other European countries did not (and does not now) require higher standards of due diligence in the case of bank acquisitions than non-banks.[69]

42. The FSA has suggested as an alternative to an outright ban on contested takeovers that as part of a new regime that would require FSA (or PRA) approval for any sizeable acquisition there could be "a strong presumption that major contested takeovers would not be approved, or would only be approved if supported by exceptionally strong capital backing, given that specific risks are created by an inability to conduct adequate due diligence."[70]

43. The argument put forward in the FSA's Report, that the absence of a formal statutory basis to intervene was sufficient justification for regulatory inaction, was contradicted by the evidence, both of our advisers and of Mr Sants. We support Sir David Walker's conclusion that the FSA should have done more to examine the risks of the deal. It should have intervened at an early stage. It should and could have intervened at a late stage, albeit with more difficulty. Early regulatory examination of such deals now takes place, in the absence of further statutory support. The FSA's failure to assess the risks of the deal represents a serious misjudgement on the part of the supervisory team and the senior management. We need a regulator with the self-confidence to intervene, even if it might cause some destabilisation in the short-term. We recommend that Government include an explicit requirement for the PRA to approve major bank acquisitions and mergers in forthcoming legislation. This should be considered in the context of the Treasury Committee's previous recommendation that the House of Lords consider amending the Bill to make competition an objective of the PRA.

44. We note the FSA's and our specialist advisers' recommendation with respect to independent advice being sought in cases of major acquisition, and recommend that this matter be consulted on, and if necessary, included in legislation. Sir David Walker questioned whether contested takeovers are appropriate in the banking sector at all. In such cases, because only limited information on the takeover target may be available, management and the regulator both face difficulties in being able properly to understand, plan and manage capital and liquidity. We recommend that HM Treasury, working with the relevant public bodies, report on the legislative or other changes it proposes to make to the current regime regulating acquisitions in the banking sector.

Changes at the FSA since the crisis

45. The FSA's Report argues that since the financial crisis, alongside significant changes in global capital and liquidity regulation, it has significantly overhauled its own supervisory practices. Lord Turner writes in his foreword that "the FSA's approach to supervision has been radically reformed in almost every respect—with more resources, better skills, a more intensive approach and far greater focus on the key prudential issues of capital, liquidity and asset quality."[71] He also notes that when he arrived as Chairman in September 2008, he "found an organisation already strongly committed to learning the lessons of the past and to changing its approach."[72]

46. The FSA Report argues that "the lessons learned from the failure of RBS and from the FSA's deficient supervisory approach [...] have already been reflected in the complete transformation of the FSA's approach to the supervision of the largest high impact firms."[73] Mr Sants supported the view that considerable change has already taken place at the FSA. He said that: "From March 2008 [...] we embarked on a radical change to the entire approach to supervision and a wholesale change to the people involved."[74] The FSA Report supports this, stating that "the vast majority of changes [to the regulatory and supervisory framework] have already been made. This reflects the radical overhaul of the FSA's approach to supervision, and of global regulatory standards, which had begun even before the failure of RBS and has continued since."[75] According to the Report these changes have resulted in:

Dramatic increases in the scale of total resources devoted to the supervision of high impact firms. RBS is now supervised by a team of 23 people, rather than six in August 2007, just before the onset of the market crisis. In addition, this team is able to draw on greatly increased specialist resources.

Far greater focus on the core prudential issues of capital adequacy and liquidity, supported by increased specialist skills and informed by far more detailed firm reporting.

Far greater focus on asset quality issues, including through the use of detailed stress-testing.

A more intensive and intrusive style of supervision, with the FSA more willing to challenge management judgements and decisions.

