House of Commons

Treasury Committee

Banking Crisis
Written Evidence – Part 3

This is a volume of submissions, relevant to the inquiry Banking Crisis, which

have not yet been approved for publication in final form. Any public use of, or
reference to, the contents should make clear that it is not yet an approved final
record of the written evidence received by the Committee.

Only those submissions written specifically for the Committee have been
included.

-1-
List of written evidence
Page

70 Odey Asset Management (second submission) 3

71 Linda Kaucher, London School of Economics 10
72 Dr Damian Tambini, POLIS/London School of Economics 15
73 Sir Michael Rake, Guidelines Monitoring Group 19
74 Richard Pereira 20, 26
75 Standard and Poor’s 34
76 Lord Stevenson and Andy Hornby 38
77 Lloyds Banking Group 42
78 Paul Moore, Ex-head of Group Regulatory Risk, HBOS Plc 46
79 Professor Prem Sikka (supplementary memo) 53
80 Investor Voice 56
81 Mick McQuade 61
82 FSF ICAEW 70
83 Ian Johnstone 73
84 Philip Slaymaker 75
85 Findlay Turner 77
86 Kais Uddin 79
87 Financial Services Authority 83
88 Greg Pytel 94
89 Guernsey Financial Services Commission (supplementary memo) 102
90 Gavin Fryer 103
91 KSFIOM (supplementary memo) 105
92 Tony Shearer (supplementary memo) 109
93 Which? (supplementary memo) 113
94 Charities Aid Foundation (supplementary memo) 115
95 Financial Reporting Council (supplementary memo) 120
96 Clive Menzies 139
97 Chris Wilson 140
98 ACCA 141
99 Peter Hamilton 147
100 HM Treasury 148
101 Financial Services Compensation Scheme 149
102 Tony Shearer (supplementary memo) 154
103 AIMA (supplementary memo) 157
104 Ron Parr 161
105 Citizens Advice Scotland 163
106 Common Good Party 187
107 Carmel Butler 192
108 Philip Murphy 214
109 Manifest 216
110 Phil Bale 251

2
 Further memorandum from Odey Asset Management

Action on Troubled Debts and how to Kick-start Corporate Lending

We judge there is a significant opportunity for government to restart the credit flows through
the financial and real economy of the UK, to make that happen fast, to ensure fair value for
tax payers, and to do this with an exit strategy in mind.

We recommend a two-stage package of UK government intervention:

• a national bank for troubled debts or government guarantee scheme

• active intervention to kick-start corporate debt markets

… other interventions will be necessary as the crisis progresses and should be coordinated
with this package. Without this scheme as a foundation, existing and future measures look
likely to fail.

We also offer a comment and proposals on HM Treasury’s latest guidance on the

proposed asset protection scheme to deal with bad debts (page 3).

Key arguments:

- a recent IMF working paper* showed that 60% of all global banking crises in the last
30yrs (42 crises in total) were ended by a bad bank or troubled debt guarantee structure. This
structure is missing from the policy response in the UK today.

- the buyer of last resort approach for company debt is analogous to the US TALF
intervention scheme. The TALF provides evidence that this approach delivers significant
positive effects for the wider economy and population.

- international experience provides elements of successful road-maps for implementing

the proposals.

- these measures would not hand UK banks a ‘free lunch’. It will ensure that solvent
UK banks remain in private sector control.

- the two building block measures will work best when accompanied by other sensible
policy measures including credit guarantee schemes, and the much needed flexing or
suspension of those Basle 2 rules which have a pro-cyclical impact.

- there is no reason for government to make a loss over the life of the project.

3
Stage One: create a National Bank for Troubled Debts or government guarantee scheme

1. A bad bank or troubled debt guarantee scheme is an essential part of a successful healing
process to this banking crisis.

2. The fundamental problem is too much debt. This is exacerbated by the fact that all
investors and lenders know that the UK banks have bad debts inside them still to come out,
but they do not know how bad those debts are. As long as opaque, impaired assets remain on
bank balance sheets the negative feedback loop of deleveraging and losses will continue. This
means that markets will remain dysfunctional, credit availability scarce, and the banks will be
focused on reducing their exposure through de-leveraging.

3. De-leveraging is ultimately quite simple, either you attract more equity or you shed assets.
Without balance sheet repair, it is currently near impossible for many UK banks to raise
equity capital. Therefore they have to de-leverage, reducing lending to companies and
households.

4. Banks in the EU are now valued at below their audited measures (tangible book value or
net assets) which makes it very difficult to raise new capital. Barring full-scale nationalisation
of swathes of the banking sector at huge cost to the taxpayer they will therefore de-leverage.
This is the negative death spiral in which we currently find ourselves. So if banks cannot raise
equity we must help the sector shed troubled assets. The most transparent, efficient and
scalable way to do this is a national bank for troubled debt (a bad bank structure).

5. The banking crises in Sweden in the 1920s and the early 90s make a relevant case study.
To quote the Governor of the Swedish Central Bank in 1997** (the Riksbank) the problems of
the early 90s "seem to have been more extensive than those which arose in Sweden in the early
1920s." Yet in the 1920s the fall in GDP totalled 20% versus around a decline of ‘only’ 6% in
the 1990s. Why the difference? In large part because "the two periods differ substantially in
the management of the crisis." The early 90s Swedish model is one of prompt, transparent
handling of the banking sector problems following the trusted route of:

liquidity - recapitalisation - bad bank structure.

6. The mechanism for establishing the price of an asset as it enters the bad bank, coupled
with the extent to which the banks could participate in any eventual upside are key points in
the process. But the models (details below) show solutions are possible, whether at strategic
level the means is (a) a separate bad bank or (b) guarantees issued by government, in
exchange for premiums paid by the banks, but with the now underwritten assets staying
on banks’ balance sheets. The troubled assets are currently so realistically marked to market
that this scheme could operate on the calculation that government can avoid a loss over the
life of the scheme. If any UK banks chose not to participate, negotiating for higher prices
from government, then that would be left up to them. All UK banks would be treated equally.

Comment on HM Treasury initial information on proposed asset protection scheme

4
7. We welcome the fact that the government is considering an asset protection scheme,
however the lack of detail in the initial 4 page release from 19 Jan is disappointing.

8. We assess that markets, investors, and savers will judge it essential to have the detail
fleshed out and the policy implemented, at the very latest, alongside the full-year results of the
banks in mid/end February 2009.

9. Waiting until co-ordinated agreement has been achieved amongst the G20 is likely to have
further very negative consequences for the UK banks.

10. It is not only the share prices which have fallen, but the value of subordinated debt
instruments issued by the banks have in many cases reached badly distressed levels. This
creates risk for pension holders as the insurance sector holds substantial amounts of this type
of bank debt. For example, Legal & General and Prudential collectively own £4bn of
subordinated bank debt.

11. Our analysis shows that the reduction in risk weighted assets (RWAs) which the banks
could gain from a guarantee scheme would be highly beneficial. But since the public policy
objective is to make bank balance sheets sufficiently strong for them to substantially increase
lending, additional measures will be necessary. We recommend that the Committee consider
the following:

(i) the first loss tranche of 10% to be borne by the banks, according to the Treasury plan,
will need to be booked against FY09 profits and staggered throughout the year, if it is
not to further destabilise the banks
(ii) the further residual exposure of c10% of the credit losses which exceed the first loss
amount must at least be staggered through 2010/11
(iii) the government must recognise that receiving a fee for the guarantee reduces the
ability of the banks to raise lending in the short-term. The two policy objectives are
directly opposed. We think it better that the policy measures achieve their prime
objective, and therefore counsel against sending more mixed messages to the banks,
and against giving with one hand while taking with the other
(iv) for the guarantee scheme to be effective it has to fully address market fears over
further heavily dilutive recapitalisations or nationalisations at a future date. The
means to do this, are to add the above measures to the package, and to demonstrate
that banks will be able to significantly improve profit margins so that capital can start
to rebuild “organically” via retained earnings. We suggest the optimum way for
banks to achieve this is to purchase corporate debt, which will help fund companies
and in the current climate offers banks significant profitable opportunities. In short,
for some of the UK banks to remain going concerns it is necessary that their bad
debts are dealt with; that the costs of that are distributed over a period of years
because the banks’ capital is too fragile to pay for it upfront; and that it is made
possible for investors to see how banks are going to earn their way back to health in
the coming years.

5
 12. What is imperative is that policy-makers act at speed.

Stage Two: intervention to kick-start corporate debt markets

13. This part of the package has elements similar to the steps taken under the TALF scheme
in the US. The Term Asset-backed securities Loan Facility (TALF) scheme is bringing down
the cost of mortgages to American home-buyers. It is a $200bn facility that helps market
participants meet the credit needs of households and small businesses by supporting the
issuance of asset-backed securities (ABS) collateralized by student loans, auto loans, credit
card loans, and loans guaranteed by the Small Business Administration (SBA). It is all about
changing practical things in the real economy for the benefit of the public at large.

14. In our view, a European model would work best via purchases of corporate debt by the
UK government, either through a new agency founded for the purpose or, and this would be
most effective, through the UK banks. It could also function EU-wide.

15. In outline, the government provides financing, for a fee, to the UK banks (or to a new
agency) which can be used under this scheme only to purchase corporate debt in the
secondary market. The effect of this is to reduce credit spreads, thus making it possible for
companies to borrow again in the primary market at sensible prices. The benefit for the
banks is that they will be able to make a profit margin on the secondary market debt which is
higher than their existing business. This may require an element of compulsion being exerted
on the banks. However, the margin uplift they receive would be substantial enough, we
estimate, to more than cover the most extreme impairment scenarios on the banks’ real
economy loan books as the recession bites. But without the bank for troubled debts, many
UK banks will be in no position to be purchasing more debt in secondary markets or to make
fresh loans.

16. So under our scheme, companies get cheaper credit, banks get to become going concerns
once again, the virtuous circle benefits the wider economy, and public policy objectives can be
achieved.

17. The two measures in the package are interdependent. Without such a transfer of bad
assets banks may be encouraged to defer the reporting of losses for as long as is legally
possible. The Japanese banking system of the 1990s and the US post Savings and Loans crisis
point up how such lack of transparency compounds and extends the problem.

18. Policy-making, thus far, has been far more proactive than the 1930s, yet credit spreads are
comparable to those in the 1930s (see Fig 17 below). Intervention in corporate credit markets
is necessary to resolve the crisis.

6
Facts and models for a troubled assets bank - what we have so far

(i) US TARP – troubled asset relief program, size $700bn

The TARP scheme embraced the concept of a ‘bad bank’ since its initial purpose was to
purchase difficult-to-value assets from banks and financial institutions. However the concept
was lost in the immediate need to provide liquidity and stop banks going bankrupt. Also
there were problems over how to value and purchase these opaque troubled assets in non-
functioning markets. The first $350bn of TARP capital was used mostly to recapitalise
financial institutions, including the car finance industry ($255bn in varying amounts to >120
banks, $40bn in pref shares of AIG, $20bn to Federal reserve bank NY as equity tranche of
TALF, $20bn to Citigroup, $14bn to GM/Chrysler).

(ii) The Citigroup model

However, of all the first-round TARP money, the $20bn to Citigroup came closest to fulfilling
the original ‘bad bank’ concept. For the $20bn investment the US Treasury and Federal
Deposit Insurance Corporation (FDIC) received $7bn in pref stock with explicit participation
in gains and losses for $306bn of ring-fenced troubled assets. The potentially toxic assets
remain on Citi’s balance sheet and their precise composition will be disclosed at some future
date. So this approach gets around the issue of having to value and disclose the assets in
question. In many ways though, the Citi model is an imperfect solution. It lacks
transparency and, in not removing the assets from Citi’s balance sheet, the capital relief is not
substantial or immediate, meaning that the bank is less likely and less able to go out and write
new loans. The bank is strengthened, but the wider public policy objectives are not achieved.

(iii) TALF, term asset-backed securities loan facility

Not a ‘bad bank’, but highly significant as it marked a new form of intervention with
government acting as a buyer of last resort. The Fed was mandated to go into the market and
buy $600bn of agency Mortgage Backed Securities debt (MBS). The result was that agency
MBS yields tightened significantly and mortgage rates (closely correlated to MBS yields)
have fallen from 6% to 5.1% today (see graph). The remaining portion of the TALF sees
$20bn of Fed equity being levered 10x to create $200bn of loans to buy AAA rated Asset
7
backed securities for newly originated auto/student/credit card/small and medium company
loans. As this portion of the TALF commences in Feb09, it should start to have a similar
impact on consumer credit pricing/credit availability in the US as it is already having
successfully on US mortgage rates.
Chart below shows falling US mortgage rates, with TALF impact at end of period.

(iv) UBS model, similar to Citi except assets moved off balance sheet into a Special
Purpose Vehicle (SPV)
$60bn of risk assets placed into an SPV funded by a $54bn 8yr loan from the Swiss National
Bank (SNB) at Libor+250bp and $6bn of equity from UBS. This $6bn of equity in the JV was
effectively sold to SNB by UBS for $1, and UBS had to raise a further CHF6bn to restore its
capital ratios. There is no further recourse to UBS, but in the event of any upside UBS stand
to gain a share of profits. This approach reduced UBS’ hard-to-value assets from CHF55bn to
<10bn, with resultant capital relief, in one fell swoop.

*IMF Working Paper:

http://www.imf.org/external/pubs/ft/wp/2008/wp08224.pdf
**Riksbank:
http://www.riksbank.se/upload/1722/970829e.pd

8
January 2009

9
 Memorandum from Linda Kaucher, London School of Economics

Current negotiations within the international trade agreement framework, especially of trade
in services, will have an overriding effect on the UK government’s right to regulate financial
services.

The failure of the Committee to take account of this within the Terms of Reference of its
Inquiry, appears to indicate a failure of the UK parliament, or at least of this Committee, to
take proper account of the international commitments the EU is making on behalf of the UK,
and to which the UK is committed by its membership of the EU. This would then indicate a
failure of the UK parliament to accept the full dimensions of the legal status of the UK as a
member state of the European Union.

If this has been through oversight, then this submission seeks to emphasise the need to
consider the ‘other jurisdiction’ of EU engagement with international trade agreements,
particularly with the World Trade Organisation, and within that, the WTO General
Agreement on Trade in Services (GATS).

While this submission makes reference to points within the various sections of the Terms of
Reference (indicated), because the substance of this submission relates to the inquiry overall,
it has been neither appropriate nor practical to attempt to sub divide the submission to fit the
preferred presentation model.

Notwithstanding this, this submission is mostly concerned Section 1 of the terms of reference:
Securing financial stability

It seeks to demonstrate how the UK Government’s ability to secure financial stability will be
inhibited through EU commitment to international trade law, in the form of the WTO
General Agreement on Trade in Services (GATS).

How the WTO General Agreement on Trade in Services agreement prohibits options in the
Banking Crisis.

Trade in services agreements are more intrusive into the processes of domestic regulation
than trade in goods agreements, affecting and limiting the scope of national regulation.
‘Services’ also underpins all other forms of trade, especially through financial services. And
services agreements are of particular significance in countries that have or have had services
economies, like the UK.

Purpose of the GATS

The fundamental purpose of the WTO General Agreement on Trade in Services (GATS) is
the progressive liberalisation of ‘services’, including of financial services. Under the
Agreement, in negotiating Rounds, countries, and in the case of EU member states, the
European Trade Commission commits to progressive deregulation, without reversals.

10
According to the Terms of Reference, this inquiry is largely concerned with regulation.
However, the GATS imposes meta regulation over domestic regulation. In the EU, this means
limiting and prohibiting national regulation within member states, increasing the rights of
transnational corporations, including financial corporations.

Relevance of the GATS to Financial services and to audit corporations

The GATS enforces deregulation and limits the reregulation of financial services, particularly
through the Special Annex on Financial Services1. It also strengthens the market power of the
big 4 global auditing firms (ToR 1.1) through the Special Memorandum on Accountancy2.

Financial services, accountancy, and basic telecommunications are all exceptions to the
requests and offers process of the GATS, whereby all countries (and the EU) commit which
services sectors they choose to liberalise. There is a general imperative to liberalise these
services; it is not optional. Liberalising these services is a condition of WTO membership.

The GATS generally limits governments’ ‘right to choose the measures they believe can best
achieve their objectives’. However, GATS Disciplines on Domestic Regulation in the
Accountancy Sector3 actually specify a narrow category of ‘legitimate’ government policy
objectives, and then apply a ‘least trade restrictive’ ‘necessity test’ to regulation of the
accountancy profession’4.

Thus, rather than ensuring regulation of accountancy, and as the 1.1 of the ToR suggest is
desirable, and as trade rhetoric of ‘transparency’ might suggest, the Domestic Disciplines on
Accountancy in the GATS actually enforces transparency of domestic regulation. (Annex 3).
This means that national, as well as subnational regulation, can more easily be challenged by
transnational corporations as being trade restrictive.

The Arthur Anderson corporation was involved in writing these rules, which have been
described as ‘Enron style’5.

1
This paragraph extract from the GATS Annex on Financial Services shows the contradictory wording
of allowing prudential measures, yet not if they conflict with commitments to the deregulatory trade
agreement. Ambiguity, is common in WTO wording, allows for challenge under the Dispute
Mechanism, and for interpretations in decision-making, wherein decisions are made on the basis of
trade liberalisation only. From http://www.wto.org/english/tratop_e/serv_e/10-anfin_e.htm
2
http://www.wto.org/english/news_e/pres98_e/pr118_e.htm
3
www.wto.org/english/news_e/pres98_e/pr118_e.htm
4
Kelsey, Jane (2008) Serving Whose Interests? The Political Economy of Trade in Services
Agreements p109
5
Depalma, A. ‘A WTO Pact Would Set Global Accounting Rules’, New York Times, 1st March 2002,
online at
http://topics.nytimes.com/top/referenc/timstopics/orgnaisations/w/world_trade_organi
sation/index.html?offset=30&query=TREATIES&field=des&match=exact
11
 With this form of meta regulation, it is transnational corporations, with their wealth of legal
and other resources that can benefit most from this. In this way the GATS generally and
particularly the Domestic Disciplines on Accountancy strengthens the power and reach of the
big 4 accountancy firms.

There is currently a ‘standstill commitment’6 prohibiting the introduction of any regulation

before the completion of the current GATS 2000 Round is signed up, at which point these
more specified commitments will come into force.

These particular provisions in the GATS should be taken into consideration in ToR 1.1.

Mechanisms and timeline of completion of current GATS Round

The current Round of the GATS commenced in 2000. The following year, the Doha Round
commenced. The Czech EU presidency, in its work program delivered in January (Annex 1),
has indicated the intention to pursue a completion of the Doha Round as soon as possible.
Therefore the GATS Round and/or the Doha Round are likely to be finalised in the early
months of 2009.

While including the GATS in the ‘single undertaking’ of the Doha Round has been a leverage
mechanism for encouraging countries to expand their GATS offers, because of the difference
in start date, it is technically possible for the GATS can be signed up separately, even without
agreement on the other parts of the Doha negotiations i.e. Agriculture and NAMA (Non
Agricultural Market Access – manufactured goods).

When the GATS 2000 Round is finalised, offers become commitments. and under
international trade law, reregulation, including of financial services, will be restricted

UK government role in GATS

UK parliamentary attention to trade agreements has been minimal, and the committee
structure has tended to deter attention to how they affect the UK.

Where there has been Parliamentary, or Parliamentary Committee attention to the WTO
Doha trade talks, it has been in terms of ‘development’, with the Overseas Development
Committee, focussed on the effects on developing countries. In keeping with this, the focus

6
Before the end of the forthcoming round of services negotiations, which commence in January 2000,
all the disciplines developed by the WPPS are to be integrated into the GATS and will then become
legally binding. Today's decision by the Council includes a “standstill provision”, effective immediately,
under which all WTO Members, including those without GATS commitments in the accountancy
sector, agree, to the fullest extent consistent with their existing legislation, not to take measures which
would be inconsistent with the accountancy disciplines.
12
has been on the Agricultural and to some degree the Non Agricultural Market Access
(NAMA - manufactured goods) Agreements, but not on services, and not on effects of the
trade agenda here.

GATS and nationalising and renationalising

Once the GATS commitment is made, it will prohibit any nationalisation. While the
Chancellor has said that ‘all options are on the table’, it is a concern that, through this EU
commitment, the UK is agreeing to the prohibition of important options, and especially in
relation to the banking crisis. The deepening crisis may require nationalisation of banks, as
well as of other facilities, but the EU GATS commitment will prohibit this. The UK
Government is promoting the completion of the negotiations, while failing to inform the
public of the implications

Actual ‘nationalisation’ is being avoided in the bailout mechanisms, despite the amounts of
public moneys the government is committing in its attempts to limit the crisis.

The loss of the option of nationalisation should be considered in reference to Section 2 of the
Terms of Reference, ‘Protecting the taxpayer’, as an important element in failure to protect
the interests of taxpayers.

The GATS also prevents reversals of public service privatisations and liberalisations, even
where they have shown to be detrimental, or costly, to a service.

When services have been privatised here they have been simultaneously liberalised, though
not named as such. ‘Liberalisation’ means that the contracts have been offered to overseas
companies. It is the ‘liberalisations’ that are committed to the trade agreement, a commitment
that these will not be reversed. So inherently, the privatisations, on which they are based,
become irreversible, too.

Again, with public hardship this option may be needed but will be prohibited by the GATS
sign-up. This ideological commitment to ‘free trade’ and to ‘liberalisation’ and to corporate
welfare should not be structurally enforced over the rights and needs of UK people.

Secrecy

Because of the EU structure, and the nationally focussed media, information at the EU level
can be kept from the public, and indeed from the national parliament and its committees.

As well as the lack of attention in the national context, there is what can only now be
described as secrecy at the EU level and at the WTO level.

Peter Mandelson as EC Trade Commissioner was heavily criticised for lack of transparency
and his failure to reveal the identity of lobbyists with whom he was having contact, by the EU
Ombudsman.

13
What the EU has demanded of other countries is not made public.

The EU revised offer on GATS7, the current offer, was tabled by Peter Mandelson 2nd June
2005 without publicity; in fact it was ‘hidden’ by the French and Dutch referenda that
weekend. It is difficult to locate on the internet. It is also difficult to decipher.

At the WTO level, Pascal Lamy, Head of the WTO, in his 18th Dec 2008 statement on future
trade talks (Annex 2), avoids any mention of ‘services’ negotiations, even though they have
been considered part of the ‘single undertaking’ throughout, so are in fact included. A single
reference to the requests and offers process, unique to the GATS, signals that inclusion.

He also urges, in his statement, that states do not bring any media attention future to talks. In
Geneva in July 2008, the services meeting was very effectively kept out of the public eye,
despite the global media attention to the trade talks. This was done by withholding the report
until the world’s media had reported that ‘Doha is dead’, and had left Geneva.

This degree of secrecy, keeping information from the public at all these levels, appears to
reinforce the importance of the GATS negotiations, as well as the probability that, if the
information were in the public sphere, the commitments would be rejected.

When the committee is considering the banking crisis, and its deep implications, this is
extremely significant. It is to be hoped that they committee will seriously consider the
information and the points raised here.

January 2009

7
http://ec.europa.eu/trade/issues/newround/doha_da/pr020605_en.htm
then click ‘read the text of the Revised Offer
14
 Memorandum from Dr Damian Tambini8, POLIS/London School of Economics

I am grateful for the opportunity to respond to the Inquiry. My response focuses on only one
of the points raised by the Committee:

1.11 The role of the media in financial stability and whether financial journalists should
operate under any form of reporting restrictions during banking crises.

Summary

As the author of a recent report on financial journalism by POLIS: a media and society Think
Tank based at the London School of Economics I have conducted over 30 interviews with
some of the UK’s leading financial journalists and editors in recent months. This research
asked financial journalists about how they approach their professional responsibilities as
journalists and what challenges they face in carrying them out. I have also interviewed
journalists, regulators, PR professionals and other interested parties in and outside the UK.
The research ‘What are Financial Journalists For?’ was published in November 2008 and is
available at: http://www.polismedia.org/workingpapers.aspx

Interviewees were drawn from the established news media but also elsewhere in the media
including the new media.

On the basis of this research I argue that the news media may contribute to financial stability
if information was more selectively released, but that this may not be a good thing. I also
argue that self-regulation rather than new legal obligations on journalists is likely to be an
effective solution in this case.

Based on a review of the literature and these expert interviews, I think it is reasonable to
conclude that:

A. The Role of the Media in financial stability

Markets depend on information. The established news media – among other intermediaries -
foster the flow of information about the market, and about particular companies, to investors,
citizens and consumers, thus enabling them to make informed decisions. By applying well
established journalistic strategies of verification, media organizations help ensure that
information is as accurate as possible given time, regulatory and resource constraints. By
ensuring a competitive approach to news and information provision, and by reference to
established professional ethics, the established media help ensure that information is
provided as rapidly as possible, and that that information is of a high quality. From the point
of view of stability, this may not always be a good thing: stability may be better served if
information is selectively leaked to a limited number of market participants. The impact of
information on prices may create the potential for shocks and panics therefore, but whilst a

8
Dr Tambini is a member of the Communications Consumer Panel. This submission represents a
purely personal view and does not represent a Consumer Panel or Ofcom view.
15
staged, leaky approach to information provision might serve ‘stability’ better, it would be
unjust.

Journalism is undergoing radical change currently however which impacts the ethical and
regulatory structures that secure the reliability of news and information, and the ability of
news organizations to invest the necessary resources in verification. Alongside what I refer to
as the ‘established news media’ new intermediaries provide financial and business news and
information whilst operating outside of the legal and ethical framework of journalism.
Despite these radical changes, the Polis research supports the following views:

1. Media reporting can and does move markets. The regulatory framework for news
media recognizes that media reports can have an impact on market sentiment in
general and on prices of particular securities, and this is supported by ample research
evidence.
2. There is (therefore) ample scope for market abuse by the media. Recent scandals such
as the ‘City Slickers’ case in the UK and the Foster Winans case in the US show that it
is possible for certain journalists to gain advantage by market manipulation, including
through rumor fueled short selling. Research tends to support the view that in the UK
and the US such practices are rare, and the established media tend to act as a brake
rather than a lubricant on rumor driven runs (at least when these are based on false
rumors).
3. Media may reinforce volatility. It is acknowledged in studies of the behavior of news
journalists that they may be subject to herd mentality; tending to agree among
themselves on what ‘the story’ is in response to an announcement and in the case of
running stories seeking news that fits with a particular notion of ‘the story’. These
tendencies may reinforce herd and momentum market behaviors but there is little
solid research evidence on this. By volume, it is likely that the impact of media
reporting on the majority of investment decisions is marginal. Most high volume
institutional investors do not rely on established news media for their information.
4. News Media can act as a conduit for unfounded rumors. Whilst all media outlets do
have established procedures for verifying news stories, they also provide tips and
rumors in certain columns and broadcast forms (such as analyst quotes). Media are
changing: the division between fact and comment may be becoming less obvious to
readers - but currently at least, audiences (as with the HBOS rumors of March 08)
turn to the established news brands in order to verify stories.
5. The legal framework on market abuse applies to journalists as it does to anyone, but
there are jurisdiction problems and enforcement is patchy. Journalists do enjoy
certain immunities from the regulatory framework, and there is evidence that
regulators are reluctant to engage with them. In the UK journalists that offer
investment recommendations are exempt from the conflict of interest disclosure
requirements that apply to others, and they – due to informal arrangements- are less
likely to be required to reveal their sources than others.
6. The effectiveness of the ethical and self regulatory framework operated by the PCC,
and by individual media outlets is uncertain. The numbers of complaints against the
PCC code articles on financial journalism is extremely low. And there is nothing in

16
 the existing code, or professional practices, that deals with the issue of the macro
impact of financial reporting on general market sentiment.

In conclusion, it is evident that the news media perform a crucial role in bringing information
to the market: there is no conclusive evidence that the media as a whole or in specific
instances reinforce volatility, but there is a possibility that certain newsgathering behaviors
might encourage a herd mentality in the market. The news media, and professional reflection
and self-regulation of journalists are focused on verification of information and not on the
consequences of publication, or processes of selection or agenda setting.

B. Should journalists operate under any form of reporting restrictions during banking crises?

1. The principle of press freedom is very important – though of course journalists

operate under many restrictions. The European standard according to the ECHR is
that such restrictions have to be necessary in a democratic society and in accordance
with law. Restrictions would have to meet that test.
2. Existing restrictions are in place relating to market abuse (as well as general
restrictions on libel, intellectual property and so forth).
3. Journalists tend to be well aware of restrictions and operate within them.
4. Rules that apply ‘to journalists’ ‘during crises’ raise the obvious question of who
decides who is doing journalism, when is a banking crisis underway and so forth.
Definitional problems are becoming more pronounced because the activity of
journalism is no longer defined by a technology of delivery, and the technology of
delivery is no longer a guarantee of a particular self-regulatory framework.
5. The more convincing arguments against reporting restrictions are not those based on
principle (e.g. ‘the principle of freedom of the press’) but those based on the
impracticality of reporting restrictions and their likely perverse consequences. Even if
there were restrictions, information and rumor would circulate but more of the
audience would turn to unregulated platforms that do not profess to be doing
‘journalism’ and which do not exhibit any form of self restraint. There are advantages
of getting information into the market as quickly as possibly and serious
disadvantages if barriers are introduced. From the point of view of financial stability,
artificial blocks and bottlenecks in the provision of information may exacerbate
financial shocks and, further introduce obvious inequalities and mistrust in access to
trusted information. These are likely to have political as well as economic
consequences.

In conclusion, new legal restrictions on reporting are likely to do more harm than good. But
the Committee could encourage smarter regulation and encourage a new approach to self-
regulation. At a time of intense – perhaps unprecedented- financial pressure on all
established media (broadcasting and the press) it is unlikely that news providers will prioritize
ethical and professional reflection, so they should be incentivized and encouraged to do so.
This is always most effectively done if there is the possibility of legislation lurking in the
background. Much can be done to encourage responsible financial and business journalism
through ensuring access to information, protection of sources and so forth, but the quid pro

17
quo for this should be a genuine attempt to develop a code of responsible conduct that reflects
on the macroeconomic impact of reporting styles.

More research is necessary to better understand how business journalists are responding to
current changes and challenges, but it is already clear that business and financial journalists
should be encouraged to develop their ethical and professional practices through self-
regulation, and it is likely that new legal restrictions would hinder journalists in their
important work and not result in improved financial stability.

"Free speech and a free press not only make abuses of government powers less likely, they also
enhance the likelihood that people’s basic social needs will be met," .."Improvements in
information and the rules governing its dissemination can reduce the scope for these abuses in
both markets and in political processes. Many of the decisions taken in the political arena have
economic consequences. Also, better and timelier information results in better, more efficient
resource allocations."

Joe Stiglitz In: The Right to Tell. World Bank, 2002.

January 2009

18
 Letter from Sir Michael Rake, Guidelines Monitoring Group

Just a quick note on your remarks at this morning’s Select Committee hearing on the Banking
Crisis, which referred to the Guidelines Monitoring Group’s first report on private equity
disclosure.

You mentioned you thought that half of the firms have not complied with the guidelines.

That impression may have been created by serious misreporting of the GMG’s findings by
some sections of the press today (but not others, see the Lombard column in the Financial
Times). The position is as indicated in the Executive Summary of our report which has been
emailed and mailed to your office. All of the companies which are either obliged to work
within the Walker structure, or have volunteered to take part in it, complied with the
initiative.

Half met all the requirements in full without any further advice from ourselves; in other cases
relatively minor omissions were identified and either already have been or are in the process
of being corrected.

Whilst this is the first year the regime has been in place, and there is always room for
improvement, I have been extremely impressed by the level of co-operation that I have
received from the industry and their understanding of the importance of transparency.

I look forward to discussing the report with you and the next steps that the Guidelines
Monitoring Committee would like to take.

January 2009

19
 Memorandum from Richard Pereira

1. Executive Summary & key issues covered

1.1. The Implications of the hedge fund industry for financial stability
1.1.1. Systemic risk - may be low due to diverse strategies and diverse quality and
sizes of managers across the whole hedge fund industry. But it is a risk that is not
formally measured or monitored. So more needs to be considered. See section
3.1.2 for my suggestion
1.1.2. Specific risk - controls on counterparty risk exposures and use of leverage are
key. We have not experienced a contagion where more than one large hedge
fund manager has collapsed within a very short period of time we should be
aware that this could be disruptive to the financial system. See section 3.1.3
1.1.3. Current issues affecting hedge fund industry
1.1.3.1. Significant investor redemptions in 2008. See section 3.1.4.1
1.1.3.2. Significant loss in most investment strategies in 2008. See section 3.1.4.2
1.1.3.3. Restrictions on investor redemptions. See section 3.1.4.3
1.1.4. Alignment of interests with their investors is key. See section 3.1.5
1.1.5. Further transparency and regulatory involvement should be welcomed by the
hedge fund industry. In particular measures to monitor systemic risk – see
section 3.1.6 - for an idea on how to do this.

1.2. Short selling

1.2.1. Short selling is considered by many hedge fund managers as a valuable
feature. See section 3.2.1
1.2.2. Business failure unlikely to be caused by short selling. See section 3.2.2
1.2.3. Stock lenders can stop lending stock. See section 3.2.4

1.3. The Future of the Hedge Fund Industry

1.3.1. It is possible that the events taking place in 2008 may lead to an eventual asset
re-allocation within the hedge fund sector to higher quality funds. This may lead
to some recovery in the AUM of the hedge fund industry in the medium term.
In this scenario the risk that greater volumes of funds are held with the largest
hedge funds may possibly add to systematic risk See section 3.3.2

1.4. Corporate Governance issues

1.4.1. A strong corporate governance structure is recognized to be a critical factor
to the ultimate long term success of the investment. See section 3.4.1
1.4.2. Independence between front office and control functions is important. See
section 3.4.2
1.4.3. Dominance risk is a key concern – see section 3.4.3 and 3.4.4

1.5. Shareholder rights and responsibilities

1.5.1. Fund documents should fully describe the investment and restrictions – see
section 3.5.2
20
 1.5.2. Regular Investor reporting is crucial – see section 3.5.3

1.6. Investor due diligence

1.6.1. Hedge funds use of due diligence checklists to give information to investors –
see section 3.6.1
1.6.2. Leading hedge fund investors tend to look very closely into the funds
operations as part of their due diligence and treat it as a continual process – see
section 3.6.2
1.6.3. Regulators should consider due diligence spot checks to ensure that standards
are maintained and that information used in marketing reflects is current and
investors are informed of changes. – see section 3.6.3
1.6.4. Key man risk is an important area of focus and succession plans are important
– see section 3.6.4

2. Brief Introduction to the submitter

2.1. I was an Executive Director at JP Morgan Securities Ltd in London. I worked in the
Structured Alternatives investments business area and have strong experience of
working with leading hedge fund managers, understanding hedge fund trading
strategies & risks and investor requirements for alternative investment risks and due
diligence.
2.2. My academic and professional background: I graduated with a 1st Class Mathematics
degree from Imperial College and I am a qualified actuary (FIA) and chartered
accountant (ACA).
2.3. My professional qualifications and experience with institutional investment
managers gives me a strong understanding of alternative investment allocations and
the motivation for investing in this asset class

3. Detailed Comments on the issues likely to come up in the committee meeting

3.1. The Implications of the hedge fund industry for financial stability

3.1.1. Hedge funds that operate to highest standards of risk management, corporate
governance tend to make an important contribution to the financial industry.
Hedge funds that can produce positive returns over long periods with low
volatility and low correlation – provide risk diversification to their investors
3.1.2. There are a diverse range of strategies within the hedge fund industry and this
may produce some level of diversification across the whole industry to reduce
the presence of a systemic risk to the financial system. However in 2008 Hedge
Fund Index performance measure shows that the hedge fund industry
experienced losses to varying degrees across most strategies – with the notable
exception of Global Macro investing strategies showing gains at index level. But
systemic risk is not formally measured and we should realize that what is not
measured cannot be managed. The concept of the systemic risk monitoring may

21
 be improved by further transparency measures that I have mentioned below (see
section 3.1.6) - in my comments on transparency
3.1.3. The specific risk of the failure of very large funds may disturb the markets and
cause a significant issue within the financial markets if counterparty exposure
and the level of leverage and correlation of exposure are not properly monitored
& controlled. We have seen large hedge funds fail, but have not witnessed the
impact of multiple failures of very large hedge funds within a short period of
time. This type of contagion could be disruptive and may cause financial
instability, especially if the counterparty exposures were not covered
3.1.4. The key issues that are currently in the hedge fund industry relate to:
3.1.4.1. Redemptions requests from investors: A recent FT article 22 January 2009,
referred to a data source that indicated that investors have withdrawn 20
percent of their money from hedge funds in 2008 and hedge fund assets
shrank by $782bn to $1,210bn. Some hedge managers have suspended or
limited withdrawals, which have disappointed investors who need cash. A
leading hedge fund manager in 2008, was recently said to have stated in his
2009 outlook to investors “We think it’s a mistake for managers to use gates
and other tools to limit investor access to their funds” and “While we
recognize the difficulties of the current environment, we think it is a
manager’s responsibility to raise liquidity to meet the redemption needs of
their investors.”
3.1.4.2. Losses from investment strategies – significant losses for some funds in
2008 will mean that these hedge funds may not receive future performance
fee payments until losses are earned back in future years. Due to the size of
losses in some funds the risk is that it may weaken the alignment of
interests of these hedge fund managers to their remaining investors
3.1.4.3. Lack of liquidity in the market, some managers who are enforcing
redemption restrictions are suffering from the lack of market liquidity for
underlying financial instruments. However, these managers may offer the
explanation that selling illiquid assets at this time would damage investors
who remained invested
3.1.4.4. Banking sector has now become more conservative when lending to
hedge funds this has lead to further de-leveraging pressure within hedge
fund
3.1.5. A very important principle for leading hedge funds is to establish an alignment
of interests with their investors. This typically occurs in the following 3 ways:
3.1.5.1. Performance payments to hedge fund managers only occur if their
investors are profitable. This is usually controlled using a high water mark
(HWM), this means that the hedge fund will have to earn back any loses for
investors before it can share in future profits
3.1.5.2. Hedge fund managers can invest their wealth in the same hedge fund to
share in investment losses and gains with their external investors
3.1.5.3. Some funds may include claw back provisions that allow for a return of
profits earned in previous periods if they lose money in future periods

22
 3.1.6. Further transparency should be welcomed by the hedge fund industry. In
particular measures to monitor and measure systemic risk. Transparency may
be improved by reporting of hedge fund positions to the regulator (this would
need to be done in the strictest confidence and data should not be available to the
public). This process can allow the regulator to consider the aggregated position
information and consider the level of market and credit risk exposure and
conduct risk analysis to determine if a systemic risk is possible. The analysis and
measurement of systemic risk could allow for timely intervention.

3.2. Short selling

3.2.1. Short selling is considered by many hedge fund managers as a valuable feature
in promoting the efficiency of the markets and plays a part in some hedge fund
strategies.
3.2.2. It is unlikely that business failure is caused by short selling. Failure usually
results from fundamental problems with the underlying business (for example:
weaknesses in business model and operating results, inappropriate financial
capital structure (i.e. too much balance sheet leverage), weak board level
management control and decisions etc)
3.2.3. The impact of short selling on the market price of a company stock will
depend on the volumes of short sellers in a time period. It is important that
statistics can be kept to check how volumes of buyers, sellers and short sellers
impact a share price
3.2.4. The short seller will typically need to borrow stock from a stock lender Stock
lending is an activity some institutional investors (who are usually long stock),
may engage in to increase income by earning fees from stock lending. Stock
lending is not usually a significant source of income and some institutions
stopped this activity in the last quarter of 2008 since it may result in a self
defeating impact, as their long portfolios would suffer from increased market
risks. When stock lenders decide to stop lending stock then it is more difficult
short sellers to carry out their trades. In October 2008 the FT reported that some
stock lenders CALSTRs, CALPERS and APG temporarily suspended the lending
of their financial stocks (i.e. banking stocks)

3.3. The Future of the Hedge Fund Industry

3.3.1. It is possible that 2009 may see another fall in assets under management
(AUM) of hedge funds due to de-leveraging and investor redemptions
3.3.2. However, some long term investors will view their asset allocation to the hedge
fund sector as a long term investment strategy and they would not judge this
asset class based on the results of 1 or 2 years. It is possible that the events taking
place in 2008 and 2009 may lead to an eventual asset re-allocation within the
hedge fund sector, as investors make investments in hedge fund managers who
are perceived to be higher quality and operate leading standards of risk
management and corporate governance. This may lead to some recovery in the
AUM of the hedge fund industry in the medium term. In this scenario the risk

23
 that greater volumes of funds are held with the largest hedge funds may possibly
add to systematic risk.
3.3.3. Long term hedge fund investors who are looking for high risk adjusted returns
(and a low correlation returns with traditional asset classes) are likely to find the
hedge fund industry an important asset class to achieve their portfolio objectives
of achieving higher long term returns with low volatility
3.3.4. Hedge fund’s that have successfully operated to meet the objective of
protecting investor’ capital and generating positive returns with low volatility
over medium to long term time periods may stand to benefit most from this
asset re-allocation within the sector

3.4. Corporate Governance issues

3.4.1. Many of the world’s most successful hedge fund investors place high
importance on the organization and governance of a hedge fund. A strong
corporate governance structure is recognized to be a critical factor to the
ultimate long term success of the investment. But standards of corporate
governance vary widely within the hedge fund industry.
3.4.2. Independence of between front office and control functions is important.
Independent control functions that can competently focus on valuation, risk,
and liquidity management processes from outside the front office and
independently report to the CFO or CRO without restriction or conflict
3.4.3. Internal procedures need to monitor and control the existence of dominance
risk. Dominance risk occurs when a key person who makes trading & business
decisions is not open to discussion with colleagues either on the trading desk,
staff from control functions or investors about the risks they are taking.
Dominant individuals often have built an internal infrastructure where they have
the ability to circumvent controls and overrule other members due their status in
the fund. Dominance risk maybe a factor in many problem cases where there is
a sudden deterioration in performance due to excessive risk taking or fraud
3.4.4. Dominance risk maybe reduced by: rigorously applied limit structures and
independent approval requirements to trade risks above exposure limits, well
documented investment & risk committee meetings, clear reporting lines,
transparency with investors in due diligence and subsequent reporting,
regulators, auditors, administrators and a prudent attitude by the main traders
3.4.5. The existence and ability of the appointed regulator to make random spot
checks. For example by attending scheduled investment & risk committee
meetings and to test the documented control framework of the fund will also
help

3.5. Shareholder rights and responsibilities

3.5.1. Investors in the hedge fund industry include pension funds, insurance
companies, endowments, banks, fund of hedge funds, family offices and high net
worth individuals
3.5.2. Shareholders rights are usually set out in the hedge fund prospectus. As
discussed above some hedge fund prospectus documents given the hedge fund

24
 manager to impose restrictions on redemption requests. When these restrictions
are enforced it is usually a disappointment to the restricted investors and can
cause a loss of confidence with the hedge fund and its ability to manage liquidity.
The legal structure of the fund should be clearly documented in the prospectus.
Shareholders should ensure that fund documentation confirms that there is an
alignment of interests of the hedge fund manager
3.5.3. Regular Investor reporting is crucial. The investor reporting should available
for random spot check audits by a regulator and each fund should present
investors with the most relevant information on the fund’s performance, risk
(market, credit, operational counterparty and liquidity where relevant) and
performance outlook

3.6. Investor due diligence

3.6.1. Hedge funds usually complete a formal due diligence checklist to ensure that
they can satisfy investor questions. This has become an industry practice and the
checklist can be used by some hedge funds in their marketing efforts and are
often circulated to potential investors. This is a useful first step in the investment
process.
3.6.2. However, some of the world’s most successful hedge fund investors believe
that it is also important to be to able sit down with the hedge fund managers who
make the decisions, and understand what these managers are doing and how it is
implemented in trades. This can be extremely useful when trying to get
comfortable with new strategies, new funds or understand the principle factors
affecting the risk of the investment – this approach is likely to be more widely
adopted.
3.6.3. Regulators should consider due diligence spot checks to ensure that standards
are maintained and that information used in marketing reflects is current and
investors are informed of changes. The best managers understand that due
diligence is a continual process and keep their investors informed
3.6.4. Key man risk is an important area of focus. For hedge funds that may be
perceived to suffer from key man risk, it is important that they have a clear
succession plan present to improve stability of performance

January 2009

25
 Further memorandum from Richard Pereira

4. Executive Summary & key issues covered

4.1. The role of auditors in the banking crisis, and whether any reform to that role is
desirable.

4.1.1. It is important to understand how the “going concern” assessment was

made by auditors at the end of 2007 and will be made at the end of 2008. The
going concern assessment is an important part of financial statement preparation
and also the audit process. This process is not usually fully disclosed in annual
report – to assist with transparency - a potential reform is that this should be
disclosed. It is a very important assessment and may change the basis of account
preparation and can lead to qualified opinions – if this is done recklessly than the
audit opinion would be misleading – see sections 3.1.1 to 3.1.4. Section 3.1.3
contains a fact pattern in the case of RBS – showing the importance of the
going concern concept and also examines what period of time the concept of
“foreseeable future” may refer to.
4.1.2. Over the period from 2004 to 2007 the asset side of the largest UK bank
balance sheets increased significantly in size – how was the potential increased
risk of this situation dealt with in the audit process – see section 3.1.5
4.1.3. Auditors usually focus on material issues and set a level of materiality on
the issues they focus on. For transparency auditors should disclose the level of
materiality they have used when auditing financial statements – this is not
usually done. If materiality levels were increased during the period from 2004 to
2007 –it could be possible that important risks were not given the attention they
deserved at their origin – see section 3.1.6
4.1.4. Do auditor’s rely on credit rating agencies in making going concern
decisions (e.g. i) to assume an existing strong credit rating may indicate access to
additional debt capital is possible if necessary or ii) if capital adequacy regimes
refer to credit rating agency ratings on assets to determine if a financial
institutions capital is adequate compared to the regulatory minimum ). If
auditors implicitly rely on credit rating agency rating work and credit rating
agencies also rely on audited financial statements when they set their credit
rating - then this may be a dangerous circularity and potential flaw that needs
reform – see section 3.1.7 and section 3.2.5
4.1.5. Shadow banking system eg Structured Investment Vehicles (SIVs) and
other off balance sheet vehicles and the impact on the banks – see section 3.1.8
4.1.6. To what extent did UK auditors – apply the important principles or lessons
from the US Sarbanes – Oxley (“SOX”) regulation (even if it was not legislation
in the UK) – during the audit of the largest UK banks - see section 3.1.9
4.1.7. Fair value – the recent G20 Financial Reform Paper suggests a fair value
reform is required for illiquid and distressed markets. This is different to the
message from the IASB Expert Advisory Panel issued a paper in October 2008 –
what do the auditors of UK banks think is correct – see section 3.1.10
26
 4.2. The role, and regulation, of credit ratings agencies (“CRA”) in the banking crisis,
and whether any reforms are desirable.

4.2.1. In November 2008 - The European Commission put forward a proposal and
rules to regulate the credit rating agencies (“CRA”) – it attempts to restore
market confidence and increase investor protection. Could the CRA comment
on the proposal and rules – see section 3.2.1
4.2.2. CRA performed badly – The European Commission has put forward why
they felt CRA performed badly – see section 3.2.2
4.2.3. The European Commission also discussed how the CRA contributed to the
financial crisis – see section 3.2.3
4.2.4. The recent G30 Financial Reform Paper called A framework for Financial
Stability dated 15 January 2009 suggests a reform to reflect the risk of potential
valuation losses in which CRA also allow for liquidity and price volatility – see
section 3.2.4 What do CRA think about this suggested reform and the
workability of it? This G30 reform suggestion may be difficult for CRA to
achieve as this would be a significant departure to their focus on credit risk and
may lead to more uncertainty in their risk ratings due to the assumptions
necessary.

5. Brief Introduction to the submitter

5.1. I was an Executive Director at JP Morgan Securities Ltd in London. I worked in the
Structured Alternatives investments business area and have strong experience of
working with leading hedge fund managers, understanding hedge fund trading
strategies & risks and investor requirements for alternative investment risks and due
diligence. My work experience also gave me exposure to the Credit Rating Agencies
in the context of rated structured products and methodologies that they apply to
varies types of credit product.
5.2. My academic and professional background: I graduated with a 1st Class Mathematics
degree from Imperial College and I am a qualified actuary (FIA) and chartered
accountant (ACA).
5.3. My professional qualifications and experience give me an insight into the practical
working of credit rating agencies and auditors

6. Detailed Comments on the issues that may be relevant in the committee meeting

6.1. The role of auditors in the banking crisis, and whether any reform to that role is
desirable.

27
6.1.1. Going concern is the term given to the fact that a bank or business has
adequate resources to continue in business for the foreseeable future. Director’s
will usually make this assessment and will adopt the “going concern” basis when
preparing the accounts. However auditors will normally have to assess this
assumption during their audit of the financial statements and determine if they
reflect a true and fair view. For the year ended 2007 for the major UK banks,
including RBS and HBOS the auditors agreed that these banks were a going
concern and had adequate resources
6.1.2. The process of how an audit firm independently determines if it is also their
view that the business is a going concern should be well documented. For
transparency and better understanding of the process - would the auditors of the
major UK banks – for example RBS, HBOS and Barclays to comment on the
process they would normally use to assess & collect evidence to determine if a
banking group is a going concern and how this is documented on their audit
files. For example in 2007 the auditor’s of RBS and HBOS agreed that these
entities were going concern. Would the relevant auditors be able to
independently publish the work they did to independently agree with the board
of directors assessment of going concern status. If an auditor recklessly
conducted its assessment going concern then this may mean that the audit
opinion would be misleading. The UK’s new Companies Act finally which
received the Royal Assent on 8 November 2006, includes a new auditing offence.
The new criminal offence, which will apply where the auditor knowingly or
recklessly includes in his audit report any matter which is misleading, false or
deceptive in a material particular, or where he omits any required statement
within the report.
6.1.3. A suggestion for the future is that auditors should disclose in the financial
statements how they make their independent assessment that the company is a
going concern.

In accounting, "going concern" refers to a company's ability to continue

functioning as a business entity. It is the responsibility of the directors to assess
whether the going concern assumption is appropriate when preparing the
financial statements. A company is required to disclose in the notes to the
financial statements whether there are any factors that may put the company's
status as a going concern in doubt. The company's auditor must consider
whether the use of the going concern assumption is appropriate, and whether
there are material uncertainties about the entity's ability to continue to operate as
a going concern that need to be disclosed in the financial statements. Financial
statements are prepared on the assumption that the entity is a going concern,
meaning it will continue in operation for the foreseeable future (agreed to be 2 to
3 years) and will be able to realize assets and discharge liabilities in the normal
course of operations.

On 27th February 2008, RBS issued its 2007 annual report & accounts. On page
119 the auditors (Deloitte & Touche) opinion concluded ‘‘In our opinion the

28
 financial statements give a true and fair view, in accordance with IFRS, of the
state of the Group’s affairs as at 31 December 2007 and of its profit and cash
flows for the year then ended’’. Just 8 weeks later, on 23rd April 2008, Royal Bank
of Scotland ‘RBS’ announced a write-down of £5.9bn before tax, following its
exposure to the credit markets and on 30th April 2008, RBS announced a rights
issue of £12bn to shore up its finances. The rights issue was announced as part of
a trading update and is one of the largest seen in UK corporate history. The
rights issue was to allow RBS ‘‘to retain more capital in its balance sheet to meet
the risks of default by borrowers than it had been doing". The closing date for the
£12bn cash requirement was 10th June 2008. The fees paid to advisers by RBS for
the £12bn rights issue prospectus cost the bank £246m in advisors’ fees and
related costs. The cost includes £210m of fees for the issue’s underwriters —
Goldman Sachs, Merrill Lynch and UBS — with the remainder paying for
lawyers’ and auditors’ fees and other costs. The auditors (Deloitte & Touche)
although they did not conduct an audit, opined that they had conducted their
work in accordance with the Standards for Investment Reporting issued by the
Auditing Practices Board in the United Kingdom which consisted primarily of
comparing the unadjusted financial information with the source documents,
considering the evidence supporting the adjustments and discussing the Pro
Forma Financial Information with the Directors. They stated that they planned
and performed our work so as to obtain the information and explanations we
considered necessary in order to provide us with reasonable assurance that the
Pro Forma Financial Information has been properly compiled on the basis stated
and that such basis is consistent with the accounting policies of the Group. Just
weeks after the £12bn rights issue RBS required further capital injections
resulting in a further £20bn from the UK Government on 13th October 2008.
Going concern means that the business is viable and has sufficient funding for
the next 12 months at the very least.

The above fact pattern begs 3 important questions:

i) how did Deloitte & Touche arrive at the conclusion that RBS was a going
concern on 27th February 2008 when just 8 weeks later RBS announced a
material write-off of £5.9bn and was not a going concern without raising
£12bn in new capital?
ii) When the audit opinion was formed & signed on the 27th February 2008
did the auditors have the view that the foreseeable future was 2 to 3 years
or 8 weeks. This “opinion” would have been important to shareholders
and public interest and this lack of disclosure may be viewed as
misleading ?
iii) What do the auditors on your panel think may be a reasonable period
that is referred to by the term “foreseeable future” ?
6.1.4. The auditors of UK banks should be asked to disclose how they intend to deal
with the going concern uncertainties present in the banking system for year end
2008 – for example in relation to assessing if adequate resources are available and
the fair value assessment for troubled asset positions

29
6.1.5. In the period from 2004 to 2007 the asset side of most of the largest UK bank
balance sheets increased significantly in size. For example:
6.1.5.1. Assets as at 31/12/2004 of HBOS was £442,881 million compared to
£666,947 million as at 31/12/2007
6.1.5.2. Assets as at 31/12/2004 of RBS was £583,467 million compared to
£1,900,519 million as at 31/12/2007
6.1.5.3. Assets as at 31/12/2004 of Barclays was £522,089 million compared to
£1,227,361 million as at 31/12/2007
6.1.5.4. To what extent did the audit processes adapt to the potentially higher risk
of misstatement in this increased asset base - in particular in respect of 2
significant issues:
6.1.5.4.1. the risk there were more complex assets on the balance sheet; and
6.1.5.4.2. how would the auditor gain comfort that these volumes of assets
were suitable for the banks balance sheet
6.1.6. Auditors usually focus on material issues and set a level of materiality on the
issues they focus on - this may be related to the size of assets in the balance sheet
or the size of the turnover or net profit. For transparency auditors should
disclose the level of materiality they have used when auditing financial
statements. This is currently not done. Given the increase in the asset side of
most of the largest UK bank balance sheet from 2004 to 2007 – it would be
important to know if the auditors of the UK bank increased their materiality
limit. If materiality is increased, as the balance sheet increases in size then this
may introduce a selection or audit bias whereby risks go unchecked (or less
checked) since they may not be picked up in the audit process until it is too late
and the exposure becomes too big. For example if an area experiences significant
growth in size over a short time – is it possible that the auditors may not focus on
that area while it’s balance sheet presence, profitability and risk profile is still
being formed and still not yet significant compared to the materiality gauge that
is being used by auditors
6.1.7. Auditors may implicitly rely on credit rating agency rating of the banks that
they audit during their audit process. It is important to establish if this is a factor
that is implicit in the going concern assessment. For example, is there is an
implicit assumption that the bank will be able to access the debt capital markets
to raise debt to increase solvency if required – because it has a sufficiently high
rating. This may lead to a circularity in which 2 important parties (i.e. external
auditors and credit rating agencies) implicitly rely on each other’s work. This
may be a flaw in the system at times when problems arise or about to arise – see
section 3.2.5
6.1.8. Shadow banking system vehicles eg Structured Investment Vehicles (SIVs) to
what extent did auditors consider that the risk of failure of SIVs held off balance
sheet may lead to balance sheet problems if these vehicles had to be consolidated.
Is the risk that off balance sheet vehicles may suffer problems that force them
back onto the balance sheet a factor that is considered during the audit. This risk
may change the balance sheet profile excessively and may test the going concern
assumption.

30
 6.1.9. After the failures of Enron, World Com - the US introduced SOX which forced
changes that raised awareness to control risks in some of the areas (see below) -
to what extent did auditors of our largest UK banks consider and follow the
important principles implied by the SOX regulation, even if it may not be legally
enforceable in the UK – for example:
6.1.9.1. Auditor independence to avoid conflicts of interest –restriction on audit
firms providing non audit services (e.g. consulting services) for the same
client
6.1.9.2. Corporate Responsibility – independence of external auditors and bank’s
audit committee and also Independence of audit committee members and
management. Independence of external auditors and board management.
On this later point – for some of the largest UK banks there seems to be a
relationship between audit firms and significant/influential members of the
board of some of the UK banks (or is it just coincidence):
6.1.9.2.1. RBS auditors are Deloitte & Touche and the former CEO Sir Fred
Goodwin was a Deloitte & Touche partner
6.1.9.2.2. Barclays auditors are PWC and the current FD Chris Lucas was a
former PWC partner – Head of Banking and Capital Markets at PWC
6.1.9.2.3. HSBC auditors are KPMG and the current FD Douglas Flint was a
former KPMG partner
6.1.9.3. Executive compensation and boardroom failure – appropriate effective and
independent remuneration committee who would review the board
members compensation to ensure that it was not excessive and lead to short
term behaviour. Strong corporate governance to assess the competence of
senior management to ensure that board members had the expertise and
technical knowledge to understand the complexities of the business
6.1.10. Fair value – the recent G30 Financial Reform Paper called A framework for
Financial Stability dated 15 January 2009 suggests under their Fair Value
recommendation 12 a) Fair Value accounting principles and standards should be
re-evaluated with a view to developing more realistic guidelines for dealing with
less liquid instruments and distressed markets. However the IASB Expert
Advisory Panel issued a paper in October 2008 on Measuring and disclosing fair
value in markets that are no longer active – indicating the principles of fair value
calculation in these markets. The auditors of the UK banks should indicate their
view on the subject of fair value in illiquid markets and what reforms are or
maybe needed due to uncertainties in the fair value approach

6.2. The role, and regulation, of credit ratings agencies (“CRA”) in the banking crisis,
and whether any reforms are desirable.

6.2.1. In November 2008 - The European Commission put forward a proposal and
rules to regulate the credit rating agencies (“CRA”) – that attempt to restore
market confidence and increase investor protection. Could the CRA comment
on which of the rules they have most issue with. The new rules include:

31
 6.2.1.1. CRA may not provide advisory services – in particular to advice issuers
on how to get a better rating
6.2.1.2. CRA cannot rate financial instruments if they do not have sufficient
quality information to base their ratings
6.2.1.3. CRA must disclose models, methodologies and key rating assumptions to
the public
6.2.1.4. CRA must publish an annual transparency report
6.2.1.5. CRA must appoint 3 independent directors on their boards, one of whom
is an expert in securitization and structured finance. These directors can
serve for less than 5 years and their remuneration cannot depend on
business performance
6.2.2. The European Commission also discussed why CRA performed badly
6.2.2.1. Conflicts of interest: CRA work with issuers of rated instruments and are
usually paid by issuers – there is substantial risk that may compromise their
independence and objectivity. CRA staff who prepare the ratings may be
subject to incentives that may affect their judgement
6.2.2.2. Quality of ratings compromised by CRA profit motives
6.2.2.3. Insufficient transparency about how they develop their ratings – eg
processes, models, methodologies etc
6.2.2.4. Lack of supervision – CRA have not been subject in Europe to formal
control and surveillance by public authorities
6.2.3. The European Commission also discussed how the CRA contributed to the
financial crisis and gave credit when it was not justified by economic
fundamentals:
6.2.3.1. CRA failed to sufficiently consider the risks inherent in more complicated
financial instruments (e.g. structured finance products that may be founded
on risky assets, like US subprime mortgages)
6.2.3.2. CRA underestimated the risk that these instruments may not pay interest
or the debt itself
6.2.3.3. CRA failed to promptly reflect deteriorating market conditions in their
ratings
6.2.4. The recent G30 Financial Reform Paper called A framework for Financial
Stability dated 15 January 2009 made Recommendation 14 b) Risk ratings issued
by the CRA should be made more robust, to reflect the risk of potential valuation
losses arising not just from default probabilities and loss in the event of default,
but also from the full range of potential risk factors (including liquidity and price
volatility). Could the CRA comment on the workability of this proposal from
the G30
6.2.5. Credit rating agencies may have relied on audited financial statements in
making their credit rating estimate for the banks. This has a circularity that is
concerning. Also see section 3.1.7

January 2009

32
 Memorandum from Standard & Poor’s Ratings Services

1. Executive Summary

1.1 On 13 January 2009 Standard & Poor's Ratings Services ("S&P") was invited by the
Treasury Committee to give evidence at its session on 28 January 2009. This follows
previous evidence submitted by S&P on 7 November 2007 and oral evidence given at
the hearing on 13 November 2007 by Mr Ian Bell and Mr Barry Hancock of S&P. Mr
Bell and Mr Hancock will return to give evidence on 28 January.
1.2 We have focused our written evidence on three topics where we hope our views will be
of assistance to the Treasury Committee.
1.3 In section 3 we summarise the recent actions taken by S&P to reinforce its internal
policies and procedures. This includes in particular a set of 27 initiatives which we
announced in February 2008.
1.4 In section 4 we comment on the current state of the draft EU legislation. We believe
that legislation for the regulation and supervision of credit rating agencies ("CRAs")
could, if appropriately calibrated, support efforts to rebuild confidence in ratings and
we are continuing to maintain a dialogue with regulators and policymakers over
various provisions in the draft legislation.
1.5 In section 5 we comment on the future of the CRA industry, particularly in terms of
the "issuer pays" model. Although we recognise that there are potential conflicts of
interest in the "issuer pays" model we believe that potential conflicts can arise within
any model. Other models may also generate additional difficulties.

2. Standard & Poor's

2.1 S&P is a business unit of The McGraw-Hill Companies Inc., a global business service
provider in the fields of financial services, education and business information. S&P is
known as one of the world's leading providers of independent credit ratings. It has
been engaged in issuing credit ratings since 1916. The total amount of outstanding
debt rated by S&P globally is approximately US$32 trillion in more than 100 countries.
S&P rates and monitors developments pertaining to these issuers from its operations in
23 countries and markets around the world. It employs approximately 8,500 people
worldwide.

3. Recent Action taken by Standard & Poor's

3.1 In its previous report, the Treasury Committee expressed concern about the potential
conflicts of interest faced by CRAs and urged them to put in place policies and
procedures "to identify, manage, and where incapable of being managed out, disclose
conflicts inherent in their individual business models".9

9
Paragraph 204 of "Financial Stability and Transparency", Sixth Report of Session 2007- 08,
published on 3 March 2008.
33
3.2 Since last giving evidence to the Committee, S&P has taken extensive actions to address
the concerns raised by the Committee and other commentators. These actions have
included specific measures that are designed to enhance our policies and procedures
for addressing and managing the potential conflicts of interests that may arise in the
course of our business. In particular, in February 2008 S&P announced 27 new
initiatives, which are designed to enhance our ratings practices and processes whilst
also providing the market with greater insight and understanding of the analysis and
information that supports our ratings. These initiatives are designed to promote the
following broad objectives.

(a) Governance: the integrity of the ratings process

As part of our changes to governance, we are introducing the following measures that are
designed to address potential conflicts of interest:-
• We now hold periodic reviews with the Audit Committee of McGraw-Hill,
our parent company, to discuss S&P's overall governance and compliance
functions.
• We have formalised functions with responsibility for policy governance,
compliance, criteria management and quality of the ratings.
• We have established an Enterprise Risk Oversight Committee that operates
independently of the business, and which is responsible for providing
independent oversight of risks that could impact the ratings process.
• Establishing an Office of the Ombudsman (effective 16 February 2009) that
will address concerns related to potential conflicts of interest and analytical
and governance processes that are raised by issuers, investors, employees
and other market participants across S&P's businesses.
• We have implemented "look back" reviews for analysts in certain roles who
leave the firm to work for issuers, investors or arrangers.
• We have instituted a new policy for the rotation of lead analysts.
• We are enhancing our level of employee training.
(b) Analytics: enhancing quality of ratings analysis and opinions
We are establishing a Model Oversight Committee to assess and validate the
quality of data and models used in our analytical processes. We are also taking
steps to complement traditional credit rating analysis by highlighting non-
default risk factors that can influence the valuation and performance of rated
securities (such as market liquidity, volatility, correlations and recovery).
Other initiatives are being implemented that are designed to enhance our
surveillance process.
(c) Information: providing greater transparency and insight to market
participants

We are introducing ten separate initiatives in this area. For example, we have taken steps to
simplify and provide broader market access to ratings criteria, underlying models and
analytical tools. We are also taking steps to better explain the comparability of ratings across
different classes (i.e. structured, corporate and government issued securities).

34
 (d) Education: more effectively educating the market about credit ratings and
rated securities

We are implementing five measures that are designed to promote a better understanding of
the ratings process, the features of the securities that we rate and the role of ratings in the
financial markets.
3.3 Since announcing these actions we have published updates, so that there is
transparency on the progress that we are making in implementing them.
3.4 These actions are not designed to replace our previous systems and controls, but to
reinforce them. There were, for example, already safeguards in place that were
designed to ensure that our ratings were not influenced by potential conflicts of
interest. Among other things, analysts' compensation was not linked to the revenues or
profits attributable to an analyst's ratings work. In addition, ratings decisions were
(and continue to be) made by committees, and not individual analysts.
3.5 Our actions are nevertheless important in developing our procedures across a variety
of areas. We believe that they will help us to demonstrate our commitment to the
integrity, quality and transparency of our work.

4. Options for the Oversight of Credit Rating Agencies

4.1 As the Committee will be aware, the European Commission has now proposed
legislation for the regulation of CRAs. Other countries in which we operate (such as
Japan and Australia) are also formulating regulatory frameworks and the United States
already has regulation in place.
4.2 S&P believes that appropriate systems for the regulation and supervision of CRAs
could support efforts to rebuild confidence in ratings and help to promote high quality,
independent and internationally consistent credit ratings for the market.
4.3 Our view is that any system of regulation should be designed to promote certain core
objectives. In particular, it should seek to promote an internationally consistent
standard of regulation, preserve the analytical independence of CRAs and incorporate
a proportionate and workable supervisory framework. We continue to discuss the
current EU proposals with a range of interested parties, in order to ensure that the final
legislation works in the interests of the market as a whole.

5. The future of the credit rating agency industry

5.1 S&P is aware that many commentators have questioned the suitability of the "issuer
pays" model, primarily on the basis of concerns over conflicts of interest.
5.2 S&P believes that all available models present their own potential challenges. In
particular, other models would also present potential conflicts of interest (the Treasury
Committee has already recognised that if investors pay for ratings this might only serve
"to encourage conflicts in the opposite direction ").10 In all cases, steps will be required to

10
Paragraph 205 of the Sixth Report of Session 2007-08.
35
 manage any potential conflicts of interest. We are, as explained above, taking steps to
demonstrate that we manage appropriately the potential conflicts of interest that arise
in our model.
5.3 There are also other problems that are likely to be associated with other models, such
as inequalities in the information being made available to market participants.

January 2009

36
 Memorandum from Lord Stevenson and Andy Hornby

INTRODUCTION

1. We very much support the Committee's objective to identify lessons that can be learned
from the banking crisis. This crisis has affected most major economies and most major banks
across the world for well over a year. The significant contraction in liquidity and the sharp
decline in asset values have had a major impact on the banking system, companies and
households. We therefore welcome the opportunity to submit evidence on this crucial
subject.

2. We start by making it clear how profoundly sorry we are about what has happened at
HBOS. Our shareholders have experienced a large decline in the value of their holdings - a
decline shared by many of our colleagues. Our hard working colleagues and our customers
have experienced considerable anxiety and strain. And we also deeply regret the impact of the
events of the last 18 months on the communities which we serve.

3. We discuss:

• First, the events that have impacted HBOS.

• Second, a number of the questions in your brief about the future.

HBOS

1. HBOS had performed well in relation to its competitors on a range of financial and non
financial indicators since its foundation in 2001. As well as generating significant profits and
shareholder value, we created a large number of jobs, invested in the communities in which
we operate and took the lead on a number of social issues. HBOS was, for example, the largest
provider of social bank accounts in the UK.

2. Why then, it may be correctly asked, did HBOS encounter such huge difficulties?

The summary answer is the liquidity pressures that HBOS experienced as a result of the
first failure in wholesale markets for over 70 years. Although HBOS was able to secure
adequate capital and liquidity for the first 14 months since August 07, the Lehmans
bankruptcy dramatically increased the liquidity threat.

3. In more detail ...

From August 2007 wholesale markets became extremely constricted.

Unprecedented global circumstances affected virtually all the top banks in the world and
HBOS specifically. Many non banking institutions, such as money market managers,
withdrew from wholesale markets while banks themselves sought to manage their liquidity in
a more restrictive manner. Asset prices fell sharply in the USA - particularly residential

37
property - and this in turn had a serious impact on confidence and the value of investments
held by banks all over the world in their treasury portfolios. Ironically the global nature of the
markets compounded the problems as the challenges in one developed economy were quickly
replicated elsewhere. This led to a need for additional capital and/or liquidity support being
provided to a large number of the world's largest banks by their governments in 2008 (e.g.
Bank of America and Citigroup in the USA; Fortis, Commerzbank and UBS in Continental
Europe).

In August 2007 when the market dislocation began, HBOS remained able to fund itself
adequately, albeit with shortening maturities, for the next 14 months.

Although HBOS had significant reliance upon wholesale funding since the creation of HBOS
in 2001 we had taken a number of initiatives to lengthen the average maturity of our
wholesale funding to leave ourselves less exposed to potential dislocation in wholesale
markets. One of the main reasons that HBOS was able to continue to fund itself despite the
collapse in wholesale markets was this strategic decision taken by the Board some five years
earlier to extend the maturity of its wholesale obligations by taking a substantial permanent
hit to its Profit and Loss account. In addition from 2007 onwards we further pulled back on
our growth of assets in every market we served. Despite the extremely difficult market
conditions, we had managed to continue funding ourselves adequately through the wholesale
markets for 14 months since August 2007 and we had strengthened our capital base in
anticipation of future recessionary trends.

However, the bankruptcy of Lehman Brothers led to a significant further deterioration in

the London interbank wholesale markets. Wholesale funding was now operating virtually on
an overnight basis only. This quickly led to the conclusion that we should secure a more
stable long term solution in the form of the acquisition by l.loyds TSB.

4. In summary the loss of liquidity in the market that started in 2007 but was so dramatically
increased by the Lehmans bankruptcy was the overriding reason for the strategic problems
encountered by HBOS.

Two other issues while themselves neither of them the cause of HBOS' strategic problems
have aggravated them.

• First, while HBOS took a decision in 2005 not to invest in subprime securities, we
invested in highly rated AAA asset backed securities. Although we did this to
maintain a significant liquidity portfolio, as the global economy deteriorated, so did
the valuations of a number of these securities.

• Second, our exposure to some sectors of the UK commercial property market - in

particular house building - came under increasing pressure following large falls in
sales volumes and the very fast rate of asset depreciation caused in recent times by the
deteriorating economy.

38
5. To sum up the learning from HBOS' recent experiences ...

• First and foremost the collapse in wholesale markets following the bankruptcy of
Lehmans was the one factor which caused the Board of HBOS to seek a different long
term solution.

• At the same time, given the collapse in the financial system that has taken place,
HBOS would have been in a stronger position had it made less investment in AAA
securities and less investment in some sectors of commercial real estate.

In the next section we address those questions the Committee has asked in relation to which
we have the most direct experience and draw attention to some issues that may be relevant in
trying to learn from the past for the future.

SOME KEY ISSUES

1. Liquidity. The primary issue for the authorities in the UK and throughout the world is how
to maintain liquidity in wholesale markets. It looks as though in most economies in the world
governments and central banks have devised schemes to provide liquidity to banks who are
solvent but who have been caught by the collapse in wholesale markets. That in our view is a
correct and necessary response to recent events.

It raises the long term question for the future as to the appropriate use of wholesale markets
by banks and the appropriate public position of central banks. It is clear that while deposits
must be the core source of banking lending, authorities will need to continue to take
authoritative action to facilitate the continued function of wholesale markets. It is also going
to be essential for banks to agree with regulators an appropriate proportion of lending that
should be financed from wholesale markets.

2. Capital. The problems encountered by HBOS as we have outlined above stemmed, not
specifically from capital but from liquidity. We entered this phase in August 2007 with capital
ratios that satisfied the FSA's criteria; we boosted them with a further raising of capital
through a rights issue conducted in the first half of 2008. However, we should put on record
our support for the measures the Government has taken to increase the capitalisation of the
major British banks which is an important step to instilling long term confidence in the
sector.

3. Regulation. We do not think that there is ever likely to be one "ideal" method of regulation.
The very difficult question remains of devising a regulatory system which is capable of
preventing or moderating the instabilities of the last 18 months while leaving the financial
institutions with a sense of responsibility for their own affairs.

The core challenge for regulators and banks is to ensure there is sufficient liquidity and
capital retained in the system during strong economic times in order to be resilient to
significant global shocks.

39
CONCLUSION

This submission has addressed the issues that faced HBOS last year before going on to raise
some issues for the future. We would also like to repeat our deep regret at the effect of recent
events on all our stakeholders. The backdrop was the unprecedented failure in wholesale
markets and its effect on liquidity especially after the significant further deterioration
following the Lehmans bankruptcy. Whilst we worked hard to adapt to these conditions, the
deal with Lloyds TSB was the right transaction for the HBOS Group.

February 2009

40
 Memorandum from Lloyds Banking Group

1. Introduction

1.1 We welcome the opportunity to submit evidence to the Committee’s enquiry into the
banking crisis.

1.2 We have focused our comments primarily on the position of Lloyds TSB as the
acquisition of HBOS was only completed on 19th January 2009, however, there will be
incidences when we refer to the Lloyds Banking Group when we look to the future. We
have also made some observations on what underpinned the crisis and the steps taken
by the Government and other Tripartite authorities to address the issues.

2. Why did the financial crisis happen?

2.1 In looking at the current crisis and what needs to be done, we believe it would be
helpful for the committee to split the crisis into two parts – the financial markets crisis
and the deteriorating global economy.

2.2 Coming into 2008, the UK economy enjoyed 60 consecutive quarters of sustained
expansion. Inflation remained very low globally and in the UK household incomes
grew strongly and asset markets boomed, notably housing. This booming economy
meant that demand for borrowing outpaced the growth of savings. Banks, therefore,
increased their borrowing from the financial markets to meet this demand. At the same
time, there was a search for yield by investors who wanted to invest in instruments that
would give them higher returns. This, with the demand for borrowing, led to a huge
growth in financial innovation and more complex structured credit products.

2.3 The current banking crisis has happened essentially because of a collapse of confidence
which has caused the money and capital markets to stop working properly. In a world
which has become very risk-averse, banks and other investors have become reluctant to
lend to each other. All banks, including the stronger ones, have therefore faced
increased difficulty sourcing funding, this has meant their ability to lend in turn to their
customers has been affected.

2.4 The banks which have borrowed most from the markets have been the most affected.
In the UK there is now a lending gap, as foreign and non bank institutions have
withdrawn from the market and retrenched to domestic markets. Over the last ten
years, these institutions accounted for around half of new corporate loans and
approximately 45 per cent of mortgages.

3. Accountability

41
3.1 We believe that, at a global level, risk was mis-priced and the sophistication of the new
instruments out-paced the ability to manage and understand their long term
implications particularly in a less benign economic environment. However, this lack of
understanding was not just an issue for the banks. Regulators and Central Banks
around the world did not always grasp the inter-dependencies in the financial system
and the true nature and scale of the risk being taken by some banks. There was also a
general lack of understanding of the dependency of the major economies on non-bank
financing. To be fair this was always going to be difficult due to the sheer complexity of
the system. The priority now is to address the systemic risks and for everyone, including
the banks, to work together to restore confidence in the financial system and the
economy. We are working hard to that fulfil those objectives.

4. Position of Lloyds TSB

4.1 Lloyds TSB entered the financial crisis in a strong position. This was due to our
relationship banking strategy, our strong business model, our prudent risk approach
and our philosophy of taking a through the cycle approach. Furthermore, we had
anticipated that the benign economic environment was unlikely to last and had as a
result positioned our business to avoid riskier parts of the lending market.

4.2 Relationship banking is at the heart of Lloyds TSB’s strategy. That means working with
and understanding the financial and non-financial needs of its customers, building a
relationship with them to help them grow and prosper. Lloyds TSB takes pride in a
“through the economic cycle” approach to credit policy, which means stability, thereby
helping and working with customers through the good times and the bad.

4.3 One test of Lloyds TSB’s relationship model is whether it is able to quickly respond to
the short term borrowing needs of its customers. Because of the strength of its financial
position, Lloyds TSB remained “open for business” throughout 2008 and committed to
maintaining a broad range of products and actively marketing them to customers. In
2008, Lloyds TSB provided 1 in 4 mortgages and personal loans in the UK and its net
mortgage lending was up over 60 per cent in 2008. It was also the first bank to pass on
full benefit of the recent Bank of England base rate cuts on variable rate mortgages and
to SME customers. In terms of the SME sector, our lending grew by 19 per cent.

4.4 As a result of our financial strength, in September 2008 we were one of the very few
institutions who were in a position to be able to acquire HBOS, when it became affected
by the global problems in the banking system.

4.5 By early October 2008, confidence in the sector was at a low point worldwide and the
most important issue was restoring confidence and stability. In the context of the
unprecedented turbulence in global financial markets and as part of the Government’s
action to stabilise the UK banking system, HM Treasury had discussions with Lloyds
TSB on the additional capital it would be required to hold, to have access to the
Government backed provision of liquidity. Based on these discussions the Boards of

42
 both of Lloyds TSB and HBOS agreed to raise £17bn of capital across both banks,
through a combination of ordinary shares, which were underwritten by the
Government, and preference shares. We welcomed the investment by the Government
as it represented certainty of capital availability and relatively attractive pricing -
compared to a traditional rights issue approach. Because of these benefits, Lloyds
TSB’s already robust capital position was further enhanced and this allowed the Group
to drive forward with its plans to help acquire HBOS.

4.6 On the 19th January, we announced the successful completion of the HBOS acquisition.
Lloyds Banking Group has a robust capital position. We also continue to attract funds
in the wholesale markets at prices below most of our peers. We continue to believe that
the acquisition of HBOS makes a compelling business opportunity as it is a good
business, with great brands, great people and has a strong customer franchise.

5. Government measures

5.1 We have been fully supportive of the measures the Government has taken to restore
confidence to the banking sector. As we mention above, in October last year,
confidence in the sector was at a low point worldwide and the most important issue was
restoring confidence and stability. The Government took a number of steps to address
these problems which we believed were necessary. The Government showed leadership
in the UK and this formed part of a globally co-ordinated approach to addressing the
systemic market issues.

5.2 In January this year, the Government announced a package of measures with the aim of
stimulating the economy and encouraging more lending. We welcome this package and
are studying these proposals in detail and are having a constructive dialogue with
Government particularly around pricing and collateral.

5.3 However, despite the efforts of banks and the government, there will still remain a gap
in lending capacity which has been created by the withdrawal of foreign banks and non-
bank institutions. In order to fill this gap, which represents 50 per cent of capacity, the
British banks that remain in the market would have to more than double their lending.
It is absolutely in line with Lloyds Banking Group’s strategy of relationship banking to
support our customers and we will continue to help our customers during these
difficult times and we will make funds available to customers that meet our lending
criteria.

6. Conclusion

6.1 We have experienced unprecedented market dislocation across the world in the last
twelve months.

43
6.2 We support the Government in the steps they have taken to restore capital and funding
levels, and in the drive to restore confidence and financial stability.

6.3 Lloyds TSB has been able to maintain its support to our customers, in particular
mortgage customers and SMEs, because building relationships with customers
throughout the economic cycle is at the heart of its strategy. Our robust funding
position enables us to do this.

6.4 We are entering a more challenging period for the economy and Lloyds TSB will
continue to support its customers during this difficult time, ensuring that they have
access to the finance, products, advice and relationships that they require.

6 February 2009

44
 Memorandum from Paul Moore, Ex-head of Group Regulatory Risk, HBOS Plc

1. My background and credentials

1.1 I was Head of Group Regulatory Risk (GRR) at HBOS between 2002 and 2005. I reported to
the CFO, Mike Ellis. I had formal responsibility for the bank’s policy and oversight of executive
management’s compliance with FSA regulation.

1.2 From an FSA perspective, I was the Approved Person at the relevant time for the Control
Functions 10 (Compliance Oversight) and 11 (Anti Money-Laundering).

1.3 Prior to joining HBOS, between 1995 and 2002, I was a Partner in KPMG’s Financial Sector
Practice in London specialising in regulatory services where I advised quite a number of FTSE100
clients on regulatory matters.

1.4 I have been involved in UK Financial Sector regulation since it began in 1986. I am a Barrister
by profession.

2. Executive summary of the main points I wish to make

2.1 My evidence relates to all sections of the Committee’s Terms of Reference but is drawn
specifically from, and relates specifically to, my personal experiences at HBOS.

2.2 The main points I wish to make are these:-

2.3 I believe that there are important general lessons to be learned from my personal experiences
as a risk and compliance professional at HBOS and elsewhere that could assist the Committee and
others in the public policy debate about what needs to be changed in the governance and regulatory
system to help to ensure that the same risks are mitigated in the future.

2.4 In order to draw out the general points that need to be made, it is necessary to tell at least a
part of the rather complex personal story that occurred at HBOS and I request the Committee’s
forbearance with this because it draws into sharp focus the lessons about the crucial importance of
really effective governance. I give a short summary of the key facts of my story at HBOS in this section
(2.12 to 2.19 below) and add some further factual information that I would like the Committee to
consider in section 3 below.

2.5 The key general points I wish to make are these:-

2.6 In my view, as an experienced risk and compliance practitioner, the problem in finding the
real cause of the banking crisis is being made more complex than it needs to be.

2.7 I believe that we are missing the wood for the trees and that the key solutions to prevent such
an event happening again are simpler than we think. In relation to policy changes, I make some short
recommendations that the Committee may wish to consider in section 4 below.

2.8 But let’s start with the cause and this fairly obvious proposition: even non-bankers with no
“credit risk management” expertise, if asked (and I have asked a few myself), would have known that
there must have been a very high risk if you lend money to people who have no jobs, no provable
45
income and no assets. If you lend that money to buy an asset which is worth the same or even less than
the amount of the loan and secure that loan on the value of that asset purchased and, then, assume
that asset will always to rise in value, you must be pretty much close to delusional? You simply don’t
need to be an economic rocket scientist or mathematical financial risk management specialist to know
this. You just need common sense. So why didn’t the experts know? Or did they but they carried on
anyway because they were paid to do so or too frightened to speak up?

2.9 What my personal experience of being on the inside as a risk and compliance manager has
shown me is that, whatever the very specific, final and direct causes of the financial crisis, I strongly
believe that the real underlying cause of all the problems was simply this - a total failure of all key
aspects of governance. In my view and from my personal experience at HBOS, all the other specific
failures stem from this one primary cause.
2.10 In simple terms this crisis was caused, not because many bright people did not see it coming,
but because there has been a completely inadequate “separation” and “balance of powers” between the
executive and all those accountable for overseeing their actions and “reining them in” i.e. internal
control functions such as finance, risk, compliance and internal audit, non-executive Chairmen and
Directors, external auditors, The FSA, shareholders and politicians.

2.11 As I recently commented on the BBC Money Programme called HBOS: Breaking the Bank
“Being an internal risk and compliance manager at the time felt a bit like being a man in a rowing boat
trying to slow down an oil tanker.” If we could turn that man in the rowing boat into a man with a tug
boat or even the Pilot required to navigate big ships into port, I feel confident that things would have
turned out quite differently.

2.12 When I was Head of Group Regulatory Risk at HBOS, I certainly knew that the bank was
going too fast (and told them), had a cultural indisposition to challenge (and told them) and was a
serious risk to financial stability (what the FSA call “Maintaining Market Confidence”) and consumer
protection (and told them).

2.13 I told the Board they ought to slow down but was prevented from having this properly
minuted by the CFO. I told them that their sales culture was significantly out of balance with their
systems and controls.

2.14 I was told by the FSA, the Chairman of the Audit Committee and others that I was doing a
good job.

2.15 Notwithstanding this I was dismissed by the CEO (he wrote that it was “...his decision and his
alone”). I sued HBOS for unfair dismissal under the whistle blowing legislation. Ironically, I was also
the “Good Practice Manager” for whistle blowing purposes at HBOS but could hardly report my case
to myself!

2.16 HBOS finally settled my claim against them for substantial damages in mid 2005. I was
subjected to a gagging order but have decided so speak out now because I believe the public interest
demands it.

2.17 At this point I want to stress in the strongest possible way that I am simply not interested
in blame and I don’t think it really ever works. I was ultimately fairly compensated by HBOS. What I
am very interested in is the future. As I wrote once at to my boss at HBOS itself what we need this
crisis to do for us is “to create a watershed here so we can move on from the issues of the past (from
which we can learn but not blame) to the brave new world of the future.” Although, key people at
46
HBOS did do wrong, I am also sure that their intentions were usually good and, in a sense, they were
also caught up themselves in what the Greek tragedies would call the “ineluctability of fate”.

2.18 Returning to my story: after I was dismissed and to prove just how seriously HBOS took risk
management, I was replaced by a new Group Risk Director who had never carried out a role as a risk
manager of any type before. The individual concerned had primarily been a sales manager and was a
personal appointment of the CEO against the initial wishes of other Directors. You can’t blame her for
accepting the job as it got her on the Group Management Board and shortly afterwards the main
Board.

2.19 On any reasonable interpretation, this appointment could not have met the FSA’s “fit and
proper” requirements for the roles of CF 10 (Compliance Oversight) and CF14 (Risk Assessment)
which are as follows:-

“In determining a person's competence and capability, the FSA will have regard to matters including but not
limited to.....whether the person has demonstrated by experience and training that the person is able, or will be
able if approved, to perform the controlled function.”

2.20 All these matters were reported to the HBOS Non Executive Chairman of the Audit
Committee as well as the FSA. I was given no protection or support. A supposedly “independent
report” by HBOS’s auditors said HBOS were right but failed even to interview key witnesses.

2.21 I believe that, had there been highly competent risk and compliance managers in all the banks,
carrying rigorous oversight, properly protected and supported by a truly independent non-executive,
the external auditor and the FSA, they would have felt comfortable and protected to challenge the
practices of the executive without fear for their own positions. If this had been the case, I am also
confident that we would not have got into the current crisis. I believe that my personal story of what
happened at HBOS demonstrates this exactly.

2.22 To mix a few well known similes / metaphors / stories, the current financial crisis is a bit like
the story of the Emperor’s new clothes. Anyone whose eyes were not blinded by money, power and
pride (Hubris) who really looked carefully knew there was something wrong and that economic
growth based almost solely on excessive consumer spending based on excessive consumer credit based
on massively increasing property prices which were caused by the very same excessively easy credit
could only ultimately lead to disaster. But sadly, no-one wanted or felt able to speak up for fear of
stepping out of line with the rest of the lemmings who were busy organising themselves to run over
the edge of the cliff behind the pied piper CEOs and executive teams that were being paid so much to
play that tune and take them in that direction.

2.23 I am quite sure that many many more people in internal control functions, non-executive
positions, auditors, regulators who did realise that the Emperor was naked but knew if they spoke up
they would be labelled “trouble makers” and “spoil sports” and would put themselves at personal risk.
I am still toxic waste now for having spoken out all those years ago! I would be amazed if there were
not many executives who, if they really examined their consciences closely, would not say that they
knew this too.

2.24 The real problem and cause of this crisis was that people were just too afraid to speak up and
the balance and separation of powers was just far too weighted in favour of the CEO and their
executive.

47
3. A brief factual summary of my experiences at HBOS

3.1 As Head of Group Regulatory Risk at HBOS I was required to be the Approved Person who
exercises the key significant influence function for the “Controlled Function 10” i.e. “compliance
oversight”. This role requires the incumbent formally to oversee the adequacy and effectiveness of the
systems and controls in place around the entire HBOS Group for ensuring compliance with FSA
requirements. The role is rightly regarded by the FSA as an important safeguard of the firm’s
compliance with the regulatory regime.

3.2 By its very nature the role of Head of GRR requires the incumbent to challenge the HBOS
Group in relation to any aspect of its systems and controls, where those systems or controls are, or
may be, inadequate to ensure that the Group complies with FSA requirements. In addition, he is
required to raise challenge in relation to the way in which approved persons carry out their
responsibilities and, in particular, in relation to their integrity, due skill, care and diligence. Failure to
raise such challenge in appropriate circumstances would not only be a dereliction of duty to HBOS
but could also lead to personal disciplinary action against the incumbent by the FSA.
3.3 It follows that there is a natural tension between the need to raise legitimate challenge on the
one hand, and the likely reaction of those individuals who are the subject of the challenge. There is
also the risk that the individual who raises the challenge will be criticised for the style or tone of the
challenge.

3.4 During my period as Head of GRR at HBOS, at the beginning of 2004 the regulatory risk
profile of HBOS was higher than it had ever been; and higher than the Board’s appetite for such risk
should have been. By November 2003, the FSA had assessed key parts of the Group as posing high or
medium-high risks to the achievement of its statutory objectives of maintaining market confidence
and protecting consumers. They wrote that they were concerned that “…the risk posed by the HBOS
Group to the FSA's four regulatory objectives is higher than it was perceived”.

3.5 The FSA also wrote in relation to the Halifax (called “Retail”) “There has been evidence that
development of the control function in Retail Division has not kept pace with the increasingly sales
driven operation…” and “There is a risk that the balance of experience amongst senior management
could lead to a culture which is overly sales focused and gives inadequate priority to risk issues.”

3.6 My operating plan for GRR was accepted by the Group Audit Committee and the FSA. That
stated that there were three prerequisites for success. These were:
• “The strength, depth and quality of our relationships and communications with the FSA. This
requires much more work so that all the requisite parts of the group are working in harmony, with
one strategy and a completely different level of coordination….”

• “The credibility of Group Risk functions operating as a truly effective second line of defence. This
depends on the standards and policies they set, the depth and quality of the oversight they
perform and the strength of the relationships they have which allow them to provide functional
and technical leadership. But even more important, it will depend crucially on the FSA’s
confidence in this work.”

• “The demonstrable and enthusiastic engagement of the operating divisions in the work carried
out by Group Risk functions.”

3.7 It is impossible and would be inappropriate in this memorandum of evidence to set out more
than the very briefest summary of the evidence of what happened during that period. It was a very
48
busy time and the facts are very complex. Our focus was specifically to improve the regulatory
standards and policies of the Bank and increase the depth and quality of the oversight my department
performed. In particular we focused our attention on compliance with the FSA’a first three Principles
for Business. i.e.

1 Integrity A firm must conduct its business with integrity.

2 Skill, care and A firm must conduct its business with due skill, care and diligence.
diligence

3 Management and A firm must take reasonable care to organise and control its affairs responsibly and effectively, with
control adequate risk management systems.

3.8 Suffice to say that given the circumstances, I was obliged to raise numerous issues of actual or
potential breach of FSA regulations and had to challenge unacceptable practices and the conduct of
others in fulfilling their obligations under the Principles for Approved Persons including very senior
executives. Understandably and however hard we tried to be polite, fair, and evidential, the work we
carried out was bound to upset some people. It was inevitable.
3.9 Just to give a flavour of some of the key facts but without providing all the supporting
corroborative documentation, I can testify as follows:-
3.10 My team and I experienced threatening behaviours by executives when carrying out its
legitimate role, in overseeing their compliance with FSA regulations. At this point I would just like to
quote from an email I sent to Mike Ellis the CFO in June of 2004 which gives a flavour of the culture
with which we had to contend in carrying out our legitimate (and required) oversight activities:-

Mike,
We have spoken at some length this morning on this and more generally about the current issues in
dealing with Retail. We really do have to do something...and you may wish to lead this...to change the
whole tone of engagement. This is not a battle of wits but a joint attempt to do what is right for the
organisation. Yes, now that people with a huge amount of external experience are now accountable in
GRR for oversight, it is not surprising that the level of enquiry is going to be more detailed - that is to
be expected...and actually welcomed.

Some behaviours are going to need to change, particularly the sentiment that constantly questions the
competence and intentions of GRR carrying out its formal accountabilities for oversight plus the ever
present need to be able to prove beyond reasonable doubt as if we were operating in a formal judicial
environment. The more we adopt this approach, the more adversarial it all becomes, the more
emotional it becomes, the more personal it becomes and the worse the relationship becomes. It
becomes a vicious circle which needs to be broken. We need you and Andy [Hornby] to intervene
here to create a watershed here so we can move on from the issues of the past (from which we can
learn but not blame) to the brave new world of the future. Actually, the responsibilities for getting into
the current position are held all around the organisation and not just in Retail...and I include Group
Risk functions in this. What would be absolutely fatal would be if there was ever a perception - explicit
or implicit - that different parts of GF&R took different views. Then you get the "divide and rule"
happening. We must all be as one and communicate as such.

We will get there but there will also be some pain in the process of change.

Paul”

3.11 The CFO to whom I reported failed constantly to provide adequate support when issues arose.

3.12 He strongly reprimanded me for suggesting at a Group Audit Committee that a person with
my role should be protected by having a direct reporting line to the non-executive in case they had to
raise criticisms of the executive.

49
3.13 He (along with others apparently) strongly reprimanded for raising issues relating to a
“cultural indisposition to challenge within certain parts of the firm” when reporting to the Group
Audit Committee. I said - “I would not want the Committee to be under any illusion as to how strong
the tensions were as GRR carried out its oversight work and I have to say that there have been some
behaviours which I would consider to be unacceptable.” The KPMG Audit Partner told someone who
reported back to me that he thought I had a “death wish” following this meeting.

3.14 The Company Secretary failed to minute crucial comments I made at a formal Board Meeting
which I attended to report on a detailed review that Group Regulatory Risk had carried out to
determine whether the sales culture at HBOS had got out of control. It had. The minute should have
read

“That from a strategic perspective, very careful consideration should be given [by the Board] in the
development of Retail’s operating and strategic plans as to exactly what level of sales growth is
achievable, given current capacity, without putting customers and colleagues at risk.”

When I raised this with the CFO he suggested in writing that I would be wrong to request an
amendment. He wrote:-
Paul,
HBOS minutes are not a record of verbatim comments as this would be incredibly time consuming
and repeat a lot of what is in the agenda papers and, therefore, a matter of record. We encourage
open discussion at meetings and wouldn't wish people to be speaking - just for the record. If there is
something important that is said and not covered in documents of record - then it should be minuted -
but I thought that the Board minute was OK. You should be under no doubt that we do and always
will adopt proper procedure. I can't comment on the Retail RCC as I wasn't there.
If you have concerns, I suggest that you discuss the same with the Company Secretary (ie Harry
Baines not his secretary Pamela) who can advise you more fully on the minuting process. The Board
minutes for July were approved at the September meeting.

3.15 I was strongly reprimanded by the CFO for tabling at a Group Audit Committee meeting the
full version of a critical report by my department making it clear that the systems and controls, risk
management and compliance were inadequate in the Halifax to control its “over-eager” sales culture.
Mysteriously, this had been left out of the papers even though I had sent it to the secretary. When I
sent it out as a late paper to the distribution list for the Group Audit Committee papers, he wrote as
follows:-

Paul,
This really looks bad and just look at the circulation list! There was no need to attach the appendices
to your report in the first instance as they have already been seen/made available to all Board
members. But if you were going to do so we ought to have got it right. People will be wondering why
we are circulating separately a document they've already seen - its looks like we're making an issue of
it when we're not.

3.16 I was making an issue of it! The Chairman of the Group Audit Committee thanked me for
tabling the full version of the report and said that he now understood how serious the issues were.

3.17 As I have said, it is not surprising with all the difficulties that there were going to be people
who would be upset. In a sense, the very nature of challenge is this and openness to challenge is a
critical cultural necessity for good risk management and compliance – it is in fact more important
than any framework or set of processes.
3.18 Notwithstanding the difficulties we had faced, Group Regulatory Risk received excellent
feedback from almost all quarters for the work it had done including:-

50
• The FSA were positive and said on 26 November 2004, “Our relationships with GRR in particular
have been good…We are quite comfortable to rely on GRR…and that is the real test”.

• Mr Tony Hobson the Chairman of Group Audit Committee said in November 2004 that he could
not “believe the turn-around in our relationships with the FSA”.

• MORI reported that the major organisational change in GRR had been effected highly
successfully.

• PwC concluded in a report on the effectiveness of risk management at HBOS that “We have been
impressed with the limited number of senior personnel that we have interviewed in GRR”. I was
amongst those they met.

• On 30 November 2004, another main Board Director wrote “An excellent year all round building
on a similar result in 2003.” On 30 November 2004, Mr Tony Hobson added to this, “Thanks for
the opportunity to contribute and to see your views [on GRR]. Very helpful. It’s obviously very
positive feedback for Paul and the team and I can only reiterate your positive views.”

3.19 Notwithstanding the positive feedback, as explained in section 2 above I was then summarily
dismissed (portrayed as “redundancy”). James (now Sir) Crosby, the then CEO of HBOS contrary to
HR policy, HBOS’s own internal ethics policy called “The Way We Do Business” as well as all other
principles of fairness (let alone employment law) wrote - “The decision was mine and mine alone”.
He said that I had lost the confidence of key executives and non executives but refused to
explain why. I claimed that my dismissal was unfair and that I had a claim both for unfair dismissal
and for a claim under s.48 of the Employment Rights Act 1996. In other words, I had a “whistle-
blowing claim” under that Act for raising Protected Disclosures.

3.20 HBOS finally settled my claim against them for substantial damages in mid 2005 and I signed
a gagging order at the time in our settlement agreement.

3.21 As I stated above in section 2 above, a supposedly “independent report” by HBOS’s auditors
said HBOS were right but failed even to interview key witnesses. No doubt they and the FSA would
rely upon this report. In relation to this report, you should be aware that, following the very first
response to the report from my lawyers and me which challenged it vigorously, HBOS settled within a
very short time.

3.22 As referred to in section 2 above, on my unfair dismissal a person was appointed as Group
Risk Director who was an ex sales manager who had no experience of risk management or
compliance. I have already referred to this in some more detail in section 2 above. This was a personal
appointment of James Crosby and some might question whether this fulfilled his fiduciary duties as a
Director under Company Law or Principle 2 and 3 of the FSA’s Principles for Business set out above.

3.23 My concerns on this appointment were reported to the FSA but despite the clarity of their
guidance on assessing fit and properness (see section 2 above) they permitted the individual
concerned to become an Approved Person. It is extraordinary in my view that the FSA permitted this,
when this role is so important to the fulfilment of their statutory objectives. Maybe they felt
constrained as James Crosby was a non executive director of the FSA at the time?

51
3.24 One final interesting but telling anecdote of my personal story relates to Charles Dunstone
(founder of the Car Phone Warehouse). Charles was a non-exec director of HBOS which made good
sense given their strategy of turning the bank into a retailing operation. He is clearly an outstanding
business leader. But, strangely, he was also appointed to be the Chairman of the Retail (Halifax) Risk
Control Committee (a divisional audit committee). He admitted to me that he was very friendly with
Andy Hornby and that they met quite often socially. Of course, he was supposed to be challenging
Andy Hornby. He obviously had no technical competence in banking or credit risk management to
oversee such a vital governance committee. Another HBOS non-exec said to me one day of him and
his role “Well, they got that appointment wrong, didn’t they”. Even more extraordinary than this,
Charles Dunstone himself admitted to me and my colleague one day words to the effect that he had no
real idea how to be the Chairman of the Retail Risk Control Committee!

3.25 This just shows how little real regard HBOS had for the importance of the non-executive
roles. It is also probably in breach of Principles 2 and 3.

4. Some recommendations for policy analysis and development

4.1 A very short summary (and not yet fully thought through) of the list of some of the policy
points which arise out of my experience which need to be debated are as follows:
4.2 Remuneration and performance management of exec...e.g. regulatory sign off, bonuses held in
a trustee account over longer time frames to ensure short termism does not take hold
4.3 A more detailed policy and rules which allows the FSA to test the cultural environment of
organisations they are supervising e.g. tri-annual staff and customer survey. There is no doubt that
you can have the best governance processes in the world but if they are carried out in a culture of
greed, unethical behaviour and indisposition to challenge, they will fail. I would now propose
mandatory ethics training for all senior managers and a system of monitoring the ethical
considerations of key policy and strategy decisions within the supervised firms.
4.4 Much more formal qualifications and competencies for risk managers and compliance
professionals so that only fit, proper and competent people can be appointed as CF10, CF11 and 14 –
Compliance Oversight, Anti-Money Laundering and Risk Assessment. These roles are becoming as
important as CFO role and need something like the ICA / Institute of Actuaries to regulate their
training and competence.
4.5 Regular formal independent audit of risk management, compliance and internal audit
functions to keep them honest – and to make them feel they will be backed up / protected if they do
their jobs properly and cause a bit of inevitable friction.
4.6 Risk management and compliance with at least an equally weighted reporting line to a non-
exec with sufficient time and profile to balance the executive. The non executive need to be
“executive” in relation to their primary accountability of overseeing the executive. No person
responsible for a key internal control function can be dismissed without a full and minuted meeting of
the non-exec and the incumbent must be given a right of reply. The FSA should formally approve
such decisions.
4.7 Much much more focus on competence and independence of non-executives e.g. register of
non-work social meetings, pre-appointment investigation of “links” / potential conflicts of interest e.g.
cross-board connections..I’m on your remuneration committee if you’re on my audit committee, pre-
appointment record of reasons why a person is competent for a particular committee.
52
4.7 Much more involvement of the regulators in the terms of reference of the statutory auditors –
the level of cost associated with formal independent audit is inadequate and needs to be radically
increased. How can a firm like HBOS be audited for £5m or less?
4.8 Much more rigorous and prescription of the regulation of affordability and suitability
requirements for the sale of credit products...to prevent ordinary people who cannot resist the
temptation of getting into excessive debt.
4.9 Further development of Whistle Blowing rules to make sure that those who raise legitimate
issues are not just “bought off” with shareholders money....the case should be reviewed by the
regulator and action taken if necessary to ensure those responsible cannot get away scot-free.
4.10 Much much better pay for senior regulators so that the FSA can recruit the best – pay twice as
much, get four times as much done at eight times the quality.

5. A final observation
5.1 One final observation I would make about the HBOS disaster is this; wasn’t it actually Sir
James Crosby rather than Andy Hornby who was the original architect of the HBOS retailing strategy?
At first this was good in that it purported to be a “Customer Champion” strategy. The problem was
that a reduced margin strategy is predicated on the need for improvements in cost control and at the
same time massive increases in sales. It is now clear that this disastrous “grow assets at all costs”
strategy was what led to HBOS’s downfall and humiliating demise by the forced acquisition by Lloyds.

5.2 Sir James is still the Deputy Chairman of the FSA and advises the government on how to solve
the mortgage crisis. Some might now also question what his “contribution to financial services” has in
fact been when this will have led to millions of people in excessive debt, 10,000s who will lose their
jobs and many more whose balance sheets have been impacted by the precipitous fall of the HBOS
share price – apart from the reduction in competition in the retail financial services market threatened
by the new Lloyds Group?

5.3 Shouldn’t the Committee be asking him to testify?

February 2009

53
 Further memorandum from Professor Prem Sikka, University of Essex

At the Committee’s meeting on 28 January 2009 there was some discussion of auditor
obligations. The response from some members of the panel was that examining business
models was no part of auditor’s duties. This is somewhat misleading and I would like add a
few comments.

Auditor duties are not defined in any great detail in the Companies Act 2006. Section 495
states that the auditor’s report

“must state clearly whether, in the auditor’s opinion, the annual

accounts—
(a) give a true and fair view—
(i) in the case of an individual balance sheet, of the state of affairs
of the company as at the end of the financial year,
(ii) in the case of an individual profit and loss account, of the profit
or loss of the company for the financial year,
(iii) in the case of group accounts, of the state of affairs as at the end
of the financial year and of the profit or loss for the financial
year of the undertakings included in the consolidation as a
whole, so far as concerns members of the company;
(b) have been properly prepared in accordance with the relevant financial
reporting framework; and

‘True and fair view’ is open to interpretation.

Accounting standards provide the framework for financial reporting. The ‘Statement of
Principles11’ issued by the Accounting Standards Board (ASB) states (Chapter 1) that the

“The objective of financial statements is to provide information about the reporting

entity’s financial performance and financial position that is useful to a wide range of
users for assessing the stewardship of the entity’s management and for making
economic decisions.

It adds (Ch 1, p. 19) that

Present and potential investors need information about the reporting entity’s financial
performance and financial position that is useful to them in evaluating the entity’s
ability to generate cash (including the timing and certainty of its generation) and in
assessing the entity’s financial adaptability.

Subsequently it states (p. 25) that

11
http://www.frc.org.uk/images/uploaded/documents/Statement%20-
%20Statement%20of%20Principles%20for%20Financial%20Reporting.pdf
54
 Investors require information on financial performance because such information:
(a) provides an account of the stewardship of management and is useful in assessing
the past and anticipated performance of the entity;
(b) is useful in assessing the entity’s capacity to generate cash flows from its existing
resource base and in forming judgements about the effectiveness with which the entity
has employed its resources and might employ additional resources; and
(c) provides feedback on previous assessments of financial performance and can
therefore assist users in modifying their assessments for, or in developing expectations
about, future
periods.

Accounting standards are primarily aimed at preparers of financial statements, but auditors
cannot ignore them because the Companies Acts require them to report compliance. That
task cannot be completed without an understanding of the business model and inherent risks
because it shapes any measure of financial performance and financial position.

A pile of ornate wood in a junk yard is unlikely to be worth a great deal of money. But the
same in an art gallery or an auction house would justify entirely different value. Without
appreciating the nature of the business, auditors cannot make a meaningful assessment of the
amounts appearing in financial statements.