A far greater focus on the competence and expertise of top management and non-executive directors involving, for instance, pre-approval interviews for all those occupying significant influence functions.[76]

47. Sir Mervyn King, Governor of the Bank of England, in his 2011 Mansion House Speech called into question whether some of the changes undertaken by the FSA were of use. He argued that, "Process—more reporting, more regulators, more committees—does not lead to a safer banking system. [...] Targeted and focussed regulation, allowing senior supervisors to exercise their judgement, does not require ever-increasing resources."[77]

48. The Treasury Committee inquiry into LIBOR in July 2012 led us, on the basis of its dealings early in 2012 with the board of Barclays, to believe that the FSA has recently altered its regulatory approach to a more judgement-led one, in line with what the Governor was advocating. We concluded:

The messages that Lord Turner and Mr Bailey gave to the Barclays board this year provide evidence of the evolution of a more judgement-led approach on the part of the FSA. Lord Turner said that the change to this approach began as long ago as 2008, and it featured in his Mansion House speech in 2009. Judgement-led regulation is welcome: the FSA has concentrated too much on ensuring narrow rule-based compliance, often leading to the collection of data of little value and to box ticking, and too little on making judgements about what will cause serious problems for consumers and the financial system. In February, though, the FSA judged that it was the overall culture, rather than just a particular behaviour, of Barclays that represented a risk, and so took steps to address this directly. This intervention was not routine or coded. It was a loud and clear expression of the concerns the FSA had about the culture at Barclays and should have been clearly understood by the board. This innovative action is also welcome. The episode shows, however, that judgement-led regulation will require the regulator to be resolutely clear about its concerns to senior figures in systemically important firms.[78]

49. The Financial Services Bill currently before Parliament proposes the establishment of a macro-prudential regulator, the Financial Policy Committee, within the Bank of England, to monitor and respond to systemic risks. It also proposes that the current FSA be split into two bodies: a micro-prudential regulator, the Prudential Regulation Authority (PRA) created as a subsidiary of the Bank of England, and a conduct of business regulator, the Financial Conduct Authority (FCA). Lord Turner argued that the establishment of the PRA will ensure that a focus on prudential issues is maintained[79], thereby addressing one of the problems currently faced by the FSA which Lord Turner argued is that "the sheer span, from prudential regulation of major banks to the conduct regulation of IFAs [independent financial advisers], is just too much to do".[80] As noted in the FSA's Report the current regulatory structure makes "the FSA responsible for the entire range of financial regulation issues - from the prudential soundness of major systemically important banks to the conduct of some 25,000 financial intermediaries."[81]

50. While there is a good deal of agreement that the FSA's approach was flawed, there is less agreement about what should replace it, with criticism of some aspects of the new regulatory arrangements proposed by HM Treasury. With the Turner review in 2009, the FSA began adopting several reforms to its supervisory approach, including a move to intensive supervision. However, the new statutory structure proposed in the Financial Services Bill places considerable discretion in the hands of the Bank of England for the conduct of prudential supervision. It appears from the remarks of senior Bank of England executives, that a fundamentally different approach to the task is being developed by the PRA. Outcomes are however what count. The Committee welcomes the emphasis on the exercise of judgement before process. The Committee notes that the Bank of England published a document outlining the PRA's approach to banking supervision on 15 October 2012, but we have not yet been able to digest it. The Parliamentary Commission on Banking Standards should examine The PRA's approach to banking supervision in the light of our recommendations.

Making the FSA/PRA Board effective

51. It is clear from the FSA's Report that the FSA Board did not perform adequately in the run-up to the financial crisis. In evidence to us Mr Sants stated that "the Board primarily restricted itself to its policy role of rule making, and took relatively little interest in the supervisory model. In my view, there was very little challenge by the Board of the executive on the way we went about supervision. Clearly, in my view, that was a failing of the Board."[82] Mr Sants went on to note, however, that this had "since been rectified, and in bringing in the new supervisory enhancement programme, the Board rigorously engaged with the executive team as to the nature of that model and whether that model would address the shortcomings of the past."[83] The FSA Report supports the suggestion that the role of the FSA Board has changed considerably since the summer of 2007.[84]

52. It is clear that prior to the onset of the crisis the focus of the FSA Board was disproportionately on conduct of business matters at the expense of prudential issues. The FSA Report gives the following figures to illustrate this:

Looking at the FSA Board minutes, it is noticeable that during the period between January 2006 and July 2007:

Of the 'major topics' discussed at the FSA Board, one out of 61 related in some way to bank prudential risks and issues.