Auditors are required to satisfy themselves that the reporting entity is a going concern, which
may be interpreted as ‘twelve months from the balance sheet date’. Auditing standards have
long been used to narrow auditor responsibilities and encourage auditors to be ‘passive12’
because that is economical of audit effort and enhances firm profits.

It has long been established that auditors should approach each audit with an ‘inquiring
mind. In his judgement in the case of Fomento (Sterling Area) Ltd. v Selsdon Fountain Pen
Co Ltd [1958] 1 All ER11 at 23, Lord Denning said that

“An auditor is not to be confined to the mechanics of checking vouchers and making
arithmetic computations. He is not to be written off as a professional “adder-upper
and subtractor”. His vital task is to take care to see that errors are not made, be they
errors of computation, or errors of omission or commission, or downright untruths.
To perform his task properly, he must come to it with an inquiring mind – not
suspicious of dishonestly, I agree – but suspecting that someone may have made a
mistake somewhere and that a check must be made to ensure that there has been
none”.

12
Prem Sikka, "Audit Policy-making in the UK: The Case of "The auditor's considerations in
respect of going concern", European Accounting Review, Vol. 1, No. 2, 1992, pp. 349-392.
55
I would submit that auditors merely relying upon management representations are not
meeting the ‘inquiring mind’ standard. This standard requires auditors to understand the
nature of the business and its risks.

Auditors often seek refuge in auditing standards without pointing out that they are
formulated by committees and structures controlled by the industry itself. The UK auditing
standard on going concern13 advises auditors to be ‘passive’ i.e. not plan the audit to look for
any specific problems. For example, page 21 states that

“… when there is a history of profitable operations and a ready access to financial

resources, management may make its [going concern] assessment without detailed
analysis. In such circumstances, the auditor’s conclusions about the appropriateness
of this assessment normally is also made without the need for performing detailed
procedures. When events or conditions have been identified which may cast
significant doubt about the entity’s ability to continue as a going concern, however,
the auditor performs additional procedures …”.

Under the auditing standard, auditor might perform additional procedures only when put
upon inquiry, but offers no justification as to why the auditor needs to be ‘passive’ in the first
place and why bank auditors did not learn anything from the recent financial banking
problems. Once put upon inquiry the ‘going concern’14 auditing standard states (paras 11-12)
that

“in obtaining an understanding of the entity, the auditor should consider whether
there are events or conditions and related business risks which may cast significant
doubt on the entity’s ability to continue as a going concern. … The auditor should
remain alert for audit evidence of events or conditions and related business risks
which may cast significant doubt on the entity’s ability to continue as a going concern
…”

The auditing standard requires auditors to examine company cash flow, profit and other
forecasts, if any. It is difficult to see how any such document can be understood or examined
in any meaningful way without a good understanding of the nature of business and its risks.

Overall, my contention is that it is difficult to see how auditors can make any meaningful
assessment of risks without understanding the business model of the client company and the
structure of its main assets and liabilities. Any auditor just relying on management assertions
and claims would be negligent.
February 2009

13
http://www.frc.org.uk/images/uploaded/documents/ACFAB2.pdf
14
Auditing Practices Board (2004). International Standard on Auditing (UK and Ireland) 570:
Going Concern. London: APB (available at
(http://www.frc.org.uk/images/uploaded/documents/ACFAB2.pdf ).
56
 Memorandum from InvestorVoice

InvestorVoice (www.investorvoice.co.uk) is a forum established for individual stakeholders

in publicly quoted companies. It has been created to ensure that shareholders, debt holders,
employees, pensioners and other interested individuals are able to express their anonymous
views on the performance of the companies in which they have a financial interest. The
forum’s initial focus has been on financial institutions, corporate governance and institutional
shareholder engagement.

We have been following with interest the Treasury Committee's deliberations on the
"Banking Crisis" and indeed the United States of America's House Committee - Oversight
and Government Reform hearings on this issue.

Institutional Investors
There has been much finger pointing and blame allocation surrounding the crisis including
excessive leverage, rating agency failure, inappropriate incentive schemes, poor risk
management, poor Board oversight and executive hubris. However, in our opinion, one area
that has not been highlighted is the poor corporate governance that has been displayed by the
institutional shareholder community and to date it has escaped much investigation and
criticism. The Combined Code describes the responsibilities of institutional shareholders.
Considering the part and full nationalisation of a number of our banks, the concern over
compensation schemes, the replacement of many board directors and the reversal of business
strategies, it is difficult to believe that institutional shareholders have fully adhered to their
obligations under the Code.

Institutional shareholders had control over 90% of the equity of the United Kingdom's
financial institutions and as a result had the ability to influence executive compensation plans,
strategy, risk taking, corporate governance and board appointments. Our analysis of the
voting at Annual General Meetings on these issues indicates that in most cases, institutional
investors have voted with management, with most resolutions being passed by 95+% of the
votes. In general, it has been the private shareholders who have queried board appointments,
strategic issues, executive compensation plans and risk management.

We have chosen two examples to demonstrate our point. First, in August 2007, when
analysts and the financial press were expressing concern about the Royal Bank of Scotland's
proposed acquisition of ABN Amro, the transaction was approved by 94.5% of the
shareholder votes. Second, in May 2008, HSBC shareholders voted 88.4% in favour of the
proposed executive compensation plans which enabled executives to receive an additional
950% in compensation over their base pay. The high level of approval was achieved even
after PIRC and the Association of British Insurers both publicly expressed concerns over the
plans. There are a significant number of other examples which we could provide.

Mandatory Disclosure of Voting

One initiative that would improve the focus of institutional investors on corporate governance
is the introduction of mandatory disclosure by institutional investors of their voting on
shareholder resolutions for all UK listed companies. Such legislation does exist in other
countries. At present, it is voluntary in the UK and the majority of fund managers do not
publish such information.

Two other initiatives that could also assist in improving corporate governance are:

Director Re-election
57
We would also support the Association of British Insurer's recommendation to have all
directors submit themselves for re-election at the Annual General Meeting. At present,
directors stand for re-election on a rotational basis with the norm being every three years. We
hold that it is inappropriate for shareholders to be forced to stand back for a period of up to
three years before they are able to remove their representatives in whom they have lost
confidence.

Board Evaluation
In addition, we would propose the strengthening of the Combined Code's provision on
Performance Evaluation. At present, listed companies are required to evaluate the
effectiveness of their board, its committees and its directors. However, many companies self-
assess and provide little detail of the assessment in the annual report and accounts.
Consideration should be given to providing more prescriptive requirements on both the
conducting and reporting of the evaluation.

Further memorandum from InvestorVoice

1.6 Potential reforms to the remuneration structures prevalent in financial services.

1. 0 Senior Executive Compensation

In the majority of organisations, senior executive compensation is determined by the
Remuneration Committee. Much of the research into determining compensation and
compensation schemes for a company is provided by Remuneration Consultants. These
consultants are usually selected by senior executives within the company. The senior
executives have a vested interest in choosing a consultant whom they believe will recommend
the most attractive scheme.

Additionally, Remuneration Consultants have a vested interest in proposing schemes that will
enable executives to increase their overall compensation. We are not aware of any
Remuneration Consultant who has recommended a decrease in senior executive
compensation.

Executive management advise the remuneration consultants in determining a peer group of

companies for market comparison. Our research shows an increasing trend for UK
companies to include United States companies in the peer groups selected. However, very
few US companies include a UK company in their peer group.

Once the Remuneration Committee has agreed the new compensation scheme, the company
will then discuss it with their largest institutional investors and possibly also with corporate
governance firms. The scheme is then put to an advisory vote at the company’s Annual
General Meeting (AGM).

The advisory vote on executive compensation at the 2008 AGM of every UK bank was “For”
approving the Remuneration Report. Over 88% of the votes were in favour of the schemes.

58
We provide one example for consideration. In May 2008, even after a) much media
criticism, b) a recommendation of a vote against the “excessive” plan by the corporate
governance firm PIRC and c) the issuance of an “Amber Top” warning by the Association of
British Insurers, one UK bank still received an 88% vote in favour of the proposed new senior
executive compensation scheme. The approved scheme enables the top five executives to
share a total compensation of £125 million over a three year period, (average £8.33 million
per executive/per annum).

At the time of the bank’s AGM, 11,829 million shares were eligible to be voted, 4,359 million
(36%) were voted of which 328 million shares voted “Withheld”, 910 institutions controlled
10,800 million (91%) shares. Based on these figures, at least 60% of the institutional
shareholders’ votes were not voted.

The above highlights significant weaknesses through out the process. To address these
weaknesses, we would recommend consideration of the following:

• Remuneration consultants should be selected by and report only to the Remuneration

Committee.

• The Remuneration consultants’ industry should establish a code of ethics. The code should
include a ban on recruitment organisations from undertaking remuneration consultancy.

• It should be mandatory for institutional shareholders to publish how they have voted on all
resolutions submitted to vote at the AGM of UK listed companies.

• UK institutional shareholders should be encouraged to vote on all AGM resolutions.

1.2 Remuneration Structures in the Financial Services Industry – Bonuses

The fundamental purpose of the remuneration system is to assist in attracting and retaining
talented executives. The remuneration structure should be supported by other systems to
encourage loyalty to the employer. Unfortunately, these other systems tend to be weaker in
investment banking. This is partly to do with the competition by investment banks for the
best talent and also, but to a much lesser degree, the over exaggerated “perform or be fired”
culture in the industry. Previous evidence given to the committee estimated that employee
turnover in investment banking is 25% per annum. We estimate that, in “normal market
conditions”, at least 15% of individuals depart one firm to earn more compensation at
another, leaving 10% departing for performance management purposes – i.e., “being fired”.

The crucial issue in this sector concerns bonus payments and payment received for non-
performance. In general, bonuses were established to enable salaries to be kept “low” and then
reward high performance with bonuses. However, basic salaries are still regarded as
considerable when compared with other sectors of the economy. Bonuses for investment
bankers can be exceptionally large, even multiples of the executive directors.

59
Bonuses are paid generally in relation to the profits generated. Profits are calculated on a
realised and unrealised basis as at period-end. Unrealised profits are determined by valuing
positions at market value as reported by the market or an exchange. The problem arises when
positions are valued at market at period end and a large profit is determined and bonuses are
paid but in the next period, the values fall and losses arise. The bonus has already been paid
and there are no “claw-back” provisions in employment contracts. The process rewards
success but does not penalize subsequent failure. This will strongly encourage risk taking.

The losses at the main investment banks at the end of 2008 were caused by substantial falls in
the “mark to market” valuations of trading and structured assets or by realised losses as the
firms attempted to deleverage, pushing market values down further.

• Shareholders should demand that all bonus payments should have a “claw-back” option.

• It should be mandatory for companies to state the ten largest compensation payments to non-
director employees in the Annual Report.

Other Areas of concern

2.0 Board Performance Evaluation

The Combined Code of Corporate Governance, (the Combined Code), requires that
companies should assess the performance of their Board, its committees and its individual
members on an annual basis. This was done by all of the UK nationalised and part-
nationalised financial institutions. Each institution reported in their Annual Report that its
board, committees and individual members had been effective.

It is difficult to see how such an assessment could be valid, when all the Boards have required
significant restructuring. One institution dismissed ten of its directors, including its
Chairman and CEO, within a year of determining that they were all deemed effective. The
performance evaluation was a self-assessment.

The above highlights significant weaknesses through out the process. To address these
weaknesses, we would recommend consideration of the following:

• Board Performance Evaluation should be conducted by external parties.

• The Financial Services Authority (FSA) should review the full Board Performance Evaluation
of each UK listed financial institutions in detail and discuss the findings with the Senior
Independent Director.

• The Combined Code should be more prescriptive on the disclosure of Board Performance
Evaluation information to be published in Annual Report.

60
3.0 Institutional Shareholder Engagement

The Combined Code states that institutional shareholders should apply the principles set out
in the Institutional Shareholders’ Committee’s ‘‘The Responsibilities of Institutional
Shareholders and Agents – Statement of Principles’.

The principles include the following:

“Instances when institutional shareholders and/or agents may want to intervene

include when they have concerns about:
• the company’s strategy;
• the company’s operational performance;
• the company’s acquisition/disposal strategy;
• independent directors failing to hold executive management properly to account;
• internal controls failing;
• inadequate succession planning;
• an unjustifiable failure to comply with the Combined Code;
• inappropriate remuneration levels/incentive packages/severance packages; and
• the company’s approach to corporate social responsibility.”

The principles also include a range of actions that institutional shareholders may take, if they
are unsatisfied with a company’s response:

“holding additional meetings with management specifically to discuss concerns;

• expressing concern through the company’s advisers;
• meeting with the Chairman, senior independent director, or with all independent directors;
• intervening jointly with other institutions on particular issues;
• making a public statement in advance of the AGM or an EGM;
• submitting resolutions at shareholders’ meetings;
and
• requisitioning an EGM, possibly to change the board.”

Whilst a number of institutional shareholders have stated that they have engaged with bank
boards on a number of occasions, it appears that none have utilised the fool range of available
actions.

The above highlights significant weaknesses through out the process. To address these
weaknesses, we would recommend consideration of the following:

• The Combined Code should be more prescriptive on institutional shareholder engagement

with companies.

• Institutional shareholders should publish details of engagements with companies in the past
three months on their website.

February 2009
61
62
 Memorandum from Mr Michael McQuade

1. Confidentiality
1.1. I am more than happy that any information or opinions that I give in this submission
remain in the public domain however I would ask that my personal contact details
should not be published and should remain confidential as I have no wish to be
inundated with spam emails or unsolicited telephone calls.

2. About Michael Douglas McQuade

2.1. I am a retired bank manager. In 1964 I joined the Leicester Trustee Savings Bank and
in 1975 I was appointed manager of the TSB in Lutterworth, Leicestershire. At that
time I was the youngest appointed lending manager. (TSB had just begun to lend to
its customers). During my career I managed a number of branches then was
appointed to an Area role. When I was forced into early retirement in 2001, by Lloyds
TSB Bank plc, I was working on various projects including Complaint Handling and
Telephony. I was a Director of the Lloyds TSB No 2 Pension Fund. During my time at
the bank I achieved a number of notable successes:
2.1.1. – I saved the bank £6 million per year (every year) in cash management
2.1.2. – I saved the bank from being fined by the FSA for untimely management of
investment proposals.
2.1.3. – I lent more money on mortgage from my branch in Leicestershire than the
whole of the other branches in the County put together.
2.1.4. – My bad debt record was exemplary.
2.1.5. – I wrote the chapter in the Bank Lending Manual that dealt with Overdraft
Reviews.
2.1.6. – I designed an Objective Based Appraisal System used to support
Performance Related Pay and introduced it across the TSB national branch
network.
2.1.7. – I was the first branch manager to sell £1 million of life insurance cover.

3. Summary of the main points of this submission

I would like the Committee to consider my views on:
• Professionalism in banking
• Historic regulation in the mortgage market
• Effects of de-regulation
• The mortgage borrower
• TSB and Building Societies as Public Limited Companies
• Who Pays the Price

63
3.1. Professionalism in banking
3.1.1. When I started my career in banking it was made clear to me that if I expected
to progress toward an appointment then the minimum standard that I would
need to achieve was to become an Associate of the Institute of Bankers, now the
Chartered Institute of Bankers. I studied General Principles of Law including,
sources of law, contract and tort. I studied Principles of Accounting so that I
could understand company accounts, total and marginal costing, budgetary
control and investment appraisal.
3.1.2. Today bank staff are encouraged to study for the Financial Planning
Certificate to enable them to sell insurance products. Bank staff are encouraged
to be licensed to sell home insurance, car insurance, mortgages, life insurance
and pensions. Professional banking qualifications are very low on the priority
list. Proof? Ask the Chartered Institute of Bankers for the statistics of UK ‘ACIB’
award made over the last 25 years and look at the trend line.
3.1.3. We cannot expect our front line banking staff to offer professional advice to
help customers manage their business and personal finances when they have a
sales biased education and the focus of bank ‘Customer Service’ is based upon
selling bank products.

3.2. The Page Report

3.2.1. Around 1976 a government commission looked into the future of the TSB and
banking in Great Britain. The findings were published as The Page Report. This
report proposed that:

(1) – The joint stock banks, then the Big 5, Barclays, National Provincial,
Westminster, Lloyds and Midland should concentrate on serving the commercial
customer.

(2) – The TSB should be developed to service the banking needs of the general
public.

(3) – The Post Office Savings Bank should be developed to service the personal
banking needs of those people who lived in areas where it was uneconomic for
banks to operate.
3.2.2. The report was ignored.
3.2.3. The bank branch network has been destroyed, profit before service left many
without easy access to personal banking services.

3.3. Historic regulation in the mortgage market

3.3.1. In 1973 I bought my first house, a terraced house in Leicester. To obtain a
mortgage I had to have saved regularly with a building society and built up a
deposit in my account.

64
 3.3.2. Saving regularly had two purposes, (1) to build the deposit and (2) to prove to
the building society that I could regularly put on one side a sum of money and
still maintain a standard of living.
3.3.3. In 1973 only building societies were allowed to lend money over 25 years for
house purchase. Bank lending did not extend beyond 10 years and the rates
charged were significantly higher than those charged by building societies.
3.3.4. Tax relief was available on building society mortgage interest.
3.3.5. Building society mortgages were only available for the purchase of the
borrower’s principle place of residence.
3.3.6. Building society mortgages were not available for the purchase of second
homes or houses in the rental sector.
3.3.7. Building society mortgages were in short supply and prospective borrowers
often had to wait their turn.
3.3.8. The buying of houses to rent was considered a business enterprise and
borrowers were directed to the banks for a commercial loan. Bankers in those
days considered lending in proportion to the borrowers stake in the enterprise.
Buying houses to rent required the borrower to use their own money and the
bank lent in multiples of the borrowers stake, double nothing was nothing! The
bank held the deeds as security. The loan to value ratio never went above 70% of
the value of the property and this valuation was taken not on the open market
freehold value but on a 7 – 10 year return on rent. The repayment period rarely
reached 10 years.
3.3.9. In every case where I lent money to a customer I always looked for two things,
an intention to repay and an ability to repay. The first I covered by looking at the
borrowers banking history and checking with a credit reference agency and the
second I covered by completing an income and expenditure account. If the
borrower proposed to take on the commitment to repay a given sum each month
and he or she had not been saving that same sum over at least the previous six
months, where was the repayment coming from? What was to be given up? Was
that reasonable? Following these principles my lending was sound but more
importantly my customers never entered into commitments that they could not
afford.

3.4. Effects of de-regulation

3.4.1. During the 1980’s the government of the day pursued a policy of a free market
economy. De-regulate the market place and allow competition to drive out
inefficiencies and allow the market to find its own level.
3.4.2. Building societies were allowed to borrow money from the wholesale market
and make it available for mortgage borrowers. Borrow short and lend long! Not a
sound business philosophy, totally dependent upon the continuing supply of
short term wholesale funds. The experience of 2007 proves this point.

65
3.4.3. Banks were allowed to lend money for house purchase on mortgage loans over
25 years.
3.4.4. The sudden free availability of mortgage funds across the market place
initiated the housing boom. With freely available funds and more buyers in the
market competing for a limited supply of houses the market responded like any
other market, the price went up. This deregulation of mortgage lending was a
major cause of the boom in property prices in the last quarter of the last century.
3.4.5. With building societies having endless capital to lend and the banks entering
the market bringing their massive lending capacity, there were insufficient
borrowers able to take up the supply of money to buy principal places of
residence. The banks and building societies had to become inventive in lending.
Lending on house purchase was seen as low risk, “Safe as Houses”!
3.4.6. Tax relief on mortgage interest is withdrawn.
3.4.7. The effect of tax relief being withdrawn and the inexhaustible supply of
money meant that the loan purpose was no longer restricted to buying the
borrowers principle place of residence. Banks and building societies fell over
themselves to refinance each others mortgage lending to provide the borrower
with fund to buy anything. One recent TV advert showed an obese couple sitting
on a sofa saying that XYZ Finance Company made it very easy for them to
refinance their mortgage over 300 easy monthly payments so that they could
have a new kitchen and there was enough money left over to go on holiday.
This couple had borrowed money for a two week holiday and were paying for it
over 25 years!
3.4.8. Deregulating the finance market gave rise to lenders advertising to encourage
the general public to “free the equity in your home”. Again, questionable. Equity
was not freed from the home, the home remained exactly as before, the borrower
was encouraged to become deeper in debt.
3.4.9. Excess funds to lend, a booming property market and minimal regulation led
the mortgage lenders to offer ‘non-status’ mortgages. Instead of the lender
confirming the income of the borrower and lending in proportion to it, the
prospective borrower simply stated the amount of money he or she earned and
in exchange for paying a higher interest rate the stated income was taken on face
value and not confirmed. Some borrowers borrowed more than they could
sensibly afford to repay which was fine while both parties were fully employed
but became impossible when incomes reduced for whatever reason.
3.4.10. Not satisfied with offering ‘non-status’ mortgages, lenders now moved to
100% mortgage loans and these loans even covered carpets, white goods installed
by builders and also included stamp duty and solicitors fees! 100% lending meant
borrowers had no commitment of their own and hence nothing to protect when
the times became difficult.
3.4.11. Non-status mortgages and the booming property appealed to greed. Greedy
borrowers philosophy was to borrow maximum today, fund repayments from

66
 capital and either relax when real earnings caught up or else sell after a couple of
years and pocket the property capital appreciation.
3.4.12. Deregulation opened up buy to rent propositions. Buy a house and rent it
out. The rent covers the mortgage payment and the borrower uses the capital
appreciation to support further borrowing to buy more houses to rent. The effect
of this deregulation in university towns is that low priced housing is snapped up
by buy to rent landlords leaving first time buyers priced out of the market.

3.5. The mortgage borrower

3.5.1. Sadly we live in a consumer led society. The government today is actively
promoting initiatives to try to stimulate the retail economy. Consumers are
encouraged to consume and not to save. The general public want everything
today and are not content to wait and improve their standards of living over
time.
3.5.2. In 1973 I bought my first house, a terraced property. At that time my
expectation was to progress in my job to the point that I could afford to move to
a semi-detached property and then when my career developed to move to a
detached property. We started with hand-me-down furniture. We used the local
launderette to wash our clothes. Today instead of waiting until we can afford
improvements in our life style, they are bought on credit. There is no recognition
of financial management failure when mortgages are refinanced to provide
money to purchase cars and holidays.
3.5.3. The general public want all of the materialistic things that a retail economy
has to offer. Lenders have had too much money to lend and any lender who
adopts a regulatory or controlling policy like confirming income or completing
income and expenditure forms will soon lose lending to a competitor. In any
event in a booming economy what losses do occur are more than covered by the
profits from new business growth. That is, until there is no new business growth.
3.5.4. Most members of the general public have never had lessons in financial
management. School children are not interested in budgeting to pay the
electricity bill or the mortgage. These things are not real in their lives. My
children never turned off lights or ate the last slice of bread in the old loaf until
they started to pay the bill. The general public will not, of their own volition
draw up family budgets, they need stimulation at appropriate times to recognise
the importance of forward planning.
3.5.5. More people respond to greed than to need, indeed many salesmen’s sales
pitch appeals to greed and ignores need. Lenders and deregulation have done
nothing to reverse this trend. Lenders have actively appealed to greed to
encourage borrowers to remortgage their homes and buy consumer goods that
they do not need. I have need of a television set, my need is satisfied by my
existing set, it is a few years old and is digital. However, I am bombarded daily
with advertising coaxing me to buy a 42 inch plasma home theatre. Why? I do

67
 not need one and I cannot afford to buy one but if I borrowed on my credit card,
loan or mortgage I could have it today.
3.5.6. We are all naturally greedy people, some of us have self discipline, others,
however, need help.
3.5.7. Last year, post nationalisation, Northern Rock Building Society was criticised
for over zealous repossession. A borrower was shown on television standing
outside his home, that had just been repossessed. He was lamenting that he had
lived there for over 30 years and now it was gone. How could that be if he had
bought the house on a mortgage over 25 years? Clearly this man had
remortgaged his home to yield money to spend on things other than his home.
Who was to blame?

4. TSB and Building Societies as Public Limited Companies

4.1. In the 80’s the free market was everything. The Page Report had been rejected and the
government was on a path to privatisation. The Trustee Savings bank was an
anomaly, nobody owned it. The government wanted to see it privatised and
eventually the courts approved.
4.2. At floatation the Bank was worth £865 million. Floatation raised £1,000 million and
the whole of the share capital came back to the Bank. TSB Bank plc was worth £1,865
million on Day 1 and it had £1,000 million in cash in its bank and no concrete plans
to spend it.
4.3. Floatation may or may not have been a good idea but the reality of the situation was
that TSB management were steeped in TSB culture and background. They were not
hard faced commercial businessmen who had built successful business in a
challenging market place. Prior to floatation TSB was limited in its activities by acts
of parliament and its future was guaranteed by the Treasury/National Debt Office.
4.4. In British economic history here had never been, nor has been since, a company that
had £1,000 million cash to spend/invest. This frightening situation was made worse
by the Company not having grown this nest egg from its successful trading activities
but by its being given it almost as a windfall on a plate. The frightening situation was
made terrifying by the fact that the purse strings were in the hands of inexperienced
managers.
4.5. TSB bought Hill Samuel Bank for a price agreed before Black Monday. Following
stock market collapse on Black Monday the valuation of Hill Samuel fell but TSB
went ahead and bought Hill Samuel at the pre collapse price. The Bank then
expanded its commercial lending book and suffered great losses.
4.6. Within a few short years TSB had lost £1,000 million.
4.7. The TSB failure was not unique. Building societies rushed to privatisation as did the
nationalised industries. In all cases management of these organisations was swept
along by ‘group think’, the euphoria of the 80’s of deregulation and open market
freedoms. No thought was given to expertise to manage these new privatised

68
 companies. Is it any wonder that so many of the companies floated in the 80’s have
been taken over by other businesses?
4.8. When Peter Burt was Chief General Manager of Bank of Scotland, he had 5 criteria to
be considered before taking over another business:

1 - Will it prejudice the continued independence / existence of the Bank?

2 - Is it "community type" banking? That is, inside existing skill capabilities.
3 - Does it have a worthwhile share of a worthwhile market?
4 - What can we bring to the party in terms of competitive advantage?
5 - Does it make economic sense? We have long pockets but very short arms!

The second part of point 2 and the whole of point 4 are absolutely essential. In the
case of TSB, managing a public limited company worth nearly £2 million was outside
the skills of the TSB Board and senior management team. Investing £1,000 million
safely was clearly beyond their capability. They would have been better to have
invested in a Post Office Savings Account!

Clearly Bank of Scotland failed on Point 4, they had no capability to manage Halifax
Building Society. BOS did not have a highly successful mortgage operation, the
management of Halifax Building Society had managed to steer the privatised bank
into difficulty that required the BOS intervention and BOS had nothing to bring to
the party to shift the culture. Without a shift in culture more of the same will bring
about more of the same.
4.9. Abbey National and Alliance and Leicester have both suffered from enthusiastic
building society managers who do not have the experience to run multi million
pound companies.

5. Recommendations that you would like the committee to consider

5.1. Reregulate Mortgage Lending

5.1.1. As soon as possible introduce legislation to regulate lending. The maximum
period of borrowing should be limited to the life of the asset bought, e.g. house =
25 years, new car = 5 years, holiday = 1 year.
5.1.2. Limit mortgage lending to provide funds for house purchase only
5.1.3. Require borrowers to save deposits.
5.1.4. Set maximum loan to value limits, say 90%.
5.1.5. Prohibit ‘non-status’ mortgages. Require all income to be confirmed.
5.1.6. Encourage responsible lending which includes confirming that the borrower
can actually afford the loan.
5.1.7. Shorten the loan periods for buy to rent properties to 10 years.
5.1.8. The effect of the above limitations will, (a) limit the number of new
mortgages, (b) keep house prices in check and affordable to first time buyers, (c)

69
 encourage prospective home owners to save, (d) give homeowners equity to
protect when times get tough, (e) prevent the over enthusiastic from living
beyond their means.
5.1.9. Whatever new initiatives are introduced into the market place care must be
taken not to allow freely available funds to drive up house prices.

5.2. Reward Saving

5.2.1. If prospective home owners are to qualify for a mortgage they must save their
deposit and their purchase costs. Qualifying schemes should be made available to
savers to encourage them to save.

5.3. Shared Ownership Housing

5.3.1. Encourage home ownership through shared ownership schemes. Government
funds, or carefully controlled PFI funds, should be made available to Housing
Associations or appropriately authorised/controlled lenders, to allow them to
participate in shared ownership of properties on the open market. Provided that
the homeowner has a stake in the property he has something to protect. The
homeowner should be responsible for the maintenance of the property and
sensible arrangements made at outset to clarify how the homeowner buys an
increasing share in the property.

5.4. Scrutinise Merger Propositions

5.4.1. When financial institution propose to merge or take over others, they ought
to be required to address Peter Burt’s 5 criteria.
5.4.2. In answer to the questions at 6.4.1. above the reviewing panel ought to ask my
generation of lending banker’s two favourite questions, “How do you know
that?” and “What if..?”

6. Who pays the price?

6.1. Every decision ever made has a price to pay. The price may simply be the opportunity
cost of the decision or it may be as drastic as life or death.

6.2. When lenders lend recklessly?

6.2.1. The first person to pay is often the borrower. He lands in debt that he cannot
afford. Irrespective of who ought to take responsibility, the borrower generally
loses.
6.2.2. The family of the borrower. It is hardly the children’s fault when the family
home is repossessed.
6.2.3. The shareholder of the lending company. As a shareholder either directly or
via a pension fund, bad debts lead to lower profits which lead to lower dividends
and lower share valuations. Mr General Public has absolutely no power through
his or her share voting rights to moderate the behaviour of companies. It is a

70
 myth to suggest that ordinary shareholders have influence. That is not true, only
the big investment funds and city analysts have the ability to persuade.

6.3. When the Board/Senior Management make errors?

6.3.1. The first people to pay are the employees at the sharp end of the business, jobs
disappear, people are made redundant. The senior managers who made the bad
decisions are often protected with contacts that have to be bought out, they are
often rewarded by huge lump sum payments to vacate their chairs. Junior staff
who have performed exactly as required and who did not make mistakes in their
jobs have little or no protection.
6.3.2. The shareholder, bad decisions lead to lower profits which lead to lower
dividends and lower share valuations. Again Mr General Public has absolutely no
power through his or her share voting rights to moderate the behaviour of
companies.

6.4. Shareholders
6.4.1. There is some mythical view postulated that shareholders are rich people. This
cannot be further from the truth. Most shareholders are not rich. Most
shareholders do not own shares in their own names. Most people are
shareholders through their pension funds or through their life insurance policies.
6.4.2. By and large, young people do not invest directly in shares, it is the middle
aged and elderly who’s children have grown up and have an eye to their
retirement who invest in shares many through personal pensions or unit trusts.
6.4.3. All shareholders, whether direct or indirect have paid a very heavy price due
to the banking crisis. Many people have seen their wealth and their dividend
income disappear through absolutely no fault of their own. It is unreasonable
that the government should now expect them to suffer further.
6.4.4. All reasonable effort should be given to limit any bonus payment given to any
group of employees simply for doing their job. That is what salaries and wages
are for. Bonuses should only be paid for exceptional achievement and should
only be paid from the profits generated by the exceptional achievement. Reward
success not failure.
6.4.5. I believe that it is unreasonable for government to prohibit banks, who have
borrowed from government, from paying a dividend. Direct shareholders often
live on those dividends and pension companies need dividends to pay pensions.
There has to be a better way than penalising the shareholder for the errors of
those protected.
11 February 2009

71
 Memorandum from the ICAEW Financial Services Faculty

IDEAS FOR ENHANCING CONFIDENCE IN BANK REPORTING

Introduction

The Treasury Committee, at its hearing on the role of auditors in the banking crisis on 28
January
2009, invited the major auditing firms to suggest areas where the role of auditors might be
strengthened in the audit of banks. The ICAEW Financial Services Faculty is responding to
this invitation after consulting with practitioners in the six largest UK auditing firms.

In summing up these sessions, the Chairman, the Rt Hon John McFall MP, said that auditors
had done a decent job of fulfilling the duties expected of them in statute but questioned
whether that role was appropriate. The relationship between auditors and the Financial
Services Authority (FSA) is central to that question. To help the Committee consider these
matters, we set out five areas where the role of auditors could be extended:

1. Financial information outside the accounts

2. ‘Pillar 3’ risk disclosures
3. Regulatory returns to the FSA
4. Control activities chosen by the FSA
5. Bank-specific meetings with the FSA

The aim of these ideas is to contribute to enhanced public confidence in banks by increasing
trust in the information that banks report to the public and to the regulator. Currently,
auditors focus on banks’ financial statements specifically and work in the interests of
shareholders. The wider public may not understand that auditors have only limited
involvement with other financial information provided by banks.

The audit profession can contribute to greater confidence in banks by providing objective,
expert opinions on the information reported by banks, so that those relying on that
information can be confident that it has been properly prepared. In assessing each of the
suggestions we make for extending the auditor’s role, the following would need further
consideration:

• the exact nature of work to be performed, how this fits with current professional
standards and whether new guidance would need to be developed;
• consulting stakeholders to ensure that any new measures are practical and add value;
• identifying the costs of implementing change, ongoing costs and how they compare to
benefits;
• avoiding the creation of expectation gaps which could damage confidence. For
example, assurance work does not provide guarantees and it focuses on the quality of
the reported information rather than the appropriateness of the underlying reporting
requirements; and

72
 • the international context, including maintaining UK competitiveness and drawing on
the best of current thinking.

The following paragraphs set out our ideas in more detail.

1. Financial information outside the accounts

Some of the financial information reported by banks does not form part of the audited
accounts. For example, banks normally provide capital ratios, which are the regulatory
measure of the amount of capital they hold, in their annual report. At the moment, auditing
standards require that where information is in the annual report but not part of the accounts
‘the auditor should read the other information to identify material inconsistencies with the
audited financial statements’. Auditors are not, however, required to obtain additional
evidence to support the other information. The UK Government has previously taken the
view, after extensive consultation, that it is not necessary to extend the audit scope beyond the
financial statements. The FSA and Government should consider doing so for banks, at least in
relation to financial information such as capital ratios.

2. ‘Pillar 3’ risk disclosures

In 2009, banks will be required to report greater detail of their risk positions under new
regulations introduced by Basel II, called ‘Pillar 3’ disclosures. Basel II includes an option to
require Pillar 3 disclosures to be audited. After consultation, the UK government and FSA
took the view that it would not take up this option to require an audit of the disclosures.
Many banks are likely to make these disclosures in their annual report, but outside the
accounts. In this case auditors will only need to read the disclosures for inconsistency with the
financial statements as in 1 above. The rules also allow banks to make Pillar 3 disclosures
outside the annual report, for example on their web-site, in which case there is no
requirement for auditors to check them. The FSA should reconsider the decision not to
require an audit of Pillar 3 disclosures in the light of changed circumstances.

3. Regulatory returns to the FSA

Banks’ regulatory returns to the FSA include a range of financial information, for example on
liquidity, large exposures, a bank’s balance sheet and capital. At present, these returns are not
subject to review by auditors. The present regime for banks arose under the Financial Services
and Markets Act 2000 (FSMA). It differs from the insurance sector, where regulatory returns
are reported on by auditors. Before the introduction of FSMA, banks’ returns were subject to
periodic review by auditors.

The FSA should consider whether reintroduction of a review of key bank regulatory returns
by auditors would be useful.

4. Control activities chosen by the FSA

The FSA has powers under section 166 of FSMA to commission reports by auditors on
specific issues. These reports are used mainly when a specific problem has been identified and
tend to be forensic in nature and relatively expensive. While it is for the FSA to decide what
type of information best supports its supervisory approach, more general reports looking at

73
banks’ controls used to be commissioned under the previous regime, when section 39 of the
old Banking Act applied. The FSA could make greater and more regular use of their existing
powers under section 166 to obtain more information about the operation and application of
controls or compliance with regulations.

5. Bank-specific meetings with the FSA

Bank auditors are required to communicate with the FSA in specific circumstances, including
when they suspect management fraud, consider there are going concern issues or for
significant rule breaches. Depending on the nature of the concern, some communications will
involve banks’
management while others will not. Written communications may be followed up by
meetings. Outside these prescribed circumstances, the need for additional contact between
auditors, management and the FSA is up to the judgement of the supervisor.

The current situation differs from the old regime where there were regular bipartite and
tripartite
meetings to discuss the financial statements audit and section 39 reports. It is worth looking
at whether more regular meetings with auditors would help the FSA gain additional insights
into the banks they regulate. The knowledge that such meetings were taking place ought also
reassure the public. Indeed, it could even be made a requirement that periodic meetings are
held with the auditors for particularly important regulated banks, so that it is not left to the
discretion of the supervisory team.

In support of this, we note that the FSA is advocating annual bilateral meetings with the
auditors of all high impact firms.

10 February 2009

74
 Memorandum from Ian Johnstone

I am a retired banker aged 57 with I believe a very clear insight into the changes in attitude
within the banking Industry which have led to the current crisis. Prior to my "retirement" at
aged 53 I held a senior managerial position within the corporate bank at Barclays with
responsibility for teams in the East Midlands, Yorkshire, the North East and Borders of
Scotland. Our brief as a specialised unit of the corporate bank was to assist businesses in poor
but not terminal financial health utilising a range of skills developed over a 30 year period.
Our units achieved significant levels of success but were significantly downsized in 2000 -
2005 as the country enjoyed a benign economic climate and growth fuelled by enhanced
property values.

Significantly for the banks - and this applies not only to Barclays the short termist views to
compel senior career bankers to retire in their early to mid 50's denuded the banks of the
necessary skills to recognise the early signs of a changing economy, enforce prudent levels of
lending, and counter the expansionist aspirations of senior management.

During my initial years with Barclays in the early 70's great importance was placed upon
achieving the Bankers professional qualification through the Chartered Institute of Bankers.
Barclays maintained three bespoke training institutions for the development of its staff as well
as using the likes of Manchester Business School to develop its managers and potential
managers with a sound understanding of risk management, the long established principles of
sound lending, appreciation of business strategy and the mechanics of accountancy , profit
and loss and cashflow.

All Senior managers were qualified through the Institute Exams and had generally spent
many years of their career developing an understanding of business and had become skilled
in questioning techniques to establish viability of business proposals.

This has now changed. Many of the banks "managers" are no more than salespeople ,
unqualified and formula led - an approach which has been introduced by those determined to
cut costs in pursuit of enhanced profits to meet the extraordinary bonus culture which now
prevails within most banks.

Managers are no longer required to obtain the industry long held professional qualifications
through the Chartered Institute of Bankers so few bother to spend the hours of study
necessary.

The Training establishments through which many thousands of Barclays staff passed
developing their skills as they did so have all be sold off.

Training is now focussed upon sales and the achievement of sales targets and it is little
wonder therefore that the pursuit of growth at any cost to achieve short term targets and the
bonuses linked thereto has ended in disaster.

75
I fear that the current investigation will focus upon the losses predominantly in the personal
lending / mortgage sector arising out of securitisation and frankly the coming together of a
greedy nation of "must have now" with bankers blinkered to risk and driven only by bonus
related short term sales targets, and overlook a more fundamental problem which lies within
the banking industry - a lack of skills in the management of risk.

As a result of the banks policies to let the higher paid mature and experienced bankers retire
in their early 50's during the period 2000-2005 they no longer have that essential resource that
has been available to them in the past - experience.

The result's we are already seeing - bankers "frightened" to lend because they do not have the
experience, skill or time to recognise and differentiate between a good well managed
business experiencing short term difficulty and a poorly run business on a downward spiral.
They do not have the skills, experience or "bottle" to recognise a good young business
experiencing growing pains and one which has no realistic future.

They have not received the training to effectively interrogate a new business proposition and
separate the wheat from the chaff.

Whilst examining the failures which have led to the current position I do hope therefore that
the treasury committee will regard as part of its brief the essential need to look to the future
and to ask the banks why they have abandoned significant management risk training , what
alternatives to their in house training schools they intend to establish and of overwhelming
importance when will they begin again to require their lending staff to acquire the
professional qualifications which are so clearly demanded by other professions.

Clearly no one would countenance lawyers turning up in court without appropriate

qualification or accountants signing off accounts without their competence to do so bound
within their professional qualification so why are bankers so special that their training and
examination of their competence to lend can be so readily abandoned.

The results of that folly are now clear for all to see.

February 2009

76
 Memorandum from Philip Slaymaker

The Chairman & Committee might be interested to hear of my views on the recent banking
crisis based on 31 years employment with a major clearing bank

I joined Barclays upon leaving school in 1969 with the then minimum requirement of 5 GCE
'O' level passes including English and Maths. In addition I had 2 GCE 'A' level passes that
gave me a higher starting point on the salary scales

I worked through the traditional departments of the banking branch whilst also transferring
between branches to gain wider experience, all this time receiving regular reminders from
Local Directors who were then experienced bankers, that it was very important for me to
study for and pass the exams of The (now Chartered) Institute of Bankers. I followed their
advice and gained the Associate qualification.

After 13 years, I gained a junior managerial position, then continued working in a variety of
branches with increasing levels of responsibility

In the early 1990's I was appointed as Manager of a branch within the Thames Valley and
then encountered the Head Office and Regional Executive target mentality that was, I
believe, largely behind the current fiasco and that has been highlighted by the Committee and
the media. I will give you two examples: -

• Each branch in the region was given annual targets for product sales when the bank
changed to a sales culture and monthly progress charts sent out to each branch. One
of our targets was to increase the number of current accounts, in itself a praiseworthy
objective. Early in the year, when comparing tables, I noticed one branch had achieved
their annual target in one month. I telephoned my peer to ask how he had
achieved this to be told that he had closed all the old 7 day notice deposit accounts and
opened new current accounts, albeit without the customers' agreement. He then wrote
to each one of them saying that their old account was no longer available, giving them
details of their new account. To the Executive his performance was marvellous in that
targets had been exceeded and a bonus was awarded. In reality the process actually
cost the bank a lot of money in the direct and indirect costs of closing and opening
accounts and it could have been argued that the Manager was guilty of a breach of the
disciplinary procedure
• We also had a target for the sale of personal loans; these required an application form
and were then credit scored. In that area there was a large criminal ring well known to
the Police, Fraud Investigation Units and all the banks and credit card companies. If
an application came in for a name or address common to this criminal activity and the
credit score was 'give loan' I overrode this decision to 'deny loan' in the belief that this
would stem the flow of funds. One day, unannounced, a Director responsible for sales
called and challenged me on the override rate for my loans that was significantly
higher than those in higher branches. I explained the background but was told in no

77
 uncertain terms that if the decision by the bank's credit scoring system was 'give loan'
then this is what I should be doing. I suggested that it might save time if I put a waste
paper bin full of £20 notes in the banking hall and invited customers to help
themselves. He refused to move on this point, telling me that the bank was bigger than
me. Several months later I received another unannounced visit from a Risk Director
wanting to know why my Bad and Doubtful debt provisions were so high

I could recount other instances like this but for brevity have limited my comments to these
two that demonstrate the drive for short term target achievement that flew in the face of an
experienced banker wanting to gain genuine current account customers and lend to the
person or business rather than a form. This type of lending approach does, in my view, give
rise to a better prospect of any borrowing being repaid. Any idiot can advance money to
achieve or exceed targets and those that did found themselves rewarded with promotion and
the incoming manager being left with the challenge of sorting out the mess poor lending
decisions

Like many of my colleagues, I was encouraged by the allocation of shares by profit sharing
schemes and purchased more shares through SAYE schemes. We have been hit badly by the
fall in share prices and the suspension of dividends

I accepted voluntary redundancy in 2000 as I was unhappy to continue working in the sales
driven environment that the bank had turned into. I do believe that appointing more line
bankers with experience to major roles would have made more sense than, for
example, employing one with a supermarket background

Those executives responsible for this disaster were merely looking at short term targets and
therefore bonus achievement without any regard for the long term strength and security of
their business and well being of their shareholders and staff

I shall be grateful if this message could be made available to the full Committee and would be
willing to discuss any thoughts in greater detail or assist in your deliberations if this would
help

February 2009

78
 Memorandum from Findlay Turner

By way of Introduction I retired after 33 years as a partner in one of the larger firms of
chartered accountants a few years ago and am currently chairman of one of Scotland’s largest
charities with over £100M and some 4000 properties under management.

I have therefore continued to be deeply involved in governance issues in retirement and like
many have been staggered by the apparent breakdown in the governance of many of the
banks.

I have been following with great interest your committee's current enquiry and you are to be
congratulated on its conduct.

I have been particularly concerned with many others at the effect of the reputation of my own
profession ( 2 director's 1 former 1 continuing of RBS are CA's) and have obtained assurances
that our institute (ICAS) is closely monitoring the situation and in the event of disclosures on
which they can formally act the appropriate action will be taken.

My particular purpose in writing is to advise you that on raising similar issues of professional
standards and discipline with The Chartered Institute of Bankers in Scotland (CIOBS) I have
been informed that:

• it is purely an educational body providing qualifications to the industry

• only a small minority of bankers take their qualifications and there is no requirement
to do so
• only a small number of senior managers and staff are chartered bankers
• the institute has no powers to monitor members conduct or deal with professional
complaint
• removal from the institute only follows findings of guilt elsewhere e.g. by prosecution
or the ombudsman
• the FSA's preference is to regulate firms not individuals

The CIOBS notepaper has the logo "Leading Financial Professionalism". Sir Fred Goodwin is
a fellow and the Corporate Counsel of RBS is the current president!!!

I believe that CIOBS has high standards of education including ethical conduct but it is
entirely toothless in enforcing professional standards.

It would seem at least theoretically possible and highly likely that people can reach fairly
senior positions in banks without appropriate qualification and perhaps even without a
background in the industry.

It would seem appropriate to be asking. Is this acceptable when in many other sectors of the
finance industry and elsewhere appropriate levels of qualification are enforced.? Is it yet
another contributory factor to the crisis?

79
It is a common complaint amongst branch staff in banks whom I know that they have felt
demeaned they are no longer "bankers" but "salesmen". Perhaps that's where the cause of the
crisis begins and ends. There would seem a widespread lack of integrity and professionalism.

I felt this might be another aspect of which you should be aware.

I am sure you get plenty of mail but I could contribute with observation on issues of
governance, auditing, the accounting profession the conduct of the banks and regulation if
you would find it helpful.

I can send you copies of my interchange with CIOBS if you wish.

February 2009

80
 Memorandum from Kais Uddin

I would like to bring to the attention of the committee the following issues concerning the
crises in banking and finance in the United Kingdom.

The deregulation of the finance sector in the 1980's created many thousands of jobs in the
United Kingdom and brought us great prosperity. However the permissive or lax regulatory
and supervisory mechanisms fuelled speculation and greed on unprecedented scales. The
Government appears to have encouraged the so called irrational exuberance by setting
unrealistic growth targets and by failing to act when the banks were both overstretching
themselves, and, through reckless lending policies, overstretching individuals and businesses.
The four large accountancy firms that audit our major banks appear to have been incapable
or unable to spot problems that would have been revealed with the most cursory look into
the financial and risk management processes. Clearly the receipt of large fees from their
clients may have also triggered in auditors a prolonged rash of exuberance, rational or
otherwise.

It may well take a change of Government encourage politicians to take the bold and radical
decisions needed to get us out of this mess.

The Financial system has proved to be an abysmal failure, for individuals, businesses, and
society. It may well take a generation to undo the damage caused and find new mechanisms
to reign in the worst excesses of free market capitalism, ie greed and selfishness.

Pensions continue to be mis-sold. Controls and oversight that are meant to protect
individuals after the scandals of the 80s and 90s have so little impact on the behaviours of
institutions, that they are not worth the paper they are written on. Another generation are
being consigned to poverty by the government and the cosy cartels in the finance sectors.

Unless this Government acts now to create a new , state led pensions scheme, that offers some
guaranteed future returns, no matter how modest, the vultures in the financial services sector
will continue to exploit hard working people, safe in the knowledge that they will not get
caught out. The myth that private companies have any clue about how markets will do over a
40 to 50 year period should be laid to rest. The notion that they act in the interests of policy
holders would be laughable if the matter was not so serious. If bank bosses have no trouble
creating phoney bonus and incentives schemes for themselves, why should they want to
create fair incentive schemes for their sales teams?

Apart from the continuing scandal of pensions miss-selling, I witness the dispensing of poor
advice to people in the branches of high street banks. Just recently I overheard a junior
member of staff of a well known high street bank pressuring a very old man to take his
savings out of a simple interest bearing account to one linked to the vagaries of the stock
market and that would probably tie his money in till after his death.

81
It was a case of petty theft from a very vulnerable person and the remarkable thing is that
this is happening on every high street every day. Poorly trained and poorly paid branch
"advisers" are being encouraged, if not black mailed into selling " products" that they would
never dream of recommending to their nearest and dearest.

The people that are suffering the most are of course the vulnerable and old, often that living
alone, financially naive and victims of system that turns ordinary bank employees into con
men and women. Who cares? Not the bank bosses, not the regulators, and apparently, not
the Government.

With respect to mortgages, I have witnessed , over a number of cycles, property bubbles in
poor inner city areas. Poor extended families that are perfectly capable of servicing a
mortgage are shunned by so-called mainstream lenders. They fall prey to usurers that write
dodgy mortgage applications to so called back street lenders, but at rates that would make
you weep. And of course the ultimate owners of these firms are often the mainstream lenders.
Shylock would blush.

In contrast our high street banks have provided dodgy loans and mortgagees to so called
professionals or couples, on the basis of fantasy future earnings potential or self certified
mortgages. These are the people who are most likely to default, despite the relatively
favourable terms offered, in contrast to the poor inner city families that carry on to servicing
the interest payments on so called mortgages that can never be paid off.

Pensions, mortgages, savings and loans have become a minefield for ordinary people. The
system encourages greed and theft. The exuberance on the part of rich middle and third age
men that run the institutions has not been irrational, far from it. As was clear from the
Treasury Committee meeting with ex HBOS, RBS, and others, these men have no banking
qualifications, had no understanding of the deals the deals they agreed, no sense of caution
or so called " prudence". Instead they became extraordinarily rich on the back of a financial
bubble they had perpetuated, with the permission of the regulators and the incredulous
approval of the Government. Their exuberance is based on the knowledge that the old boys
club of unqualified CEOs, Chairman, and non executive directors, have gold plated " won't
get into goal cards" granted by regulators and politicians that are also guaranteed to have
golden third age lives, bolstered by lucrative consultancy contracts and directorships, from
very companies they are supposed to oversee. No wonder they are the " Masters of the
Universe".

So what should be done to clear the stables? I have no idea. I am not a qualified banker… but
neither are many of the old boys that the Committee are speaking to just now. The non
apologists, under the tutelage of the public relations men.

However, in the interests of " hard working families" I have a few short term suggestions.
These are the following:

82
 • Create a National Pensions Scheme run by the state to fund long term infrastructure
projects and abolish thee exorbitantly expensive private finance schemes. The returns
should be as good as those offered to 30 year PFI schemes.

• Outlaw banks from pressuring older people to move their money from simple saving
schemes into risky investments that help to pay the bonuses of Directors and
Chairmen.

With regard to specific issues concerning the banking and credit crises:

• Forbid banks from providing services to individuals. Leave that to the building
societies and other saver owned lenders.

• Review the role of auditors of the top 10 UK banks. Did they collude with the banks to
provide a false picture of the health of these institutions?

• Did they act negligently, incompetently or fraudulently, or a combination of one or

more of the aforementioned in signing off the accounts?

• If not, tighten up the auditing rules so that accounts are worth the paper they are
written on and failure to comply with the rules should result in prision sentences for
audit firm bosses.

• Break the cartel that controls the auditing of the top 100 businesses in the UK. If
necessary, create an independent public sector auditor.

• Stop the musical chairs in top jobs between the top accountancy firms and FTSE 100.

• Cap salaries and bonuses for the financial sector. Incentives for senior personnel
should be long term ( 5 years or more), and based on a combination of share price
increase, and societal measures, such as jobs created.

• Undertake a forensic examination of accounts and all major transactions between

financial institutions. In cases where appropriate levels of diligence and risk
management did not apply, the Government should not foot the bill.

• Undertake a forensic examination of the instruments used to assess risk or package

and sell debt. In cases of negligence, incompetence or sheer criminality, legal
proceedings should be instigated in special courts.

• Ensure all bail outs from the tax payer are repayable at commercial rates over the next
30 years.

83
We also need a high powered investigation into the activities of regulators, banks, and their
auditors and relationships with HMG, especially the Treasurer and PM's office over the last 5
years. A detailed understanding of what went wrong, over how long, who was responsible,
what needs to change is needed. We also need new rules that prevent regulators and
politicians from being seduced by the riches of this sector.

In the medium term a new financial system is needed, with new rules, new players and new
aims. The world order is changing. We need financial institutions capable of regulating ,
policing and disciplining , and shutting down global players and those that aspire to be global.
Markets have to act in the interest of society, not the other way round.

February 2009

84
 Memorandum from the Financial Services Authority (FSA)
1. This memorandum is submitted to the Committee as part of its inquiry into the Banking
Crisis and in advance of the FSA’s evidence session on 25 February. It covers:
• the origins of the financial crisis;
• the required regulatory response to the crisis across the world;
• the UK Tripartite Authorities’ response to the crisis; and
• the steps the FSA has already taken and is planning in response to the crisis.

A. ORIGINS OF THE FINANCIAL CRISIS

2. Over the last 18 months, and with increasing intensity over the last six months, the global
financial system has suffered its greatest crisis in over 70 years. The origins of the crisis
can be explained by a number of factors. The FSA Chairman set these out in a speech on
21 January, and we expanded on this analysis in our Financial Risk Outlook (published on
9 February). They include:
• Growth of significant global imbalances over the last decade: Large current account
surpluses accumulated in the oil-exporting countries, China, Japan and some other
east Asian developing nations, while fiscal and current account deficits grew in the
US, UK and some members of the Eurozone.
• Increasing complexity of the securitised credit model: Lower risk-free interest rates
produced an intense search for higher yield at low risk. This demand was met by an
increase in volume and complexity of the securitised model of credit intermediation.
• Rapid extension of credit and falling credit standards: Between 2000 and 2007,
credit extension in the US, the UK and some other countries grew quickly. This credit
extension was partly driven by the rapid development of securitisation, with an
increasing proportion of UK mortgages credit packaged and sold as residential
mortgage-backed securities, thus not appearing on the originator bank’s balance sheet.
In addition, lending on balance sheet grew rapidly, as banks competed for market
share, often funding their rapid growth with easily available wholesale funding. This
rapid expansion of credit was accompanied by declining credit standards both in the
household and corporate markets.
• Property price booms: The rapid extension of mortgage credit and of commercial
real estate loans developed into a boom where rising property prices drove the
demand and supply of mortgage credit, resulting in even higher property prices.
Continuously rising prices convinced both borrowers and lenders that high loan-to-
income ratios or high loan-to-value were acceptable given the potential for future
capital appreciation. The widespread extension of credit on terms that could only be
justified on the assumption of future house price appreciation was particularly
symptomatic of the US sub-prime market.
• Increasing leverage in the banking and shadow banking system: The increasing
scale and size of securitised markets and their mounting complexity were

85
 accompanied by a significant escalation in the leverage of banks, investment banks
and off-balance sheet vehicles, and the growing role of hedge funds. Large positions in
securitised credit and related derivatives were increasingly held by banks, near banks,
and shadow banks, rather than passed through to traditional, hold-to-maturity
investors. Hence, the new model of securitised credit intermediation was not one of
‘originate and distribute’. Rather, credit intermediation meant passing through
multiple trading books in banks, leading to a proliferation of relationships within the
financial sector. This ‘acquire and arbitrage’ model resulted in the majority of
incurred losses falling not on investors outside the banking system, but on banks and
investment banks themselves involved in risky maturity transformation activities. The
explosion of claims within the financial system resulted in financial sector balance
sheets becoming of greater consequence for the economy, with financial sector assets
and liabilities in the UK and the US growing far more rapidly as a proportion of gross
domestic product than those of corporates and households.
• Underestimation of bank and market liquidity risk: The growth of the securitised
credit market and bank leverage and the multiplicity of inter-bank claims were also
accompanied by changing patterns of maturity transformation and in many cases by
serious underestimation of bank and market liquidity risk. Maturity transformation –
holding longer term assets than liabilities – was increasingly performed not only by
banks, but also investment banks, off-balance sheet vehicles and, in the US, by mutual
funds. This made the financial system overall increasingly reliant on liquidity through
marketability - the ability to meet liabilities through the rapid sale of an increasingly
wide range and much increased value of long-term credit instruments. When the
crisis struck, the assumption that the markets for these instruments would remain
liquid was proven wrong as concerns spread about the quality of such instruments.
3. These interrelated effects and relationships resulted in a self-reinforcing cycle of irrational
exuberance in pricing of both credit and volatility risk. Credit spreads on a range of
securities and loans fell steadily from 2002 to 2006 to reach very low levels relative to
historical norms. In addition, the price charged for the absorption of volatility risk fell,
since volatility itself appeared to have declined to very low levels.

B. THE REQUIRED REGULATORY RESPONSE TO THE CRISIS ACROSS THE

WORLD

4. In response to the Chancellor of the Exchequer’s invitation to Lord Turner to conduct a

review of banking regulation, we will publish a Discussion Paper in March on reforming
the banking regulatory policy framework. The main purpose of this paper is to set the
direction and define the changes that we believe are required in international regulation,
and which we will be proposing in discussions with international colleagues and in the
European Union.
5. The Discussion Paper will address some fundamental questions raised by the
unprecedented events in financial markets over the past year. It will set out our thinking
on liquidity and capital policies, our wider view on a global regime and some observations
on the regulatory architecture that determines such policies.
86
6. It will outline a range of concerns and possible solutions to deal with them. Within these,
capital and liquidity are particularly important.
• Capital: Important issues for the international capital framework raised in the
Discussion Paper include the level of capital that we expect banks to hold, the quality
of capital and whether risk-based capital needs to be supplemented by a non risk-
sensitive measure (such as a leverage ratio). We will also address questions relating to
cyclicality/procyclicality of risk-based capital requirements and, linked to that, the
complementary roles of micro and macro-prudential regulation. These views will feed
into the Basel Committee on Banking Supervision and the Financial Stability Forum’s
consideration of new approaches to the regulation of the capital adequacy of banks.
This will involve adjusting Basel II in a number of ways, including requiring higher
minimum levels of bank capital than have been required in the past, and in particular
capital which moves more appropriately with the economic cycle. In addition, more
capital will be required against trading books and the taking of market risk.
• Liquidity: New approaches to the management and regulation of liquidity are equally
important. It is crucial that the regulation of liquidity is recognised as at least as
important as capital adequacy. The lack of a defined international standard has
reflected the extreme complexity of liquidity risk. Measuring and limiting liquidity
risk is crucial, and reforms to international regulation need to include both far more
effective ways of assessing and limiting the liquidity risks individual institutions face,
and a better understanding of market-wide liquidity risks. In December 2008, we
issued a Consultation Paper proposing a tighter surveillance regime for liquidity. The
Discussion Paper will consider whether any additional action is required, including to
help deal with macro-prudential considerations.
• Accounting: The Discussion Paper will consider the extent to which accounting
standards contributed to the swings in the market and potential responses to limit
this.
• The institutional coverage of prudential regulation: Significant steps have already
been taken, or are under international discussion, to extend accounting and regulatory
coverage to the so-called ‘shadow banking’ institutions (such as investment banks and
off-balance sheet vehicles). The Discussion Paper will consider whether these actions
go far enough.
• Cross-border cooperation and coordination within Europe and globally: The
Discussion Paper will consider whether there is scope for better coordination and
cooperation between regulators in normal times and during periods of crisis. It will
also comment on regulatory cooperation in the EU.
• Executive remuneration: Last autumn, we issued a Dear CEO letter on incentive
frameworks. The Discussion Paper and related publication will continue to develop
our work in this area to seek to ensure incentives are aligned with responsible risk
management practices.
• Credit ratings agencies: We continue to support the Treasury in the negotiation of a
new European registration regime for credit ratings agencies (CRAs) and we will
prepare for subsequent implementation. We believe there is a need for international
87
 consistency in the approach to overseeing CRAs and we will continue to contribute to
the various international fora considering this issue. We will also continue to work
with market participants to mitigate the risk that investors could rely on ratings as a
guarantee of asset quality (both now and in the future), or could assume that it is
intended to carry implications for price levels rather than purely for probability of
default.
• Credit default swaps and counterparty risk: We will work with our international
regulatory counterparts, market participants and infrastructure providers to make
trading and operational arrangements for over-the-counter (OTC) derivatives,
including credit default swaps (CDS) more robust. In particular this work will support
the further development of central counterparty (CCP) facilities for the majority of
CDS trades. We will work with others to ensure that any CCP facilities are
appropriately structured and risk-managed, with a suitable level of regulatory
cooperation to reflect the international nature of these markets.
7. The financial crisis has revealed two major weaknesses in the overall approach to
regulation and to wider macro-economic policy, which need to be addressed: the lack of
macro-prudential analysis and policy, and the inadequate approach to the supervision of
multinational financial institutions.
Macro-prudential
8. In retrospect, one of the crucial policy failures in the years running up to the crisis was not
the inadequate supervision of any specific financial institution, but the failure to recognise
huge inherent system-wide risks and that the cycle of irrational exuberance was close to
reaching a crisis point. Regulators, central banks and finance ministries need significantly
to improve their system-wide analysis of financial stability risks and design appropriate
policy responses, whether via regulatory action, such as counter-cyclical capital and
liquidity requirements, or via monetary policy tools. This needs to be coordinated at
international and national level and buttressed by procedures to ensure that international
bodies are free to carry out reviews of major countries’ management of their economies,
including their financial services sector.
9. A further priority is to ensure that in future financial activities are always regulated
according to their economic substance, not their legal form. One of the striking features of
the years running up to the crisis was that a core banking function – maturity
transformation – was increasingly being performed by institutions that were not legally
banks, but the off-balance sheet vehicles of banks (SIVs and conduits), investment banks
and mutual funds. To different degrees in different countries these ‘near banks’ or shadow
banks escaped the capital, leverage and liquidity regulation which would apply to banks.
In the case of SIVs they also escaped the degree of disclosure and accounting treatment
which would have applied if the economic activities were performed on balance sheet. In
future, it is essential that if an economic activity is bank-like and poses a significant risk to
consumers or to financial stability, regulators can extend banking-style regulation. In
addition, it is important that accounting treatment reflects the economic reality of risks
being taken.
International view

88
10. Regulators need to address issues in the current approach to the regulation of cross-
border financial institutions. Weaknesses arise from the inherent contradictions between
the desire for open competition and for cost efficiency, which argue for treating firms as
global entities, and the fact that bankruptcy laws, depositor protection regimes, and the
fiscal resources which support bank rescues, are national.
11. The entry into administration of the UK-regulated investment firm in the Lehman
Brothers group raised issues in two major areas: prime brokerage (particularly in relation
to access to clients’ assets following insolvency) and the post-trade infrastructure. In other
respects, the UK and international financial architecture was able to manage the default of
an entity of this scale.
12. The collapse of Lehman Brothers, caused by underlying solvency problems, highlighted a
number of areas of international regulation, which will need to be reviewed, including:
• whether the existence of better early warning mechanisms could have identified the
build-up of problems in the firm;
• whether a simpler group structure would have improved transparency regarding the
firm's activities and strengthened regulatory oversight of the group;
• whether the capital framework for investment banking is appropriate;
• the extent to which there should be a degree of consistency in limits on firms’ rights to
use a client’s assets;
• whether the regulatory framework generally should place greater emphasis on
ensuring firms are structured to deliver better or quicker outcomes in an insolvency
situation, e.g. through enhanced planning for their own insolvency;
• how the international framework for crisis management can be strengthened; and
• whether the collapse of the group into separate insolvency proceedings for each legal
entity and jurisdiction is the optimum way to resolve the failure of a large, cross-
border group.
13. This raises fundamental issues about the appropriate future regulatory and supervisory
approach to such international groups, including:
• whether host-country supervisors should take a more national approach, requiring
strongly capitalised local subsidiaries, ring-fenced liquidity and restrictions on intra-
group exposures and flows; how far this would mitigate risks in inherently interlinked
global groups; and what implications for cost efficiency and international capital flows
would result;
• how international ‘colleges of supervisors’ can be made effective in enhancing
cooperation between home and host supervisors; and
• whether it is feasible to achieve greater cooperation in crisis resolution and whether
this could extend as far as shared decision-making and agreed burden-sharing.

The EU dimension

89
14. As a member of the EU, the UK operates and applies its regulatory regime within the
framework of EU law. Recent events, including the crisis in Icelandic retail bank
branches, demonstrate that the EU single market rules need to be reconsidered. There are
two possible directions for change.
• Restrictions on passporting: There could be limitations placed on the passporting
rights that firms in EEA Member States have, and which permit them to set up a
branch in another Member State and operate there subject to the authorisation and
prudential oversight of the home state. These limitations might, for example, enable
Member States to require firms to undertake their retail operations in fully capitalised
subsidiaries, thus increasing the jurisdiction of national regulators. Alternatively, host
state oversight and control of branches might be increased by giving the host more
explicit rights to prudential data, and in consultation with the home state, permitting
the host to impose proportionate and graduated restrictions on the activities of a
branch. The aim would be to limit the exposure of depositors in the branch to
material weaknesses which the firm is failing to address effectively, well before there is
a risk of default. Host state oversight over EEA branches would therefore approach
that of branches from non-EEA countries.
• Greater pan-European coordination: This could extend the EU’s arrangements for
peer review, which are currently confined to how supervisors have implemented EU
directives. They might include rigorous assessment of how supervisors perform
specific supervisory functions, and of how individual supervisory colleges are
working. It could include peer review of the viability of deposit insurance schemes in
Member States. It might include deposit insurance requirements that are less
dependent on the industry or fiscal resources of individual countries. Longer term, it
might be necessary to introduce an EU mechanism which could include, for example,
central monitoring and oversight on countries’ implementation of regulatory
standards.
15. We do not have a clear set of proposals on these issues, but we believe it is important that
there is real debate. In our view, the current approach is not sustainable.
16. The European Commission has invited a group chaired by Jacques de Larosière to make
proposals to strengthen European supervisory arrangements covering all financial sectors.
We expect the Larosière Group to report to the Commission by the end of February. The
Group's terms of reference are to consider:
• how the supervision of European financial institutions and markets should best be
organised to ensure the prudential soundness of institutions, the orderly functioning
of markets and thereby the protection of depositors, policy-holders and investors;
• how to strengthen European cooperation on financial stability oversight, early
warning mechanisms and crisis management, including the management of cross
border and cross sectoral risks; and
• how supervisors in the EU's competent authorities should cooperate with other major
jurisdictions to help safeguard global financial stability.

90
C. THE RESPONSE OF THE UK TRIPARTITE AUTHORITIES TO THE FINANCIAL
CRISIS

17. We have been working closely with the other Tripartite Authorities and the Financial
Services Compensation Scheme (FSCS) to respond to the financial crisis. The
Government announced two packages of measures in October 2008 and January 2009
combining the following elements:
• Bank recapitalisation scheme: The deliberate creation of bank capital buffers
sufficient to enable banks to maintain lending to the real economy even if future credit
losses and asset write-downs are large. To achieve this, we conducted stress tests
which modelled the potential for future credit losses and write-downs in the event of a
severe economic recession. We required banks to attain capital levels such that, even if
such stresses arose, their core tier-1 capital ratios would remain above 4%. The
Government stood ready to provide the required capital if it was unavailable from
private sources, making capital investments in Royal Bank of Scotland, Halifax Bank
of Scotland, and Lloyds TSB.
• Regulatory approach to capital regulation: We explicitly clarified that these capital
buffers are intended to be used to absorb losses and not to maintain core tier-1 ratios
significantly and permanently above 4%. We supplemented this in January by further
action to ensure that the detailed implementation of Basel II capital adequacy rules did
not introduce unnecessary and unintended procyclicality in capital requirements.
• Asset protection scheme: The announcement in principle of a government bad asset
insurance scheme which will help ensure that bank losses do not exceed stress test
estimates, thus offsetting potential fears that lending growth combined with higher
than expected losses could drive capital ratios below minimum acceptable levels.
• Bank funding: Government guarantees of bank medium-term funding to overcome
the decline of confidence in the banking system, and to ensure that banks are not
constrained from extending credit by inability to raise funds.
• Securitised credit: Further government guarantees, announced in principle in the
January 2009 package, for the issue of securitised credit and in particular of residential
mortgage-backed securities.
• Bank of England liquidity facilities: The extension of Bank of England liquidity
support facilities to banks.
• Credit easing: Authority to the Bank of England to conduct significant ‘credit easing’
activities, directly buying assets (such as corporate bonds) in markets where it appears
yields have been significantly swollen, and prices depressed, by exceptionally high
liquidity premia.
Banking Act 2009
18. The Banking Act 2009 was given Royal Assent on 12 February. We are now working with
the other Authorities to draw on the lessons learned from events since summer 2007.
This includes reviewing and where necessary enhancing the Tripartite arrangements for

91
 coordination both at times of crisis and in ‘normal times’, including keeping the FSCS
informed in a timely way to enable it to discharge its responsibilities effectively.
19. We are also close to finalising a Cooperation Protocol with the Bank of England, which
builds on and codifies the bilateral relationships that have developed since 1997 and also
reflect the Bank’s new responsibilities under the Act.
Compensation scheme
20. The Tripartite authorities and the FSCS have worked closely to ensure the faster payout of
compensation to depositors. The scheme has worked well in unprecedented
circumstances, compensating hundreds of thousands of savers in a matter of weeks,
including paying compensation on behalf of the Government and Iceland in the case of
Icesave. (Further details are provided in the separate FSCS memorandum to the
Committee).
21. We are also working closely with the Tripartite Authorities and the FSCS to reform the
compensation scheme in light of recent experience. We published a Consultation Paper
in January outlining: how fast payout of compensation can be facilitated; eligibility for the
scheme; information disclosure requirements on firms; and how, working with the FSCS
and the industry, we will raise consumer awareness of the compensation scheme. A
further Consultation Paper will cover the treatment by the FSCS of temporary high
deposit balances and deposits held on behalf of third parties, e.g. solicitors' client
accounts. We will continue to review whether changes need to be made to the limits, tariff
measures, classes and cross subsidy arrangements within the current structure of the
FSCS, and will take account of the debate around pre-funding. We continue to believe the
scheme should focus on protection within FSA-regulated entities and should not be
extended to offer protection to UK citizens investing into offshore entities.

D. THE FSA’S RESPONSE

Regulatory philosophy
22. Historically, our regulatory philosophy has been defined by the strapline of ‘more
principles-based regulation’. This has often been misunderstood. Principles-based
regulation means, wherever possible, moving away from prescriptive rules to a higher-
level articulation of what we expect firms to do. This has the major advantage of placing
on firms explicit responsibility to decide how best to align their business objectives and
processes with the regulatory outcomes we have specified. The focus of our philosophy,
however, is not only on our principles, but also on judging the consequences of the
actions of the firms and the individuals we supervise. Given this philosophy, a better
strapline would be ‘outcomes-focused regulation’.
23. In our view, the global financial crisis and the problems in specific firms have
demonstrated more than ever the need to adhere rigorously to this regulatory philosophy.
We will therefore take into 2009/10 a clear commitment to embed fully outcomes-focused
regulation in our supervisory processes, working in a proportionate and risk-based way.
We also believe that events have demonstrated the importance of an integrated approach
to the supervision of individual firms. To analyse fully the risks inherent in a given firm,

92
 the supervisor must have oversight of both the full range of the firm’s business and its
prudential and conduct issues.
24. We are determined to incorporate the lessons we have learned from recent events in our
drive to improve the delivery of this regulatory philosophy through our supervisory
process.
FSA supervision
25. In our Financial Risk Outlook and Business Plan, published recently, we have set out our
view of the risks to markets, firms and consumers and our work programme to mitigate
these risks.
26. A key area of our focus will be to maintain and secure financial stability. We must in
particular manage and address the risks associated with valuations and asset quality;
deleveraging; the lending outlook; business models; corporate defaults; and competition
and market consolidation. At the heart of our efforts to promote financial stability and
manage these risks is our supervision of firms. Over the coming year we will continue to
challenge individual firms to be well governed, to be financially sound, to manage
effectively the risks inherent in their business models and markets, and to meet our
standards in the way they deal with their customers. Our Supervisory Enhancement
Programme has built on our existing capabilities.
27. This programme has, in fact, now closed. We believe that it has given us enough of a
foundation for the longer term structural, as well as cultural, change necessary to achieve
the intensity and rigour of supervision to which we aspire. The onus is now on all staff
involved in supervision to embed the revised components of our strengthened operating
model in the day-to-day running of our business.
28. Key deliveries from the programme included the following:
• A compulsory and irreducible programme of regular meetings with the senior
management, control functions and non-executive directors of firms subject to our
‘close and continuous’ regime (that is, high impact firms). This is to establish and
communicate to the firm the minimum level of interaction we expect, and will now
include:
o an annual meeting with the firm’s senior management to focus specifically on the
business and strategic plans for the firm;
o an annual meeting with the external auditors; and
o specific items of management information to support these meetings (such as
annual strategy documents, operating plans, particular Board reports and the
Management Letter provided from the external auditors).
• A regulatory period between formal ARROW assessments of maximum two years for
each high-impact firm. During this period, we are now holding more formal internal
‘checkpoints’ on a six-monthly basis to provide more FSA senior management input
and oversight of the supervisory approach for the firm.
• Increased scrutiny of candidates for Significant Influence Functions (SIFs),
particularly the Chair, CEO, Finance Director and Non-executive Directors of high-

93
 impact firms. This scrutiny includes interviewing SIF candidates where appropriate
and a greater focus on their personal accountability in post.
• A new group of supervision advisory specialists who will conduct a regular quality
review of the supervisory process for all high-impact firms. It will also provide
support to the supervisory teams.
29. There are a small but critical number of outstanding elements remaining, each with a
longer-term delivery timeframe. These are in the areas of risk identification (particularly
our ability to collect and then harness effectively the use of information and intelligence
so that front-line supervision staff benefit from more timely and relevant financial
analysis, business model and other data based on peer firm review). The other area is the
delivery of a Training and Competence regime for our supervisory staff, which is part way
through development, although the training element of this has already gone live.
Alongside this, the introduction of a tenure policy, to provide continuity of supervision
for relationship-managed firms, should enable a deeper level of supervision to be
achieved.
30. All of this is underpinned by a necessary increase in our supervisory staff, including the
level of senior FSA resource available to support supervision. We have increased
resources in many of our specialist prudential as well as conduct risk areas and we also
now assign an irreducible minimum to each of our high-impact firms. To date, we have
filled 65% of the additional positions and are therefore on track to achieve 100% (280
additional staff) by our target of summer 2009.
31. There are, however, necessarily limitations to supervisory oversight and we believe that
our improvements need to be matched by greater engagement by shareholders and non-
executives who should be the first line of oversight of firms’ executive management.
Remuneration policies
32. In October 2008 we wrote to the chief executives of major UK-based banks, both British
and foreign-owned, making clear that remuneration policies in many firms have been
inconsistent with sound risk management and have given staff incentives to pursue
policies that undermined the impact of systems designed to control risk. We asked them
to review their remuneration policies against a set of criteria and, if necessary, take action
to change them. We are now considering the types of sanction that we can impose if firms
do not comply with our requirements.
33. We are preparing a further paper on these issues which we will publish at the end of
March. This statement will include:
• a summary of the findings of our review of remuneration policies;
• a revised set of the criteria set out in our October 2008 letter – which we are likely to
issue as a Code; and
• a statement setting out the action that we intend to take in future on remuneration.
34. In pursuing this agenda, we will work with others. We welcome the announcement by the
Treasury of an independent review of corporate governance of the UK banking industry
being undertaken by Sir David Walker. We look forward to working closely with him.
We are also contributing to international work on remuneration policies. A working
94
 group of the Financial Stability Forum has commissioned a survey of remuneration
practices in global wholesale banking firms and is consulting with experts in the field. It
will produce a report for the G7 towards the end of the first quarter of 2009.
Consumers
35. We will adopt a balanced approach to conduct and prudential risk because we recognise
that consumers are particularly exposed in these difficult economic times. We will ensure
we are heavily engaged in mitigating the detriment which will stem from this fact. We
will strengthen our supervisory focus on Treating Customers Fairly (TCF). The
embedding of the TCF agenda into our supervisory process is critical to ensure that it is
an enduring feature of our regulatory regime.
36. In addition to responding to the current economic downturn, we will continue our focus
on consumer capability and adjust our programme appropriately in the light of the
changed economic circumstances. Our focus on consumer issues will also continue to
include work on transparency to ensure that, where appropriate, we properly equip
consumers with the best information to make informed decisions. In the coming year we
will continue the Money Guidance Pathfinder project in partnership with the Treasury, to
test the provision of free, impartial guidance on money matters.
Short selling
37. Over the coming year we will continue our work on developing the regulatory regime for
short selling. The market turbulence over the past year and concerns over the role which
short selling has played in this prompted us to take various emergency measures,
including a ban on short selling, and undertake a comprehensive review of the practice.
We remain clear that in normal market conditions short selling is a legitimate technique
that promotes price efficiency and assists liquidity, and is not in itself abusive. However,
we recognise that in some circumstances, especially in times of market uncertainty, short
selling can have a negative effect.
38. The proposals put forward in our February Discussion Paper on short selling are intended
to mitigate these negative effects without removing the benefits which short selling brings.
Rather than imposing permanent direct constraints on short selling, we consider that the
best way forward is enhanced transparency. In our view, disclosing significant individual
short positions to the market is the best way of improving transparency and we think that
a regime of this type should be applied to all UK stocks.
39. We decided not to extend the temporary ban on the short selling of UK financial sector
stocks when it expired in January. We considered that the circumstances which led to its
introduction had changed, not least due to the initiatives by the government, with a
lessening of the risks which had caused us the greatest concern. We have maintained the
disclosure regime and continue to scrutinise closely trading in financial stocks, following
up on any suspicious trading patterns which indicate the possibility of market abuse. We
do not consider that short selling was a major contributory factor in determining the fall
in the share prices of certain banks in the period following the ban's expiry. However, we
have made it clear that we are prepared to reintroduce the temporary ban, without
consultation if necessary, should circumstances require it.

95
16 February 2009

96
 Memorandum from Greg Pytel

The Largest Heist in History

Building the Great Pyramid: The Global Financial Crisis Explained

When the financial crisis erupted at the end of September 2008, there was an unusual sense of
incredible panic among banking executives and government officials. These two
establishment groups are known for their conservative, understated approach and, above all,
their stiff upper lip. Yet at the time they appeared to the public running about like headless
chickens. It was chaos. A state of complete chaos. Within a few weeks, however, decisions
were made and everything seemed to returned to normal and back under control. The British
Prime Minister Gordon Brown even famously remarked that the government “saved the
world.”

But what really caused such an incredible panic in the establishment well known for its
resilience? Maybe there are root causes that were not examined publicly and the government
actions are nothing more than a temporary reprieve and a cover-up? Throwing good money
after bad money, maybe?

Money Making Machine

In order to answer these questions we have to examine the basic principles on which the
banking system operates and the mechanisms that caused the current crisis. Students at the
A-level are taught about “multiple deposit creation,” It is the most rudimentary money
creation mechanism for banks, which if administered properly serves the economy and public
at-large very well. In the deposit creation process a bank accepts deposits and lends them out.
But almost every lending returns soon to the bank as a deposit and is lent again. In essence,
when people borrow money they do not keep it at home as cash, but spend it, so this money
finds its way back to a bank quite quickly. It is not necessarily the same bank, but as the
number of banks is limited (indeed very small) and there is — or was — a very active
interbank lending. In terms of deposit creation the system works like one large bank.

Therefore, the same money is re-lent over and over again. If all depositors of all banks turned
up at the same time there would not be enough cash to pay them out. However, such a
situation is highly unlikely. Every borrower repays his loan and pays interest on it. In
principle, the difference between a loan and a deposit interest rate is a source of the banks’
profit. Naturally, banks have to account for some creditors that will default and reflect it in
the lending interest rate, or all the creditors who repay cover the costs of defaults. On top of it,
the banks possess their own capital to provide security.

Fundamental to this deposit creation principle is the percentage of deposits that a bank lends
out. The description above used a 100% loan-deposit ratio, meaning that all deposits are lent
out. In traditional banking this ratio was always below 100%. For example, years ago,
Westminster Bank (before it merged into National Westminster Bank), intended to lend out
86.5% of every deposit. For every £100 deposited, the bank lent out £86.5, while the remaining

97
£13.50 was retained in the banks reserve with a small portion of it kept in the Bank of
England. In practice, this ratio was the bank’s control tool on deposit creation process,
ensuring that the amount of money supplied to the market was limited. According to this
principle, for every £1 deposited, a bank lends out £0.865. After only 5 cycles the amount is
reduced to below £0.50 and after 32 cycles it is below 1 penny. If this process continued
forever the total amount of money lent out of a pound would be less than £6.41. With every
cycle of deposit creation, a bank built up its reserves, ultimately collecting almost entire £1 for
every £1 initial deposit. Added to capital repayments, interest payments on loans and the
bank’s own capital base this system ensured that that there was always enough money in the
bank for every depositor. For years banks worked as a confidence trick – the notional value of
deposits and liabilities to be paid by the bank exceeded the value of money on the market.
Since only a very small number of depositors demand cash withdrawals at the same time and
almost all these paid-out deposits are deposited in a bank again quickly the banks ensured
that every depositor got his money while circulating money in the economy and stimulating
growth. The loan-deposit ratio was a self-regulating tool. As with every cycle it multiplies, the
reduction of amounts created decreases exponentially and quickly. The faster the deposit
creation cycles occur the faster the reduction progresses, thus accelerating with every cycle.
The total “created” from the original £1 deposited in a bank is a finite, not more than £6.41 at
the 86.5% loan-deposit ratio, backed by nearly £1 reserve. It is an inverted pyramid scheme
starting from a fixed initial deposit base and quickly reducing through deposit creation cycle
to zero.

Building a Pyramid

In a City bar back in 1998, an academic was discussing modern banking with his City
colleagues from university. He was encouraged to invest in shares as their growth was well
above inflation. He pointed out, however, that the inflation index does not take into account
the growth of share price and as a consequence the market will run out of cash to pay for
shares at some point. The only way would be down—a shares price crash. His City colleagues
argued that there would be additional money coming in from different economies preventing
a crash (a pretty thin argument in the world of global banking as foreign investors were
already market players.) They also argued that the modern financial instruments allowed
“securitisation”, “hedging” the risk and “leveraging” the original investment. Indeed it was a
killer argument.

The deposit creation process is at the heart of the banking system servicing the public and
stimulating economic growth. The modern banking instruments of securitisation, hedging,
leveraging, derivatives and so on turned this process on its head. They enabled banks to lend
more out than they took in deposits. According to Morgan Stanley Research, in 2007 UK
banks loan-deposit ratio was 137%. In other words the banks were lending out on average
£137.00 for every £100 paid in as a deposit. Another conservative estimate shows that this
indicator for major UK banks was at least 174%. For others like Northern Rock it was a
massive 322%. [For more details, refer to Table A.] Banks were “borrowing on the
international markets” and lending money they did not have but assuming to have in the
future. Likewise, “international markets” were doing exactly the same. At first sight it might

98
not seem so much different than deposit creation. Deposit creation is lending money by the
banks they do not have on the assumption that they will get enough back in sufficient time in
the future from borrowers.

On closer examination there is a remarkable difference. With every cycle of the 86.5% loan-
deposit ratio every £1 deposited is reduced becoming less than £0.50 after 5 cycles and less
than 1 penny after 32. With a loan-deposit ratio of 137% — lending £137 for every £100 —
not to mention 174% or indeed 322%, the story is drastically the opposite. Imagine a banker
gets the first £1 deposit in the first week of a new year and lends it out. Imagine that twice
every week in that year the amount lent out comes back to him as a deposit and he sustains
such deposit creation process with a ratio of 137% twice every week for the year. This is a
perfectly plausible scenario on the current electronic financial markets. By the following New
Year’s Eve, the final amount he finally lends out from the original £1 is over £165 trillion (165
with 12 zeros, or over 16 times the amount governments have so far injected into economy).
The total amount lent out in a year by a banker is over £447 trillion. Significantly with a loan-
deposit ratio 100% or above no reserve is created.

It is an acknowledged monetary principle that the lending interest rate cannot be below 0%.
This would allow borrowers to borrow money and banks would keep paying them for doing
so. Indeed, there would be no incentive to lend and borrowing would have become a source
of income for a borrower. Ultimately, lending would have stopped completely. It is a very
similar principle that the loan-deposit ratio cannot be 100% or above, as in such
circumstances, an amount of money coming from economic activities into deposit creation
cycle would be multiplied very rapidly to infinity. Economic growth and inflation would not
be able to catch up with it, which happens if loan-deposit ratio is below 100%.

The loan-deposit ratio below 100% that traditionally served as a very strict self-regulating
mechanism of money supply stimulating the economy becomes a killer above 100%. The
banking system becomes a classic example of a massive pyramid scheme. But as with every
pyramid scheme, as long as people and institutions are happy not to demand cash
withdrawals from the banks it is sustainable. Any bank can always print an impressive
account statement or issue a new deposit certificate. The problem is whether the cash is there.

The qualitative and quantitative difference between loan-deposit ratio of 0% and 99% is
infinitely smaller than between 99% and 100% or 101%. With ratios between 0% and 99%, we
always end up with a money-making machine that creates a finite amount of money out of
the initial deposit with a reserve nearly equal to the original deposit. If a ratio climbs to 100%
or above the amount of money created spirals to infinity, if above 100% with exponential
speed and no reserve is generated in this process. It is little wonder that Northern Rock which
used the ratio of not less 322% collapsed first well ahead of others, HBOS with a ratio of
around 175% ended up in a meltdown scenario later, while HSBC that used the ratio of not
more than 91% was relatively safe (being a part of the global banking system, however, it has
been at a risk stemming from the actions of other banks). [For more details, refer to Table A.]

Facing the Inevitable

99
For years the impressive-looking banks results brought a lot of confidence and the City was
hailed as a beacon of the British economy. Bank executives, traders and financiers collected
huge bonuses — not surprisingly, a lot of it in cash, rather than financial instruments.
Influential economists and politicians alike justified stratospheric bonuses and hailed the City
as the workhorse of the economy. Government strategic decisions were quite often
subordinate to the objective of keeping the City strong. Irrational exuberance triumphed.
Ultimately, City executives, traders and financiers proved to be pyramid purveyors not any
more sophisticated (although perhaps better mannered) than their Albanian gangster
counterparts who carried out a similar scheme 1996-97.

As with any pyramid scheme (and as long as there is still cash in the scheme) the beneficiaries
are the operators of the scheme and “customers” who know when to get out of it. During the
hectic dawn of the current financial crisis it is very likely that bank executives realised that it
was the time that their pyramid started collapsing. This easily explains why banks stopped
trusting one another and interbank lending collapsed. It was impossible to predict which
node (financial institution) of a pyramid scheme would collapse next. There was a very
distinct risk that if a bank lent money to another, the next day the bank-borrower may be bust
and the money would be gone.

The collapse process, always an instant one, is accelerated by a dramatic loss of confidence
amongst the pyramid customers. Once a single customer cannot withdraw his deposit, a great
number of others start demanding payouts. City executives must have known this mechanism
and explained to the government officials that unless the state shifts its weight injecting cash,
guaranteeing deposits and lending, the system was bound to collapse. The Northern Rock
case was a good dry run that pyramid purveyors gave government officials in September
2007. Facing a complete meltdown and an “Albanian scenario” the government acquiesced to
the bankers’ demands by injecting cash on an unprecedented scale and giving wide
guarantees.

The Route to Recovery

This is only the beginning of the story. According to some estimates there are around $2
quadrillion worth of financial instruments (like securities) that cannot be redeemed due to
the lack of cash in the system — so-called toxic waste. These instruments are in the financial
system and there are prospective beneficiaries of these instruments when they are redeemed,
however. Furthermore they appreciate in value and attract interest so their notional value
continues increasing over time. Governments around the world injected cash into the global
banking system to a tune of around $10 trillion, or 200 times less than $2 quadrillion. At the
same time they allowed bank executives and financiers who organised this pyramid scheme to
remain at their posts to manage the injected money. Governments became the ultimate
customers of pyramid purveyors with the hope that when they offer their custom it would
somehow stop the giant pyramid scheme from collapsing. This is extremely naïve and very
dangerous. The incredibly fast growth to infinity of pyramid schemes, which is only
accelerating, will ensure that the government will not stand a chance to sustain it, unless this

100
massive pyramid scheme is brought to a halt and liquidated. But there is no sign of
governments contemplating doing that yet.

If governments do not liquidate the global pyramid scheme, the money they injected will be,
in time, converted into toxic instruments (e.g. securities) and cashed in by organisers and
privileged customers of these schemes (or in the case of Albania, gangsters and their customer
friends). As the amount injected is around 200 times less than the notional value of toxic
instruments, the economy will not even see a difference. It will be a step back to September
2008, only now with trillions of dollars of taxpayers’ money spent to sustain the pyramid
scheme. It will be merely throwing good money after bad. But can governments afford to
come up again with the same amount money and do it 200 times over or more? This is based
on a very optimistic assumption that the notional value of toxic instruments is not increasing.
If governments take the route of continuing to inject money, they will make taxpayers
dependant on the financial system in the same way that criminal loan sharks control their
customers — their debt is ever increasing and customers keep on paying forever as much as it
is possible to extract from them.

In a normal free market economy a business that fails should be allowed to collapse. If a
business is a giant pyramid scheme, like the current financial system, it must be allowed to
collapse and its executives and operators should face prosecution. After all running pyramid
schemes is illegal. Letting the banks collapse would have been a far more commercially sound
solution than the current approach, provided the governments would have secured and
guaranteed socially vital interests directly. For example, individual deposits would be
guaranteed if a bank collapsed. Deposit accounts records, along with mortgage and genuine
business accounts, would be moved to a specially created agency of the Bank of England
which would honour them with government help. If a pension fund collapsed due to a bank
collapse, individual pensioners would continue receiving their unchanged pensions from the
social security system. This would guarantee social stability and a normal flow of cash into the
economy.

The hard part would be to liquidate financial institutions while sifting through their toxic
waste and to distinguish genuine non-toxic instruments and the results of pyramid scheme
operation. Deposits, mortgages and business accounts are clearly non-toxic in principle.
However, in the modern banking they were mixed with potentially toxic assets. This would be
a gargantuan task.

The current “quantitative easing” (printing cash) is an attempt to convert more toxic
instruments, like securities, into cash, albeit at some inflationary costs, and make them state-
guaranteed, as cash is guaranteed by the state. It is just another trick of the financial pyramid
purveyors to extract even more cash from taxpayers through the governments on the back of
the scheme. Looking back to the 1990s, Albanian gangsters must feel really crossed
considering that they were not offered such a “rescue” package first by Albanian government,
and then by the World Bank and International Monetary Fund.

101
Unless and until the governments identify, isolate and write off toxic instruments held by
financial institutions every pound put into “rescue” is very likely to end up being good money
thrown after bad. (The governments, as ultimate customers of the global pyramid scheme, are
supplying the pyramid purveyors and beneficiaries with tax payers’ cash and the largest heist
in history continues.) Alongside the liquidation process, but after the toxic waste has been
isolated and fenced off in failed financial institutions, governments must launch a fiscal
stimulus package and go after the pyramid purveyors and beneficiaries to recover any cash
and assets from them and bring them to justice. As the financial pyramid scheme is global,
any action — including the recovery cash and assets — must be global, too. It is intriguing
that banks in traditional offshore financial centres like Belize, US Virgin Islands, Bermuda, do
not appear to suffer from liquidity problems. They do not require rescue packages even
though a lot of them are subsidiaries of much larger banks which are affected by the current
crisis. Is it a sheer coincidence that, for example, the loan-deposit ratio at US Virgin Islands
banks is at a very prudent 42%? Little doubt there is a lot of cash there not created in those
little economies. Mr John McDonnell MP [Member of Parliament in the UK] wrote in The
Guardian on 20 February 2008:

“One series of offshore trusts associated with Northern Rock were called Granite (presumably
a witty pun on the Rock bank). Granite holds approximately 40% of Northern Rock's assets,
around £40bn. Yesterday, the Treasury minister told the house that "Granite is and has always
been a separate legal entity".

Let's look at that: Northern Rock does not own Granite, that's true. It is however, wholly
responsible for it: it's officially "on" its balance sheet in its accounts. But it is legally "off" its
balance sheet when it comes to getting hold of its assets as the basis for the security of the
sums owed the Treasury.

Granite is based in Jersey, an offshore tax haven where Northern Rock's best assets sit outside
the reach of taxpayers. So the bill to nationalise Northern Rock will, in fact, be nationalising
only dodgy debt, which will increase the burden on the taxpayer and put at risk the jobs of
Northern Rock workers. The sad truth is that by failing to regulate the financial sector
adequately, the government has been hoist by its own neoliberal petard. The participants in
this tax dodge will be allowed to walk away with millions, when workers may lose their jobs
and the taxpayer risk billions."
Epilogue

Some economists see overvaluation of financial instruments as the root cause of the current
financial crisis. Overvaluation was not a necessary factor, but only a contributory and
accelerating factor that worsened the crisis. The crux of the matter is that financial
institutions have considered financial instruments, like securities, as good as cash and added
them as cash in the deposit creation cycles at a rate that brought the loan-deposit ratio to
100% or above. Without non-cash financial instruments considered as cash it is impossible to
go above 100% in a deposit creation cycle. And it does not matter if these instruments were
given proper risk characteristics individually discounting their notional, face value. As long as
with any residual value, they have been added in deposit creation process to an extent that its

102
ratio was 100% or above, the disaster was only a matter of time. Because of exponential
character of the creation it was a matter of a short time.

Loan-deposit ratio above 100% is like (untreated) AIDS. As it progresses it weakens the
immune system of economy that safeguards against adverse events: natural disasters, wars, etc
or sometimes unpredictable mood swings of market players. The current crisis was triggered
by the collapse of subprime mortgage market (effectively overvaluation of assets). This time
the system, for years having had been weakened by loan-deposit ratio above 100%, also
collapsed altogether. It was a giant pyramid and it was bound to crumble anyway (for
whatever direct cause). It was like a human suffering from AIDS whose death was not caused
by AIDS directly, but by pneumonia, flu, infection, etc. However it is AIDS that made the
curable illnesses lethal.

Until recently the world enjoyed a sustained period of high growth and low inflation and the
fact that it came to such an abrupt end does not come as a surprise. It was in the very nature
of the pyramid scheme mechanism. The deposit creation process with a ratio above 100%
guaranteed impressive-looking economic growth figures. At the same time there were no
extra cash hitting Main Street, as there was no extra cash printed. In this context, the high
growth of property prices is no surprise. In their huge majority and extent, these are, in
practice, cashless interbank transactions. The world stayed oblivious in this economic miracle
like customers of a pyramid scheme being happy with the figures on their statements until
they wanted to withdraw money. But like with any pyramid scheme, the financial system ran
out of cash, with the outcome of a lack of liquidity, not high inflation.

103
TABLE A

UK BANKS
[source: http://news.bbc.co.uk/today/hi/today/newsid_7648000/7648508.stm,
http://www.timesonline.co.uk/tol/money/property_and_mortgages/article5106455.ece]

BANK LOAN/DEPOSIT RATIOS MARKET SHARE

HSBC 90% 2.8%
RBS 112.3% 6.2%
Barclays 123.45% 6.3%
Lloyds TSB 140.84% 8.1%
Alliance & Leicester 172.41% 3.6%
Bradford & Bingley 172.41% 3.9%
HBOS 175.43% 20.1%
Northern Rock 322.58% 8.1%

Weighted average LOAN/DEPOSIT RATIO = 174.26%

Additional information:

- the RBS position includes ABN AMRO – without it RBS position was around 135% [source:
MS Research/Howard Davies Presentation -
http://www.lse.ac.uk/collections/meetthedirector/pdf/Banking%20and%20the%20State%2002
.10.08.pdf]

- Abbey position after acquisition of Bradford & Bingley was 75% [source:
http://www.santander.com/csgs/StaticBS?blobcol=urldata&blobheader=application%2Fpdf&
blobkey=id&blobtable=MungoBlobs&blobwhere=1205449310144&cachecontrol=immediate
&ssbinary=true&maxage=36000]

TABLE B
[source: MS Research/Howard Davies Presentation -
http://www.lse.ac.uk/collections/meetthedirector/pdf/Banking%20and%20the%20State%2002
.10.08.pdf]

COUNTRIES/REGIONS LOAN/DEPOSIT RATIOS

UK 137%
Germany 121%
USA 105%
France + Benelux 103%
UK + Asia 89%

February 2009

104
 Supplementary memorandum from the Guernsey Financial Services Commission

Further to the Commission’s previous submission, and the oral evidence I gave on 3
February, I am writing in relation to a question asked by Sir Peter Viggers to confirm that the
Commission has no objection to the Committee obtaining from the FSA the details of any
dialogue or correspondence with the Commission concerning the banking crisis.

I would like to add the following context to the comments I made on 3 February about the
need to recognise how important it is to ensure effective cross-border regulatory cooperation.
Without such cooperation, both in normal times and at times of crises, it becomes virtually
impossible to protect depositors with an institution in one jurisdiction if that institution has
operations in other jurisdictions. The danger, not only to depositors but also to international
finance and trade, is that in the absence of effective cooperation jurisdictions will have little
alternative to adopting protectionist policies involving the ring-fencing of assets and capital
and the curbing of cross-border activities. Such measures would raise costs, reduce flexibility,
and make global recovery and growth much more difficult.

This is a major issue for all jurisdictions, not just for Guernsey and the UK. I n my capacity as
a member of the Executive Committee (the governing body) of the International Association
of Insurance Supervisors (IAIS), I am aware that a considerable amount of work to address
the problem of poor cross-border regulatory cooperation is being carried out by the Financial
Stability Forum, the Basel Committee on Banking Supervision, the International
Organization of Securities Commissions and the IAIS itself. During meetings in Brussels last
week, I met representatives of the European Commission, the Geneva Association (which
represents the largest international insurance groups) and a number of senior international
regulators. They all identified the problem of achieving effective cross-border regulatory
cooperation as one of the main issues to be addressed as a matter of urgency. What is needed
in concerted international action to remove the legal, political and attitudinal barriers which
currently exist.

6 February 2009

105
 Memorandum from Mr Gavin Fryer

This week’s Select Committee Meetings with Bankers

I acted as a senior Regulator and Investigator at the Stock Exchange in the City of London
during 30 years to 1992, responsible from much of 25 years for the standards of conduct and
disclosure by public companies and their directors. Worldwide.

This week senior Bankers are to be questioned by your Committee. As you know formulation
of the questions is key to avoidance of obfuscation and ensuring you obtain truthful
responses. More has to be done to bring a sense of reality to these Chairmen and Chief
Executives. Their feet left the ground some time ago.

Bonuses
Contractual bases for payment of Bonuses should be immediately annulled by the
Government now that it is clear these banks have lost shareholders and depositors money
(some not for the first time) and now rely on taxpayers’ money for their life-blood. A defence
by banks that relies on a need to retain key staff should be directly challenged, given that these
‘so-called’ skilled people actually lost everything ‘at the casino’, so there was no skill worth
keeping there! Payment of bonuses would be payment using taxpayers’ money in many cases.
Bonuses have to be earned over maybe a 4-5 year perspective, not given away like annual
Christmas gifts.

Understanding of commitments
The entire area of understanding and training for employees to undertake complex
transactions in securitised third party commitments and other derivatives must be reviewed.
Whatever were the Financial Services Authority doing in this respect? No entity with a
banking licence should be permitted to enter into this type of business without their senior
executives, including the executive and non-executive directors being tested and questioned
about their understanding.

Responsibility
The bank directors know-how and understanding of their business commitments must be
questioned to the point of asking what actual training did these directors have before
committing banks to contracts that lost billions (some Baring directors escaped by a few hairs
breadth being taken to Court and being held personally responsible). Given directors and
senior executives have focused largely on bonuses and share options, I believe that the
Secretary for Trade should deem all those found to be responsible for exposing bank
shareholders and depositors funds to such risks with little regard for the consequences should
be disqualified under the Companies Acts from ever again acting in such capacities in any
British corporate entity.

Such skewed skill and know-how ought to be investigated by an All-Party Commission

perhaps chaired by yourself. After all these banks are responsible for the biggest corporate
losses ever in the UK.

Training in future
In future senior bank directors and managers should without exception be put through
106
training, not only about the technical side with a focus on the consequences of entering into
complex commitments involving time, interest rate risk, currency risk, counter-party risk,
domestic and international economic scenarios, etc., but also their role in directing a public
corporation that must be fully accountable for its actions to all sectors of their stakeholders.
That latter aspect seems to have been ignored.

Special Deposits
Special deposits in cash should in future be made at the Bank of England using a ratio of say
1:10 so that no bank operating in the UK should be permitted to enter into securitised or
derivative business in excess of ten-times the special deposits. And the Bank of England must
monitor such ‘traffic’ not merely watch it pass-by.

Exposure to risk
Certainly these long-established businesses that were managed successfully through all kinds
of difficult periods for over 100 years have been almost totally destroyed in what seems like
three-four years. We know much of the exposure was created with a mindset that seems to
have been established following promulgation of the Bank of England’s paper Competition
and Credit Control in about 1978 after which most managers of banks’ loan books seem to
have ‘lost their heads’, vide South American loans.

Next Steps
Furthermore, I worry that taxpayers’ funds may be applied in a renewed splurge of
speculative business by banks, yet regarded as ‘oiling the wheels’ of what have actually
become rusty vehicles in the breakers’ yard. There are very few people who really understand
such complications. I know because I investigated examples in the late 1980’s and 1990’s (and
incidentally I was for some years directing investigations into suspected insider trading and
dealing with scores of Department of Trade Inspectors).

Rewarding employees on the basis of a bank enlarging its portfolio of such lethal instruments
without regard for the consequences must stop.

7 February 2009

107
 Supplementary memorandum from the Kaupthing Singer & Friedlander Depositors’
Action Group

The Kaupthing Singer & Friedlander Depositors’ Action Group would like to thank you for
the opportunity to present evidence at the Treasury Select Committee hearing held on 3
February 2009. In addition the group would like to thank the committee members for the
interest shown in our plight and the diligent questioning of the authorities involved in the
demise of our bank.

The Action Group would like to bring to the committee’s attention a few points arising from
our evidence presented to the committee on 3 February 2009. We hope that the committee
finds the opportunity to pursue these issues with the relevant parties in light of the ongoing
question of culpability in the case of the failure of Kaupthing Singer & Friedlander Isle of
Man. Currently, although the Isle of Man Government assured you that it was taking its
responsibilities seriously, it does not seem to reflect this sentiment by behaving in the same
way as other Governments worldwide in ensuring that depositors do not suffer as a result of
their actions.

As a general point we would like it noted that as far back as 2001 the Isle of Man was
promoting itself using the following endorsement from the FSA:

"For protection of investors, the Island has developed an effective regulatory regime under the
auspices of the Financial Supervision Commission.

The Island was the first to receive "designated territory status" under the UK Financial Services
Act, granted only to those jurisdictions deemed to provide a degree of protection and regulation
comparable to that applicable in the United Kingdom. Investors can therefore rest assured that
their affairs will be conducted in a well regulated and responsible manner – a vital source of
reassurance and security to may clients who may live far afield and have little or no previous
experience of the Isle of Man"

Is it not important that once granted “designated territory status” the FSA either leaves
the regulatory authority, in this case the FSC, to operate independently, or when the FSA
does get involved in influencing movement of funds, the FSA takes full responsibility for
the consequences?

POINTS REGARDING THE FINANCIAL SERVICES AUTHORITY

1. Depositors would wish to understand why the FSA sanctioned the takeover of Singer
& Friedlander (a well known and reputable British bank) by Kaupthing Bank, when
members of the board of Directors’ of Singer & Friedlander (including the CEO Tony
Shearer) made representations to them indicating that those running Kaupthing Bank
were not ‘fit and proper’ to run a UK bank.

108
2. Despite these warnings from existing management, not only did the FSA sanction the
takeover of Singer & Friedlander but they allowed the corporate structure to be
changed 16 months later. This resulted in parental control for the Isle of Man branch
being changed from the UK bank to Kaupthing Iceland. It is as a direct result of this
change in corporate structure that the depositors in KSFIOM find themselves in the
position they are in. Why did the FSA allow this to happen, bearing in mind the
warnings given and the change in regulation for existing depositors that this corporate
change entailed?

3. In January 2007, the FSA allowed a British Building Society (the Derbyshire) to be
taken over by Kaupthing without any regard for the impact on existing Derbyshire
depositors. The parental guarantee, once provided by Derbyshire UK, was transferred
to Kaupthing Iceland but no due diligence appears to have been performed by the FSA
as to the credibility of this new guarantee which has proved to be worthless. Why?

4. The FSA held discussions with the Isle of Man regulator (FSC) which resulted in over
£580m of KSFIOM assets being held on deposit in the UK sister bank when it
collapsed. You have heard from the FSC that discussions took place between the
regulators detailing the regulatory constraints under which the UK bank would be
required to operate (a fact withheld from the TSC by the Lord Turner at the first
hearing into the banking crisis). Depositors would like to know why the FSA,
apparently, allowed these constraints to be breached.

5. Furthermore, depositors would like to know why the FSA chose not to hold
discussions with the FSC, as the issues surrounding KSFUK gained greater urgency,
despite the UK regulator knowing the extent of KSFIOM’s exposure to the UK bank.
This appears to go against the Memorandum of Understanding held between the two
regulators as well going against recent precedent set with the Bradford & Bingley
issue.