Of items reported to the FSA Board within the CEO's report, one out of 110 related to bank prudential issues either in general or in relation to specific banks.

Of 229 items reported by the Managing Director of Retail Markets (who was responsible for the supervision of major banking groups such as RBS), there were five items which in some way concerned bank prudential issues.[85]

53. Sir David Walker entered a plea of mitigation for the performance of the FSA Board leading up to the crisis:

The FSA board were, like just about everybody else, victims of the intellectual environment. They thought that markets were inherently stabilising and efficient. Many of us certainly were part of that belief, which proved to be wholly erroneous, massively, dangerously wrong. I think that criticism of any board does need to aim off for the fact that the policy environment was one in which the areas of concern that were appropriate for a regulator were to do with conduct, mis-selling, all that stuff, and that the dispersal of risk into the wider markets made the system more whole and stable, which was, as I say, a massive misjudgment.[86]

When asked whether the FSA Board was culpable for what had occurred in relation to RBS, Sir David answered:

No, not culpable. I think we have to change the policy expectation of what the board [...] does and, therefore, the Committee's views and the legislation in relation to the PRA and so on are hugely significant. In the circumstances of the time, given the pressures that were on the board in other matters to prioritise conduct issues, I think it is quite hard to fault the board.[87]

54. He did, however, support the idea that boards in general needed to change their function:

I would be in the camp of saying that the responsibility of non-executive directors—not only in financial services, which is our focus here obviously—in a board environment, which is after all the most important policy decision-taking entity in the free world after elected bodies like parliaments and councils and so on, is to be much more challenging of the executive proposition in the normal course than has ever been the practice hitherto.[88]

55. It is clear that there are lessons from the RBS failure for how the board of the PRA should be constructed. Mr Knight and Sir David Walker argued that the opportunity presented by the move to the PRA should:

Be taken to give greater weight than in the past to constituting the regulatory Board at least in part with independent members who can draw on current or immediately recent relevant institutional and market experience.

[...] The benefit for the PRA Board and for the whole regulatory process of having better access to such topical relevant experience should in our view be regarded as outweighing the negative associated with the increased conflict problem on the occasions when specific regulatory decisions were the subject of Board discussion.[89]

56. Mr Sants supported the idea that the PRA Board would need this type of experience: "it is vitally important for the independence that the PRA board do come with current industry experience."[90]

57. We agree with the suggestion of our specialist advisers that the PRA Board should have independent members with extensive current or very recent market experience. We recognise the potential for conflicts of interest. As we concluded in our Report on the Accountability of the Bank of England, the interpretation of what constitutes a conflict needs to be assessed on a case-by-case basis at the time of appointment, and particular conflicts should be dealt with by committees as they arise. When a potential conflict arises in relation to a member of the Board of the PRA, the rest of the Board, led by the Chairman, should therefore exercise its judgement as to how to deal with it, as is standard practice on the boards of major public companies. The exercise of that judgement needs to be supported by a set of rules to which all members of the Board would be required to agree, and which should be published. In response to the Treasury Committee's request in June 2011, the Bank disclosed its code of conduct for members of the Financial Policy Committee.

Need for higher quality people to deliver higher quality regulation

58. With the move to a separate Prudential Regulation Authority the question arises of how that should be staffed. The importance of having higher quality senior managers and staff at the new regulatory bodies is highlighted in the FSA's Report, which notes that "In future it is important that the prudential supervision of the largest UK banks includes significant direct involvement of the most senior PRA and FCA executives."[91] However, two issues were raised in evidence about staffing of the PRA and FCA: What resourcing would be required and the degree to which the PRA should go for a career-regulator approach as opposed to utilising private sector experience.