6. It would appear that KSFUK was acting more as a Private Equity institution rather
than a high street deposit taking bank and yet the FSA, aware of this fact, still allowed
retail deposits from the Isle of Man to be placed within the UK entity. Considering the
vastly different risk profiles of both institutions, depositors would like to know why
the FSA believed this to be appropriate place for their deposits to rest at this crucial
time.

109
POINTS REGARDING THE FINANCIAL SUPERVISION COMISSION (Isle of Man)

1. The FSC permitted a bank within its jurisdiction (KSFIOM) to place 48% of its assets
with a single entity. Not only did it allow the assets to be placed with a single entity
but the entity (KSFUK) was part of the same group over which the FSC had concerns.
Depositors believe that, at the time of the asset transfer, the FSC must have been aware
that should KSFUK fail (as subsequently happened) then KSFIOM would be
destroyed along with its sister bank. Irrespective of the FSC’s understanding of
conversations held with the FSA, it is unimaginable that any reasonable, risk
management process would sanction such a transfer at that time - so why did the FSC
allow it to happen?

2. Mr Aspden referred to this at the TSC as ‘upstreaming’ however we contend that this
was not ‘upstreaming’ since, due to the change in corporate structure between KSFUK
and KSFIOM, there was no direct relationship between the two and therefore no
automatic ‘downstreaming’ possible.

3. In addition to allowing the transfer of assets as detailed above, the FSC failed to
require KSFIOM to put in place any protection, such as ring-fencing. Why?

4. To compound the errors in points 1 & 2, the FSC failed to put in place any procedures
to ensure that this incredible risk and exposure was monitored on an ongoing basis.
Why?

5. The FSC has told the committee that assets were placed with KSFUK following in
depth discussions with the FSA during which details were provided to the Isle of Man
regulator surrounding the controls being put around KSFUK. There appears to be no
evidence that the FSC carried out any due diligence on the information provided by
the FSA. Was this all taken at face value? Could the fact that the FSC’s head of
supervision, Michael Weldon, was once seconded to the FSA have any bearing on
this? Although John Aspden has promised to provide evidence of these conversations
to the TSC, attempts by our lawyers to access this information has been stonewalled
(see attached correspondence)

6. Why did the FSC rely so heavily on the Memorandum of Understanding held with the
FSA? As the situation deteriorated why was there no attempt to rectify the situation?
KSFIOM refused to move money on deposit from life companies after 1 October
2008, eight days before the bank’s demise, yet there is no evidence that there was any
attempt to retrieve the position with KSFUK at this time.

7. Depositors believe it is important that the committee are made aware of potential
conflicts of interest in this debacle. John Cashen is a commissioner in the FSC and
also a director of KSFIOM whilst Donald Gelling is a director of KSFIOM whilst
holding the position of Head of the IPA (a division of the FSC).

110
POINTS REGARDING THE DEPOSITORS COMPENSATION SCHEME

We believe that The Chief Minister may have misled the TSC regarding the efficiency of the
DCS on the Isle of Man.

£150m is being made available by the Isle of Man Government to any DCS that may be
triggered by liquidation of a bank on the Isle of Man with compensation up to a maximum
cap of £350m, the balance of the funds being gathered through a levy on local banks – any
funds in this regard are yet to be collected (Mr Brown suggested this was ‘earmarked’ which
we contend to be an exaggeration). It is anticipated that future funds gathered through
specified levies on the local banks could take up to 20 years to be paid out under the DCS.

It should be noted that the maximum cap is a total that is applicable to all banking
institutions that fall into liquidation before 9 October 2009. This means that if another bank
were to suffer a similar fate as KSFIOM before that date the maximum payout of £350m
would be shared by depositors in that bank as well thus reducing individual payouts to
depositors. This means that any Scheme Manager that is appointed would be unable to
calculate total liabilities under the scheme before this date since the future is unknown.

Currently and in the absence of contributions from the IoM banks, the maximum available in
the DCS is £150m with the estimated current liability under the DCS to KSFIOM depositors
standing at £208m. From this it can be seen that there is already a gap in funding that may be
due to all KSFIOM depositors under the implementation of this scheme.

A further complicating factor is that potential claimants have six months to submit a claim
from the date the scheme is triggered and the Scheme Manager is duty bound to wait to see
the total number of claimants before any money is paid. So if KSFIOM was liquidated on 19
February, the Scheme Manager would have to wait until 19 August 2009 before making
arrangements to pay any claim and would then be able to do so only on the basis that there
was a degree of certainty that no other IOM banking institution was likely to fall into
difficulties before 9 October 2009.

It is therefore unlikely that even a proportionate claim would be paid until October 2008 at
the earliest.

All in all, the DCS on the Isle of Man does NOT offer the same route of recompense as the
UK Government offered to Kaupthing UK or Icesave depositors in the UK. It has a totally
different mechanism in mind, built to combat historic potential liabilities rather than the
banking crises we find in the new world of 2008/09. However since even the Isle of Man
Government is unable to explain its own scheme in writing to depositors, despite our
encouragement and help, the outcome for those unfortunate enough as to be involved is
extremely unclear.

111
February 2009

112
 Supplementary memorandum from Tony Shearer

Information provided to the FSA

At the hearing of the Treasury Select Committee into the Banking Crisis on Tuesday 3rd
February I was asked to provide to the Committee copies of any:

• Written memoranda that I had supplied to the FSA

• Notes of any meetings or phone calls that I had with members of the FSA.

Attached are copies of the relevant documents that I have managed to locate, namely:

• A memo that I prepared about some aspects of Kaupthing's published accounts

("Appendix 1")
• A memorandum that I prepared headed "In my opinion their strategy is ‘a dash
for respectability’" ("Appendix 2")
• An email from Chris Aujard (Group Compliance Director at S&F) to me dated
14th April 2005 referring to a conversation he had had with Kevin Halpin, and
referring to a meeting that I was having with the FSA later that day ("Appendix 3")
• A note headed "Project Kellogg" which is an outline agenda for a meeting at the
FSA on 14th April 2005 ("Appendix 4")
• My hand written note of the meeting with the FSA on 14th April 2005 ("Appendix
5")
• A note headed "Project Kellogg" which is an outline agenda for a meeting with the
FSA on 15th April 2005, with my handwritten notes below it ("Appendix 6")

I should point out that in the usual course of business I, and colleagues at Singer &
Friedlander, had frequent contacts with people at the FSA. The frequency of these contacts
rose during the period that led up to, and after, the announcement of the Offer from
Kaupthing for Singer & Friedlander. These contacts came in the different guises of emails,
meetings and phone calls. Some of these I would have recorded, and some not.

When I left Singer & Friedlander, I left most of my records at the offices in New Street,
because they were the property of the company and not mine. I did take a few papers, and
also some emails and other electronic records.

For example, I attended a breakfast in March 2005 with the Chairman of the FSA, Sir Callum
McCarthy, when he said that the FSA had three roles:

• To prevent a systemic failure of the banking system

• To help redress the imbalance between consumers and product providers by reducing
inequality of knowledge/literature and
• To make dealing with the FSA a good experience

113
I said I agreed with him, but said that my experience at S&F was that the matters that we had
to deal with with the FSA were about completely different matters, the "minutiae and trivia".
As a result of this exchange I wrote to Sir Callum and asked him to come to our offices and
we would show him at first hand. Some correspondence ensued and I arranged for him to
come to our office at New Street (a meeting that I had to cancel when the approach from
Kaupthing became public knowledge). As an example, I do not have any of this
correspondence as I left it at New Street.

One very specific contact that I had with the FSA and which is relevant to the evidence I gave
on 3rd February 2009, was that on 14th April 2005 Paul Selway-Swift, Jonathan Spence and I
with Jan Putnis (of Slaughter & May) met Jonathan Fiscal, Kevin Halpin and James Dresser at
the FSA. We discussed the progress with Kaupthing’s Offer for S&F, the FSA’s approval
process, and also our concerns about Kaupthing as a “fit and proper person”. At this point I
had a list (Appendix 1) showing the cross-shareholdings in Kaupthing between it and various
shareholders, and also the share dealing, service contracts, and loans involving the Chairman
and CEO of Kaupthing. I am almost certain that I gave this information to the FSA. I also had
at that meeting the document (Appendix 2) which I would have used at that meeting. I am
not certain whether or not I left a copy with the FSA.

It is also at about this point that I spoke on the telephone to Paul Shirley about my specific
concerns re Kaupthing. The documents in Appendices 1 and 2 were the documents that I
used to brief myself as I spoke to him.

On 15th April 2005 I attended another meeting at the FSA, almost certainly involving
Kaupthing as well. This was to discuss what information the FSA needed to approve the
change of control. I am sure that Armann Thorvaldsson and Jim Youngs of Kaupthing were
at this meeting too.

Names of the directors of Singer &Friedlander Group and other parties

I was also asked by the Select Committee to provide the names of the other directors of Singer
& Friedlander Group plc, and other parties at the relevant times in 2005.

The directors were:

• Paul Selway-Swift, Chairman

• Warwick Jones, Finance Director and Chief Operating Officer
• Jonathan Spence, Head of the Bank
• Richard Bernays, Non-Executive
• Mark Austen, Non-executive
• Sarah Rutherford, Non-executive

Sir Brandon Gough was a Non-executive up to about March 2005, and so was involved in the
early stages of the decisions relating to the discussions with Kaupthing. I think that he had left
by April 2005.

114
Other relevant parties were:

• The partner from Slaughter & May, Martin Hattrell

• The partner/Director from Cazenove, Tim Wise
• The Head of Risk at Singer & Friedlander, Conrad Clarke
• The Head of Compliance and Legal Services at Singer & Friedlander, Chris Aujard

6 February 2009

Reaction to the response by the FSA to my evidence

rd
On 3 February I understand that the FSA made a statement available that said:

"The concerns raised by Mr Shearer and his fellow directors were based on information in the
public domain and related to corporate structure and governance concerns in the acquiring
group, Kaupthing.

We made a full assessment of the situation at the time, including consulting with the home
regulator, in accordance with EEA rules. As the home regulator, the Icelandic regulator
confirmed there was no reason why the transaction could not go ahead.

In addition, as part of the change of control process, we required Kaupthing to take a number
of actions to address governance issues in London, including the appointment of independent
non-executive directors. The application was processed within our normal time frame, it was
not 'rushed through' as Mr Shearer claims.

It is important to note that the failure, three years later, of Kaupthing Singer & Friedlander
related to different issues, in particular, the impact of the global financial crisis on the Group's
liquidity and the rapid withdrawal of retail deposits caused by the collapse of the Icelandic
economy."

Regards
Kirsty Clay

Kirsty Clay
Head of Media Relations”
The FSA acknowledges that my colleagues and I did raise our concerns with them. It also:
1. states that it obtained some form of comfort from the Icelandic regulator;
2. states that it also made a “full assessment of the situation at the time”;
3. required Kaupthing to take a number of actions, of which the only one specified is to
appoint independent non-executive directors;
4. states that it processed the application for change of control within the normal time
frame and

115
 5. states that the cause of the failure of Kaupthing Singer & Friedlander was “the impact
of the global financial crisis on the Groups’ liquidity and the rapid withdrawal of retail
deposits caused by the collapse of the Icelandic economy”.

I would like the opportunity to respond to all of the above points.

My responses (which I would like to explain in person to the Select Committee in more
detail) are, in summary:
1. To rely on a reference from the Icelandic regulator is like asking Ronnie Biggs’s
mother for a character reference and then letting him out on bail. The FSA does not
state that I for one also expressed serious concerns about the quality and experience of
the individuals at Kaupthing, and also about their business model;
2. The FSA has not so far said what other actions were involved in their “full
assessment”. They certainly did not make any further enquiries of anybody else with
the S&F group;
3. Nor do the FSA say what actions they took other than to require the appointment of
two non-executive directors;
4. I am happy to discuss the timeframe of the change of control. The FSA is wrong;
5. It is debatable as to what caused the collapse of Kaupthing. But the reasons that there
is a global financial crisis is largely attributable to bad management of financial
services companies around the world, including the Icelandic banks – not the other
way round!

The FSA do not comment on any of the other ‘red flags’ that I was asked to discuss in the
Select Committee. Not only did I give the FSA my reasons for not staying, but in about
October or November 2005 the Group Finance Director announced that he was leaving,
and then in about January 2006 the Head of the Bank also announced he was leaving. In
about February or March 2007 the Heads of Risk and Compliance were both also asked to
leave. The FSA do not state whether this alerted them, whether they interviewed any of
them, or whether they asked the two non-executives if they had spoken to any of them, or
knew why they were leaving.

One aspect of a sound regulatory system should be that the Regulator should encourage
people to come to them with their concerns even if this causes those individuals conflicts
with the other members of the management team. The Regulator should support
(privately and publicly) those people who do so, if their concerns are well placed. If the
FSA wants executives to act responsibly, it cannot leave high and dry those who alert
them to potential issues.

One aspect of our concern was that we didn’t think Kaupthing’s business model was
suitable because they were like a leveraged hedge fund rather than a traditional bank –
borrowing money to buy shares and then making a media splash to ramp the share price.
Specifically they ramped the Singer & Friedlander share price (a target that they were
about to bid for) so they could take a profit on the 19.5% they held even though it would
mean that they would have to pay extra to buy the outstanding 80.5%!

116
6 February 2009

117
 Supplementary memorandum from Which?

Competition in retail banking and the home credit market

Further to my evidence session on consumer issues at the Treasury Select Committee inquiry
into the banking crisis on Wednesday 14 January, I thought it would be helpful to clarify
Which?’s position on competition in the banking sector and the home credit market.

As a principle Which? believes that increased competition will normally deliver better
outcomes for consumers in terms of quality, price and asses to goods and services. You
correctly noted in your questions, Which? wants greater competition in the banking sector in
order to deliver better value products for consumers. As was confirmed in the Cruickshank
Report and in the recent OFT study of personal current accounts, the UK market for banking
is uncompetitive. This has only been made worse by recent consolidation, most notably the
formation of the Lloyds Group, which now has around 30 per cent of the current accounts
market and 28 per cent of the mortgage market. Our research has demonstrated that the
larger, established banks generally offer lower customer satisfaction than the newer entrants.
We are therefore extremely concerned by the prospect of less competition in the banking
sector and believe a more competitive market would help deliver real benefits to consumers at
all income levels.

However, you were obviously right to suggest in the evidence session that competition is not
the only way to improve outcomes for consumers in financial services. For this reason,
Which? has never shied away from campaigning for robust intervention where consumers are
treated unfairly or the market cannot deliver the products and services that consumers need
at a price they can afford. For example, we led the campaign for reductions in unauthorised
overdraft charges, an issue which is now being considered by the High Court and the OFT.
We also proposed tough measures to tackle the mis-selling and bad value that characterises
the multi-billion pound market for payment protection insurance (PP1). Following evidence
from Which?, the Competition Commission recently proposed a series of tough measures
that will significantly reduce consumer detriment in the PPI market. In both these cases we
facilitated and encouraged consumers to seek redress, winning back thousands of pounds for
many people who had been unfairly treated. We have further pressed Government to
establish a free national finance advice network, an idea now being piloted by the FSA in the
North East and North West as ‘Money Guidance’. It is worth noting that in all these areas it
is those on low incomes who will benefit most by forcing change in the market,
demonstrating Which?’s commitment to fight for all consumers.

In your questions at the inquiry you raised the detriment caused to your constituents through
door-step lending and this is an area we have taken an interest in particular through the
investigation of the supercomplaint initiated by the NCC in 2006.

The home credit market was not one of the issues we referred to in our submission to the
committee nor have we carried out a recent market analysis in this area. Our proposals on

118
increasing competition specifically related to the mainstream retail banking sector and we
have not stated that consumers would benefit from higher levels of door-step lending.

We have concentrated during the banking crisis on approaches where we believe we can add
value, and we work with other organisations where they are best placed to intervene or
comment as a result of their position or evidence they have collected. Which? Is not a debt
advice agency and is not part of the Government funded approach to intervention in that
area. On doorstep lending we are sympathetic to the policy approach of CAB who
concentrate on supporting consumers in financial distress and through their bureaux
network have recent empirical evidence of how the market is working. Like CAB we welcome
extra support for the development of Credit Unions.

For Which? to develop a new policy initiative in this area would require us to prioritise
research in this area and the evidence of the work of the Competition Commission, following
the supercomplaint by the NCC, suggests that the market solutions to improve consumer
outcomes have already been fully analysed. An alternative to the market providing credit for
consumers unable to access mainstream credit would possibly be a State backed lending
scheme, in addition to Credit Unions, and the government is perhaps best placed to consider
that as part of its public policy objectives.

I hope this clarifies Which?’s position but please contact me if you would like to meet to
discuss further.

Doug Taylor

February 2009

119
 Supplementary memorandum from Charities Aid Foundation (CAF)

1. Introduction

1.1 This information is given to support evidence given to the Treasury Committee by John
Low, Chief Executive of Charities Aid Foundation on February 3rd 2009.
1.2 The Charities Aid Foundation (CAF) is a registered charity that aims to help charities
and social enterprises make the most of their money. CAF provides financial,
investment and fundraising services and works directly with tens of thousands of
charitable organisations across the UK and internationally.
1.3 CAF has a strong history of campaigning for changes in policy and legislation in order to
improve the giving environment and to secure supportive legal, fiscal and regulatory
conditions for donors, charities and social enterprises. Our knowledge and
understanding - gained through direct experience and research - makes us a trusted
voice on giving and the effective use of charitable funds.
1.4 This evidence relates in part to the collapse of Icelandic banks in October 2008 and the
impact upon charitable organisations. However, the issues raised and proposals for
future action have wider relevance.

2. Impact of the collapse of Icelandic banks on charities

2.1 Extent of potential loss

2.1.1 Following the collapse of Icelandic banks in early October 2008, it became clear that
charitable funds were in jeopardy. CAF, together with the National Council for
Voluntary Organisations (NCVO), Charity Finance Director’s Group (CFDG) and The
Association of Chief Executives of Voluntary Organisations (ACEVO) were asked by
the Financial Services Secretary, Lord Myners, to collect data about the extent of
exposure. 48 charities came forward with a combined total of £86.6m deposited funds.
2.1.2 Subsequently, Naomi House Hospice and Cats Protection have spearheaded a coalition
‘Save our Savings’ to lobby the government for assurances that their savings will be
returned in full. The 30 charities involved with the coalition have stated that they have
collective potential losses of £50m
2.1.3 The organisation with largest amount at risk is Cats Protection, who held £11.2m with
KSF. However the greatest proportionate impact has been reported by Naomi House
Hospice, with £5.7m which equated to a third of its total assets.
2.1.4 We believe that the full extent of the exposure is likely to be considerably higher than
£86m. Some depositors who would have qualified for compensation as retail depositors
would be unlikely to come forward and other potentially large amounts may be missing
due to fear of reputational risk.
2.1.5 Prior to entering administration, the website of KSF claimed to hold £230m of charitable
funds on deposit.

2.2 Impact of potential loss

120
2.2.1 The amount of charitable funds tied up in failed Icelandic banks is relatively small
compared to the estimated £12bn total funds banked by UK charities.15
2.2.2 The relative impact varies across these organisations, dependent upon the amount
deposited by the charity as a proportion of total assets. Many organisations will have
diversified their deposits across a number of separate authorized entities and managed
their funds so that this loss does not immediately jeopardise their sustainability.
2.2.3 Three months after the failure of the Icelandic banks the real impact is beginning to be
felt by some charities. On 25th of November, Naomi House was forced to suspend
services. Its hospice-at-home service, which provides carers for families with terminally
ill children in emergency situations, will not be resumed until the charity has had its
money returned.
2.2.4 The administration process could take years and this could present very real problems
for these charities especially as they try to weather the current economic storm with
stretched resources and increasing demands on their services.
2.2.5 The impact of the lack of these funds is exacerbated by additional difficulties including
falling interest rates and the decreasing value of Stirling.

3. Key Issues

3.1 UK/Non-UK Jurisdiction

3.1.1 Most of those charities that we know to have been caught in the Icelandic crisis were
depositors with Kaupthing Singer & Friedlander, a UK-based banking subsidiary of
Kaupthing bank. This is therefore within UK jurisdiction and regulated by the FSA.
3.1.2 We are led to understand that, prior to being bought by Kaupthing, Singer and
Friedlander actively marketed services to charities. This meant that charities were
disproportionately impacted by the failure of this bank.
3.1.3 By placing KSF and Heritable (the UK subsidiary of Landsbanki) into administration,
the UK Government have acted very differently than has been the case with other UK
banks such as Northern Rock, Bradford and Bingley, Lloyds TSB/HBOS and RBS, which
similarly failed to meet the FSA’s threshold conditions on capital, but received
Government support to continue.
3.1.4 Furthermore on October 9th, Treasury announced that retail depositors in Heritable and
KSF (Edge depositors and Private Banking clients) would receive a 100% deposit
guarantee. This was also extended to retail depositors in Landsbanki (Icesave) which is
not a UK, FSA regulated bank. It can be contended that while the Government
provided deposit protection to some extremely wealthy and financially sophisticated
private investors, some of whom had money in offshore banks such as Landsbanki, they
have taken no steps to provide protection for charities which placed charitable funds,
held in trust for public good, in a UK regulated bank.

3.2 Credit rating agencies/advice

3.2.1 Charities, along with other organisations including Local Authorities, deposited funds in
Icelandic banks on the basis of credit ratings.

15
CAF estimated based on NCVO Almanac (2007)
121
3.2.2 The best information available to charities rated the Icelandic banks as AA up until very
soon before the failures.
3.2.3 These ratings reveal only limited somewhat misleading information, rather than giving a
deeper more accurate picture of security and liquidity.

3.3 Eligibility for compensation through Financial Services Compensation Scheme

(FSCS)
3.3.1 Currently some charities fall under the definition of retail depositors and are therefore
eligible for compensation up to £50k. However the criteria for eligibility, established by
the FSA, is based on the Companies Acts 1985 and 2006 and equates charities to small
businesses.
3.3.2 The current framework does not recognise charities as having distinct charitable
purpose.
3.3.3 The compensation level of £50k for those who would be eligible (if Government did not
intervene to guarantee all deposits) would not be sufficient to sustain services in many
cases, thus placing organisations in jeopardy.
3.3.4 Many larger charities will fall outside of the criteria for the FSCS, as they are deemed
‘wholesale depositors’ and will therefore not be entitled to any compensation, should a
bank fail. This can place vital services at risk.
3.3.5 Unlike businesses, which more routinely rely on equity and debt finance, it is important
for charities to maintain sufficient levels of reserves and unrestricted funds to ensure
sustainability and survival, especially in difficult times.

3.4 Lack of clarity and poor communication

3.4.1 The eligibility criteria for compensation under the FSCS is opaque and it is difficult for
some charities to assess their own eligibility or to seek reassurance.
3.4.2 In early October, after the collapse of the Icelandic banks, clarity was sought from the
Charity Commission and the FSA on how the compensation scheme applied to
charities. As a result of lobbying from CAF, information was subsequently placed on
their websites.
3.4.3 Those affected, including the coalition, ‘Save our Savings’, have pushed for clear
information from Government on their position, but this has not been forthcoming.
3.4.4 There is also very little clarity on how banks are authorised and which banks are part of
a larger group or parent company, where the FSCS would pay compensation up to the
limit of £50,000 only once, irrespective of how many different institutions a person held
accounts with.
3.4.5 This poor communication leads to increased insecurity in the sector and lack of
confidence in the banking system.

3.5 Need for improved financial acumen in the third sector

3.5.1 We recognise that third sector organisations do, of course, have an obligation to make
sound investment and financial decisions on the basis of risk and return, and must be
accountable for how funds are managed. However, in reality, some organisations and
their boards of trustees contain limited financial expertise. Financial management may

122
 be carried out by volunteers or by workers with little knowledge of these areas. We
want to see this situation improved.
3.5.2 Independent financial advice can be very costly for organisations with very limited
resources.
3.5.3 The level of complexity in the market and the contamination of deposits and
investments has created an environment that is incredibly difficult to understand. With
sophisticated and well-resourced organisations such as Local Authorities, the Audit
Commission and others placing funds in Icelandic banks, it is unrealistic to expect the
third sector to demonstrate higher levels of insight.

4 Proposals for future action

4.1 Improved financial information

4.1.1 We would call for improved comprehensive and reliable credit rating information. We
would suggest that a separate rating based on true security and resilience of deposit
takers could be developed. Information available to financial managers must go beyond
interest league tables and clearly show security and liquidity.
4.1.2 Tailored or accessible financial information could be made available to charities through
the Charity Commission, perhaps in partnership with the Institute of Credit
Management (ICM).
4.1.3 Greater clarity about risk and compensation eligibility should be made available with
financial products, perhaps through a ‘traffic-lights’ system or health-warnings available
at account-opening. This would alert customers to issues such as country risk and how
individual institutions are authorised and relate to others, as well as the financial
security of the bank itself.

4.2 Increasing the financial acumen in the sector

4.2.1 In order to strengthen the sector and levels of accountability, Government should invest
in capacity building of financial acumen across the sector.
4.2.2 The valuable work of the Finance Hub (part of the Capacity Builders pilot programme)
has unfortunately been allowed to decay since funding was withdrawn and we would see
real value in taking forward some of the projects – particularly the Funding Advisors
National Network (FANN), which Government chose not to take forward.

4.3 Role of the regulators

4.3.1 The FSA and Charity Commission should work more closely together to ensure that
issues for charities are effectively taken into account by the FSA.
4.3.2 Closer working would also enable the Charity Commission to interpret and effectively
communicate financial regulatory issues for the sector.

4.4 Charitable organisations to be treated as a separate depositor class for the purpose of
the Financial Services Compensation Scheme (FSCS).
4.4.1 Currently the rules governing eligibility are based on organisational form rather than
organisational purpose.

123
4.4.2 Charitable organisations should be classified as a separate depositor class which would
be automatically eligible for compensation, irrespective of organisational structure.
This would recognise the nature of how these funds are both raised and used, and the
unique and vital role played by the third sector in society.
4.4.3 It is, we believe, unpalatable for such organisations to be placed in jeopardy through
failure of the banking system, especially where the organisation has taken every
reasonable step to act responsibly. The immense social return generated by charitable
organisations and the potential long term costs to society resulting from loss of
charitable services should be considered a priority.
4.4.4 It is the assumption that compared to small retail depositors, wholesale depositors have
a greater ability to access and mitigate financial risk. Although we would agree that
there should be strong requirements for charities to act responsibly and accountably, we
would assert that charities often behave more like individuals than commercial
operators, irrespective of the size of their assets.
4.4.5 Angela Eagle (Dec 4th Debate on the case of Naomi House Hospice) stated that
additional protection for Naomi House was problematic as it was deemed a wholesale
depositor and ‘there are no easy answers available, short of guaranteeing all the
wholesale depositors as well as the retail depositors. That is a large amount of money
and we would be criticised for using it in this way’ and went on to state that it would be
equally undesirable for Government to make judgements about which charity was
‘worthy’ and which were not. We believe that a separate depositor classification, based
on definitions of charitable purpose, would address these understandable difficulties
and enable the Government to demonstrate support to the sector.
4.4.6 The classification of charities as a separate depositor class would also allow for greater
clarity of communication and increase understanding and confidence across the sector.

February 2009

124
 Supplementary memorandum from the Financial Reporting Council

THE BANKING CRISIS - AUDITORS

During the discussion at the Treasury Committee meeting on 28 January 2009 about the
impact on auditor independence of auditors providing services in relation to the
securitisation of loans or mortgages to the banks they audit, I agreed to write to you to
provide additional information about the steps being taken on this within the Financial
Reporting Council (FRC).

Audit quality

In pursuit of our overall aim of promoting confidence in corporate reporting and governance
the FRC has specified the outcome which it seeks in relation to auditing, which is that “Users
of audit reports can place a high degree of reliance on the audit opinion, including whether
financial statements show a true and fair view.”

Although there is widespread agreement that “audit quality” is important, there is a lack of a
common understanding of the components of audit quality. In order to promote a better
understanding of the components of audit quality the FRC published a Discussion Paper
(‘Promoting Audit Quality’) in November 2006. The paper identified four main components
within audit firms (the culture within the firm, the skills and personal qualities of partners
and staff, the effectiveness of the audit process and the reliability and usefulness of audit
reporting) and several factors outside the control of audit firms, including the approach to
corporate governance taken by the auditor’s clients.

The Auditing Practices Board (APB), which is one of the operating bodies within the FRC
and whose constitution establishes its independence from the audit profession, has
promulgated, following public consultation, a series of Ethical Standards which are designed
to underpin audit quality by establishing what is required to provide confidence in the
integrity, objectivity and independence of auditors.

Current requirements of ethical standards

In addition to the general principles that apply to all non-audit services, the APB’s Ethical
Standards contain a number of specific requirements or prohibitions in relation to particular
categories of services. One such category is ‘transaction services’, of which services in relation
to securitisation transactions are an example. The APB’s current Ethical Standards prohibit
any transaction services where:
• There is reasonable doubt as to the appropriateness of a related accounting treatment;
• Such services are provided on a contingent fee basis and:
o The fees are material to the firm; or
o The outcome is dependent on a future or contemporary audit judgment; or

125
 • The engagement would involve the firm undertaking a management role.

It appears to me that from our discussion last week that the Committee is particularly
concerned where services are provided by auditors with the objective of taking transactions
off balance sheet. The APB’s standards address this issue in the first bullet above where the
transaction gives rise to doubt as the appropriate accounting treatment.

Nature of services provided by the auditors of Northern Rock

A particular focus of the debate has been on the additional services provided by
PricewaterhouseCoopers (PwC) to Northern Rock in 2006. In the 2006 Northern Rock
financial statements this work is described as ‘verification of historical financial information
and the performance of certain agreed upon assurance procedures for securitisation
transactions’.

Following publication of the Treasury Committee’s report ‘The run on the Rock’ dated 24
January 2008, the staff of the APB have discussed the services provided with PwC.

One noteworthy feature of the approach taken by Northern Rock was that although they used
a securitisation structure (‘Granite’) the mortgages that were securitised were included in the
Northern Rock’s consolidated financial statements (ie they remained “on balance sheet”).

It is our understanding that the PwC work undertaken typically comprised:

(a) Agreed upon procedures whereby details of the mortgage pool were verified to original
documentation on a sample basis. This provides assurance to investors that information
on mortgage characteristics (e.g. postcode of a property, or the ratio of the loan to the
value of the property) has been recorded accurately on the tape of data used to compile
the mortgage pool.
(b) Confirmation that any analyses of the mortgage pool presented in prospectuses or
investor presentations had been performed accurately.
(c) Tests to confirm that controls and other administrative procedures had been performed
for those securitisations that are marketed in the US. This work is required by the US
Securities and Exchange Commission.

The APB understands that PwC did not advise on the accounting treatment of the
securitisations and, indeed, as the securitisations remained on balance sheet ,that there were
no complex accounting issues.

The work was, therefore, similar in nature to both audit work and the work which a reporting
accountant (most commonly the auditor) performs on prospectuses used by companies
raising external finance by way of bond or rights issues. Based on this understanding of the
work undertaken, the services of the nature of those provided by PwC to Northern Rock in

126
2006, do not breach either the principles or the specific requirements of the APB’s current
Ethical Standards and are not incompatible with PwC’s role as independent auditor.

Re-consideration of the Ethical Standards

Notwithstanding that analysis, and having regard to the Committee’s recommendation, the
APB has considered whether the services provided by PwC should be prohibited in the future.
Because such services are in essence, no different to routine audit work, the APB does not
believe that the Ethical Standards should be varied to prohibit them.

It might, however, be possible to imagine other circumstances where services in relation to

securitisation transactions should be prohibited by the Ethical Standards.

Therefore during 2008, the APB considered whether changes need to be made to its Ethical
Standards to broaden the circumstances in which transaction services, including those
relating to securitisation transactions should be prohibited. Its present conclusion is that
where services are not inconsistent with the objectives of the audit of the financial statements,
there do not need to be substantive changes to the current Ethical Standards.

The APB’s conclusion, and the reasons for it, will be set out in a public Consultation Paper to
be issued within the next month and stakeholders will be asked whether they support the
analysis and conclusion. In particular, the Consultation Paper will ask whether respondents
are aware of any other characteristics of transaction services that should be added to the list of
criteria warranting the prohibition of the services concerned.

I will communicate to the Treasury Committee the results of this consultation and the action
that the APB plans to take as a result.

Importance of retaining principles based approach

It is important that ethical standards remain principles based. Principles based standards are
more difficult to circumvent than standards that contain a large number of specific rules and
prohibitions. This is particularly important in relation to non-audit services because of the
large number of different services that can be provided and the way that these services are
tailored to a particular client situation. As a result, it will never be feasible for a standard setter
to develop rules to cover all possible situations. Any attempt to do so could easily be
overcome by audit firms ‘repackaging’ their services so a prohibited service appears to be
permissible.

At the Committee’s hearing on 28 January members of the Committee questioned PwC about
its reaction to the 2008 report of the FRC’s Audit Inspection Unit (AIU) in which the AIU
publicly criticised PwC for having a policy which in the AIU’s view was contrary to the
principle that auditors should not be incentivised for selling non-audit services to their audit
clients despite there being no clear breach of an ethical rule. The AIU’s approach

127
demonstrates both the importance of principles based ethical standards and that it will not
shy away from ensuing that they are adhered to.

Further information

To provide a fuller context for these observations I enclose a report that describes:
1. The work that the FRC has undertaken to more fully understand, and explain, the
different components of audit quality;
2. The origins of the APB’s Ethical Standards for Auditors and the work the APB has
subsequently undertaken to satisfy itself that they remain ‘fit for purpose’;
3. The importance of the ethical standards fostering a principles based approach; and
4. The analysis that has been undertaken by the APB when considering whether
securitisation services, of the nature PwC provided to Northern Rock in 2006,
needed to result in changes to its standards.

I hope that you will find this letter and the enclosed report to be of assistance as the
Committee considers the evidence that it has obtained during its inquiry into the banking
crisis. If you would like any further information on the FRC’s thinking regarding
securitisation services supplied by bank auditors, or indeed any other matter within the FRC’s
remit, I would be pleased to provide it.

Paul Boyle, Chief Executive

February 2009
ANNEX

SECURITISATION SERVICES SUPPLIED BY BANK AUDITORS

1. Introduction

1.1 This paper sets out the context for the Auditing Practices Board (APB)’s
conclusion that securitisation services, of the nature provided by
PricewaterhouseCoopers (PwC) to Northern Rock plc (Northern Rock) in
2006, are not inconsistent with the objectives of an audit of the financial
statements and need not be prohibited unless:
• There is reasonable doubt as to the appropriateness of an accounting
treatment;
• Such services are provided on a contingent fee basis and:
- The fees are material to the firm; or

128
 - The outcome is dependent on a future or contemporary audit
judgment; or
• The engagement would involve the firm undertaking a management role.

1.2 In particular this paper describes:

• The work that the Financial Reporting Council (FRC) has undertaken to
more fully understand, and explain, the different components of audit
quality;
• The origins of the APB’s Ethical Standards for Auditors (ESs) and the
work the APB has subsequently undertaken to satisfy itself that they
remain ‘fit for purpose’;
• The importance of the ESs fostering a principles based approach; and
• The analysis that has been undertaken by the APB when considering
whether securitisation services, of the nature PwC provided to Northern
Rock in 2006, needed to result in changes to its ESs.

2. Audit quality

2.1 Public confidence in the operation of the capital markets depends, in part, on
the credibility of the opinions issued by auditors in connection with their
audits of financial statements. Such credibility depends on the belief that a
high quality audit has been undertaken - however there are differing views as
to what is necessary for an audit to be ‘high quality’.

2.2 Adherence by auditors to rigorous ethical standards is clearly an important

aspect of audit quality but there are other factors that also need to be
considered. In order to better understand all of the components of audit
quality, and to obtain the views of stakeholders as to what steps were needed
to maintain and enhance audit quality, the FRC published a Discussion Paper
‘Promoting Audit Quality’ in November 2006. This described the importance
of the culture within the audit firm, the skills and personal qualities of audit
partners and staff, the effectiveness of the audit process and the reliability
and usefulness of audit reporting, as well as several factors outside the
control of audit firms, including the approach to corporate governance taken
by the auditor’s clients.

2.3 Respondents to the ‘Promoting Audit Quality’ supported the FRC’s views as to
the main elements of audit quality and, while making a number of
suggestions as to how audit quality could be increased, did not call for
further curtailment in the provision of non-audit services or for other actions
to increase auditor independence.

2.4 The FRC has used its work on audit quality to issue an Audit Quality
Framework (see Appendix 1). The FRC hopes that the Framework will assist
audit committees when undertaking their annual review of audit
effectiveness, as well as companies, stakeholders and regulators with an
interest in understanding audit quality.
129
3. The APB’s work on ethical standards

3.1 Prior to the collapse of Enron, auditors applied a Code of Ethics established
by their accountancy bodies. In 2002, following Enron, the Government set
up the Co-ordinating Group on Audit and Accounting Issues (CGAA) to
review the UK’s regulatory arrangements for statutory audit and financial
reporting16.

3.2 The provision of non-audit services by auditors was one of the topics
considered by the CGAA and the relevant extract from their findings is set
out in Appendix 2. One of the CGAA’s conclusions was that UK
requirements should continue to be based on principles rather than rules.

3.3 The CGAA also recommended that the responsibility for setting standards for
auditor independence should be given to a body independent of the
professional accountancy bodies. The APB, which was established in 1991, to
set auditing standards independent from the auditing profession, was the
obvious body to set ethical standards as the majority of its members are not
practicing auditors (see Appendix 3).

3.4 After extensive consultation17, the APB finalised the ESs in October 2004. The
ESs are consistent with the CGAA’s recommendations in that they:
• Are based on principles and adopt a threats and safeguards approach.
• Strengthen the restrictions on certain non-audit services - in particular
those highlighted by the CGAA.
• Clearly set out the type of safeguards that need to be applied when
permitted services are provided.

3.5 The APB’s approach for developing its standards is described in Appendix 4.
A particular feature of this approach is that it requires the active involvement
of audit committees in the consideration of auditor independence. This fits
with the responsibilities of audit committees of listed companies as
established by the FRC’s Combined Code on Corporate Governance.

3.6 In 2007 the APB undertook a review of the ESs and concluded that they were
meeting the needs of stakeholders and working in practice. One of the key
factors supporting this view was the fact that the volume of non-audit
services supplied by auditors to their clients had reduced significantly during
the period, as set out in Appendix 5. The APB’s conclusions were supported
by stakeholders who responded to the consultation paper18 on the subject. As

16 The CGAA reported to the Secretary of State for Trade and Industry and the Chancellor of the
Exchequer in January 2003.
17 Draft ESs were issued in November 2003. There were 70 respondents from a variety of stakeholder

groups.
18 A Consultation Paper containing draft revised ESs was issued in October 2007. A relatively large

number of investors and representatives of audit committees responded to this Consultation Paper.
130
 a result the APB determined that it could restrict revisions to the ESs to those
that were needed to reflect changes in law since 2004 and other, relatively
minor, matters to add their clarity.

3.7 After the APB had completed its review and consulted on the changes that it
decided needed to be made to the ESs, the Treasury Committee published its
report on its inquiry into Northern Rock. This report raised questions about
the provision of securitisation services by a bank’s auditor.

3.8 As some of the changes to the ESs related to changes in company law that
took effect on 6 April 2008, the APB decided to finalise the revised ESs in
March 2008 and consider securitisation services separately19.

4. Importance of principles based standards

4.1 While the ESs contain a number of specific requirements and prohibitions
(including the prohibition of certain non-audit services) they are also
principles based. In particular they require audit teams to analyse all aspects
of auditor independence and prevent an audit being undertaken unless the
audit engagement partner can conclude that any threats to the auditor’s
objectivity and independence can be reduced to an acceptable level.

4.2 Some suggest that a potential weakness of a principles based system is that it
is hard to police. In fact the contrary can often be the case. By way of
example the FRC’s Audit Inspection Unit (AIU) publicly criticised a firm (by
coincidence PwC) for having a policy which, in the AIU’s view, was contrary
to the principle that auditors should not be incentivised for selling non-audit
services to their audit clients, despite there being no clear breach of a
requirement from the ESs. An extract of the AIU’s report on its review of
PwC for 2007/8 audits is included as Appendix 6 to this report.

4.3 A principles based approach is particularly important with respect to the

provision of non-audit services because of the large number of different
services that can be provided and the way that these services are tailored to a
particular client situation. As a result, it will never be feasible for a standard
setter to develop rules to cover all possible situations. Any attempt to do so
could easily be overcome by audit firms ‘repackaging’ their services so that a
prohibited service appears to be permissible.

5. Analysis of specific non-audit services provided by the auditor to Northern

Rock

5.1 As noted in the Treasury Committee report of 24 January 2008, for the year
ended 31st December 2006, Northern Rock paid £1.8m in fees to PwC of which

19In its March 2008 Feedback Paper the APB noted that there were a small number of additional
matters that remained to be considered including the Treasury Committee’s concerns regarding
securitisation services.
131
 £1.1m related to the group audit and £700,000 related to reporting
accountants’ services in connection with securitisation transactions.

5.2 As more fully described in Appendix 7, the work undertaken by PwC in

relation to the securitisation services involved the verification of the factual
accuracy of information presented in prospectuses and investor presentations
and the performance of certain agreed upon procedures. The work was
undertaken so that the information provided to potential investors was of an
appropriate standard. Over recent years similar work has been undertaken
by the auditors of other UK banks and, indeed by bank auditors elsewhere in
the world. It is relevant to note that, in the interests of investor protection, in
the US there is a specific requirement for annual work to be undertaken on
the servicing of securitised assets by an independent accountant20.

5.3 The nature of the work undertaken in respect of securitisation services

overlaps, to a degree, with that undertaken by the auditor in its statutory
audit and is similar in nature to the work which a reporting accountant (most
commonly the auditor) performs on prospectuses used by companies raising
external finance by way of bond or rights issues. APB staff understand that
the costs of securitisation services would be much greater if this work were to
be undertaken by another firm of accountants, to the detriment of the
shareholders of Northern Rock. This is particularly the case in relation to the
US requirements referred to above.

5.4 Appendix 8 sets out the APB’s assessment of the significance of each of the
relevant threats to auditor independence that arise from the supply of the
securitisation services of the nature provided to Northern Rock. As a result of
this analysis the APB has reached the conclusion that securitisation services,
of the nature of those provided to Northern Rock in 2006, are not inconsistent
with the objectives of the audit of the financial statements and need not
therefore be prohibited unless:
• There is reasonable doubt as to the appropriateness of an accounting
treatment;
• Such services are provided on a contingent fee basis and:
a. The fees are material to the firm; or
b. The outcome is dependent on a future or contemporary audit
judgment; or
• The engagement would involve the firm undertaking a management role.

5.5 This conclusion, and the reasons for it will be set out in a Consultation Paper
to be issued within the next month and the APB intends to specifically ask
stakeholders for their views on its analysis and conclusion.

20New regulations were introduced by the SEC in January 2006 regarding disclosure and public
reporting requirements related to publicly-issued asset-backed securities.

132
Appendix 1 – Audit Quality Framework

Driver Indicators
The culture  The culture of an audit firm is likely to provide a positive contribution to audit quality where 
within an audit  the leadership of an audit firm: 
firm  • Creates  an  environment  where  achieving  high  quality  is  valued,  invested  in  and 
rewarded. 
• Emphasises the importance of ‘doing the right thing’ in the public interest and the effect 
of doing so on the reputation of both the firm and individual auditors.  
• Ensures partners and staff have sufficient time and resources to deal with difficult issues 
as they arise. 
• Ensures  financial  considerations  do  not  drive  actions  and  decisions  having  a  negative 
effect on audit quality. 
• Promotes  the  merits  of  consultation  on  difficult  issues  and  supporting  partners  in  the 
exercise of their personal judgement. 
• Ensures robust systems for client acceptance and continuation. 
• Fosters  appraisal  and  reward  systems  for  partners  and  staff  that  promote  the  personal 
characteristics essential to quality auditing. 
• Ensures  audit  quality  is  monitored  within  firms  and  across  international  networks  and 
appropriate consequential action is taken. 
The skills and  The skills and personal qualities of audit partners and staff are likely to make a positive 
personal  contribution to audit quality where: 
qualities of audit  • Partners  and  staff  understand  their  clients’  business  and  adhere  to  the  principles 
partners and  underlying auditing and ethical standards. 
staff  • Partners and staff exhibit professional scepticism in their work and are robust in dealing 
with issues identified during the audit. 
• Staff  performing  detailed  ‘on‐site’  audit  work  have  sufficient  experience  and  are 
appropriately supervised by partners and managers. 
• Partners and managers provide junior staff with appropriate ‘mentoring’ and ‘on the job’ 
training.  
• Sufficient training is given to audit personnel in audit, accounting and industry specialist 
issues.
The effectiveness  An audit process is likely to provide a positive contribution to audit quality where: 
of the audit  • The audit methodology and tools applied to the audit are well structured and: 
process  o Encourage partners and managers to be actively involved in audit planning. 
o Provide a framework and procedures to obtain sufficient appropriate audit evidence 
effectively and efficiently. 
o Require appropriate audit documentation. 
o Provide for compliance with auditing standards without inhibiting the exercise of 
judgement. 
o Ensure there is effective review of audit work. 
o Audit quality control procedures are effective, understood and applied. 
• High quality technical support is available when the audit team requires it or encounters 
a situation it is not familiar with. 
• The objectives of ethical standards are achieved, providing confidence in the integrity, 
objectivity and independence of the auditor. 
• The collection of sufficient audit evidence is not inappropriately constrained by financial 
pressures.
The reliability  Audit reporting is likely to provide a positive contribution to audit quality where: 
and usefulness  • Audit  reports  are  written  in  a  manner  that  conveys  clearly  and  unambiguously  the 
of audit  auditor’s  opinion  on  the  financial  statements  and  that  addresses  the  needs  of  users  of 
reporting  financial statements in the context of applicable law and regulations. 
• Auditors properly conclude as to the truth and fairness of the financial statements.  
• Communications with the audit committee include discussions about:  
o The scope of the audit. 
o The threats to auditor objectivity. 
o The key risks identified and judgements made in reaching the audit opinion. 
o The qualitative aspects of the entity’s accounting and reporting and potential ways 
of improving financial reporting. 

133
Appendix 2 – Extract from the final CGAA report, including recommendations in
relation to the provision of non-audit services to audit clients

1.31 Joint provision of audit and non-audit services poses a significant problem for auditor
independence. Auditors supply a wide range of services, including for example
corporate finance, tax compliance and planning services, IT, legal services, assurance
services and management consultancy services. The ratio of non-audit services
supplied to the audit client has increased rapidly in recent years, as the major audit
and accountancy firms have developed their range of businesses and have built on the
audit relationship. More recently, the separation of the principal accountancy firms
from their wider consultancy businesses may change this statistical trend; there are
also signs that companies are more reluctant in the post Enron environment simply to
look to their auditors as the supplier of choice of additional services.

1.32 Whilst there is little clear support for the view that joint provision has in fact
compromised auditor independence, it undoubtedly raises significant concerns as to
the appearance of auditor independence21.

1.33 It is common ground that the auditor should not supply non-audit services which
involve the auditor in taking management decisions, auditing own work or acting as
an advocate for the client in an adversarial situation (other than where the auditor’s
involvement is trifling or incidental). The more general danger is that the auditor,
faced with a potential conflict or tension between the statutory responsibility to the
shareholders for the audit, and the commercial pressures resulting from the wish to
supply non-audit services, compromises objectivity or is perceived to be doing so.
These pressures are of course the greater where the value of the non-audit services is
substantial and the desire to retain a significant income stream at their strongest.

1.34 Set against these concerns, there can be efficiencies in joint provisions and thus
restricting the ability of companies to buy, and auditors to provide additional services,
may have an economic cost. Joint provision can also enhance audit quality, since the
knowledge gained may deepen the auditor’s knowledge of the business and its
management. And as a matter of basic principle, the choice of supplier of any service
should be left to the customer unless there is very good reason for outlawing it.
Existing audit regulation is alert to these threats to independence and requires the
auditor to reduce the risks to an acceptable level if the non-audit service is to be
supplied.

1.35 In our interim report we concluded against an outright ban on the provision of non-
audit services to an audit client, but also that the existing requirements did not offer
adequate safeguards against independence threats.

21
See for example Beattie and Fearnley (2002) Auditor Independence and Non-Audit Services: a
literature review.

134
 In order to deliver tougher mechanisms to ensure auditor independence, we
recommended that each type of service which auditors currently provide should be
assessed against a number of key principles, in particular that:

– auditors should not perform management functions or make management

decisions; and
– auditors should not audit their own work.

1.36 The main elements of our recommendations on non-audit services are:

• that UK requirements should continue to be based on principles rather than
rules;
• but that there need to be tougher and clearer safeguards to ensure that joint
provision of an audit and non-audit services does not undermine auditor
independence in fact or appearance:
• through regulation of the audit firms:
o tougher requirements governing the supply of non-audit services to audit
clients
o independent setting of auditor independence standards
o emphasise within the monitoring system on the application of these
requirements in the major audit firms
• by listed companies:
o an enhanced role for the Audit committee in approving purchase of non-
audit services and justifying this to shareholders
o new guidance for audit committees
o fuller disclosure of the value and nature of non-audit services bought from
the auditor

135
Appendix 3 – Members of the APB

During the period to 31 March 2009 the members of the APB were:

Andrew Chambers Director, Management Audit LLP

Richard Fleck Partner, Herbert Smith
(Chairman)
Jon Grant Executive Director of the APB
Lew Hughes Formerly Deputy Auditor General, Wales
Paul Lee Director, Hermes Investment Management Ltd
Keith Nicholson Partner, KPMG
Ronan Nolan Partner, Deloitte Ireland
Graham Pimlott Non-executive Director
Minnow Powell Partner, Deloitte
Will Rainey Partner, Ernst & Young
David Thomas Group Controller, Invensys plc,
Tom Troubridge Partner, PricewaterhouseCoopers
Stuart Turley Professor of Accounting, University of
Manchester
Martin Ward Partner, Dodd & Co

Non-voting observers

Irish Audit and Accounting Supervisory

Ian Drennan Authority
Jim Bellingham Department for Business, Enterprise and
Regulatory Reform
Accounting Standards Board
David Loweth
Financial Services Authority
Richard Thorpe

136
Appendix 4 – The APB’s principles for standards relating to non-audit services

When the draft ESs were issued in November 2003 the APB set out its underlying
conceptual framework for the assessment of the appropriateness of an audit firm
providing non-audit services to an audit client. There was widespread support for
this framework and this was reflected in the version of ES5 that was issued in
October 2004.

The standards and guidance in ES 5 (Revised), paragraphs 6 to 39 provide direction

to auditors when applying this framework to particular non-audit services. This is
especially useful in those instances where the subsequent paragraphs of ES 5
(Revised) do not address the specific circumstances that arise.

The principles of the threats and safeguards approach to professional ethics as

applied to the provision of non-audit services to an audit client, requires the auditor
to assess:
• Whether an engagement to provide non-audit services might cause the audit
firm to serve interests or seek an objective inconsistent with its responsibility
as auditor.
• The extent to which providing a specific non-audit service may give rise to
self-interest, self-review, management and advocacy threats to objectivity and
independence.
• The significance of the threats identified and whether effective safeguards
could be implemented to reduce the threats to an acceptable level.

The conceptual framework in ES 5 (Revised) goes on to require the auditor to

communicate the issues raised by the provision of non-audit services with those
charged with governance of the audited entity. In the case of listed companies, this
communication assists the audit committee in complying with the provisions of the
Combined Code on Corporate Governance that relate to reviewing and monitoring
the external auditor’s independence and objectivity and to developing a policy on
the engagement of the external auditor to supply non-audit services. These
responsibilities of audit committees were established by the Smith Recommendation
which also arose out of the CGAA report.

The final element of the general approach to non-audit services in ES 5 (Revised) is a

need for the auditor to document the threats identified and the safeguards
implemented. This supports both internal and external monitoring of audit quality.

Since the publication of the ESs, the Government has issued legislation that requires
the disclosure of auditor remuneration in the notes to the annual accounts of a
company. The classifications followed in this legislation take into account the
categories of non-audit services that are established in ES5. This further strengthens
the links between the auditor’s assessment of the threats associated with the
provision of non-audit services and the audit committee’s policy on the purchase of
such services and makes this relationship transparent to users of the financial
statements.

137
Appendix 5 – Non-audit fees paid to the auditors of UK listed companies

The ESs were finalised in October 2004 to take effect for audits of accounting periods
commencing on or after 15 December 2004. Since this time there has been a marked
change in the fees profile of accountancy firms in respect of their FTSE 100 audit clients
as shown in the table below22.

All figures in £m 2003 2004 2005 2006 2007

Audit fees 244.4 283.5 326.0 371.3 402.4
Non-audit services* 440.4 347.9 327.4 329.3 312.4
Non-audit fees as % of audit 180% 123% 100% 89% 78%
fees
* Includes audit related work

While audit fees have increased over the period, non-audit fees have decreased. There
are a number of reasons behind this reduction in non-audit fees:
• There has been increased audit committee interest in this area, driven partly by
the recommendations of the Smith Report and new provisions in the Combined
Code on Corporate Governance that were introduced in 2003.
• Regulations and standards for auditors (both in the UK and the US23) have
impacted the relationship between non-audit and audit fees.
• Company Law in the UK has required greater disclosure of the nature of non-
audit services.
• Several of the larger audit firms have divested themselves of their IT
management consulting businesses.

In relation to the audits of large banks in the UK the trends in audit and non-audit fees
are similar to those of the FTSE 100.

22Figures are taken from the annual fee survey undertaken by Financial Director magazine.
23The SEC’s Auditor Independence Requirements arising from the Sarbanes-Oxley Act were introduced
in 2003.

- 138 -
Appendix 6 - Extract of the AIU’s report on its review of PwC for 2007/8 audits

Ethical policies and consultation 

We reviewed the firm’s ethical policies and found them to be generally comprehensive. However, in 
our view, the policies noted below should be reviewed by the firm, in light of the underlying 
principles of the ethical standards.  
 
Objectives for selling of non‐audit services to audit clients  
 
The APB Ethical Standards state that the audit firm should establish policies and procedures to 
ensure that, in relation to each audit client, no specific element of the remuneration of a member of 
the audit team is based on his or her success in selling non‐audit services to the audit client24. This 
requirement is in place in order to reduce the self‐ interest threat to independence.  
 
The firm’s policies and guidance explicitly permit internal specialists (such as tax partners) involved 
in audits, including “key audit partners” (KAPs)25, to be rewarded for selling non‐audit services to 
those audit clients, on the basis that they are not considered by the firm to be part of the “audit 
team”. Whilst the Ethical Standards exclude “professional personnel from other disciplines involved 
in the audit” from being part of the audit team for this purpose, they do not specifically state 
whether this extends to KAPs. In our view, the underlying principles of the Ethical Standards would 
indicate that they should be treated in the same way as other audit partners who are responsible for 
key audit decisions.   

24 APB Ethical Standard 4, paragraph 36 
25 “Key audit partners” are partners other than the audit engagement partner responsible for key audit decisions or 
judgments.   

139
Appendix 7 - Description of assurance services provided by PwC in connection with
Northern Rock’s actions in raising finance

APB staff have been informed that the nature of Northern Rock’s securitisation
programme was that bundles of mortgages were transferred to a Special Purpose entity
(usually Granite Trust) and these mortgages were used to secure the raising of external
finance by way of loan notes purchased by external investors. The mortgages and loan
notes were included in the consolidated accounts of Northern Rock. In substance the
transaction was therefore that the mortgages were being used to act as security for the
loan notes.

Raising finance in this way required Northern Rock to issue an investment circular, the
content of which is governed by relevant regulation. While the investment circular is
the responsibility of the Northern Rock board of directors, investment banks acting as a
sponsor, underwriter or lead manager also have certain responsibilities in connection
with it.

The service provided by PwC was primarily to provide assurance about characteristics
of the mortgages described in the prospectus or circular. PwC reports which were
prepared in connection with this work were addressed to the directors of Northern
Rock, the directors of Granite (or other companies within the group who were issuing
the notes) and the investment banks (both from the UK and the US) who were acting as
sponsor. In the Northern Rock financial statements the services were described as
‘reporting accountant services’, which reflects the similarity of the services to those
performed when companies raise external finance by way of bond or rights issues.

This work drew on PwC’s cumulative knowledge of the bank’s systems and controls
acquired during the statutory audit. It is our understanding that the work undertaken
typically comprised the following:
(d) Agreed upon procedures whereby details of the mortgage pool were verified to
original documentation on a sample basis. This provided assurance to investors that
information on mortgage characteristics (e.g. postcode of a property, or loan-to
value ratio) has been recorded accurately on the tape of data used to compile the
mortgage pool.
(e) Confirmation that any analysis of the mortgage pool that was presented in a
prospectus has been performed accurately. This typically took the form of re-
calculating tables that have been presented, using information from the list of
mortgages verified in (a).
(f) Confirmation that any information provided in investor presentations was accurate.
In addition to re-performing calculations, such as those in (b), this sometimes also
involved verifying additional information about the parties to the transaction.

140
In addition to the work undertaken on new securitisations, in 2006 new regulations26 in
the US required an annual independent accountant’s report27 confirming that Northern
Rock had complied with certain servicing requirements. APB staff understand that the
amount of work to be performed to support the SEC report was substantial and
involved detailed work on a sample of transactions as well as tests to confirm that
controls and other administrative procedures that have been performed.

26 SEC’s Regulation AB.

27 The report was made public on the SEC website

141
Appendix 8 – Analysis of threats to auditor independence arising from assurance
services provided by PwC in connection with Northern Rock’s actions in raising
finance

Securitisation services fall within the remit of the APB’s ES 5 ‘Non-audited services
provided to audited entities’. Paragraph 11 of ES 5 (Revised) requires that:
Before the audit firm accepts a proposed engagement to provide non-audited services to an
audited entity, the audit engagement partner shall:
a) Consider whether it is probable that a reasonable and informed third party would
regard the objectives of the proposed engagement as being inconsistent with the
objectives of the audit of the financial statements; and
b) Identify and assess the significance of any related threats to the auditor’s objectivity,
including any perceived loss of independence; and
c) Identify and assess the effectiveness of the available safeguards to eliminate the
threats or reduce them to an acceptable level.

Furthermore within the section on ‘Transaction Related Services’ there is a specific

prohibition that an engagement should not be performed if:
• There is reasonable doubt as to the appropriateness of an accounting
treatment;
• Such services are provided on a contingent fee basis and:
a. The fees are material to the firm; or
b. The outcome is dependent on a future or contemporary audit judgment;
or
• The engagement would involve the firm undertaking a management role.

A summary of the threats to independence and an evaluation of how they apply to the
securitisation services we understand were provided to Northern Rock is as follows:

Possible threats Relevance to securitisation services

Self- interest threats arise when the
auditor has financial or other interests
which might cause it to be reluctant to
take actions that would be adverse to the
interests of the audit firm.
In relation to securitisation services the
only self-interest threat that arises relates
to the impact on total audit firm
profitability from the provision of the
additional service. The magnitude of
this impact depends on the absolute size
of the fee for the service and whether
there were special arrangements for
calculating the fee (e.g. the existence of
contingency fees). In the case of Northern
Rock, the fees for securitisation services
are less than the audit fees and the APB
understands that there were no
contingency fee or other special billing
arrangements.

142
Self-review threats arise when the
results of the non-audit services are
reflected in the financial statements and
the auditor needs to re-evaluate that
work for audit purposes.
Management threats arise where the
audit firm take a position or
responsibility that should be undertaken characteristics of the mortgages in the
by management and, as a result, looses
objectivity.
Advocacy threats arise when the auditor PwC’s reports are addressed to Northern
acts as an advocate for the audited entity. Rock companies and to the sponsors of
Familiarity threats arise when the
auditor is predisposed to accept, or is
insufficiently questioning of the audit
entity’s point of view as a result of
having been associated with the same
client for a long period.
Intimidation threats arise when the
auditor is influenced by fear of threats.
The nature of the work does not give rise
to a self-review threat as:
• There do not appear to be any
significant accounting judgements
impacted by the securitisation
process as the mortgages involved
are included in the consolidated
accounts (i.e. they remain ‘on balance
sheet’), and
• The nature of the work performed by
PwC is supplementary to that
undertaken for audit purpose.
In the prospectus, management makes
certain assertions regarding
mortgage pool and these assertions are
confirmed by work of an audit nature.
Accordingly no management threat
seems to arise from securitisation
services.
the securitisations. While securitisation
services help the bank raise capital the
auditor is not promoting or marketing
the bonds and therefore an advocacy
threat does not arise.
The familiarity threat relates to aspects of
the audit and the audit opinion
expressed on the financial statements
and is not relevant to securitisation
services.
The intimidation threat also relates to the
audit opinion expressed on the financial
statements and is not relevant to
securitisation services.

On the basis of this analysis the APB’s conclusion is that the securitisation services
provided to Northern Rock in 2006 are not inconsistent with the objectives of the audit
of the financial statements and need not therefore be prohibited.

143
 Memorandum from Clive Menzies MSI

Summary
The focus of the committee has been on individuals, culture in the City and the failure of
regulation, all of which are important. However, there is a fundamental structural flaw in the
financial system: large complex international banks conduct a wide variety of business across the
globe with no one person capable of understanding the totality of the activities or the aggregated
risk. As long as banks remain “too large to fail”, no amount of regulation will avoid a repetition
of the current meltdown.

A more widely diversified system of specialist financial services companies where no one
institution could have such influence as to bring the whole system down, would render
regulation less important because the fallout from the failure of a single retail or investment bank
would have localised and limited consequences. Smaller institutions would have less opportunity
to pay inflated bonuses; separating commercial and retail banking activities would further reduce
the risk of contagion. If, as shown by the recent evidence given by the senior executives of HBOS
and RBS, management don't or refuse to recognise the risks in their own business, it is a forlorn
hope to expect regulators to make up for their inadequacies.

Biography
40 years commercial experience mainly in financial services including managing regulated
investment management and stockbroking businesses.
Fund Building Limited – director
Clive Menzies & Associates Limited – director

Additional information
The committee, no doubt, has more than enough documentation to wade through and I have no
wish to add to that burden. If required, I'm happy to expand on the submission, with an overview
of regulation and financial fraud since big bang (Financial Services Act 1986) and provide more
detailed justification for the recommendations below.

Recommendations
• separate investment and commercial banking by statute within UK borders
• limit financial services activities conducted by any one corporate group
• expand the criteria by which takeovers are referred to the Monopolies and Mergers
Commision (MMC)
• Use the MMC as the means to maintain dispersion of entities conducting banking and
other financial services activities

February 2009

144
 Memorandum from Mr Chris Wilson

1. Brief information about myself:

1.1 My education and training, and professional qualifications include:

- four year engineering apprenticeship at Longbridge
- ONC and HND in Mechanical Engineering
- MSc (Automobile Engineering)
- MBA
- Self-study for the Chartered Institute of Management Accountants
- Member of the Institute of Mechanical Engineers (lapsed at retirement)
- Fellow of the Chartered Institute of Management Accountants.

1.2 In industry I’ve held project-management and divisional-level line-management

positions in finance, supply chain operations and in IT at Ford, General Motors, and
International Computers. I’ve managed both small teams and a work force of more than
100. Following that experience in industry I worked for 13 years for a leading UK
management consultancy, working with board and all levels of staff of client companies
in the UK and in Mainland Europe.

My job satisfaction, both when I was in industry and as a consultant, came from running
an effective operation, achieving operational improvements and having (or achieving)
motivated employees in businesses with high ethical standards.

2. My main point with regard to the banking crisis is:

2.1 I have worked in two multi-nationals which have come close to failure. In both
circumstances all employees had to suffer hardship in terms of additional workload and
financial constraints in order to save the companies.

2.2 Similar things will be happening now in many businesses throughout the UK as a result
of the banking crisis.

2.3 It matters not what level you are, or how much you deserve recognition, there’s no money
for bonuses (life can be unpleasant and unfair; you can be caught in the wrong place at
the wrong time). In such circumstances people are motivated by survival and also have to
be motivated by those (sadly insufficient numbers of) excellent managers who can
motivate people through their leadership, example and integrity.

3. My recommendations is that:
3.1 Somehow the Treasure Select Committee has to deal with making a change in the culture
of pay and bonuses in the financial industry. For example a culture that considers that,
under the current circumstances, bonuses should still happen (regardless of whether it’s
fair or not) is just unacceptable. The bonus is that they still have a job.

145
February 2008

Further memorandum from ACCA

Our recommendations to the Committee

1. There is a need to separate the activities of retail (i.e. taking deposits and making loans) from
all other forms of banking. We welcome the Government’s moves to ring-fence depositor
accounts, as this is a key step in the right direction.

2. Remuneration design needs to be carefully thought through with a clear eye to inevitable
unintended consequences, as far as this is humanly possible. Remuneration design should be
linked to cash-flows and clear long term performance measures, rather than short term measures
of profit and vaguely defined measures of performance.

3. Banks are already heavily regulated, but the regulations appear not to be supervised very
effectively. Existing regulation for banking institutions should be more effectively supervised by
organisations with clear terms of reference, staffed by people with the right knowledge, skills and
experience, suitably empowered to challenge banking practices where appropriate.

4. Ethics and professionalism has to be at the heart of repairing the financial services sector. As
part of this project professionally qualified accountants and risk managers should be in place and
have a stronger voice and profile within the sector. They should be supported by well-qualified,
informed and engaged non executive directors who provide an appropriate level of challenge
within the sector and give their audit committees real teeth. External auditors should be able to
rely on the effectiveness of the organisations’ own Audit Committee and internal audit function
to a greater extent.

5. There is a role for regulators, credit rating agencies, institutional investors and analysts in
understanding and better explaining to the wider world what the financial services sector
actually does. This has implications for the training of these professionals and the effectiveness of
their communications skills.

6. The globalisation of business and the current financial crisis are both reasons why one set of
international accounting standards is essential. We support principles based International
Financial Reporting Standards in our role as an international accounting organisation and
oppose any trends towards national protectionism in this area.

7. External auditors are party to a wealth of corporate information. It is clear that they should
liaise with the regulator of the financial services sector on a more systematic and regular basis
than is currently the case.

8. The principles outlined in the proposed Operating and Financial Review (OFR) should be
reconsidered, and organisations should look at how they can be embedded in their reporting.

146
Within the constraints of commercial confidentiality, the OFR can be a valuable opportunity for
the organisation to reflect on its business model, its medium to long term strategy, and to be able
to communicate these to its stakeholders.

9. It should be noted that in the UK, the vast majority of companies are not subject to statutory
audit at all. While the market is doing well and confidence is high, this is fine. However, during a
period of economic recession, with companies ceasing to trade and job losses, businesses become
more nervous about doing business with each other. This is maybe an area that needs to be
considered.

Comments

1. How much are auditors to blame for the banking crisis – did they ask the right questions, and
were they looking at the right things?

The business review in a set of accounts requires, amongst other things, a board to set out the
company’s business model and significant risks to the viability of that model. Northern Rock’s
business model, for example, depended on being able to finance operations through access to
wholesale money markets, and its stock rating assumed continuing growth of borrowing and
lending. Without this access to markets the company could not have expanded and once this
market closed it ceased to be viable. There is a case for further strengthening corporate reporting
on the business model and elaborating on the risks, particularly those low likelihood/high impact
risks which could jeopardise the model.

Ultimately, the investment bank business model was unsustainable and based on erroneous
assumptions about the future of the economy. The failure that external auditors made was to
underrate the importance of their assumptions about the future. Auditing is primarily focused on
examining past events. Indeed, the auditor’s stated role is not to predict the future but to ensure
that companies’ financial statements give a true and fair view of the previous 12 months’
performance. However, financial statements themselves include assumptions about existing
trends which are then often projected uncritically into the future. Examples would be
assessments of the outcomes of long term contracts and work in progress; assessments of the
useful economic life of key assets; provisions and contingencies; assumptions about future trends
in the macro economic environment.

It is possible that auditors should have been more sceptical when making these projections,
however difficult this may seem. The audit role is not static – it should evolve as accounting,
organisations and societies evolve.

2. Conflict of interests: audit work versus non audit work done within the same companies – has
the audit community looked at this post Northern Rock and do the Financial Reporting Council
(FRC) rules provide adequate protection?

147
The potential for a conflict of interest has been well understood by the investor community,
accounting and audit firms, professional bodies and regulators for many years. The consensus
has been that such a conflict of interests can be managed through self-regulation and does not
need to be regulated by statute.

However, there is widespread concern about the dominance of the listed company audit market
by the larger audit firms, and the UK FRC has made proposals for reform - which ACCA
supports. Currently though it should be acknowledged that there appears to be little appetite for
change in the UK’s audit market, particularly from the shareholder community.

3. Does the auditor have a duty of care to stakeholders such as lenders, suppliers, customers and the
general public as well as shareholders etc?

In the UK, statutory and case law favour a narrow interpretation of an auditor’s duty of care.
Their responsibility is purely to the owners/shareholders of the company. Any extensions in the
auditor's duty of care as presently understood would have to be based on an extension of the core
purpose of the audit, which is, currently, solely to provide shareholders with an opinion on the
truth and fairness of the annual accounts.

In the light of current and future developments in financial and non-financial reporting, we
would be supportive of an evolution of the overall function of the external auditor but consider
that such an evolution would need to be accompanied or preceded by an acceptable, fair and
proportionate application of the limitation of liability issue.

Statutory audit reporting should be conducted in accordance with audit standards, and financial
statements be prepared in accordance with financial reporting standards. There is always a wider
public interest question: should financial statements and the audit reports on them avoid
reporting concerns about major public interest entities in case there is a knock-on impact on the
economy causing is a loss of confidence in the market? As implied above, the imposition of
accounting and auditing standards may restrict professional judgement.

In our view, financial statements and audit reports should fairly reflect the position of the
organisation but we need to make sure that our reporting and auditing framework does not
inadvertently contribute to pro-cyclicality or a volatility in asset prices that does not reflect
underlying economic fundamentals. Market prices reflect perceptions about the future which in
turn are influenced by psychological emotions such as exuberance and fear. The Present
emphasis of financial statements on current market values, arguably at the expense of prudence,
would seem to contribute to pro-cyclicality by presenting a rosy picture of assets, which do not
necessarily need to be liquidated, when sentiment is exuberant, and a dismal picture when
fearful.

4. Should auditors be doing more in fostering financial stability?

148
Auditors have a corporate responsibility, i.e. the responsibility to report to the shareholders of
organisations that they audit. This contributes in aggregate to fostering confidence in the
corporate sector. As the law stands, auditors have no wider legal duty to foster general or
national financial stability, and the definition of their role would have to be considerably altered
to make this one of their responsibilities.

5. How useful are financial statements, why are they so long, can anything be done to streamline
them?

Financial statements, which give an overall view of an organisation, are lengthy because of the
complexity of transactions, and the evolution of disclosure requirements for competing
stakeholders. It should be noted that they are only one source of information about an
organisation’s performance. There are other sources of information available, for example
investor packs, analyst notes and the organisation’s own website, all of which are relied on by
investors and other interested parties.

There is an acknowledgment within the accounting profession of the necessity to streamline

financial statements, in order to make them more accessible and understandable. Possible
suggested solutions include:

• The inclusion of an Executive Summary – style document at the front of the financial
statements would be a good first step
• XBRL (eXtensible Business Reporting Language) also offers a technological means of
tagging keywords and data-mining to find relevant information quickly – this direction is
under active investigation by HMRC
• Other ICT developments may include “embedding” detail in financial statements to keep
them shorter
• Account preparers should also be encouraged to use plain English!

6. Auditors operate in a litigious environment. This gives them a more defensive approach and
prevents them from disclosing important information.

This defensive stance could be mitigated through a fair, sensible and proportionate approach to
the limitation of auditor-liability issue - as referred to above.

7. How significant an issue is going concern – what can be done to mitigate the related panic. What
is the audit community doing to reduce panic and explain?

Going concern is an important issue. In the coming year, we will see some sets of accounts
highlighting going concern issues and/or auditors drawing attention to them. Primary
responsibility for the assessment of going concern rests with the Board of Directors, and good
practice varies hugely in this area. The role of the auditor is to form an opinion on the truth and
fairness of those accounts which will include the Board’s assessment. The real problem with

149
going concern is that organisations do not neatly stop becoming going concerns in line with
balance sheet dates or the dates accounts are signed. On the contrary, they can get into trouble
very rapidly – this highlights the arbitrariness of the financial year end. It is important to
remember that the going concern assessment, and the auditor’s report on that assessment, are
conducted at a specific point in time, and cannot constitute a cast iron guarantee that the
organization will be around for the foreseeable future.

Reports on listed companies are available every six months - we should consider whether
auditors could be given more responsibility at the six-month stage. External auditors should also
engage more effectively with the internal audit function, which may bring issues of going
concern to light more quickly.

As the audit role evolves, we need to look not just at cash flow and going concern but also at the
business model and how well it serves the organisation in the medium to longer-term.

ACCA, along with the FRC and the International Federation of Accountants (IFAC), is
communicating these issues to audit and accounting members and is working to communicate
them directly to wider stakeholders.

10. Should/can we view audit as part of an early warning system for problems in the financial
system?

Internal audit could make more of a contribution toward such an early-warning system than
external audit. Nevertheless, this is still only a limited contribution since the many of the implied
predictions in financial statements are largely an extrapolation of past and current trends. Clearly
this is inadequate data to rely on in a period of rapid economic change.

There is a necessity for auditors to engage more with the forward-planning of companies as we
have repeatedly stated in this evidence.

Also, if we had an Operating and Financial Review (OFR) which presented a balanced and
understandable assessment of a company's position and prospects this could let us better
examine any early warning signs that do exist and which could seriously impact on the
organisation’s viability.

11. What is the role of audit and how relevant is it in a stressed, fast-moving world?

One issue which needs to be revisited is the ‘expectation gap’ between what the public and users
of financial statements believe is the role of an auditor, and what the audit profession understand
to be their role. The general public, for example, believe that the role of an auditor is to detect
fraud and error in financial statements. However, as famously stated in Re Kingston Cotton Mills
in 1896, by LJ Lopes of the Appeal Court: the auditor is “a watchdog but not a bloodhound”.

150
Audit instils discipline, financial rigour, better corporate governance and can deter fraud. Audit
is part of the operating fabric of the economy, and the success of capital markets is dependant on
there being a competitive and stable audit market. However, there is much evidence showing that
the public and other users of financial statements do not understand what the role of audit is.
How to resolve this issue has been the subject of much debate. Possible ways forward include:

• Broadening the role and responsibility of auditors in the areas of fraud detection
• Further strengthening the independence of auditors and improving financial disclosure
• Provision of auditing education - better educating the public and users of financial
statements on the limitations of an audit

12. The unaudited society

One area which seemed to be working well before the crisis was the exempting of smaller
companies from the need to be audited. Indeed, most UK businesses are no longer audited – and
while the market is doing well and confidence is high, this is fine. However, during a period of
economic recession, with companies ceasing to trade and job losses, businesses become more
nervous about doing business with each other.

The UK companies that are audited include the FTSE 100 and 250 companies, the other main
market companies (c.2, 000) and the AIM companies (c.2, 000), Large private companies (c.12,
500), and midsized companies (c.25,000). This comes to a total of c.42, 000 companies. The
number of companies in the UK that come below the statutory audit threshold is 1,300,000. That
is to say that in the UK, the vast majority of companies are not subject to statutory audit.

It should be a cause for concern that accounting information is disappearing from the public
domain. It means that fraud, money-laundering, bribery and corruption, which all increase
during an economic recession, stand a greater chance of going undetected.

13. Corporate governance issues

ACCA’s policy paper Climbing Out of the Credit Crunch, examines five key areas: corporate
governance, remuneration and incentives, risk identification and management, accounting and
financial reporting and regulation – and recommends that accepted practices in all these areas
need to change to avoid future failures.

The fundamental responsibilities of a corporate board – to provide strategic oversight and

direction, to ensure a strong control environment and to challenge the executive – appear to have
been inadequately discharged. Remuneration and incentive packages have encouraged short
term thinking. We need to ask what inhibited banks’ boards from asking the right questions and
understanding the risks that were being run by their managements.

If banks’ existing incentive and career structures meant enormous rewards for failure, then this
needs to change. Firstly, we have to question whether the relative share of banks’ income paid as

151
remuneration compared with dividends has been in the best interest of long-term shareholders.
Secondly, risk management and remuneration/incentive systems must be linked. Executive
bonus payments should be deferred until there is incontrovertible evidence that profits have been
realised, cash received and accounting transactions cannot be reversed.

Increased transparency of regulation is also important. Most large banks now combine both
retail and investment banking activities, and the regulatory goal should be for separation of retail
from investment banking to protect retail customers from wholesale risk, or at least to alert them
to the risks if they opt to deposit funds in banks combining the two.

February 2009

152
 Memorandum from Mr Peter Hamilton

I am a barrister in practice at 4 Pump Court, Temple, London EC4Y 7AN. I have been asked by
Paul Moore to write to you as I represented Paul Moore in his whistleblowing case.

I have been surprised that it has been reported that the KPMG Report was independent. In my
view since KPMG were the auditors of HBOS, KPMG could not have been regarded as
independent of HBOS. It follows that the FSA should not have regarded it as independent.

The Report was not only of limited scope (as KPMG and the FSA, in their statement issued
today, say) but reached conclusions that a properly independent tribunal would not have
reached.

For both those reasons it is disappointing that the FSA have appeared to accept it.

The FSA should not have approved the appointment of Ms Dawson to such a senior and
important position on the basis of the evidence available to them at the time.

In the light of these points the significance of Sir James Crosby’s position at the time as both
CEO HBOS and Non Executive Director of the FSA should be investigated.

12 February 2009

153
 Supplementary memorandum from HM Treasury

UK lending

The TSC asked what percentage of UK lending in terms of businesses and household are covered
by the banks supported by the recapitalisation scheme.

The Bank of England publishes statistics relating to sterling lending to UK businesses and
households, available at: http://www.bankofengland.co.uk/statistics/statistics.htm.

Comparing this information with information in the banks’ annual reports, HBOS, Lloyds TSB
and RBS account for around 40% of lending to businesses in 2007 and 2008.

The Council for Mortgage Lenders (CML) collects data on the largest UK mortgage lenders, and
estimated market share. In 2007, HBOS, Lloyds TSB and RBS were among the ten lenders with
highest market share of the UK mortgage market (table reproduced below), with a combined
market share of 34.4%.

Gross mortgage lending, in year

2007
Estimated
Rank Name of market
2007 group £bn share
1 HBOS 73.1 20.1%
2 Abbey 35.6 9.8%
3 Nationwide BS 33.9 9.3%
4 Northern Rock 29.5 8.1%
5 Lloyds TSB 29.4 8.1%
6 Barclays 23.0 6.3%
7 The Royal Bank of Scotland 22.6 6.2%
8 Bradford & Bingley 14.0 3.9%
9 Alliance & Leicester 13.0 3.6%
10 HSBC Bank 10.1 2.8%

February 2009

154
 Memorandum from the Financial Services Compensation Scheme (FSCS)

1. This memorandum is submitted to the Committee as part of its inquiry into the Banking Crisis
and in advance of the FSA and FSCS evidence session on 25 February.

2. This memorandum covers the role played by FSCS in responding to recent banking failures,
including:

• The FSCS response to the crisis;

• The compensation dimensions of each bank default, including the costs of each;
• Financing the compensation payouts;
• Recoveries and the position of FSCS as a creditor; and
• Strengthening the compensation framework.

The FSCS response to the financial crisis

3. The current financial crisis has generated unprecedented demands on FSCS. Since 27
September 2008, five banks have been declared in default by the FSA. Bradford and Bingley plc
was the first, declared on 27 September 2008, closely followed by Heritable Bank plc, Kaupthing
Singer and Friedlander Limited and Landsbanki Islands hf (Icesave) on 7 and 8 October. London
Scottish Bank plc went into default on 30 November. The declaration of default has triggered
FSCS protection in each case.

4. To put the size and nature of the increased demands on FSCS in context, it is worth noting that
in the seven years from its inception in December 2001 to September 2008, FSCS had paid out
just over £1bn in compensation on its own behalf mainly relating to insurance and investment
failures. In the five months since September 2008, FSCS has already paid about £20bn for the five
bank defaults, largely on its own behalf but in part on behalf of H M Government (HMG) and in
respect of the liability of the Icelandic Deposit and Investors Guarantee Fund.

5. The compensation was paid to protect the holders of approximately 3m bank accounts, and
has involved three bulk account transfer payments, and the processing of more than 200,000
individual claims so far. These volumes stand in stark comparison with the previous year, in
which FSCS received 16,490 claims. They demanded that FSCS take a new approach to
compensation within the context of the Banking Special Provisions Act and also in responding to
failures across jurisdictions.

6. In relation to each default, FSCS has a primary obligation to ensure that those entitled to
compensation from FSCS receive it as soon as possible. FSCS is also required to ensure that it
secures such recoveries for levypayers as are reasonably practicable and cost effective to pursue.
Each of the defaults has been different and has required a different response from FSCS: these are
detailed further below.

155
Compensation

Bradford and Bingley plc

7. FSCS contributed £14bn to the cost of transferring the retail deposit book to Abbey on 29
September 2008, pursuant to an Order made by H M Treasury (HMT) under the Banking
(Special Provisions) Act 2008. This gave depositors complete continuity of banking services in
relation to 2.5m accounts, without having to engage individually with the compensation process.

8. The £14bn payment represented an estimate of the gross cost of compensation, had FSCS
processed individual claims from all the bank’s customers in the normal way. That cost is now
being validated by FSCS and the results will determine whether or not there is more for FSCS to
pay or a refund to FSCS to be made.

Kaupthing Singer and Friedlander Ltd (KSF)

9. KSF is a UK subsidiary of an Icelandic bank, Kaupthing, and went into administration on 8
October 2008. FSCS contributed £2.5bn to cover the cost of transferring the firm’s 157,000 online
accounts, known as Kaupthing Edge accounts, to ING. This amount paid is subject to a
validation exercise, similar to that being carried out for Bradford and Bingley.

10. In addition, FSCS is also handling individual claims for compensation in respect of KSF
accounts not transferred to ING. So far, over 4800 claims have been received and are being
processed as quickly as possible. In excess of £27m has now been paid in compensation in respect
of the non-Edge accounts.

11. A claimant entitled under FSA rules to FSCS protection will be entitled to up to £50k from
FSCS. HMG has agreed to pay such claimants compensation for losses above £50k and FSCS is
administering those payments on HMG’s behalf.

Heritable Bank plc

12. Like KSF, Heritable is a UK subsidiary of an Icelandic bank, in this case Landsbanki, and
went into administration on 7 October 2008. The position is very similar to KSF but on a smaller
scale: 22,000 accounts were transferred to ING at a cost to FSCS of £0.5bn and FSCS is currently
processing claims for the remaining eligible claimants. Approximately 350 manual claims have so
far been received. Again, FSCS is paying compensation as required under FSA rules, and is
administering top up payments for HMG for amounts over £50k to those entitled to FSCS
protection. Sums paid in respect of accounts not transferred to ING amount to about £7m.

Landsbanki ‘Icesave’
13. The default of Icesave on 8 October has presented the biggest operational challenge for FSCS.
Icesave was the UK internet branch of Landsbanki, an Icelandic bank with an EEA passport. The
bank had ‘topped up’ into FSCS, meaning that the Icelandic Deposit and Investors Guarantee
Fund is liable for the first €20,887 of any claim, and FSCS for the amount above that to the UK
limit of £50k.

156
14. As reported in the media at the time, the Icelandic fund did not step forward at the point of
failure to receive claims in respect of Icesave. In the event, FSCS stepped in with HMG to make
sure that the 214,000 people with money deposited in the UK branch of Icesave could receive
compensation.

15. FSCS developed and put an online claims system based on the Icesave internet banking
platform into effect in November and more than 190,000 people successfully transacted
electronically using this quick web-based process.

16. The remaining customers have made manual claims. Over 17,000 payments have been made
to them so far and further payments will follow as quickly as possible. Most outstanding claims
are not due for payment at this time, as they relate to fixed term deposits which have not yet
matured. A total of £3.7bn has so far been paid in compensation for this default.

London Scottish Bank plc

17. This bank failed on 30 November and is in administration. It had approximately 9,500 people
all holding either fixed term deposit or notice accounts worth over £0.27 bn. Over 9000
individual claims have so far been received, and the vast majority of claimants are now being
paid shortly after the maturity date of their deposits. Eligible claims below £50k are being met by
FSCS, and FSCS is acting as HMG’s agent in paying eligible claims to the extent that they exceed
the FSCS compensation limit.

Financing the compensation payments

18. As the Committee will be aware, FSCS does not maintain a large standing fund to meet claims
when need: pre-funding is not permitted under current legislation. Rather, FSCS raises levies
each year to enable it to meet its anticipated obligations in respect of compensation costs in the
following twelve months and to meet management expenses in the current financial year. FSCS
can raise additional levies at any point, as necessary, subject to the Management Expenses Levy
Limits and levy limits for compensation costs fixed by FSA rules. FSCS can also use recoveries
from a failed firm to reduce the levies it needs to raise. We say more about recoveries below.

19. In relation to the five defaults, FSCS originally borrowed the necessary funds through
separate short-term facilities from the Bank of England (BoE) and (for London Scottish) from
HMT. The BoE facilities have since been re-financed with longer term loans from HMT.

20. All the loan facilities are on an interest-only basis for the first three years, with the interest
rate set monthly at 12 month LIBOR plus 30 basis points during this period. FSCS will pay
interest in arrears, with interest for the period to 31 March each year being payable on 1 October
of that year. So, for the period to 31 March 2009, interest will be payable by 1 October 2009, and
so on.

21. Having taken due account of the potential impact on deposit takers of current and future
FSCS levies, the Authorities have agreed that the total amount levied to meet interest and other

157
operational costs arising from the five defaults will, in the next three years, not exceed £1bn per
annum. Any interest costs above this cap will be waived by HMT rather than recharged later.
This
means that levies in the first three years for the five defaults will fall on the deposit-taking class of
levypayers only.

22. Principal of the loans will only become payable in the first three years to the extent that FSCS
receives any recoveries from the estates of the failed banks. Otherwise, FSCS will begin the
repayment of principal in three years’ time, to a repayment schedule to be agreed with HM
Treasury in the light of prevailing market conditions at that time.

Recoveries
23. Bradford and Bingley continues to operate in solvent run-off in respect of its pre-existing
mortgage book. As a significant creditor of the Bradford and Bingley estate, FSCS is entitled to a
substantial portion of the recoveries. The Order under which FSCS payment was made stipulates
that FSCS should be no worse off in relation to recoveries than if Bradford and Bingley had been
placed in liquidation. FSCS is in dialogue with HMT about how the estate will be run down and
expects to review regularly the progress of Bradford and Bingley’s business plan with HMT with
a view to ensuring appropriate returns for the FSCS levypayer.

24. For Heritable, KSF and London Scottish, FSCS is playing a major role on the creditors
committee, working with Ernst and Young the administrators to ensure the best possible
recoveries for the insolvent estates, and FSCS as principal creditor.

25. Landsbanki is in a special process in Iceland but is not following the usual Icelandic
insolvency process. FSCS is working to ensure that the maximum possible recoveries are
obtained.

26. All these recovery processes are likely to take several years to complete.

Strengthening the framework

27. FSCS has been working very closely with the Tripartite Authorities to develop a stronger
framework to deal with banks in difficulty and to deliver compensation to depositors if a firm
goes into default. The events of the past few months have demonstrated the importance of that
work, the legislative reforms which are now making their way through Parliament and the rule
changes on which the FSA is currently consulting. Some of the key elements are set out below.

28. Compensation by deposit transfer: The Banking Act 2009 enables FSCS to continue to make
compensation payments by funding deposit transfers as applied in Bradford and Bingley, and in
part in KSF and Heritable. This spares the need for individual applications and can help deliver
continuity of banking services.

29. Funding: Access to Government funding enables speedier payments to be made than could be
achieved through the levying process. The provision in the Banking Act 2009 to allow FSCS

158
access to the National Loans Fund will smooth the operation of the current short term funding
arrangements still further in future. The Banking Act 2009 allows pre-funding to be introduced
and we will work with the Authorities to consider whether changes to the current funding
arrangements are desirable.

30. Proposals to facilitate compensation payments within seven days. The current FSA proposals
are designed to make the compensation process quicker than has been possible on recent
defaults. Although there is a package of reforms all of which are important to speeding up
payout, the most crucial is the one which requires deposit takers to maintain a single customer
view – i.e. complete, accurate and up to date data about how much each eligible customer is
owed. The FSA is consulting on rule changes for this purpose now and FSCS will invest over the
next 18 months in systems changes designed to ensure that bank data can be uploaded smoothly
into FSCS systems in the event of payout.

31. Inter-agency liaison: A close working relationship is required between FSCS and the
Tripartite Authorities when firms appear to be vulnerable to real difficulty. Existing
arrangements between FSCS and the Tripartite Authorities are being updated to reflect changes
resulting from the Banking Act 2009.

32. At the European level, the Icesave experience demonstrates that the current topping up
arrangements under the Deposit Guarantee Schemes Directive can be problematic in practice.
We continue to work with the Tripartite Authorities and our European counterparts to address
the challenges presented by the current cross-border framework.

33. Greater consumer awareness: the FSA is consulting on rules to require firms to make clear
disclosure about the compensation status of their accounts. In addition, FSA and FSCS will be
working together with the industry to increase consumer awareness and understanding of the
Scheme.

16 February 2009

159
 Further memorandum from Tony Shearer

On 10th February 2009 Mr McFall asked Sir Tom McKillip " Q919 Chairman: When I look at the
board of Royal Bank of Scotland, you had the brightest and the best. You had Sir Peter
Sutherland, who was chairman of BP and Goldman Sachs and the director general of the World
Trade Organisation, you had Bob Scott, the senior independent director, the former group chief
executive of Aviva and ex-chairman of the board of the Association of British Insurers, and you
had Steve Robson, a former Second Permanent Secretary to the Treasury. He was there with
Terry Burns when the tripartite authority was established. I could go on. The best and the
brightest were there, Sir Tom. There has to be something more fundamental here……".

I believe that the answer to Mr McFall’s question is in my earlier evidence.

These banks have become too big and diverse for any one person or board of directors to manage
or be responsible for them.

These banks:

1. are too large;

2. have too many different businesses (many with different business models needing
different experiences, knowledge and skills);
3. have too many different risk profiles;
4. have too many people (with many having the ability on their own or in small groups to
make decisions which individually can have a material impact on the profit and loss
account or balance sheet);
5. operate too many different cultures;
6. are in too many geographical areas (where it is impossible for any CEO, director or
chairman to "manage by walking about" and meet the people);
7. have shareholders pressing for greater profits; and
8. are advised by advisers pressing for larger and larger fees, and for bigger acquisitions and
more complex corporate transactions.

It is impossible to set up appropriate systems and controls for such large and complex businesses
other than over many years of painstaking attention to detail, and slow growth.

If it is that impossible a task for a CEO, then it is even more impossible for a non-executive
director, particularly the Chair of the Audit/Risk Committee.

It is for this reason that otherwise sensible people have failed.

It is also a factor that these executives and non-executive directors live in heady worlds with
peerages, knighthoods, feted by politicians and the media, membership of Government think
tanks, trips to and parties in Downing Street, rewards beyond the dreams of avarice, and PR

160
firms and departments to obfuscate and to promote them as individuals. All of this makes them
believe that they have abilities and skills that they simply have never had.

Coupled with the fact that they are surrounded by auditors, rating agencies, lawyers, head-
hunters, remuneration advisers, PR firms and non-executives who want to earn fees and who are
getting rich off their patronage, and regulators who had come from the same backgrounds, it is
no wonder that the whole system has failed.

The Select Committee's interviews with the Executives and former Executives who are and were
running our large banks showed that these people still have absolutely no appreciation that
running these very large businesses was, and is, beyond their abilities.

It is also relevant that James Crosby and the FSA had, and still seem to have, no comprehension
that it was untenable for the regulator to have for the last 6 months a Deputy Chairman who had
been CEO of HBoS at the time that it was set on its growth strategy to failure (regardless of
exactly what happened with the dismissal of one Head of Risk and the appointment of another).
They should have recognised that he was not a "fit and proper person" for this role.

The FSA should also realise that it is not fit and proper to have a chairman (ex-Merrill Lynch)
and CEO (ex-Credit Suisse) who are both former investment bankers, when UK Financial
Investments’s board is dominated by investment bankers or former investment bankers
comprising:

1. An Acting Chairman, Glen Moreno (ex-CitiCorp);

2. A total of 3 (or 6, the website has changed) other Non-Executive Directors:
a. Peter Gibbs (ex-Merrill Lynch Asset Management);
b. Lucinda Riches (ex-UBS, until the end of 2007);
c. Mike Kirkwood (ex-CitiCorp, until the end of 2008);
d. Philip Remnant (ex-Credit Suisse First Boston);
e. Tom Scholar (The Treasury);
f. Louise Riches (The Treasury);
g.
3. The Chief Executive, John Kingman, on secondment from the Treasury where he was the
former chairman of the Tripartite Standing Committee that was supposed to oversee the
stability of the UK financial markets;

4. The Executive (not on the Board) who reportedly deals on a day to day basis with its
investments in RBS and Lloyds/HBoS also ex-Merrill Lynch, and their banking analyst
also ex-Merrill Lynch.

It was Merrill Lynch which did a considerable amount of the advising, packaging and
distribution of toxic debt, that collapsed over a weekend last year, incurred one of the largest ever
corporate losses in relation to its size, advised RBS, Santander and Fortis on their acquisition of
ABN-Amro, and was sole financial adviser to Lloyds TSB on its takeover of HBoS.

161
In all these circumstances is it any wonder that the FSA cannot identify who is a "fit and proper
person". The Treasury is pouring hundreds of billions of pounds into a substantially
unreconstructed system where the same people are still managing and advising the bust
businesses and the government; and John Tiner (who was CEO of the FSA through the period
that all this excess was taking place and who lamentably failed in his duty) is now regarded as a
"fit and proper person" as the CEO of Resolution whose business is to acquire failing financial
services businesses.

16 February 2009

162
Supplementary Memorandum from the Alternative Investment Management Association

Gating

In response to the question raised by Jim Cousins on the subject of investor protection and the
gating practices of Hedge Funds, I omitted to mention that the practice of gating is not unique to
Hedge Funds and that there has been fairly comprehensive gating of all specialised commercial
property funds as a body (mostly on-shore) by UK pension funds.

Please see attached an example for the Norwich Union Pension Fund, of which one of the AIMA
Directors is a member.

Hedge Fund Standards

By the early part of 2008, a number of organisations - ourselves, the Managed Funds Association
(MFA), IOSCO, the Hedge Funds Standards Board (HFSB) and the US President’s Working
Group (US PWG) – had issued draft or final best practice standards covering the hedge fund
management industry. Though largely similar to each other in scope, these publications varied
subtly amongst each other in the recommendations they contained. This fact, combined with the
number and volume of documents which had to be perused, risked confusing rather than
assisting market practitioners who sought to conduct their business in accordance with such
recommendations.

Working with the other authors, AIMA led the development of the Hedge Fund Matrix (the
Matrix) - an online resource, which brings these best practice standards together in one
document, set out by topic. Thus, a hedge fund manager could easily compare what each
organisation says, for example, on the question of provision of information to investors (see
Section D2 of the Matrix). We felt it important from the outset that the Matrix should be both
user-friendly and publicly available (here - www.hedgefundmatrix.com). Since its publication in
October 2008, the Matrix has been visited over 1,700 times by users across the globe.

The next progression is to reduce the number of columns in the Matrix, i.e., to converge the best
practice standards wherever possible and this work is very much in hand. AIMA’s first Guide to
Sound Practices was published in 2002 and was not intended to set out hard and fast standards;
we have now reviewed our position in a number of areas and feel we can now endorse the
standards produced by the Hedge Funds Standards Board (HFSB) as well as the IOSCO
Principles in respect of valuation of assets. We believe, though, that there are certain areas where
our own work can supplement and complement that of the HFSB. We are in dialogue with that
body with a view to producing a single column of best practice standards which would be
relevant to hedge fund managers outside the US and a first draft of such a document has been
prepared and is under active review, looking to publication at the earliest opportunity.

163
We will include a report on the progress we have made in our ongoing correspondence with the
FSF in due course.

We are aware also that the MFA, in the United States, is working in a similar vein, aligning its
own Sound Practices to the best practices set out in the final US PWG Report of 15th January
2009. Our expectation is that, in the very short term future, it will be possible to condense the
nine columns of the original Matrix to two – being, essentially, a US model and a non-US model.
This will then permit further work to be done bringing these two models into alignment, where
possible.

The Children's Investment Fund Management (Uk) Llp

Remuneration Policy

The fees received by The Children’s Investment Fund Management (UK) LLP (TCI), the
investment manager, are in respect of the delegation of the provision of investment management
and related services by The Children’s Investment Fund Management (Cayman) Ltd. From this
turnover, TCI covers the costs of running the business, a part of which is the remuneration of
employees. A proportion of profits have been allocated to the subsidiary of the Charity, the
Children’s Investment Fund Foundation in periods past as well as partners in the business.

In addition to the drawings or salaries paid out monthly, partners and employees are considered
for an annual payment, which is paid on a wholly discretionary basis. A number of factors are
taken into account for the investment team, including their personal contribution to the fund’s
performance in the previous year and, to further align their interests to those of the investors, a
portion of that discretionary payment may be deferred and invested back into the fund for a
period of time (one or more years).

Blackrock Investment Management (Uk) Limited

Remuneration Policy

BlackRock’s approach to compensation reflects the value senior management places on its
employees and its client relationships. Consequently, the compensation structure has been
designed to attract and retain the best talent, to reinforce stability throughout the organization,
to encourage teamwork, and to align our interests with those of our clients. Given that BlackRock
is an independent public company, it is able to include equity as a component of compensation
packages.

For BlackRock professionals, the predominant compensation model includes a salary and a
discretionary bonus reflecting firm, business area and individual performance. Compensation for

164
portfolio managers reflects investment performance. As professionals become more senior,
bonus becomes a higher percentage of total compensation. At senior levels, a percentage of the
annual bonus is paid in the form of equity awards that vest rateably over a multi-year period
from the date of the award.

Portfolio managers for certain hedge fund products may have a portion of their compensation
determined with reference to performance fees earned on the fund. Such performance fees are
typically one fifth of the clients’ investment gains after other expenses. A portion of
compensation derived from hedge fund performance fees may be awarded in a form that tracks
the investment performance of the hedge fund and vests over a multi-year period.

BlackRock has long-term incentive programs in place as an additional incentive to retain talented
professionals, including long term equity awards that will vest at the end of five years contingent
upon the Firm’s attainment of certain identified performance measures.

BlackRock is committed to broadening equity ownership by all employees and has instituted
several programs, including an employee stock purchase plan to help achieve this goal. As part of
its comprehensive benefits package, BlackRock offers tuition reimbursement for professional
development. Other features include flexible healthcare options and retirement benefits.

Attracting, motivating, and retaining the best investment professionals have always been top
priorities for the firm. BlackRock is committed to perpetuating its corporate culture and
continuity in the employee base. Ensuring long-term career opportunities for our professionals
remains a most important senior management responsibility.

Newsmith Partnership And Investment Capital

Remuneration Policy

As requested at the Treasury Select Committee hearing on 27 January 2009 we have set out below
the remuneration policy for NewSmith Capital Partners LLP (“NewSmith”).

NewSmith Partnership and Investment Capital

As at 31 December 2008 NewSmith comprised 73 people of which 50 were working partners, and
23 were staff employees.

When partners join the firm, they are expected to purchase equity in NewSmith. In addition to
providing working capital for the business, the principal use of the partnership capital is to allow
the firm to invest alongside its clients in NewSmith’s own hedge funds. The purpose of this
investment is to demonstrate the firm’s commitment to its own funds. This commitment is
further re-inforced requesting the fund managers to also invest their own capital in the funds
that they manage. Accordingly with partnership and portfolio managers’ capital both at risk in

165
these funds our interests are directly aligned with those of our clients. The sense of partnership
and ownership created by this structure is an important part of the culture of NewSmith.

NewSmith’s partnership capital is entirely internally generated; there are no external capital
providers.

Remuneration of NewSmith

NewSmith provides both traditional fund management services to institutional pension funds
(long only business) and also manages its own hedge funds in which clients invest. Profit from
these activities is split, with broadly 50% going to the fund management teams and 50% going to
NewSmith (“the House”).

-income

NewSmith derives its income from charging management and performance fees on the assets it
manages for clients. Management fees charged on long only funds range from 0.25% to 0.5% of
the assets under management (“AUM”). The management fees charged on NewSmith hedge
funds range from 1.5% to 2.0% of AUM. These charges are consistent with market norms.

Performance fees are also charged by NewSmith where fund performance has exceeded agreed
benchmarks. In the case of long only funds performance is measured relative to the performance
of the FTSE All Share index. Hedge fund performance is measured in absolute terms. In both
cases performance fees are normally charged at 20% of the out performance against the agreed
benchmark. Again these charges are consistent with market norms.

Each fund management team has specific responsibility for the management and performance of
every fund managed by NewSmith. Each fund management team will therefore receive the
management and performance fees arising from the respective funds for which it has
responsibility.

-expenses

Income is offset by the expenses the teams have to cover as part of managing their fund. These
expenses comprise compensation for the team supporting the fund manager (research analysts,
trading and investor relations staff), administration fees from independent third party
administrators, and other general overheads. In addition all teams have to bear their share of
NewSmith’s control infrastructure costs; these costs include the compensation and overhead for
the services provided by Operations Specialists, Fund Accounting, Risk Management and
Control, Technology, Finance, and Compliance functions.

-profit share

As noted above, profit arising after the deduction of expenses from revenues is split 50/50

166
between the fund management team and NewSmith. The division of profit among the fund
management team is agreed between the fund manager and the board of NewSmith. The profit
retained by NewSmith is distributed to partners applying the parameters of the NewSmith
partnership agreement, which include profit distribution based upon the proportion of the
capital partners have invested in the firm.

I hope the above explanation provides the information you have requested. Please let me know if
any further clarification is required.

February 2009

167
 Memorandum from Mr Ron Parr

Subject: FSA INTERNAL DOCUMENTS SHOWS FSA SENSITIVE DATA IS VULNERABLE -

Risks To UK Plc High !
Cause: Bonus Driven Corruption Within the FSA.

I issued some FOI's to the Financial Services Authority (FSA).

Here's what I have found:

I was looking closely at FSA DPA and FOI compliance. I was alerted to a problem when my
FOI requests regarding complex, policy, regulation and legislation were being unlawfully tossed
over to FSA customer services. Past experience with government departments told me not only
is this a material breach but it seemed to signal an
Indication of a false auditing practice by FSA Information Managers and Directors, ie look
efficient and compliant, on paper to obtain target driven bonuses for disposal of DPA and FOI
requests.

Manifestly dishonest, and how can a regulator who engages in fraud, police fraud in the banking
sector and financial markets ? Particularly when Director of FSA enforcement Margret Cole was
responsible for issuing penalties running in to millions of pounds for data loss and data abuse by
those the FSA was regulating. This seemed to me to be a "double standard" that,
If true, would be backed up by internal evidence (ie AUDITS and it is).

The FSA has historically bullied financial journalists whenever they look too close at the
mechanics of the FSA.
Sure enough the FSA internal auditor backed up my suspicions entirely in unambiguous
Statements in the internal audit report on FSA DPA and FOI compliance - this is a real shocker !

The FSA are CURRENTLY investigating themselves for internal fraud, the investigation is in its
11th week but the attached shows the FSA were fiddling compliance audit data - THE
INVESTIGATION WAS INITIATED BY LORD TURNER'S OFFICE FOLLOWING A TIP OFF.

Using FOI and the FSA complaints infrastructure including Lord Turner I have obtained a
"Restricted Management Audit" of
FSA DPA and FOI provision by non other than the FSA's own auditors and its not pretty.

You'll see looking at the attached in particular for example the FSA auditors state:

"conformation of compliance relies on the annual certification and declarations by

Directors and these are not, in most cases supported by checks....."

"There is insufficient training and awareness of DPA requirements across the organization"

168
Source: FSA Restricted Management - Doc re: DPA compliance (see attached audit 1.1 - 1.4).

So since 1999 when Deloitte Touche audited to 2005 when FSA auditors checked - NO ACTION
TAKEN
Then from 2005 to 2008/9 - again despite Northern Rock and the near collapse of the UK
banking infrastructure and volatile financial markets the FSA sat on its behind despite a
restricted management warning by FSA auditors as follows:

"The FSA has access to,uses, and retains substantial amounts of information about individuals
and firms. Failure to comply with either Act (DPA 1998 or FOIA 2000) in the appropriate
manner could have serious repercussions for the FSA both in terms of
Possible fines and reputational damage".

Source: FSA Restricted Management - Doc re: DPA compliance (see attached FSA audit 1.1 -
1.4).

In short this is negligence and guilty knowledge all wrapped up in one. What the auditors are
warning of is that any half wit criminal can potentially access a vast amount of highly vulnerable,
sensitive material about UK PLC and all he or she needs is a temping job in the FSA and
a security pass.

A loss of highly sensitive data of this magnitude could cripple the UK economy overnight.

If you look at the "Key Failures" set out by Deloitte Touche in 1999 against failures seen by the
FSA's own auditors more recently, it appears clear and concise warnings have been systematically
ignored and DPA and FOI compliance has in fact been fraudulently falsified by FSA Directors to
obtain performance based bonuses, leaving UK Plc highly vulnerable to meltdown due sensitive
data
Loss.

The clues to any corporate failure are often evident in internal or external audits (both in this
case), they appear never to have been checked by anyone other than Deloitte in 1999 and again
by the FSA's internal auditor in 2005, on both occasions there were ongoing, un-remedied,
systemic and systematic catastrophic failure evident.