59. Resourcing the regulator was something that was self-evidently a problem in the pre-crisis FSA. Hector Sants told us that: "the quality and quantity of the supervisory staff that I inherited in the summer of 2007, as well as the procedures and philosophy they were operating to, was inadequate".[92] Mr Sants elaborated that "We had almost no investment banking expertise in the FSA. We had very limited risk analysis expertise in the FSA. We had a very small number of supervisors. [...] We had a very, very small number of competent professionals."[93] The Governor of the Bank of England, Sir Mervyn King, has argued that staff quality is not necessarily dependent on levels of pay:

People often say that you will have to pay vast sums of money to get people to come and be regulators. I do not believe that is true, and if you do pay vast sums of money you get the wrong people.[94]

60. Mr Sants did, however, make a point of notifying the Committee that the many supervisory staff, in place at the time of the crisis, were no longer at the FSA. He stated: "Of the supervisors intended to transfer to the Bank of England, [...] three-quarters of them did not hold relevant supervisory posts at the time back in the summer [of 2007]".[95]

61. Sir David commented that with respect to the quality of resource at the FSA:

I think it is better now, but the jury is out on whether it is yet good enough, and we shan't know for some time. It is not enough in these supervisory roles just to throw more accountants or lawyers or former investment bankers and whatever it is into teams. They may have an important role to play, but I think that there is a need for experience and quality of judgment, which in part comes from experience in this area. I think the FSA still have some way to go, as do most regulators on the planet, in getting enough high quality experience into the supervisory process.[96]

62. Many of the supervisory members of staff have left the FSA since the crisis. It is possible that they have taken with them valuable experiences learnt in the heat of the crisis that would have proved useful to the FSA now, and the PRA in the future. Sir David Walker referred to the words of a former Bank of England Governor, who argued that "good judgement in banking comes from experience. The trouble in banking is that most experience comes from earlier bad judgement."[97] Mr Sants himself described the crisis as a "searing learning experience."[98]

63. Sir Mervyn King, Governor of the Bank of England, in evidence to the Joint Committee on the Financial Services Bill, also argued in favour of the career regulator model, rather than a model based on secondments from the private sector:

We want to demonstrate that in the Bank of England it is possible to have a public service career where you specialise in being an effective regulator. [...] It is very striking that in other industries the regulators are not people who take secondments from the industry or have had a career working in the industry; they have expertise as regulators. That is the kind of people we need in the Bank of England.[99]

64. Even with an FSA budget of around £300 million and around 2,500 staff, Mr Sants told us that the quality and quantity of supervisory staff he inherited in 2007 was inadequate. This state of affairs turned out to be calamitous and points to a further prior failure of management and leadership. High quality supervision is dependent on regulatory staff of sufficient quality and experience. We note the Governor's comments about the desirability of cultivating career regulators. We nonetheless recommend that the PRA ensures that career regulators continue to be supplemented with people that have current or very recent commercial experience. These may be secondees, advisers or permanent employees.

17 The Financial Services Authority, The failure of the Royal Bank of Scotland: Financial Services Authority Board Report, December 2011, pp 21-22 Back

18 Qq 103-104 Back

19 Q 104 Back

20 Q 104 Back

21 Qq 106-108 Back

22 Q 130 Back

23 Qq 109-110 Back

24 Q 133 Back

25 Q 131 Back

26 The Financial Services Authority, The failure of the Royal Bank of Scotland: Financial Services Authority Board Report, December 2011, p 27, p 254 Back

27 Q 76 Back

28 The Financial Services Authority, The failure of the Royal Bank of Scotland: Financial Services Authority Board Report, December 2011, p 254; A list of FSA board members and executive committee members for the Review period can be found on pp 344-345 of this same document [http://www.fsa.gov.uk/library/other_publications/miscellaneous/2011/rbs.shtml]. Back