February 2009

169
 Memorandum from Citizens Advice Scotland (CAS)

Introduction

1. Citizens Advice Scotland (CAS) is the umbrella organisation for Scotland’s network of 71
Citizens Advice Bureau (CAB) offices. These bureaux deliver frontline advice services
throughout nearly 200 service points across the country, from the city centres of Glasgow
and Edinburgh to the Highlands, Islands and rural Borders communities.

2. In 2006/07, 91,475 new debt issues were brought to Scottish bureaux – an increase of 4% on
the previous year. This represents more than 250 debt issues brought to Scottish bureaux
each day of the year. Consumer debt remains by far the most common single issue that
clients bring to bureaux.

3. Many of these debt issues are related to the UK banks, who are one of the main types of
creditor used by bureau clients. Banks play an important role for the vast majority of adults
in the UK. They are the gateway to mainstream financial services, the provider of current
and savings accounts, and the main source of much needed credit. Banks provide mortgages
to buy homes, capital for businesses, and are a necessity for anyone who gets wages for
employment. Because of this important role that the banks have in UK society, the
repercussions of poor policies and practices have a wide and sometimes severe impact on
customers.

4. This role has increasingly come into the media spotlight in recent years following the OFT
test case in the high court, the much publicised record levels of debt, and the economic
downturn and financial crisis following the ‘Credit Crunch’. However, what has been missed
in all this has been the impact of bank actions on individuals. This briefing looks in detail at
this impact, showing the policies and practices that adversely affect clients.

5. The briefing will focus on the problems experienced by Scottish Citizens Advice Bureau
clients under the following headlines:

• Opening and maintaining accounts

• Bank charges
• Irresponsible lending
• Account management
• Third party dealings

170
Opening and maintaining accounts

6. Personal current accounts act as a gateway for customers to access financial services, and as
a basic pre-requisite for operating as a consumer in the economy. It is difficult to sustain
employment, receive benefits, and/or secure a tenancy without a bank account.

7. Almost 1 in 10 adults in Scotland do not have a personal current account, rising to 16% of
all adults in Glasgow.28 This group of people either self-exclude themselves from mainstream
financial services or experience difficulty in opening an account and holding on to this
account when they get it. Consequently, there are many adults who go in and out of
mainstream financial services and others who remain excluded on the sidelines.

Opening accounts

8. The UK Government has a financial inclusion target of ensuring that all adults have access
to a bank account. To this end, the UK banks have offered a basic bank account to adults
without access to an account. The basic bank account idea has been a relative success: 7.6
million people have signed up for a basic bank account since 200329, granting them access to
mainstream financial services.

9. However, clients still experience problems in opening a basic account. The criteria for
opening an account can be difficult for a client to meet. For example, clients need to have a
form of identity to open a basic account even if they already have an account with the bank,
including a passport, driving licence or utility bill as proof of identity. Many clients,
especially migrant workers, do not have these forms of identification and cannot open an
account.

10. Added to this, the Banking Code that provides guidance on how banks offer basic accounts
is voluntary. Bank branches are not obligated to offer a basic account to a customer even if
they meet all the criteria. Bureaux have seen clients who have been refused a basic bank
account, when specifically asking for it, for a range of reasons, including a previous debt
with the bank (even if this has been repaid), or a poor credit history.

An East of Scotland CAB reports of a client who had difficulty opening any type of account due
to a poor credit rating. The client had started new employment and required a bank account for
his wages to be paid into. However, he was told that he couldn’t open an account with one bank

28
Scottish Household Survey Annual Report 2007
29
British Banker’s Association - http://www.bba.org.uk/bba/jsp/polopoly.jsp?d=1569&a=15130

171
as he held a debt with them. Another bank told him that they would require a photographic ID to
open an account which he does not have.
A West of Scotland CAB reports of a client who was refused a bank account due to a previous
debt that had been repaid to the bank. The client was in debt to her current bank and was advised
to open a basic account with another bank to have her benefits paid into. The client spoke to the
branch manager about opening a basic account, with no overdraft or cheque book facility, which
the client was assured was available to all customers. Three weeks after opening the account, the
client was told that the account was now being closed as the client had had a previous debt with
the bank – even though this had been repaid some years ago - and that the client should not have
been offered the account in the first place.

Maintaining accounts

11. The current policy of the majority of UK banks towards customers who have been made
bankrupt is to close their account – which in turn can deny customers access to any funds in
their account including state benefits - and to refuse to open accounts for undischarged
bankrupts. The result of this policy is that clients who become bankrupt are often
marginalised and excluded from mainstream financial services, risking their employment,
benefit payments, and housing tenure.

12. This situation has moved up in the agenda in Scotland since 2008, with the advent of the
Low Income Low Assets (LILA) route to bankruptcy in April. LILA allows debtors with a
low income and high debts to make themselves bankrupt in order to release them from their
cycle of debt. The LILA scheme has resulted in a jump in the number of personal
sequestrations in Scotland, which is expected to be prolonged with a backlog of debtors
accessing LILA coupled with the expected economic downturn.

13. There were 4,514 bankruptcies in the first four months of the LILA scheme from April
2008.30 Assuming that the number of people accessing LILA remains constant in the short-
term, this figure can be extrapolated to above 13,000 this financial year. This is around 1 in
300 of the adult population in Scotland who will lose their bank account this year and
experience difficulties in opening another.

A South of Scotland CAB reports of a client who was awarded sequestration, but came back to
the bureau in distress as her bank had frozen her account. The client’s account only held her
Pension Credit which she could not access. The bureau spoke to the bank, who said that a

30
Accountant in Bankruptcy October 2008 – http://www.aib.gov.uk/News/releases/2008/10/16122123

172
bankrupt person could not hold an account with them. The bureau managed to get the client
access to her money, which she put into a Post Office Card Account.

A West of Scotland CAB reports of a client who had successfully applied for sequestration
through LILA. She had her current account frozen by her bank without warning, leaving her
without access to benefit payments. It took three weeks to resolve the issue and only a letter from
the Accountant in Bankruptcy’s office proved effective. In the mean time, the client was forced to
borrow money to feed her family.

Switching

14. The problems involved in opening and maintaining accounts affect clients in other ways.
Those with accounts tend to stick with them, often through a misplaced sense of loyalty to
their bank, which can have negative effects for the customer, including lost interest and the
loss of benefit payments needed to repay overdrafts.

15. Past and current problems with switching has lowered client confidence in switching their
own account, with the OFT market study into Personal Current Accounts31 finding that
almost half of consumers (45%) wouldn’t be confident that the switching process would be
smooth. These fears are borne out by the finding that over a quarter of clients who had
switched their account had experienced problems.

A West of Scotland CAB reports of a client who experienced problems in switching her bank
account. The client cleared her overdraft with her bank before changing to a different bank. Her
new bank told the client that they would take care of transferring the direct debits to the new
current account. However, a few months later the client received a letter from her original bank
stating that she had gone over her overdraft limit of £1000. It transpires that the bank account
was not closed and that direct debits have been going out of both accounts. The two banks are
blaming each other for the mistake, while the client’s original bank is threatening legal action to
reclaim the overdraft debt. The bureau contacted both banks and has not received a response
from either.

16. Many clients are disinclined to switch their account due to a negative past experience.
However, a number of clients who have not switched their account have never even
considered doing so. This is because they do not understand the costs of their existing
account - which they perceive to be free of charge - and therefore have little understanding
of the benefits of switching. Customers also display a misplaced loyalty to banks which they
have been with for years, when they could be much better off with a different account.
Bureaux have seen clients who have experienced significant financial difficulties through the

31
Personal Current Accounts in the UK July 2008 - http://www.oft.gov.uk/news/press/2008/84-08

173
 retention of their existing account.

An East of Scotland CAB reports of a client who experienced significant financial and housing
difficulties when his benefit payments were swallowed by bank charges. The client lost his job
and was unable to continue his contractual obligations while on Job Seekers Allowance (JSA) and
went into overdraft. The client’s housing benefit and JSA were paid directly into his account, but
all monies were swallowed up by bank charges for unauthorised overdraft, failed direct debits
and default letters issued to the client. The client went into rent arrears and was evicted by the
landlord. He is currently homeless and staying with a friend. The bureau arranged for the client’s
housing benefit to be paid directly to a landlord and another account opened for his JSA to be
paid into.

17. Low levels of switching are a distinctive feature of the personal current account market,
especially when compared to other markets in the UK. The OFT market study on Personal
Current Accounts32 found that the personal current account market has a very low level of
switching, with only 13% of consumers having switched their account in the last five years.
This compares poorly with the electricity (54%), gas (54%), and car insurance (61%)
markets, as well as with other financial products, such as credit cards (31%) and savings
accounts (20%).

18. The knock-on effect of low levels of switching is a lack of competition in the market, and
clients are therefore unable to make the threat of switching to banks that provide a poor
service. A lack of competition then manifests itself in poorer terms and conditions, as the
main banks are not incentivised to offer better deals to win more customers.

19. Despite the lack of switching, it is clear that clients can benefit from moving to another
bank. The OFT market study found that yearly savings from switching would range from
£7.50 to £110, mostly through switching to an account offering a higher interest rate. Clients
who persistently incur insufficient funds charges have potentially the most to benefit from
switching their accounts.

32
Personal Current Accounts in the UK July 2008 - http://www.oft.gov.uk/news/press/2008/84-08

174
Bank charges

20. Overdraft charges, or insufficient funds charges, has been a hugely significant issue for
Scottish Bureau clients in the last five years. They are a contributory factor to the increase in
the number of bureau clients seeking advice on debt, while bureau have been active in
helping clients to reclaim unfair and disproportionate bank charges.

21. Our evidence shows that customers have little understanding of the level and likelihood of
incurring overdraft charges. The system of overdraft charges is unclear and confusing for
bureau clients who do not understand the charges until they start to incur them – and once
charges are levied, they can be so high that they do not offer clients much of a chance to
learn from their mistake.

22. Despite the outcome of the High Court case between the OFT and the UK banks in 2008,
bureau clients continue to experience problems with their overdrafts and subsequent
charges. This response will look at the problems under the following headings:

• Disproportionate charging
• Direct debits/standing orders
• Item charges
• Multiple insufficient funds charges
• Unclear terms
• Responses to client requests

Disproportionate Charging

23. Scottish bureaux have seen a number of clients who have built up substantial charges for a
very small overdraft. These clients often go into their overdraft without realising that they
have done so, and find that they have incurred high overdraft charges at the end of the
month.

24. These overdraft charges are often highly disproportionate to the level of overdraft
infringement. This system inherently discriminates against low income customers, where
the level of charges is insensitive to the level of infringement.

175
An East of Scotland CAB reports of a client with severe mental health problems who quickly built
up substantial bank charges for an overdraft of £1.92. The client used her debit card for a
purchase of £4.25, not realising that there was only £2.33 in her account. Over the next two
months her overdraft of £1.92 grew to more than £180, solely as a result of interest and charges
imposed by the bank. The client was very worried as to how she could possibly pay this from an
income of £79 per week.

An East of Scotland CAB reports of a client who received excessive bank charges for a small
overdraft. The client is a mature student who works part-time. The client went 60 pence into his
overdraft and was charged £28 and a subsequent charge of £38. Since then, the client has been
unable to clear his overdraft. The client only earns £50 per week, and finds himself in an
impossible situation.

A West of Scotland CAB reports of a disabled, lone parent who was given an overdraft charge
after exceeding her overdraft limit for one day. The client stated that she regularly checks the
status of her account using the telephone services and was at no time made aware of a problem
with her account. The client exceeded the overdraft limit on her account for only one day and
feels that the £28 charge is excessive and unfair.

An East of Scotland CAB reports of a pensioner who received excessive charges for exceeding her
overdraft limit. The client recently exceeded her overdraft limit by £46.74, with her bank
statement showing charges of £170 for exceeding the limit. The client lodged a complaint about
the excessive charge, but despite being a pensioner found that the local manager was
unsympathetic to her situation.

25. Overdraft charges can have a significant impact on clients whose only source of income is
benefit payments. These clients can budget in pennies, then find that a slight overspend can
mean that they owe up to £100 in charges. A standard overdraft charge of £25 can be a
daunting prospect for those living on benefit payments.

26. The consequence of this policy is that low income customers can very quickly be in a lot of
debt to a bank due to a small overdraft. The customer’s low income would then preclude any
chance of getting out of the overdraft, thereby trapping the client in a cycle of debt.

27. The consequence of this cycle of debt is that clients begin to have their benefits – which are
necessities for living - swallowed up by charges. Under the present system, benefits lose
their identity when they reach the client’s account, and are used by the banks for paying
bank charges. This can leave clients with very little to live on.

176
An East of Scotland CAB reports of a client who has bank charges taken from her account each
month even though her income consists entirely of benefits. The client gets about £40 per week,
but this month’s bank charge was £120, leaving the client with £10 a week to live on. The client is
stuck in a cycle of bank charges that her limited income will not allow her to escape from.

An East of Scotland CAB reports of a client who experienced significant financial and housing
difficulties when his benefit payments were swallowed by bank charges. The client lost his job
and was unable to continue his contractual obligations while on Job Seekers Allowance (JSA) and
went into his overdraft. The client’s housing benefit and JSA were paid directly into his account,
but all monies going into the account were swallowed up by bank charges for unauthorised
overdraft, failed direct debits and letters to the client. The client went into rent arrears and was
evicted by the landlord. He is currently homeless and staying with a friend. The bureau arranged
for the client’s housing benefit to be paid directly to a landlord and another account opened for
his JSA to be paid into.

28. The system of overdraft charges impacts most severely on clients with low incomes. The
charges do not discriminate between small and large overdraft infringements, or between
high earners and low earners. The result is that low income clients are left with unaffordable
charges that do not reflect their level of infringement or personal circumstances.

Unpaid item charges

29. A common problem for bureau clients is high charges for unpaid items. This is particularly
the case for missed direct debits and standing orders. These charges are for a high amount
(commonly £35) and can be charged a number of times in the same month for a client with
multiple direct debits. The impact of this is that a client who is not in their overdraft can be
dragged over their overdraft limit by one missed payment and consequently incur a number
of charges.

30. For example, a client who has £34 in their account and has a £35 direct debit to be paid from
the account on that day will be likely to incur a £35 missed payment charge and then a £25
charge for going over the overdraft limit. This would leave the client with a £26 overdraft
and liable to receive future charges – including the missed direct debit.

31. A client may have set up multiple direct debits for the same day. If the anticipated balance is
not available to meet these costs, this can result in multiple charges for the client with
disastrous consequences.

177
An East of Scotland CAB reports of a client who went into his overdraft and consequently was
charged for missing nine direct debits. The client does not have guaranteed hours of work and
already owed more than £15,000. The client’s debt problems were aggravated by receiving £351
of bank charges for missed direct debits in a two week period. The charges are approximately the
same as his monthly wage.

A West of Scotland CAB reports of a client who was charged twice for the non payment of a
standing order. The client had insufficient funds for a standing order of £17 and received a
charge of £38 for the ‘unpaid item’. He put money into the account to cover both costs, but then
received a letter from the bank advising him of an additional charge of £28 for an unauthorised
overdraft relating to the same standing order. The customer feels that these charges are excessive
and is being charged for the same thing twice.

A West of Scotland CAB reports of a client who returned from holiday to find that she had been
charged for a missed direct debit as she was 2 pence short. The bank charged the client £35 for
the missed direct debit. The client was extremely unhappy with the charge as she has been a
customer with the bank for over 20 years.

32. Clients may be also charged for the number of items that they purchase while in their
overdraft. These charges can be significantly and disproportionately high for a client who
does not realise that they are already in their overdraft. The charges are very difficult to
predict, as it is difficult for a client to know at what point they will start to incur the charges.
The charges are also insensitive to level of the purchase, often charging the same set fee for a
£2.50 food item as luxury goods costing £1000.

33. For example, a client that enters into their overdraft while on a shopping trip could incur
charges for every item paid for over the limit. A client who buys three items over the limit
could expect a £25 overdraft charge and three charges of up to £30 for each item – a total of
£115 worth of charges.

A North of Scotland CAB reports of a client who has received excessive charges on items paid for
when in his unauthorised overdraft. The client has an authorised overdraft of £2,000, but has
occasionally been over this limit in the last year. His bank charges £30 for every item paid for
over the limit, with a maximum of three such charges per day. The client has paid a total of
£1,135 in overdraft charges in five months, mainly due to the item fees.

Multiple Insufficient Funds Charges

178
34. The variety of different types of overdraft and similar charges – insufficient fund charges,
missed payment charges, and item charges, among others - mean that clients can receive
levels of charges that are massively disproportionate to the level of infringement. It is not
inconceivable that a client could slip into their overdraft unknowingly by a few pounds, miss
two direct debits, and buy three items while over the limit. Using the cases in the briefing so
far, this could mean charges of nearly £200 for a small overdraft.

35. This is an example of a ‘snowball’ effect, in which a client enters their overdraft on one
occasion and incurs multiple charges. This effect can cause severe detriment to clients and
condemn them to an endless cycle of charges. Alternatively, clients may go in and out of
their overdraft in the same month and incur a charge for each separate occasion.

36. Analysis by MoneyExpert.com found that the average total charges are £44.98 for an
overdraft infringement and fees for an unauthorised overdraft can go much higher. Around
30 per cent of all current accounts charge a combined fee of £60 or more for straying beyond
the borrowing limit.33 By contrast, fees for defaulting on a credit card are a standard £12
after being effectively capped by a recent investigation by the Office of Fair Trading.

37. The upshot of the variety of charges that clients can incur has resulted in a substantial cross
subsidisation from those who incur charges and those who do not. According to the OFT
market study, and supported by our evidence, this cross subsidisation is from low income,
low saving clients, to high income, higher saving consumers. Indeed, the revenue made from
the customers who incur charges is actually keeping the cost of an account low for other
higher income customers.

Transparency and client awareness

38. A significant finding from the OFT market study is that consumers have a poor
understanding of the consequences of going over their overdraft limit. Consumers often
underestimate the likelihood of incurring fees and the cost of doing so. Nearly four fifths of
consumers in the market study who had been charged in the previous twelve months had
never heard of such charges, while only 7% of consumers knowingly went into overdraft.34

39. Evidence from Scottish bureaux suggests that clients can have little idea of the likelihood
and the cost of incurring overdraft charges. Unfortunately, this is a mistake that can have
long-term negative effects for a client.

33
http://www.moneyexpert.com/ContentArticle/None/Overdraft-mistake-costs-nearly-fourty-five-pounds-
on-average/Article.aspx?articleID=237&productTypeID=0
34
Personal Current Accounts in the UK July 2008 - http://www.oft.gov.uk/news/press/2008/84-08

179
A South of Scotland CAB reports of a client who incurred bank charges after assuming that his
card would be frozen after he ran out of funds. The client did not know about bank charges,
thinking that he would be told when he had no money. The bureau asked for a refund of charges,
but found it very difficult to find somebody who would talk about the client’s situation.

40. Clients need to take responsibility for knowing how their current account works and the
charges for its misuse. However, banks have a responsibility for ensuring that the terms and
conditions of use for current accounts are clear and understandable. This is not always the
case. The OFT market study raised concerns over a ‘lack of transparency’ over ‘less visible’
terms and conditions in current accounts. This is borne out in Scottish bureaux evidence.

An East of Scotland CAB reports of a client who opened a student account upon starting her
studies, and built up substantial charges without ever using the account. At some point, the
client’s account changed to a ‘royalties account’ which meant a charge of £6 per month for use of
the account. Because there was a zero balance the £6 charge put the account into the red and a
£28 per month bank charge plus interest began to be applied. By the time the client realised what
had happened, she had a debt of over £300 and rising. The client maintains that she was not told
that the unused account was going to be upgraded to the new fee-charging account nearly two
years after she had initially opened the account.

Responses to client requests

41. A significant problem for bureau clients is the attitude and actions that banks take when
clients question or ask for reprieve from charges. The responses from banks to customer
queries are unpredictable and erratic, and can adversely affect the customer.

42. Scottish bureaux have found that attempts to negotiate with banks over overdraft fees are
often met with unhelpful attitudes.

An East of Scotland CAB reports of a client who had her agreed bank overdraft removed after
sending the bank a letter requesting repayment of bank charges she felt were unfair. Upon
receiving the letter, the bank removed her agreed overdraft, leaving her liable to charges once
again, and gave the client a week to repay the overdraft (£600). The bureau feels that the bank’s
actions were retaliatory, and advised the client to report the matter to the Financial Ombudsman.

An East of Scotland CAB reports of a client whose account was frozen after he sought advice on
clearing his overdraft. The client had financial problems that had pushed his account over his

180
authorised overdraft limit. At this point, the client sought advice from the bureau to help him
stay out of his overdraft and avoid charges. The bureau wrote to the bank asking them to
consider reimbursing some of the charges to help stabilise his position while he worked out
repayments to the bank and his creditors. The bank responded by freezing the client’s account,
leaving the client with no access to funds, even though he was within his authorised overdraft at
that time. The bureau requested an explanation and was told that the account had been frozen as
the accounts were “at risk”. The client feels he is being punished for trying to be responsible with
his money and repay his debts.

A South of Scotland CAB reports of a client whose bank refused to agree to an arranged overdraft
limit leaving the client in financial difficulty. The client, who was retired, was keeping up with his
finances, but found that he was slightly in debt at the end of each month, which meant that he
was incurring significant bank charges. The client asked repeatedly for an overdraft facility of
£100 on his account, which would have allowed the client to easily get out of the cycle of
overdraft charges. However, the bank refused as the client already had a loan with them.

43. Another common response from banks is to pressure clients to take out new products while
they are stuck in their overdraft. This can include consolidation loans, re-financing loans,
and other products. Clients feel under pressure to agree to these requests as overdraft
charges mount up. It is also common for banks to ask for high rates of repayment of
overdraft arrears and to be unresponsive to other offers of repayment.

An East of Scotland CAB reports of a client who has an overdraft with a bank who is pressuring
her to take out other products as part of a repayment agreement. The client is trying to repay an
overdraft she incurred while at university. The client has since changed her account for financial
reasons. The bank has sent correspondence stating that the client must re-open an account with
them, take out a credit card, and are asking for £260 per month. The client cannot afford to pay
this amount, and has tried repeatedly to contact her branch to negotiate. Meanwhile, her account
continues to incur overdraft charges.

An East of Scotland CAB reports of clients who were offered a consolidation loan after advising
their bank that they were experiencing difficulties repaying their overdraft. The clients had an
overdraft of £3,546 which they felt unable to repay. At the time, both clients were under
considerable stress and did not fully understand the nature of the agreement. The loan included
insurance cover of £1,281 which was not required as neither of the clients are able to work, a fact
the branch manager was aware of. The clients now have a debt of £8,600, an increase of £5,000 on
the original debt.

A South of Scotland CAB reports of a client who was pressurised to take a consolidation loan to
repay his overdraft. The client is currently unemployed and living on Job Seekers Allowance. The
client noticed that the interest on the consolidation loan was greater than he was currently

181
paying on his overdraft. His income is only £42.70 per week and he is not in a position to take on
a loan.

Irresponsible Lending
44. A hugely significant problem for Scottish bureau clients in recent years has been the
inappropriate lending of credit to borrowers. The era of easy credit that has taken place over
the last decade or so has led to substantial lending to clients who haven’t been in the
position to repay their debt. Bureau have seen numerous examples of clients being given
substantial and expensive credit when they are unemployed, on a low income, suffer from
mental illness, or are likely to be too old to repay the debt.

45. Scottish bureau debt clients are less likely to be in full-time employment, significantly more
likely to be unemployed, and more likely to live in local authority housing, than the Scottish
population in general. Bureau clients are therefore predominantly low income clients – and
yet bureaux see cases every day of clients struggling with significant credit commitments.35

46. There are few adults in the UK who don’t currently have or have held credit. Many low
income consumers supplement their income with credit just to get by, or need credit to
replace essential items, such as cookers, that they cannot afford on their income.

Low income clients

47. Low income clients who need credit are often able to access it, but not at affordable levels. It
is a feature of the financial services market that the cost of a small loan is disproportionately
bigger than that of a large loan. The cost of credit is therefore greatest for those who need to
borrow the least. It also creates a perverse incentive for banks to lend more money to
customers than they need to in order to maximise income. The result is that low income
clients often have access only to unaffordable credit, and, rather than dissuading clients
from taking credit that they cannot afford, banks and others are encouraging these
agreements. This can often lead to intractable debt problems for clients.

48. Low income consumers need sustainable levels of credit, but the odds are stacked against
them. Armed with statistics stating that low income customers are a bigger default risk,
creditors place terms on customers that make credit too expensive and make these
customers more likely to default.

49. Scottish bureaux have reported cases in which clients have been given credit that is highly
disproportionate to their low level of income. In such cases, it is very difficult for clients to
make repayments on a loan and consequently take out further credit to meet payments. This
is an unsustainable situation for a client and leads to a cycle of debt that is difficult to escape.

35
On the Cards: The Debt Crisis facing CAB clients, Citizens Advice Scotland 2004

182
A West of Scotland CAB reports of a retired client who was given a loan of £30,000 by his bank.
The client is a council tenant who lives on a pension of £900 per month. The client made
repayments using five credit cards, but has now reached the limit on all of them. The client’s total
debt is now £47,000.

A North of Scotland CAB reports of a disabled client who has been unable to work for over a
decade yet was given a £10,000 loan from his bank. The client’s income consists of Incapacity
Benefit, Disability Living Allowance, and war pension, amounting to £160 a week. The client
tried to negotiate lower payments but the bank refused and would only accept the agreement
amount. The client has now fallen behind on his payments, which is causing the client
considerable stress.

A West of Scotland CAB reports of a client whose bank has lent him substantial sums of money
despite his only income being Income Support and Disability Living Allowance. The client has
now received over £10,000 of loans from his bank. The bureau wrote to the bank querying why a
client whose sole income was benefit payments was given such substantial credit, but did not
receive a reply. The client came back to the bureau to say that he has now been given an agreed
overdraft limit of £2,000. The client has used this overdraft to live on while his benefit payments
have gone towards his debts.

50. The argument behind lending to low income clients is the provision of a service to
customers who otherwise would not be able to obtain credit. However, for many of these
clients, high cost credit does not answer the problems of low income, and merely
exacerbates their problems to the extent that their low wages or benefits are completely
swallowed up by their ever increasing debt.

Clients with poor credit histories

51. Scottish Citizen Advice Bureaux have a number of clients who have been given credit
despite already having considerable debt. While this type of practice helps the client in the
short-term, in the long term it adds substantially to the client’s overall indebtedness.

52. The problem appears to lie in a ‘don’t ask, don’t tell’ attitude from banks that have not
checked whether clients already have credit and debts from other creditors. In some cases,
clients have been given credit despite already having multiple debts with the same bank.

183
A West of Scotland CAB reports of a client who was given a loan for £3,000 despite already
having over £30,000 worth of debt. Already owing some of this money to his bank, he was given
the loan without any problems or questions about his other debt. The client now has over
£33,000 worth of debt and is unable to repay this amount.

An East of Scotland CAB reports of a client on income support who was given a loan of £10,000
from her bank. The client had approached the bank for a loan advising them that her income
consisted of income support and occasionally £40 cash in hand weekly employment. The bank
did not ask for proof of the client’s income. The client already had debts of over £14,000 prior to
asking for the loan. The client used the loan to supplement her income, and could only make the
first few repayments. The client is a homeowner and is now forced into selling her home to repay
this debt.

Pressure on clients to take credit

53. Scottish bureaux have seen many cases in which clients have been offered credit when they
originally had no intention of asking for a loan and were unlikely to be able to afford credit.
This type of selling can be harmful for clients who are tempted by the offer of large amounts
of money and who do not have time to think through the cost or implications of their
decision.

An East of Scotland CAB reports of a client who was offered a loan by her bank as she withdrew
money from her account, despite having no disposable income and relying solely on benefits.
The client went into her local branch to withdraw the last £6 from her account, and was offered a
loan and a credit card by the bank teller. The client agreed, and received a £2000 loan and a credit
card with a limit of £1500. However, the client only has a little over £4 a week in disposable
income, and could never have been able to afford the offered loan. The client now has debts
amounting to £4,785 with her bank.

An East of Scotland CAB reports of a client who took out a loan with his bank after receiving
loan offer literature with his bank statement. The loan was for £8,856 repayable over five years.
The client was 81 years old, and died two years later. His wife has now taken over the repayment
of the loan as the bank had insisted that the loan was taken jointly due to her husband’s age. She
has very little means of affording the repayments and has fallen into arrears.

54. Similarly, banks put pressure on clients to take out further credit on top of their initial loan,
rather than take actions to help the client repay their original commitments. The additional
loan is often euphemistically referred to as a ‘top up’ on the loan, when in fact the top up is

184
 actually a new loan with the client paying the interest on the new loan on top of that of the
old loan.

A North of Scotland CAB reports of a client who was given a ‘top up’ on her existing loan having
gone into her bank branch asking for an increase in the overdraft limit on her bank account. The
client was kept in the branch for over three hours, during which time the client was seen by an
assistant, the manager, and an insurance representative, none of whom mentioned interest rates.
The £1,500 loan was used to repay mortgage arrears. The client then received a confirming letter
showing that the whole loan was to be repaid at 14% interest, compared to the original loan rate
of 7.4%, and the repayment schedule had been extended. The letter stated that the client had 14
days in which to change her mind. The client phoned the contact number given, and was told to
communicate by letter.

A West of Scotland CAB reports of a retired client who received calls at regular intervals by her
bank offering to “top up” her loan. The client has a number of debts which she believes amount
to around £20,000. The client was contacted by the bank suggesting that she “top up” her loan,
which she agreed to do, and now has a repayment of £243 per month. The client was unaware
that the “top up” was in fact a new loan altogether and as a result she is paying interest on
interest. The bureau feels that the bank should be taking the client’s multiple debt situation into
account each time they offer a new loan.

185
Account management

55. When clients get into arrears with repayment of credit, banks have varying policies in
response. Some of these policies can help debtors while others only hinder, making an
affordable loan difficult to repay. This section looks at the policies and practices of banks
when clients get into arrears.

Interest and charges

56. A bank’s policy on interest and charges on arrears can have a significant impact on the
debtor’s ability to repay their debt. A common policy operated by banks is the decision to
allow debtors only one short period in which interest and charges can be frozen, before they
are restarted and the debt is sold to a debt collection firm. This policy gives the debtor little
chance to repay their debts and can have the effect of increasing the value of a debt before it
is passed to a debt collector.

A West of Scotland CAB reports of a client who had interest applied to his debt due to a new
bank policy. The client has been regularly making repayments of £80 a month towards his debt
for around a year. After a review of the repayment schedule, the bank requested an additional
£92 a month payment for interest charges. The bank had a new policy of suspending interest for
a fixed period of around six months, after which interest and charges are reapplied to the
account. The bureau was informed that the account would be passed to a debt collector whether
or not the client continued to make payments. The client decided not to make payments until the
account reached the debt collector as they will not apply interest. The client then began to receive
phone calls late at night from the bank regarding the debt.

A West of Scotland CAB reports of a client whose bank began to add on interest to a debt
without warning after a period of freezing interest on the account. The client had been making
the agreed £4 repayments to the bank, but was sent a letter stating that the client was now in
arrears of £20.73. The bureau called the bank who explained that their policy is to freeze interest
for a “once in a lifetime period” of one year. After that interest gets added for 4-5 months, at
which point the account will be passed to a collector. The bureau pointed out that the client had
adhered to the payment plan and that the interest charges far outweigh what she can afford and
she will never make inroads into the debt.

186
Policies on arrears

57. Banks can also be unhelpful or unsympathetic when a client reports financial difficulties.
Common responses include increasing agreed overdraft limits, decreasing credit limits,
offering consolidation loans, and in some cases closing the client’s bank account.

A North of Scotland CAB reports of a client who had her account closed by her bank after
offering a reduced repayment for her debts. The client is a pensioner whose main source of
income is her state pension. The client was having difficulty meeting the repayments on the loan
and the bureau made a reduced offer of repayment to the bank and sent the bank a copy of her
financial statement. The bank immediately closed her bank account with the result that her state
pension which was due on that day seems to be lost. The bank was very unhelpful and would not
return calls. The bank eventually offered to open a new account and to try to trace the £380
which had disappeared.

A North of Scotland CAB reports of a client whose bank reduced his credit card limit to below
the amount that he owes. The client had reached an agreement with his bank to pay £5 a month
for a credit card debt. The credit card had a £3000 credit limit. The client received a letter from
his bank stating that his credit limit would drop from that day to £550 – he owed £570.89. In
another letter received on the same day he was asked for the full £20.89 limit plus charges.

A West of Scotland CAB reports of a client who received unsympathetic treatment from her
bank when repaying her loan. The client has a repayment arrangement in place with her bank
that was due to be reviewed in October 2008. The client received a worrying phone call from the
bank saying that there is no way that the present arrangement will continue after October and
offered a final settlement figure of £9,000 for a debt of around £11,000. They suggested if she did
not take advantage of this offer "her house would be involved".

58. A common response from a bank to a client who is reporting financial difficulty is to
increase the amount that a client can effectively borrow, for example by increasing credit
limits or authorised overdrafts. This can give a client breathing space in the short-term, but
can ultimately represent irresponsible lending as the client still cannot afford to repay what
they owe and end up with a higher amount of debt.

187
A North of Scotland CAB reports of a client whose bank continually raised his credit card limit
despite his precarious financial situation. The client has never had permanent work, yet has a
credit card limit of £11,200. The client was only able to keep paying minimum payments on his
credit card debt each month by taking cash withdrawals from his card. As a result of never
missing a payment his credit limit was increased on a number of occasions, thereby allowing the
client to get into deeper debt.

A North of Scotland CAB reports of a client whose credit card limit has been increased to £7,050
despite the client being unable to maintain payments during the past few years. The client has
been on Income Support for 17 years and has a debt of £25,000. She has numerous debts which
she has not being paying for a number of years as she is awaiting legal action to allow her to
apply for bankruptcy. The bank’s reaction to her financial situation has been to extend her credit
limit allowing the client opportunity to get further into debt.

An East of Scotland CAB reports of a client who asked for help from her bank in repaying a loan
to them. Their response was to raise her overdraft limit substantially. The client had had a series
of loans from her bank since the 1980’s, which was rescheduled as a £25,000 loan in 2006. When
the client returned to the bank for help as she was not able to cope, the bank’s response was to
raise her overdraft limit from £300 to £2,000.

Right of ‘set off’

59. The right of set off allows banks to legally transfer cash from current or savings accounts to
pay credit card or loan arrears without account holders' permission. Citizens Advice
Bureaux have seen cases of people having their pay or benefit payments removed from
accounts, leaving them unable to meet priority debts, like mortgages and council tax, and in
greater financial difficulty.

A North of Scotland CAB reports of a lone parent whose bank took £400 from her account to
repay debts without her permission. The client has credit card and overdraft debts with her bank,
with whom the bureau has been in contact with to negotiate repayments. The bank took £400
from her current account after her wages had been made in, leaving the client with no money
with which to live. The client contacted her branch who denied having any contact with the
bureau, and who stated that if the client moved her account to another bank they would take her
to court.

188
Sale of associated products

60. Another way in which a bank can put pressure on clients to repay is to encourage them to
take out further products as part of their repayment. Once this offer is in place, it can be
difficult for the client to reject the product and negotiate with the creditor. The types of
related products that clients can be under pressure to agree to include further loans,
consolidation loans, credit cards, and overdrafts.

A West of Scotland CAB reports of a client who made a repayment offer to her creditors, and was
instead offered a further loan. The loan would have helped the client to avoid default, but would
have cost a further £2700 in interest and charges. The client rejected the offer, and decided to
stick to the repayment plan prepared by the bureau.

An East of Scotland CAB reports of a client who was offered a refinancing loan after making an
offer of repayment. The bureau had helped the client to set up a repayment agreement with his
bank six months previously with interest frozen on the account. When the arrangement expired,
the bureau wrote to the bank with the same offer of repayment as the client’s circumstances had
not changed. The client then contacted the bureau to say that his bank had contacted him
offering a refinancing loan. The bureau explained to the client that the loan would put him more
in debt and he would not receive any money.

A North of Scotland CAB reports of a client whose bank will only accept an offer of repayment if
the client takes out a new consolidation loan. The client is deeply in debt, and the bureau made
offers to her creditors for repayments. The client’s bank replied to the bureau saying that they
will ‘accept’ her offer of £175 a month but only if she has a ‘new line’ opened, i.e. takes out a
consolidation loan. If the client were to accept this, she would continue to pay interest and
charges on the debt.

Debt collection

61. Bureau clients often complain of intimidation or harassment from creditors chasing
repayments on a debt. This includes creditors or debt collectors who put pressure on clients
to increase repayments through phone calls, letters, and home visits.

62. Phone calls from banks are often intimidating to clients and can happen so often that it
becomes a form of harassment. Clients are reporting receiving multiple calls every day,
including late at night, early in the morning, and on weekends. The content and tone of the
conversations can also be threatening to the clients.

189
A West of Scotland CAB reports of a client who received phone calls at all hours from his bank
after falling into arrears. The client received calls into the evening and from 8am. His wife often
took the calls and sometimes they were ‘silent’, but the client was sure they were from the bank.
The bureau wrote to the bank complaining on behalf of the client. The reply stated that all
customers who get into arrears receive phone calls like this, but the system is unable to cope with
requests not to call at certain hours. Some calls start out as silent as the operator can’t always
respond immediately. These administration difficulties at the bank cause unfair stress and worry
for clients.

Third party dealings

63. Scottish bureaux have reported banks that have refused or delayed recognising a bureau as
representing a client. The consequence of this is that the bureau cannot act on behalf of the
client while banks continue to request payments from them. This can result in clients feeling
pressurised to agree repayments without the benefit of an adviser’s input.

64. The OFT’s guidance on debt collection defines refusing to deal with authorised third parties,
such as Citizens Advice Bureaux, as ‘deceptive and/or unfair’. However, bureau have
reported a number of cases in which a bank either does not recognise a bureau as
representing a client or actively takes action against the client in response to bureau
involvement.

A West of Scotland CAB reports of a case in which a major bank refused to recognise a Citizens
Advice Bureau as representing a client. The client had asked the bureau for help to re-claim bank
charges on his account. The bureau contacted the bank by letter with a signed mandate from the
client. The response stated that the bank ‘is under no statutory obligation to record this
information and therefore I am unable to assist further with your request'. The bureau contacted
the bank again to request information relating to the bank charges, and were asked to forward
another signed mandate from the client. The bureau received no reply, so sent the letter and
mandate again, but were told on the phone that the bank had not received a mandate. The
bureau received a letter from the bank six months after first sending a letter, advising that 'with
effect from 23 April 2007 it became an offence to provide claims management services without
authorisation.' It further reads that after checks they were 'unable to confirm your company have
the required authorisation.' The letter went on to say that the bank would deal directly with the
client.

An East of Scotland CAB reports of a retired client with a loan who was upset by the harassment
she felt she was receiving on the telephone while she was trying to negotiate a solution to her
debt problems. The client had approached the bureau for help, but the bureau found that
creditors were taking a long time to respond to their letters while continuing to contact the client
directly. The client was told on the phone that her bank did not deal with third parties, including

190
the citizens advice bureaux. The bureau contacted the head office of the bank who advised that
this was not the case and that the original offer of repayment would now be accepted.

65. A recent trend reported by bureaux has been banks freezing clients’ accounts after a citizens
advice bureau has made contact on behalf of a client. The reasoning behind this action is
that the banks are protecting their own funds in case the client gets further into debt. This
seems counterintuitive, especially as many UK banks encourage customers to visit a bureau
if they are in financial trouble in their correspondence to clients.

A North of Scotland CAB reports of a client who had her current account closed after making a
reduced offer on her loan repayments. The client was in financial difficulty and the bureau made
a reduced offer of repayment and sent her financial statement to the bank. The bank responded
by immediately closing the client’s bank account, which caused the client to lose her State
Retirement Pension of £380 which was due to be paid in that day. The bureau called the bank
who were unhelpful and would not return calls. The client was left with no money whatsoever.

An East of Scotland CAB reports of a client who had her current account frozen after a bureau
contacted the bank with an offer of payment on behalf of the client. The client had been coping
with her debts until her husband had had an accident at work. She decided to do the sensible
thing and deal with her debts before they got unmanageable. The bureau sent out letters to the
client’s creditors offering repayments, but received no reply from the client’s bank. On
approaching her branch, the bank informed the client that the account was ‘frozen’ and she could
not withdraw any money. The client had £461 in her account, and was therefore not in overdraft.
The branch informed her that because she had involved the CAB, it was their policy to
automatically freeze the account. The branch further told the client that she should have come to
them for help, and not the CAB. The client duly informed them that she had approached them
and asked for a loan to tide her over until her husband went back to work, which they had
refused. The client then asked what help they could offer her, receiving the reply that as she had
involved CAB, there was no further help they could give her. The client left the branch with no
money, and two children under 10 to feed over the weekend.

Conclusion

66. Banks play a fundamental gateway role in nearly every person’s life in the UK, so it is
essential that the policies and practices of the banks allow customers to access this gateway
without undue problems and hardship. However, Scottish clients are continuing to
experience problems relating to their current accounts, overdrafts, use of credit, and
management of arrears.

Opening and maintaining accounts

191
 • Clients are struggling to open basic bank accounts due to a lack of personal identification,
previous debts with the bank, or the policies of the bank branch.
• Clients who are made bankrupt are losing their bank accounts and experiencing
difficulties in opening another.
• Clients are experiencing difficulties when switching their account, which is dissuading
other clients from considering switching

Bank charges
• Clients are receiving disproportionately high bank charges after making small
infringements in their overdraft, which unfairly penalises low income customers.
• Banks are using clients’ much needed benefit payments to pay for overdraft charges.
• Clients are being hit with multiple charges - such as insufficient funds charges, unpaid
item charges, missed payments charges, and interest - that ‘snowball’ into a high amount
that forces the client into a cycle of debt.
• Clients have a poor understanding of the likelihood and level of charges involved in their
overdrafts.
• Banks can be unhelpful in their responses to clients who try to negotiate a solution to their
overdraft problems.

Irresponsible lending
• Low income clients need affordable credit, but are often given unaffordable and
substantial credit that puts them into a cycle of debt.
• Substantial credit is being given to clients with no obvious ability to repay, including those
who rely on benefit payments, are retired, or have existing financial commitments.
• Clients who already have substantial debt can be given further loans which worsen their
situation.
• Clients can be pressured into taking loans they had not intention of asking for, and be
persuaded that taking a further loan can act as a solution to arrears.

Third party dealings

• Scottish bureaux have reported banks that have refused or delayed recognising a bureau as
representing a client, running contrary to OFT Guidance on Debt Collection.
• A recent trend has been banks freezing clients’ accounts after a citizens advice bureau has
made contact on behalf of a client.

192
67. The events of the last two or three years, including the OFT test case in the High Court and
the financial problems induced by the Credit Crunch, have triggered great interest in the
banking sector. This has highlighted many of the policies and practices that have adversely
affected customers in the last few years.

68. This interest also represents an opportunity for banks, government, and regulators, to look
at the way in which the banking sector is run. Many remedies have already been proposed
and some already implemented. However, for any remedy to be successful it needs to take
into account the impact on the individual. This is an opportunity for a new agreement to
take place between government, banks, and customers – one in which banks make their
revenue in a fair and transparent manner, and customers can access the services that they
need without the problems and the charges that they currently face.
February 2009

193
 Memorandum From Rev Dr Richard Rodgers Leader, the Common Good party

1. Thank you for working so hard to find a solution to the current financial crisis.

2. I would like to ask to make an oral submission to the committee. I realise that you have spent
a great deal of time hearing evidence but I believe I have something important and lucid to
say which has not been sufficiently drawn out by most of the people from whom you have
heard. My contribution relates to a systemic problem with the banking system as it is
currently organised which if not addressed will bias our economy towards recurrent disaster.
Furthermore I believe that people with a professional connection to the crisis have an inherit
bias against exposing this systemic defect either because they profit from it or they would be
embarrassed to “declare that the Emperor has no clothes” and to risk looking foolish and
damaging their reputation unless everyone saw the issues their way. They are reluctant to
take that risk.

3. This submission touches on various terms of reference including 1.6, 1.8,1.9,1.12,1.13 and
2.1. I append a brief CV at its foot.

4. Executive summary: Banks create money out of nothing. The chief cause of the banking
crisis is allowing commercial banks to create the non cash element (about 97%) of the money
in our economy out of nothing by issuing loans of money that didn’t exist until they lent it. It
costs the banks virtually nothing but they stand to gain hugely from the repayments of capital
and interest that borrowers have to go out and earn by the sweat of their brow. It is a bonanza
for the banks. They enjoy an unfair advantage over the rest of us; as if we let them print bank
notes freely in their back offices. If you or I did this we’d be locked up. They have no moral
reason to be allowed this special privilege. They are just businessmen acting in their own
interest. The central bank the Bank of England acting on behalf of the state in the interests
of society should enjoy the sole authority to create money. Banks should be stopped from
doing so. Every month the Bank of England should calculate how much money the
nation’s current level of economic activity requires and create it and give it to the
government to introduce into circulation by spending it on the things the government
usually spends money on. That way, no interest is payable by society as a whole just to
have this money circulating as our means of exchange. At present we pay bankers for the
privilege of using bank-loan money that they have created as our national currency. At
present they have an incentive to create too much and to egg people on to borrow more
and more or they had until the edifice collapsed recently. It’s why so many people have
been tempted into debt and why houses cost so much. The altruistic Bank of England
would have no such pecuniary interest to create and issue too much money.

5. Banks also create money by the credit multiplier mechanism by which current account
deposits are lent out to a series of other borrowers despite the risk that the depositor may
come and ask for his money back at any time and that the bank is contractually obliged to
give it to him. Most (100% minus the reserve fraction) of the original deposit is lent out as it

194
 passes through the hands of successive banks, several times over, creating more and more
bank deposit money out of the original modest deposit. Depending on the reserve fraction in
force the amount of loan money created can reach around ten times the amount of the
original deposit, thus creating out of nothing a sum equivalent to around nine times that
deposit.

6. The crucial question is “in whose ownership is money created”? At present in the UK money
is almost all created in the ownership of the commercial banks when they make loans. The
approximately 3% of our national money that is notes and coin is all that is created by the
central bank on behalf of the government. I presume that some bank loans include an entirely
legitimate element that comprises the deposits of the savings accounts of savers on the lines
of old-fashioned mutual building societies, but, I gather that most is “magicked” into
existence by sleight of hand by the banks. Money so created, when it enters circulation does
so bearing interest that society has to repay to the banks as opposed to money created by the
central bank as an agent of the state which would enter circulation debt-free (interest-free).

7. This sort of money creation activity by commercial banks gets little attention in the media. I
think it is so breathtakingly audacious that speaking of it is embarrassing to men of stature in
banking, journalism or politics. There is a tacit conspiracy of silence over it. I believe such
activity does exist, however, since this construction makes sense of observable facts, whereas
denying the possibility of such activity leaves us with a set of observations which baffle most
people.

8. Over the last ten years or so the approximate 14% pa growth of M4 money supply has far
outstripped to approximate 2% growth in GDP. I realise that this discrepancy is partly
explicable by “open market” operations of the Bank of England and purchases of British real
estate by foreign nationals. But even allowing for such factors it seems to me to show that
someone is creating a lot of money that doesn’t correspond to any real growth in the
economy. I think a big part of the answer is this spurious “creation of money out of nothing”
by banks.

9. The Daily Telegraph of 14th February 2007, quotes Steven Crawshaw the then Chief Executive
of Bradford and Bingley Building Society as saying that a reduction of the Basel II reserve
requirements was equivalent to the society having an extra £300m capital and would let it
lend out an additional £12 to £15 billion without having to raise any more capital.

10. If B&B weren’t having to raise any more capital where were they going to get the money
from? My thesis is that they planned to get it out of thin air by what I would almost dare to
call a trick with figures; and they were going to get away with it because most people get a bit
muddled about these things. Subsequently, of course, B&B got into difficulties.

11. There are three problems with commercial banks creating our money supply out of nothing:

195
12. First, they have an incentive to lend too much. It costs them very little to create this money. It
is not money they have obtained from anywhere but money they have written into existence
in their accounts by a mere book-keeping entry. In the case, say of a house purchase, the
money only comes into existence when the vendor banks the cheque written by the purchaser
who has obtained permission from the loan-issuing bank to write such a cheque. I am told
that in many cases, these days, that money didn’t exist before this instant. It wasn’t money
obtained from savers or borrowed from another bank. It was just created.

13. Banks benefit greatly by this mechanism. I would almost call it a fiddle. It costs them nothing,
or almost nothing, to issue this bank-credit-created money. On the other hand they stand to
gain enormously as the borrower labours to repay both capital AND interest over the term of
the mortgage.

14. This mechanism introduces a huge perverse incentive for banks to lend out this sort of
money that they have created out of nothing in exchange for future repayment of the debt
with earned money from the real economy and with interest that the bank demands to boot!

15. It’s an absolute bonanza for the banks. They love it.

16. They are perfectly happy that most people are muddled about how the crisis has happened.
They shelter in the obfuscation.

17. This “dodge” is so lucrative that it gives the banks an incentive to lend to many people. The
more the merrier. Since it is money that didn’t exist and since they are being paid back in real
money, the more they can do it the richer they get.

18. This is why so many people have got into debt. Yes certainly many borrowers have been rash
about taking out loans but the loan wouldn’t have been on offer if the banks hadn’t had a big
incentive to lend it and “money for nothing” is this huge incentive.

19. That’s why bankers get huge bonuses. To blame the banker is to miss the point. The point is
that the incentive is there. The senior banker can see it and being a lively chap he uses to
opportunity to the full and incentivises his subordinates to get borrowers to sign up.

20. The second problem is in whose ownership the money is being created.

21. In Britain today most money is created in the ownership of the banks and the banks issue it
as a debt with interest payable on it.

22. So British society as a whole is having to pay interest to self-interested businessmen just to
use money they have created as the currency of our land and we can never catch up. We have
to borrow more and more just to pay the interest.

196
23. There is an alternative. We as a society could issue our own money that we as a society own
outright rather than having to turn to businessmen and asking to use theirs. The banks are
being allowed to print our money, basically. They are being given an unfair advantage over
the rest of us. None of the rest of us is allowed to print money or create it by a computerised
accounting entry as the banks do.

24. If they have been lending this fictitious money to home buyers, I suspect that they have also
been lending money of similar dubious origin to hedge fund business people and derivatives
traders for the purchase of whole companies on an even more massive scale; hence the large
amount of money sloshing around the system.

25. The creation of money in our land must be brought within the domain of the state, with
the Bank of England acting altruistically as a servant of the people and the right to issue
money must be taken away from the banks.

26. Then the money created won’t all have to have interest paid on it just because it exists.

27. After the current crisis, the public will be better served by banks remaining as commercial
competitive institutions so they can compete to offer advantageous rates to savers and
mortgage borrowers and to provide a cheap efficient payments system. It is better not to
nationalise banks. It is just the creation of money ex nihilo that they should be stopped from
doing.

28. How to proceed. Customers’ deposits in current bank accounts must remain sacrosanct. They
must remain the property of the customer even if he has to pay the bank a little to look after
that money for him. He may also have to pay a little for the banks to operate the nation’s
payments mechanism. Banks, however, must not be free to dip into customers’ current
account deposits to lend them out when the depositor is not looking. This current account
deposit money must not even enter the bank’s books. Accounting would be totally separate
from the bank’s own money. It would be just like operating your own piggy bank or the safe
deposit box at your holiday hotel. The depositor would be to only one touching the money.
Then there would be no question of a run on a bank or of the bank losing current account
depositors’ money since they wouldn’t have had access to it in the first place. Banks would
howl a bit at the loss of income that honesty would involve but they would get over it and in a
competitive market the safe-keeping and payments services might even improve.

29. Saving’s account deposits would be different. Savers would actually take the step of
deliberately handing over ownership of their funds to the bank in return for the bank’s
promise to pay it back at a later date with a share of the interest it has earned by being lent
out to the bank’s borrowers, as happens at the moment. That’s fine. It’s straightforward and it
doesn’t involve any of this mysterious money creation activity.

30. The change from the present system of bank created money to money created in public
ownership by the central bank acting in the public interest, is do-able. The details need to be

197
 worked out by technicians but the decision to change to such a system is in the hand of the
people, with our politicians acting as our agents.

31. The Prime Minister should include this topic on the agenda of the G20 summit in London of
2nd April since it would be best to make such a change as an entire international polity and we
should lead the way on this. I am taking steps to get the other governments thinking along
these lines also.

32. I have read around the subject and discussed it with bank officials, academics, seasoned
monetary reformers and with members of the public. I believe I have understood the issues
correctly even if I may lack the detail of experts. Nevertheless, many of the people who have
lived with these issues for many years are too near them to see the wood for the trees.

33. We need a really lively, frank discussion of the issues from this perspective and I believe I
could help the committee in such an endeavour. You have worked enormously hard to find
answers. I respect this excellent example of diligent, careful parliamentary work. I firmly
believe that this my insight is clear and pertinent and I would love to have the chance to meet
you to pursue these issues further.

February 2009

198
 Memorandum from Carmel Butler
Consumer and Tax Payer
“...Let us be clear that the reason for today's injection is the
lack of openness and honesty by the banks on the amount of
bad debts that they have on their books...”
JOHN McFALL MP36
1. The banks have stated their case. They say: the banking crisis ensued from bad borrowers
to bad debts to toxic assets to taxpayer support. The banks with their powerful lobby,
powerful public relations and easy access to the media have framed the public debate.
Consumers on the other hand do not have such powerful infrastructure to effectively
rebut the bankers’ defamatory accusations. This written evidence challenges the bankers’
version and endeavours to dispel the bankers’ myths. The chain of events is rooted in
lenders’ abuse of unfettered power to impose unsustainable interest and charges on
consumers combined with their determination to avoid contributing to the public purse.
2. The evidence contained in this memorandum is focused on two fundamental issues.
Firstly, the consumer issues that arise in the context of Special Purpose Vehicles (“SPVs”)
that are incorporated as securitisation companies who issued the infamous “toxic-assets”;
and secondly, the taxpayer heist at the hand of the SPV securitisations companies. The
evidence will illuminate the hitherto hidden truth that the tax payer is supporting the
profits of foreign owned companies incorporated in tax havens and their private
investors.
BRIEF INTRODUCTION
3. I am British Citizen resident in the UK and a qualified lawyer admitted to practice in New
York, U.S.A. I have an LLB Laws from the London School of Economics and a JD (Juris
Doctor) from Columbia University, New York. I practiced securities law at Sidley Austin
LLP New York office from September 2006 to December 2007. Whilst at Sidley Austin I
worked on various Structured Finance transactions such as mortgage securitisations,
CDOs and various derivatives. I am also a consumer of a mortgage product that has been
securitised. Consequently, as both an ex-practitioner of securitisations and a consumer
subjected to a securitisation, the intention is to focus on consumer issues that arise from
mortgage securitisations, its central causal role in the banking crisis and its detrimental
effect on the economy and public purse.
SUMMARY OVERVIEW
4. Six key submissions are evidenced in this memorandum:
• Passing on the Interest Rate Cuts (see paras. 5 to 13). Banks do not pass on the
interest rate cuts to borrowers because they do not have that power. That power
is vested in the SPV securitisation companies.
• Openness and Honesty (see paras. 14 to 37). The Government has saved banks
from the allegedly bad debts on their books. But banks are unable to say the
extent of the bad debt problem. This is because, in truth, there are no bad debts of

36
John McFall M.P.: question to the Chancellor of the Exchequer on 19 January 2009 in reference to the
Government’s £37 billion cash support to the banking industry.

199
 any significance. Two sleights-of-hand are discussed under the headings “the
legal ruse” and “the auditor ruse”. Enlightenment of the combined effect of these
manoeuvres explains how the allegedly bad debts appear on the bankers books.
• The FSA Regulatory Role (paras. 38 to 43). The Practitioners Panel have called
for rigorous enforcement of the FSA’s MCOB rules. Consumers would concur
with this principle.
• The Fallacy of Financial Advice (see paras. 44 to 52). The source of this issue is
the mortgage originators’ failure to disclose material facts on the products sold to
consumers. The lenders’ concealments render independent financial advice a
nullity and an academic exercise.
• The Rule of Law - Repossession or Dispossession? (paras. 53 to 78). The
Financial Services Practitioner Panel calls for the faithful application of the rule of
law with respect to the performance of contractual obligations. There is no
difficulty in concurrence with this principle. Accordingly, the Treasury
Committee are invited to consider the SPV securitisation companies performance
of its contractual obligations and the effect of their abrogation from such
obligations on the functioning of the mortgage market.
• The Perfect Storm (paras. 79 to 88). The cause of the banking crisis is widely
mooted as the abrupt closure of the wholesale money markets in August 2007 but
the public debate on why the market seized is conspicuously absent. It is
submitted that new tax laws were the catalyst instilling fear which caused the
flight. The money-men fled from securitisation companies on the real prospect of
their being called upon to contribute to the Treasury. The liquidity had to be
filled. The tax-paying public was rallied to fill the gap and to suffer the economic
fall-out. Paragraphs 83 to 86 recommends: a potentially effective solution in
which the Government can revive the housing market and economy without the
need for the banker’s acquiescence to the hitherto unheeded pleas for the bankers
to commence lending.
• Conclusion (paras. 89 to 91). Confusion through concealment creates
complexity. Transparency is the antidote. Once illuminate, securitisation is
simple. Follow the asset and follow the cash which reveals that the supreme
beneficiaries of the crisis are the banks, the SPVs and their investors.
• Recommendations: The Committee is invited to consider the recommendations
at paragraphs: 37, 43, 52, 79 and especially the recommendation at paragraphs. 85
to 88.
PASSING ON THE INTEREST RATE CUTS
5. The Committee has rightly been concerned to elicit a reason for banks failure to pass on
the Bank of England interest rate cuts to borrowers and yet, do pass on the interest rate
cuts to the savers37. The answer to the question is simple. The banks have passed the
interest rate cuts to the savers because the banks have the power to set the interest rate for

37
See e.g., Chairman’s Q116, Q117, Q169 and Q170. Treasury Committee Banking Crisis Uncorrected Transcripts
of Oral Evidence

200
 the savers. Conversely, the banks do not have the power to pass the interest rate cuts to
the borrower.
6. This is because, the banks have sold the mortgage contracts to the SPVs and it is the SPVs
alone, that have the contractual power to determine the borrowers interest rates.
Consequently, it is the SPVs that decide whether or not to pass on the interest rate cuts.
It is the SPVs that have decided not to pass on the interest rate cuts.
7. This fact is evidenced by the various and respective Prospectuses that the SPVs file at the
UK Listing Authority. In general, the bank that originates the loans will make a True
Sale38 of the mortgages to the SPV which means the contractual power to set the
borrower’s interest rate is vested in the SPV.
8. Following the bank’s True Sale of the mortgages, the bank’s contractual relationship with
the borrower is extinguished. The SPV, as assignee, becomes the party that is in privity of
contract with the borrower. However, neither the bank nor the SPV inform the borrower
of the SPV’s ownership of the mortgage contract.39 The SPV will remain concealed. The
borrower is unlikely to discover the SPV’s ownership of their mortgage contract because,
following the sale to the SPV, the bank and the SPV enter into a contract wherein, the
bank agrees to administrate the mortgages on behalf of the SPV and in return, the SPV
remunerates the bank for its administrative services. Consequently, whilst the bank has
extinguished all its right and title to the consumer’s mortgage contract, the bank’s
connection to the consumer’s mortgage is through its administration agreement with the
SPV only. Following these legal manoeuvres: (i) the consumer and the SPV are in privity
of contract under the mortgages; (ii) the bank and the SPV are in privity of contract
through their administration agreement; and (iii) the world will remain ignorant of these
events because, the bank continues to service the loans as if nothing has happened.
9. Therefore, the bank’s only interest in the loans following its True Sale of the mortgages is
that of a mere administrator and servicer of the loans. It is the SPV that is the bank’s
client from whom the bank earns its servicing fees and from whom it receives its
instructions. Consequently, the bank’s loyalty is to SPV client only. The power to set the
borrowers interest rates is a contractual power contained in the mortgage contract: a
fortiori when the contract is sold to the SPV, the contractual power to set the borrowers
interest rates is vested in the SPV and not the bank. Therein is the reason why the banks
have not passed-on the interest rates cuts. It is simply because: they cannot. They must,
in accordance with their administration agreement with the SPV, implement the interest
rate policy of their client, the SPV.
10. Evidence of these submissions is best demonstrated by example. In the case of Northern
Rock, the SPV has given Northern Rock the authority to set the interest rates. However,
Northern Rock has undertaken to set the interest rate at a level that not only covers
Northern Rock’s administration costs, it is contractually obliged to set the rate at a level
sufficient to support the entirety of all the administration costs, expenses and profits of

38
True Sale means “This is a genuine sale with title passing to the issuer SPV.” Source: H.M. Revenue & Customs
CFM20030 at: http://www.hmrc.gov.uk/manuals/cfmmanual/cfm20030.htm
39
Additionally, both the bank and the SPV unlawfully suppress and conceal this information from H.M.
Land Registry.

201
 each of the numerous entities involved in the securitisation structure40. This means that
Northern Rock must set the interest rate at a level that will ensure the SPV suffers no
revenue shortfall. In the event that Northern Rock fails to set the rate at a level sufficient
to satisfy the SPVs required revenue, then the mortgage trustee may “notify the
administrator that...the standard variable rate and the other discretionary rates or margins
for the mortgage loans...should be increased...the administrator will take all steps which are
necessary...to effect such increases in those rates or margins.”41 Consequently, Northern
Rock may only exercise the interest rate pursuant to the SPV’s authority to do so under
the terms of its administration agreement, and in any event must set the rate at levels to
the satisfaction of its SPV client. In other words, Northern Rock does not have the
autonomous power to set the rates independent of its SPV client. Accordingly, it is the
SPV that controls the interest rate setting power.
11. Whilst Northern Rock has been used as the example, the Treasury Committee is
reminded that this circumstance is not unique to Northern Rock. It is standard to most
SPVs. In conclusion, it is recommended that the Committee encompass within its
inquiry consideration of the role of the SPV in the banking crisis and the relationship
between the banks and the SPVs.
12. Finally, if the Government is determined that the interest rate cuts are passed on to the
borrowers, it must ask the SPVs.
13. In conclusion, this means that the correct answer to the Committee’s question No. 17042:
“...Are the banks just pocketing a few bob for themselves here?”: the full and correct answer
is – No, it is the SPVs that are pocketing a few bob for themselves.
OPENESS AND HONESTY
14. There are no bad debts on the banks books. And if there is any bad debt, the amount is
de minimis. A primary purpose of a securitisation is: to remove the credit risk from the
bank’s books. The bank, under a ‘true sale’ will sell all its rights and title in the mortgages
to the SPV and the SPV will in return pay the bank cash for the mortgage assets. This
plain truth has remained elusive because under the terms of the true sale contract, the
bank and the SPVs have unlawfully agreed to keep the transaction concealed from the
borrower and, from H.M. Land Registry. Thus giving the false appearance to the world
that the banks still own the mortgages.
15. Two sleights-of hand are at play in this manoeuvre. One is the legal ruse, the other the
auditor ruse. This is not to suggest that the professions have conspired, they are each
compartmentalised and each are generally unaware of the combined effect.
THE LEGAL RUSE

40
See e.g., the SPV’s revenue receipts waterfall setting out the order of priority of payments to the many
and various creditors followed by the payments due to and investors. Granite Master Issuer plc
Prospectus Supplement dated 23 May 2005 at page 144 onward.
41
Granite Master Issuer plc Prospectus Supplement dated 23 May 2005 at the 1st para. on page 103
42
See Q170. Angela Knight of the BBA states in explanation that the housing market reduction is value is “affecting
the risk weighting of those assets...so the amount of capital that banks hold against that risk also increases”. In fact,
the bank have sold the assets and passed that risk to the SPV and therefore with respect, Ms Knight’s reasoning is
defective. In effect, the governments initiatives are supporting the SPVs and their investors and not (as it believes)
the banks. This begs the question, why should the tax payer be called upon to guarantee the return of investments?
Investors are warned and know that their investments may go down!

202
 16. First, the legal ruse. The law provides mortgagees with a statutory power to transfer a
legal charge.43 It is under these statutory provisions that the banks exercise their right to
assign the mortgages to the SPVs. In a contract of sale that provides for a disposition44 of
an interest in land, the legal title will be conveyed immediately from the seller to the
buyer45 on the completion date. There can be no doubt that on completion, the buyer has
acquired the legal title, but there will inevitably be a “registration gap” between the
conveyance date on which the buyer acquired the legal title and the date on which his
legal title is registered at H.M. Land Registry. During this registration gap, the law
provides that the buyer’s title: “does not operate at law until the relevant registration
requirements are met”.46
17. This is where the legal ruse comes into play. It is this “registration gap” that the SPV
unlawfully exploits in order to conceal its ownership and control of the mortgages.
Under the Land Registration Act 2002 (“LRA 2002”), the transferee47 of a registered
charge is required to register at H.M. Land Registry, its ownership of the mortgage that it
purchased.48 Therefore, it is a legal requirement that the SPV register its proprietorship
of the mortgage at H.M. Land Registry. Whilst the law implicitly permits the registration
gap as a matter of pragmatism, the law also implicitly mandates that the registration
requirements are to be observed expeditiously. Nonetheless, in contumacious disregard
for its legal duty to comply with the registration requirements of the LRA 2002, the
contract of sale expressly provides that the SPV will not register the transfer at H.M. Land
Registry indeed, the contract provides that notice of the transfer is to be concealed from
the borrowers and H.M. Land Registry and a fortiori concealed from the world49.
18. The suppression and concealment of this information from H.M. Land Registry is a
criminal offence50, and in furtherance of this offence51, the SPV’s legal title to the
mortgages is also concealed from the county courts and the Government. The Banks
remain registered as the proprietor of the mortgages and accordingly all interested parties
are deceived by this concealment with one exception. The SPV does inform its investors
that the bank sold its legal title to the SPV (to whom, the right to register the legal title to
the mortgages is important). Consequently, the bank appears to be the legal owner, but it
is not.

43
Law of Property Act 1925 s.114 and Land Registration Act 1925 s.33 (note the LRA 1925 is repealed
as of October 2003 pursuant to the LRA 2002)
44
The legal definition of a disposition includes the conveyance of a mortgage. See Law of Property Act
1925 s.205(ii)
45
See Megarry & Wade 7th Ed. Para.7-150
46
See Land Registration Act 2002 s.27(1) As legal title does not operate until registration, it operates in
equity pending registration. Also note equity’s rule that: equity regards as done that which ought to be
done.
47
A transfee is: an assignee of a legal charge. See Law of Property Act 1925 s.114(2)
48
See Land Registration Act 2002 s.27(3) and Schedule II, paras. 8 and to 10. (Sch. II, para. 10: “In the
case of a transfer, the transferee, or his successor in title, must be entered in the register as the
proprietor” (bold emphasis added). See also Law Commission Report printed 9 July 2001. Law Com No.
271 HC114 at para. 4.30
49
The contract provides that the SPV will not register unless certain events occur such as, if the
mortgage trustee wishes to enforce the security due to the insolvency of the bank, thus defeating any of
the bank’s creditors claiming against the asset.
50
See Land Registration Act 2002 s.123
51
For example, Clavis Securities were sold GMAC mortgages under an absolute assignment with full title
guarantee on or around 15 June 2006 and after some 2½ years have failed to register its ownership at
the Land Registry.

203
 19. For example, in the case of Northern Rock as the seller of mortgages, the prospectus
states: “under the mortgage sale agreement dated March 26, 2001 entered into between the
seller, the mortgages trustee, the security trustee and Funding, the seller assigned the initial
mortgage portfolio together with all related security to the mortgages trustee...” 52.
Additionally, under the terms of Northern Rock’s mortgage sale agreement, it is, “entitled
under the terms of the mortgage sale agreement to assign new mortgage loans and their
related security to the mortgages trustee”. 53 (bold emphasis added).
20. Northern Rock may remain falsely registered as the putative ‘legal owner’ but in truth,
Northern Rock is merely the administrator of the mortgage loans. Again the Prospectus
states: “The seller acts as administrator of the mortgage portfolio under the terms of the
administration agreement, pursuant to which it has agreed to continue to perform
administrative functions in respect of the mortgage loans on behalf of the mortgages
trustee and the beneficiaries, including collecting payments under the mortgage loans and
taking steps to recover arrears.”54 (Bold emphasis added).
21. The legal reality is that: (i) Northern Rock sold its legal title to the SPV, in this case, to
Granite Finance Trustees Limited55 and therefore, Granite is the legal owner; (ii)
Northern Rock is the administrator of the mortgages and falsely holds itself out as the
legal owner of the mortgages; (iii) Granite Finance Trustees Limited should be, but is not,
registered as the owner of the mortgage; and (iv) all these facts remain concealed because
Granite and Northern Rock have unlawfully contracted to suppress this information from
H.M. Land Registry.
22. Notwithstanding that the SPV conceals its legal title from H.M. Land Registry, the SPV
will, nonetheless, avail itself of, and exercise, all the statutory and contractual legal powers
that the legal owner enjoys. For example, the SPV will exercise the legal owner’s statutory
power to create a legal charge 56 on the borrower’s mortgages. The SPV will file at
Companies House a Form 395 “Particulars of a Mortgage or Charge” within the statutory
21 days, to register the Legal Charge that the SPV created against the mortgage loans in
favour of the SPV’s trustee, as security for the payment of money due to its investors and
creditors.57
23. The SPV’s exercise of the legal owner’s contractual and statutory legal powers leaves no
doubt that SPV is: the legal owner of the mortgages. Nonetheless, the banks and the SPV
unlawfully exploit the “registration gap” in a smoke and mirrors tactic to cause confusion
and conceal the SPV’s legal title. The SPV is the legal owner. The banks are the
administrators.
THE AUDITOR RUSE
24. The Treasury Committee has endeavoured to discover the amount of bad debts on the
banks’ books. An answer to that question has hitherto evaded an adequate response. As

52
Granite Master Issuer plc. Prospectus Supplement dated 23 May 2005 at page 108 under the heading
“The mortgage sale agreement”.
53
Id. See at page 113 under the heading “Assignment of new mortgage loans and their related security”.
54
Id. See at page 11 under the heading “The Seller, the administrator, the cash manager, the issuer
cash manager and the bank account”.
55
Granite Finance Trustees Limited is a Jersey incorporated company.
56
Pursuant to the mortgagee’s power as the legal owner under the Land Registration Act 2002 s.23(1).
57
See e.g. Clavis Securities plc (Reg. No.05778179) Form 395 filing at Companies House on 22 June
2006.

204
 discussed above, the bank has sold the mortgages and thereby transferred the credit risk
to the SPVs which means, that the banks do not have these (allegedly) “bad” debts on
their books.58 Therefore, to provide the Committee with the full answer, the question
must be re-framed as: having sold legal title to the debts, how do these allegedly “bad”
debts appear back on their balance sheets?
25. Likewise as discussed above, the SPVs legal title to the mortgages is also concealed from
the auditors. The auditors know that the bank originated and owned the mortgage loans
and therefore, the mortgage loans are initially and correctly ‘recognised’ as an asset on the
bank’s books. However, when the bank securitises that asset, the bank has sold the asset
to the SPV. This means that the SPV owns both the benefits and the credit risks of the
assets. Accordingly, the bank’s transfer and sale of legal title should result in the assets
being ‘derecognised’ as an asset on the banks’ books. However, the auditor’s continue to
recognise the assets on the bank’s books. This is because of an inadvertent erroneous
evaluation and application of the IAS39 accounting standard.
26. IAS39 sets out three main scenarios in which an asset will be derecognised and removed
from the bank’s books. Under any one of these three scenarios, the mortgage loan assets
that have been securitised should be derecognised with the consequent effect that the
assets are removed from the banks books.
27. The mis-application of the IAS39 derecognition policy is best illustrated by the following
example. In the Northern Rock’s Annual Report and Accounts 2007, the derecognition
policy states:59 “The Group also derecognises financial assets that it transfers to another
party provided the transfer of the asset also transfers the right to receive the cash flows of the
financial asset.” In a securitisation, that is exactly the legal effect. However, auditors are
called upon to make an evaluation of the bank’s legal rights in their analysis. The auditor
must determine who has the legal right to the cash flows. Understandably, an auditor is
not best qualified to make an accurate legal determination. Nonetheless, the auditors do
see that: (i) the bank’s legal title is still registered at the Land Registry (albeit falsely); (ii)
the auditors see the bank’s administration of the mortgage loans; and (iii) the auditors see
the cash flows from the mortgage loans are paid to the bank. In contrast, the auditors do
not see (iv) the contract of sale wherein the bank transferred to the SPV, all its title and
rights to the asset; (v) do not see the bank’s administration agreement with the SPV
which evidences the bank’s interest is merely authority to administrate the mortgage loan
asset; and (vi) do not see that the bank has no right or title to the cash flows it receives
from the mortgage loans. Consequently, the auditors understandably fail to accurately
evaluate the legal rights and accordingly fail to derecognise the asset. As a result, the asset
erroneously remains recognised as an asset on the bank’s book.
28. However, the auditors are mindful that the asset has been securitised and that such
transactions require some acknowledgment and entries in the accounts. Again, IAS39 is
the culprit. IAS39 directs the auditor to “Consolidate all subsidiaries (including any SPE)”

58
Although it is conceded that the banks may hold the SPV issued Notes in their Treasury Departments
which means: the debts are not trading losses from the bank’s loan book of advances to its customers,
but rather the (allegedly) poor investments of its Treasury Department in the banks proprietary trading as
an investor.
59
Northern Rock plc Annual Report and Accounts 2007 at page 55 para. j). Para. “j)” is essentially a
concise summary of the three main scenarios of the IAS39 derecognition accountancy standard.

205
 60
. The IAS39 therefore instructs the auditor’s to consolidate the special purpose entity61
(or vehicle), into the group accounts.
29. This is an extremely bizarre instruction to auditors for three reasons. Firstly, this
instruction contradicts the foundational principle of a securitisation structure which is:
that the originator of the asset must be ‘Bankruptcy Remote’ from the SPV. That is, that
the SPV is a wholly independent company that is in no manner whatsoever connected
with the originator of the assets it has purchased. The true sale must be an ‘arms-length’
transaction between the two wholly independent entities. This is an essential element of
the securitisation structure to ensure that the SPV and its assets are not in any way
affected by the bankruptcy or insolvency of the asset originator. Secondly, the
bankruptcy remoteness of the SPV is the credit rating agencies predominant factor for the
SPV’s Notes achieving the triple A rating. Thirdly, there is no legal basis on which a
wholly independent company, (i.e.an SPV) should be included in the consolidated
accounts of another company where the SPV is not a subsidiary or legal undertaking of
that company.
30. Notwithstanding that the SPV and Northern Rock are wholly independent and separate
companies, the mortgage loan assets and liabilities that the Granite SPV own, was
consolidated onto the Northern Rock’s Group accounts.
31. To illustrate this point, take for example Granite Master Issuer plc’s prospectus where it
expressly states: “The Issuer is wholly owned by Funding 2...The Issuer has no
subsidiaries...The Seller [Northern Rock] does not own directly or indirectly any of the
share capital of Funding 2 or the Issuer”62.
32. Therefore, when reading the Northern Rock accounts,63 the figure of £43,069.5 million
stated as a Northern Rock liability, is in fact, Granite Master Issuer plc’s liability. The
“Debt Securities” issued of £43,069.5 million is the liability of Granite Master Issuer plc, a
wholly independent company which the auditor has erroneously consolidated on to the
Northern Rock Group accounts solely because of the erroneous application of IAS39.64
That liability is Granite’s liability to its investors.
33. Likewise, Granite’s assets also appear on Northern Rock’s balance sheet. Consequently
when reading the figure of £98,834.665 million stated as a Northern Rock asset, at least
£49,558.5 million,66 is in fact, Granite Master Issuer plc’s asset.
34. The Committee is respectfully reminded that whilst Northern Rock has been used to
illustrate the point, this application of IAS39 is common practice.

60
IAS 39 Technical Summary prepared by IASC Foundation staff (which has not been approved by the
IASB). Source http://www.iasb.org/NR/rdonlyres/1D9CBD62-F0A8-4401-A90D-
483C63800CAA/0/IAS39.pdf
61
Special Purpose Entity (“SPE”) is synonymous with Special Purpose Vehicle (“SPV”)
62
Granite Master Issuer plc, Prospectus Supplement dated 23 May 2005 at page 56. See also, page 60:
Northern Rock “does not own directly or indirectly any of the share capital of Holdings or the mortgages
trustee”. See also page 62: Northern Rock “does not own directly or indirectly any of the share capital of
Holdings or the post-enforcement call option holder [namely, GPCH Limited]”.
63
Northern Rock Report and Accounts 2007. See page 45 and see in particular note 22 on page 73
64
To correct the balance sheet, the “loans and advances to customers” asset figure should be
derecognised and reverse from the asset figure against the securitised notes figure. See also note 22 on
page
65
Northern Rock Report and Accounts 2007 at page 45
66
Id. at page 73 note 22.

206
 35. In summary, the assets “appear back on the books” due to the misapplication of IAS39.
The error is compounded through the unlawful exploitation of the registration gap which
conceals the facts necessary for an accurate application of IAS39. It is this concealment
that causes the auditor confusion. These assets and liabilities should not be on the bank’s
balance sheet. They are there solely because of the combined effect of the legal and
auditor ruse67.
36. In consequence, the British tax payer is not just the supporter of British banks, the tax
payer is the unwitting guarantor and supporter of all the privately owned, wholly
independent SPVs foreign companies incorporated in tax havens. Their consolidation
into the group accounts of British banks means that the tax-payer is also funding the
capitalisation of the SPVs. These foreign SPV companies and their investors must be
extremely satisfied with the UK tax payers support. After all, there are always winners in
any crisis.
37. Recommendations:
• Auditors should reconsider the application of IAS39 and perhaps seek legal
opinions on the bank’s legal rights and obligations in its evaluation and
application of this accounting standard. It is recommended that the law firm that
acted on the actual securitisation is not used for this purpose, and that an
independent barrister may be more suitable. Moreover, an SPV should never be
consolidated into the Group accounts unless it is an actual legal subsidiary or a
legal undertaking of the Group.
• Both the SPVs and banks must be held to compliance with the Land Registration
Act 2002 and accordingly, complete the registration requirements under the Act.
For those that do not comply with the registration requirements, enforcement
action should be considered. Transparency is the antidote that will cure the
abuses facilitated by concealment.
THE FSA’s REGULATORY ROLE
38. Whilst the FSA regulates mortgages, it does not regulate the SPVs that own the
mortgages. Given that it is the SPV’s that exercise the power and control over
mortgagors, interest rate policies and repossession policies, there is a major lacuna in
regulatory oversight. Through the medium of the ruse discussed above, an added bonus
of concealment is that the SPV circumvents regulatory oversight. It may be argued that
such lacuna is covered by the FSA’s authorisation and regulation of the loan
administrator. However, this argument does not address the inherent conflict between
the bank’s compliance with the FSA’s regulations and its loyalty to its SPV client. This is
because the SPV is vigilant on the bank’s implementation of its policies under their
administration contract whereas, the FSA in contrast are widely known for its apparent
determination not to enforce68 its MCOB69 rules and regulations. Therefore, given the
choice between the impotency of FSA deterrence on the one hand, and client loyalty and

67
It is probable that tax considerations are also behind this manoeuvre, i.e., tax efficient to minimise/avoid
tax liability particularly with respect to the possibility that interest income earned in the UK would be
subject to withholding tax prior to payment to the foreign owned SPV.
68
“The FSA has been describing itself as ‘not enforcement led’ which we have challenged” Quoted from the Financial
Services Consumer Panel, Annual Report 2007/8 at page 21 para. 2.25.
69
The FSA’s Mortgage Conduct of Business Rules (MCOB).

207
 profit incentive of banks and SPVs on the other hand, the dominant motivation that will
inevitably prevail is the satisfaction of the profit incentive. This means that the bank’s
allegiance to its SPV reigns supreme over the bank’s regulatory obligations to consumers.
After all, the irony of the FSA’s ‘Treating Customers Fairly’ principle, is that the SPV is
the customer of the bank whereas, the borrower not. The borrower is in fact, the
customer of the SPV.
39. But all is not lost. The Financial Services Practitioner Panel is in consensus with the
principle that the FSA’s MCOB rules should be enforced. In its Annual Report 2007/8 it
stated: “This was a major area of risk from a consumer point of view and the Panel
considered that the Mortgage Conduct of Business (MCOB) rules were not achieving the
objectives that were intended by them – in fact, to some degree, they had served to
compound the issue “70. The Practitioners Panel then goes on to call for the FSA to
supervise and enforce the MCOB rules, it continues, “The Panel remains concerned that
the FSA’s supervisory and enforcement activities in this area continue to move too slowly to
significantly improve standards in this sector.”71 The principle quoted here is highly
laudable, and to the extent quoted above, this principle from the consumer’s perspective,
would attract strong consensus.
40. To be accurate however, the Practitioners Panel is vociferous for FSA enforcement of the
MCOB rules only to the extent that they apply to the 3,000 small businesses that provide
services in the financial intermediary sector. Nonetheless, the Consumer Panel and
Practitioners Panel both support the FSA’s enforcement of the MCOB rules in principle
and apparently, both the Practitioner and Consumer Panels would wish to achieve the
objectives that were intended by the MCOB rules.
41. Whilst the Practitioner Panel’s call for MCOB enforcement is supported in principle, it is
suggested that enforcement against the many small business in the intermediary sector
should be deferred because: (i) enforcement in that sector would yield no immediate
assistance to the consumer or small businesses; (ii) that sector of the economy is at
present, relatively inactive; (iii) it is probable that some of those small businesses may not
survive the economic downturn and the FSA should not exacerbate their plight for
survival at this juncture; and (iv) the Government aspires to assist small businesses in any
event.
42. Accordingly, in recognition that the FSA’s resources are finite and therefore should be
focused and targeted to achieve the Government’s aspirations, it is suggested that the
enforcement campaign focus on the MCOB rules to the extent applicable to mortgage
administration and mortgage repossessions. An FSA publicly announced policy decision
to take enforcement action against mortgage administrators non-compliance with the
MCOB72 would have an immediate deterrence effect, concentrate the mortgage
administrator’s mind, attitude and conduct on its regulatory obligations and in turn,
produce immediate assistance to consumers in financial difficulty. The announcement of
such policy may also achieve the added bonus that the FSA’s TCF objectives, (which were
also intended to protect consumers), may also be realised as a result of an enforcement

70
The Financial Services Practitioner Panel, Annual Report 2007/8 at page 19
71
Id.
72
Which non-compliance is standard practice and ubiquitous and it is submitted there exists and
abundance of evidence of non-compliance. See examples of consumer discussions on consumer help
forums at: http://www.consumeractiongroup.co.uk/forum/mortgages-secured-loans/

208
 policy. Moreover, an actual enforcement may have a longer-term deterrent effect and re-
position the FSA’s supremacy in the conflict between the bank’s deference to its SPV
clients prevailing over its obligations to consumers. Finally, and most pertinently, from a
public relations perspective, it may restore a large degree of public confidence in the FSA
and the financial industry generally and stem the repossession trend.
43. Recommendations:
• the Treasury Committee give its fullest support to the Panels aspirations and
immediately recommend that the FSA vigorously enforce the MCOB rules.
the courts are informed of the claimant’s73 administration and repossession legal
obligations under the MCOB rules and that the courts assure themselves of the
administrator’s strict compliance with those rules before ordering repossession.
Again, this would have immediate impact to assist consumers in difficulties.74
THE FALLACY OF FINANCIAL ADVICE (terms of reference1.9 and 3.7)
44. On 14 January 2009, Mr Tutton of the Citizens Advice Bureau gave oral evidence wherein
he enunciated the principles that “...borrowers need to have the risks properly pointed out
to them...to understand the consequences...what is the interest rate, what is it going to cost
me?...and borrowers are properly helped to decide what they are getting into.”75
45. There is an abundance of consumer laws and regulations that govern credit agreements
and in particular, govern the advice that independent financial advisers provide to
consumers on mortgage products. In practice however, the consumer’s choice of lender
and product is often a nullity and can be deemed an academic exercise. This is because,
whilst the consumer may be advised to select a mortgage product from Bank X and may
choose to enter into a contract with Bank X on that advice, the reality is that Bank X will
not be the company with whom the consumer will ultimately be in privity of contract,
nor will Bank X be the entity that performs that contract.
46. In general, neither the IFA, nor the consumer knows at the outset that Bank X will merely
originate the mortgage contract and that Bank X will sell the mortgage contract.
Moreover, whilst the consumer may be informed of the initial ‘pass-the-parcel’ of their
mortgage contracts to various entities, the consumer will never be told of the final and
ultimate owner of their mortgage contract, namely the SPV entity that securitises their
mortgage contract. In other words, neither the IFA nor the consumer is aware of, nor
considers the impact of the “originate-to-distribute model” when providing or
considering financial advice.
47. To illustrate the practical impact of the SPV’s concealment from the borrower, take for
example, a consumer that was advised to choose a GMAC-RFC standard variable rate
mortgage. Firstly, some of those borrowers would have been securitised through an SPV

73
Another legal issue arises here. Strictly speaking the claimant should be the SPV, however, the
administrator bank will make the claim in its own name. However, at law, the bank has no locus standi to
bring the claim in its own name without informing the court that it is claiming in a representative capacity.
The court therefore erroneously assumes the bank’s legal standing and is wilfully mislead by the legal
ruse to conceal the SPV. At law, the bank has no legal right to bring the claim in its own name and no
legal right to obtain a possession order against the borrower.
74
In similar terms in which the government reminded the courts to enforce the pre-action protocols
75
See Mr Tutton’s answer to Q135. It is noted that Mr Tutton made these comments in the context of store-cards
credit, however, it is averred that these principles apply to any and all credit agreements.

209
 called Clavis Securities plc. Thus, the consumer’s advice as to the lender is rendered
academic. Secondly, unbeknown to the borrowers, Clavis unilaterally decided that
borrowers who had purchased a GMAC standard variable rate mortgage contract would
be treated as if they had purchased a track-rate mortgage.76 Accordingly, Clavis’ decision
renders the consumer’s advice on product as also academic. Thirdly, it was irrelevant to
Clavis that the borrowers contracted to pay GMAC’s standard variable rate, because
Clavis at all times charged its borrowers at least 0.25% in excess of GMAC’s standard
variable rate. Accordingly, Clavis at all times demanded (and was paid) interest that the
borrowers were not contractually obliged to pay.
48. In one case on point, the non-contractual demanded interest rate overcharge was
disputed. The response was that it had the “power and liberty” to charge as they pleased.
Following a vigorous defence of this contention, it was finally conceded that it had
overcharged interest but at the same time, inferred that the overcharge was de minimis as
it only amounted to approximately £3,000. However, this amount is not de minimis to an
individual nor when taken in the context of the securitisation as a whole. That
securitisation involved a pool of approximately 4,500 mortgages contracts each of which
would have been subjected to the same contractual abuses. As Clavis had overcharged
each of those consumers an extra non-contractual 0.25% and assuming that that
overcharge was in the region of £3,000 for each consumer, such modus operandi would
yield a conservatively estimated extra £13.5 million.
49. There is an abundance of anecdotal evidence that consumers are instinctively aware that
their mortgage accounts are being abusively charged.77 However in the majority of cases,
it is improbable that consumers would be able to identify and articulate the character and
nature of the abuse sufficient to present such defence in a court. Therefore, this type of
abuse remains substantially, undetected. From the consumer perspective it inevitably
results in repossession, but on strict construction of the borrower’s mortgage obligations
it is in fact, dispossession.
50. Therefore, with respect to mortgage products that will be securitised, the notion that a
financial adviser can advise consumers, and the notion that consumers have choice, is a
pure fallacy. The evidence shows that whilst the fault cannot be laid on the adviser, it
does not change the practical reality for the consumer who will be aggressively held to
their obligations (including, in some cases demands for money which they are not
contractually obliged to pay), whilst the SPV lender will conveniently absolve itself of its
obligations (including, in some cases substituting the product with a completely different
product). Consequently, neither adviser nor borrower can make an informed decision on
that which, directly and substantially affects them. They cannot know how much the

76
“...the interest rate payable on those Mortgage Loans is a variable rate set by the mortgage lender...but...the Issuer
[Clavis] has undertaken...to set such variable rate at a specified marging or margins in excess of the Bank of England
Repo Rate...Accordingly, such Mortgage Loans are treated for all purposes as being Mortgage Tracker Rate Loans”.
Quoted from: Clavis Securities plc Asset Backed Note Programme Series 2006-1 Note Issue Supplement dated 8
June 2006 at page S-64 under the heading “Interest rate setting in relation to certain Series Portfolio Mortgages”
See also e.g., without the consent or knowledge of the borrowers, the lenders vary the terms of the mortgages: “Most
mortgage lenders in the residential mortgage market vary and extend the Standard Conditions by way of a “Deed of
Variation” the terms of which are imported into each Scottish Mortgage...each ...Series Portfolio Originator has
executed a Deed of Variations of Standard Conditions”. Quoted from: Clavis Securities plc Asset Backed Note
Programme Series 2006-1 Note Programme Memorandum dated 8 June 2006 at page 40 at section (f)(1).
77
See e.g., the numerous examples of actual experiences of consumers discussed consumer help
forums at: http://www.consumeractiongroup.co.uk/forum/mortgages-secured-loans/

210
 interest rates will be, and cannot know how much it will cost them, because all of these
variables are dependent on the arbitrary decisions of the SPV with whom the borrower is
ultimately in privity of contract—and that information is at all times, concealed78.
51. Finally, this issue highlights the importance of the principle of Transparency. To echo
the Prime Minister,79 “all transactions should be transparent and never hidden”. The
concealment of the SPV from the borrower presents the SPV with the opportunity to
abuse with impunity, safe in the knowledge that the consumer would never know who is
really perpetrating the abuse and whom they should hold accountable. The borrower
should know with whom they are in privity of contract and that information should never
be concealed.
52. Recommendations:
• Mortgage originator’s must make full and frank disclosure of the effect of
securitisation on the borrower
• The contractual formula for interest rate setting must be fully disclosed and fixed
such that the extensive discretionary powers are abated and/or
• The SPV’s unfettered powers to unilaterally inflate the borrower’s obligations
should be curbed.
THE RULE OF LAW – REPOSSESSION OR DISPOSSESSION?
53. The Committee’s attention is drawn to the Practitioner Panel’s promulgation in its
Annual Report 2007/8 under the heading “Caveat Emptor” wherein it stated: “The Panel
believes that a consumer’s legal responsibilities should be those underpinned by contract
law, which includes a duty to act lawfully and in good faith, not to make misrepresentations
or withhold material information, to abide by the terms of the contract, and to take
responsibility for his or her own decision.”80
54. The Practitioner Panel’s is commended for its enunciation of these principles under the
banner “caveat emptor” as it demonstrates that the Panel have correctly identified that
‘the buyer beware’ maxim is an appropriate forewarning which consumers should heed
when purchasing loans from powerful financial institutions. Consumers should always
be alert to the shenanigans of sellers with whom they contract. However, at this juncture
it is apposite to remind the Committee that irrespective of a prudent purchaser’s
precautions, the consumer cannot beware of that which is deliberately concealed.
Consequently, the consumer is doomed to become the unwitting counterparty to the SPV
in their mortgage contracts in any event. The consumer did not expressly agree to
contract with the SPV more accurately, it is the SPV that imposed itself on the consumer.

78
There is also an issue here with respect to the advise that a consumer received (or, as is more likely, does not
receive) from the solicitor acting in respect of the mortgage. Solicitors should advise their client’s on the risks and
obligations they are undertaking in the mortgage contract. It is noted that the legal profession are not listed in the
Committee’s terms of reference which means, that the lawyers have escaped scrutiny for their part in the banking
crisis. This is not just limited to the lack of advice to their consumer’s clients in the context of mortgage advice, but
also the conduct of the City’s securitisation lawyers in condoning and sanctioning their client’s wilful breaches of
contracts against the mortgagors.
79
“First Transparency! All transactions should be transparent and never hidden” Gordon Brown P.M.,
speech at the Labour Party Conference, September 2008.
80
Financial Services Practitioners Panel, Annual Report 2007/8 at page 14

211
 55. Two observations to the Practitioner Panel’s promulgation are appropriate. Firstly, the
Panel’s axiomatic principles are tantamount to a demand for the faithful application of
the Rule of Law. That demand invites an exorable concurrence from consumers which
invitation is unreservedly accepted. Secondly, as the Treasury Committee has rightly
observed, there are two parties to the contracts and they both share risk.81 Accordingly,
the principles apply with equal force and conviction to the SPVs legal responsibilities.
56. In consideration to the faithful application of the Rule of Law, it is necessary to illuminate
the conduct of SPVs in their performance of their legal obligations under the mortgage
contracts.
57. The material provision in the mortgage contract is that the lender will loan the advance
for a term of 25-years. The SPV imposed itself into the mortgage contract as assignee,
and as such, assented to perform this fundamental term of the contract. However, the
SPV has no intention of performing that 25-year term. The SPV uses its wide
discretionary interest rate setting powers to demand interest, often in excess of that which
the consumer is legally obligated to pay, and often sets its rates at levels that are
specifically designed to force consumers to seek to remortgage to a more reasonable rate.
For those consumers who do not, or cannot remortgage, the excessive fees and interest
rate charges are designed to guarantee arrears such that, the alleged arrears can be
contrived as the grounds for repossession. Either way, the strategy ensures that the
mortgages in the securitised pool will be redeemed within a 2 to 5 year period. Hence, the
practice is designed to defeat the SPV’s obligation to lend for the 25-year term.
Moreover, it does so in a manner that gives the impression that it is the borrower in
default of contract.
58. Therefore, with respect to the Practitioner Panel’s call for disclosing material
information, it is necessary for originator’s to disclose the material facts that (i) the
consumer’s contract will be sold to an SPV and that the SPV may not intend to fully
honour its contractual obligation to lend for the full 25-year term; and (ii) that the SPV’s
interest rates will reflect not only the bank’s administration of the mortgage loans, but
also the extensive fees and expenses82 of all the entities involved in the securitisation
transaction83.
59. Evidential support for these contentions can be found in the repossession policies and the
interest rate setting policies. There is also evidence from the lightening speed in which
the SPV pays down its Investors and there is prima facie evidence from the amount of
new business in mortgage market for remortgages84 (in comparison to new business

81
Banking Crisis – Consumer Issuers, Uncorrected Transcript of Oral Evidence 14 January 2009, Q122 Nick Ainger
82
The colossal numbers of various entities that receive on-going administration fees are astounding. See
for example Clavis Securities plc 2006-1 securitisation, Note Programme Memorandum dated 8 June
2006 and the Prospectus Supplement dated 8 June 2006, both of which informs that many different
financial institutions acting in capacities will each charge at least 24 various different administration fees
and expenses.
83
This is the inevitable as the only source of the SPV’s income is the cash flows it receives from the
borrowers.
84
Angela Knight on behalf of the BBA in answer to Q189“...but actually there is a huge amount of remortgaging going
on...Northern Rock, for example, and specialist lenders, as they come up for renewal at the end of whatever their
[fixed] term was, they [the borrowers] are seeing rates which they consider to be far too high and they are coming
back to the major providers.” Quoted from Treasury Committee, Banking Crisis, Uncorrected Transcript of Oral
Evidence 14 January 2009 to be published as HC 144-ii.

212
 written for a house purchase mortgage). Such evidence is best illustrated from actual
examples:
60. In June 2006, Clavis Securities plc became the owner of 4,293 consumer mortgage
contracts that were originated by GMAC-RFC Limited. Clavis securitised those
mortgages totalling £587,945,144 in a securitisation transaction which issued £600
million85 of Notes to Investors. This £600 million of Notes mature in the year 203186
which reflects the 25-year term of the mortgage contracts.
61. In theory, the principal amount on the Investors Notes should pay down in exact
correlation with the consumer’s payments of principal on the mortgage. From the
consumer perspective, this means that it should take at least a couple of decades to pay
down the Investors. However, the Clavis Investors Report in December 2008 shows that
miraculously, Clavis have paid down £456.8 million of these 25-year consumer mortgage
contracts in only 2½ years. This means that within the short duration of only 2½ years,
Clavis has successfully manipulated over 77% of its borrowers to redeem either through
duress perpetrated on the borrower to remortgage87 through its interest rate policy and/or
through repossession. Either way, Clavis has absolved itself of performing its 25-year
loan obligation to the vast majority of its borrowers88.
62. It is submitted that it can reasonably be inferred from these facts, that Clavis had no
intention of performing its 25-year obligation. Whilst the Clavis securitisation is used to
illustrate the point, this course of conduct is not an isolated example. It is ubiquitous
throughout the securitisation industry and illustrates that the SPVs are in breach of
contract for their evident intention not to perform and/or their failure to perform their
contractual obligation to the consumer for the 25-year term.
63. To achieve the SPVs absolution from its 25-year obligation, the SPVs use their wide
discretionary interest rate setting powers to manipulate consumers to remortgage89. For
those consumers who cannot remortgage, it is almost a certainty that they will be
subjected to repossession action at some juncture. In all cases, the interest rate charged is
designed to create arrears. There are cases where one or more of the following examples
apply: (i) borrowers who are current in their payments are suddenly informed that
arrears had accrued some years earlier for which immediate payment is demanded;90 (ii)
the arrears are contrived through applying interest and charges that the consumer is not

85
Observe the difference of some £12 million between the amount of notes issued and the amount of assets that
backed the Note issue. The aggregate amount of outstanding principal balances on the mortgages was £588 million
(which sum was also the sale/purchase price of the asset), leaving a bonanza of some 12 million extra in cash
86
Clavis issued 11 Classes of Notes in the 2006-1 Series. The first 5 Classes of Notes matured in 2031 and the
remaining 6 Classes of Notes matured in 2039.
87
This remortgaging is another facet of the securitisation industry profitability. Firstly, the remortgaged properties will
be securitised which means the consumers are back in the vicious circle. Secondly, the banking industry may charge
another set of application fees, arrangement fees etc. Thirdly, the investment banks have a further ready source of
new mortgages to securitise which yield further substantial fees and infamous City bonuses. The consumer is the
ultimate source of all these cost of all these fees, profits and City bonuses.
88
On the balance of probabilities, it is unlikely that Clavis will perform its 25-year obligation to any of its remaining
borrowers.
89
See footnote 21 Angela Knight: “at the end of whatever their [fixed] term was, they [the borrowers] are seeing rates
which they consider to be far too high and they are coming back to the major providers” (underline emphasis added).
90
See e.g., consumer comment posted on the web 27 November 2008 “They [Southern Pacific
Mortgages Limited] have recently started badgering me for arrears that they claim come from DEC 2006!”
Source: http://www.consumeractiongroup.co.uk/forum/mortgages-secured-loans/170607-spml-london-
mortgage-company.html

213
 contractually obliged to pay91; (iii) adding fees and charges and falsely claiming that they
are interest arrears contrary to the MCOB92; and (iv) the amount claimed as arrears is
exaggerated by claiming amounts that are not yet due. In all cases, the consumer has to
trust the mortgage administrator’s calculations and is rarely in a position to challenge the
accuracy of the alleged arrears. The SPV, through their mortgage administrator will
commence action grounded on the alleged arrears which are often erroneous, inflated
and/or plain false.
64. The abusive use of the SPV’s discretionary powers to demand non-contractual interest is
best explained through illustration. GMAC borrowers who contracted under GMAC’s
standard variable rate (“SVR”) product, agreed to pay GMAC’s SVR following the initial
fixed period. Under the legal principle nemo dat qui non habet93, GMAC did not possess
the contractual right to charge its SVR borrowers in excess of GMAC’s SVR rate. As
GMAC did not possess a contractual right to charge more than its SVR, it did not possess,
and could not, assign to any assignee, the right to charge GMAC borrowers in excess of
the GMAC SVR. In other words, if GMAC could not contractually enforce the borrower
to pay more than its SVR, nor could an assignee of that contract. Therefore, an SPV that
acquired a GMAC SVR mortgage had no contractual right to charge the borrower any
amount in excess of GMAC SVR. In short, an SPV as an assignee can only lawfully
demand of its borrowers to like extent that GMAC could lawfully demand.
65. However, in practice, the SPVs violate this fundamental Rule of Law and unlawfully
demanded that consumers pay at interest rates in excess of GMAC’s SVR. Failure to
remit the unlawfully demanded payment rendered the borrower in jeopardy of
repossession. Consequently, the SPVs were in breach of contract to each of those
borrowers to whom they charged interest in excess of the GMAC SVR.
66. It is the excess interest that consumers were unlawfully overcharged that often formed the
basis of the alleged arrears. Additionally, those falsely alleged arrears were used to form
the basis of the SPVs alleged right to further exacerbate the borrowers account with
considerable charges such as monthly arrears fees, debt counsellor’s fees, legal fees, etc.
Following these abusive (and unlawful) charges, the SPV’s use a further strategy of
claiming future payments as alleged arrears to further exaggerate the appearance of large
arrears. It is these strategies of overcharges and exaggerated claims, that contrive the
false appearance of the borrower’s breach of contract which the courts accept without
reservation and the borrowers are unable to challenge.
67. Again an exact example will demonstrate the point. Clavis Securities plc, through its
mortgage administrator issued proceedings on 14 December 200694 alleging arrears of

91
See e.g., consumer comments on Southern Pacific Mortgages Limited (a Lehman Bros. securitisation)
posted on the web 19 February 2009 “Well I have just been through all bank statements & there is only 6
payments missing unlike the 12 spml mentioned,these total to £4955.74. Also received an upto date
statement of spml today stating arrears now stand at £16,101.18 so that £11,145.44 in unfair charges.”
Source: http://www.consumeractiongroup.co.uk/forum/mortgages-secured-loans/170607-spml-london-
mortgage-company-9.html#post1990917.
92
Id. “Yeserday [sic] when they phoned me I spoke to 2 people and got quoted £850 as arrears and
then £615 and when I said that it didn't tally...I was also told it was not a FSA requirement to NOT add
fees etc to the arrears amount and so they would continue to do so!”
93
No one gives who does not possess. Black’s Law Dictionary, 8th Ed.
94
This case was concluded with a dismissal order on 30 January 2007, and then, following inappropriate
interventions by the Claimant’s solicitors and errors by the court service, the claim was finally dismissed by court
order in February 2008.

214
 £4,530.63 for which they requested an immediate possession order. Of the £4,530.63
claimed as arrears, £1552.27 were not arrears because that amount was not due for
payment until 31 December 2006. Nonetheless, the exaggeration of arrears strategy had
the effect of giving the court the false impression of substantial arrears which would cause
undue prejudice to the consumer before judge95. Of the remaining £2978.36 claimed as
arrears, £1489.18 represented the payment due on 30 November 2006 and therefore was
only 14 days overdue and the final £1489.18 represented the payment due on 31 October
2006 and therefore was only 44 days overdue.
68. On strict construction of the contract, the SPV invoked the one-month arrears clause to
commence the action. However, the only payment that was one month in arrears was the
October payment of £1489.1896. Moreover, on strict construction of the consumer’s
obligation to pay interest, as discussed above, interest was at all times overcharged (which
was eventually admitted97). The admitted interest overcharges amounted to some £3,000.
Therefore, in this case, out of the total alleged arrears of £4530.63: (i) £1552.27 was not
due for payment at all on the date that the amount was falsely claimed as arrears; and (ii)
the remaining alleged arrears of £2978.36 could be more accurately classified as
representing the £3000 interest overcharges rather than arrears. The conclusion is that
the entirety of the repossession claim was falsely alleged and falsely claimed98.
69. Again, whilst the example illustrates Clavis Securities plc’s unlawful breach of contract,
this conduct is not isolated to the Clavis Securitisation. It is ubiquitous generally, and
standard practice in the context of GMAC mortgages that have been assigned to other
SPVs.
70. As another example, consider the repossession policies of Northern Rock plc. The
Treasury Committee have searched for explanation for Northern Rock’s repossessions
rates and its failure to pass on interest rate cuts, adequate explanations for which has
hitherto, remained elusive. There are two fundamental questions that should be
answered in order to illuminate an adequate explanation for Northern Rock’s interest rate
and repossession policies. The first fundamental question is “who” sets these policies and
the second question is “why” the policies are implemented and apparently immutable.
71. Northern Rock merely administrates the mortgages on behalf of the SPV that owns the
mortgage contracts99. The SPV that owns the mortgage contracts that Northern Rock
originated is Granite Finance Trustees Limited (a Jersey incorporated company). It is
Granite Finance Trustees Limited that exercises the contractual powers under the

95
A county court judge often has between 20-30 repossession cases in his/her daily cause list. The court sits for
only 5 hours per day, which means that the judge has little time to assess the integrity of the Claimant’s claim form
and the consumer is rarely legally represented. Therefore acting as litigant-in-person the consumer is considerably
disadvantaged, often emotionally distressed and intimidated by the court process.
96
Compare the FSA’s definition of “arrears” “(a) a shortfall (equivalent to two or more regular payments) in the
accumulated total payments actually made by the customer measured against the accumulated total amount of
payments due to be received from the customer;” See the Glossary in the FSA Handbook. See also FSA Handbook,
MCOB 13.3.1
97
The overcharging was admitted on or around September 2008, albeit that they maintained the argument that they
had power and liberty to charge and apply their SVR (in excess of GMAC’s SVR) at their sole discretion.
98
Whilst on this occasion, the case concluded in favour of the consumer (a rare occurrence). The vast majority of
consumers as litigant-in-person may not have the knowledge or skills to defeat such claim. Therefore, the Treasury
Committee are requested to be mindful that these SPV strategies for claiming repossession would ordinarily result in
a possession order against the consumer.
99
See the Granite Master Issuer plc Prospectus Supplement dated 23 May 2005, page 101 and the schematic on
page 8.

215
 mortgage contracts and it is Granite Finance Trustees Limited that determines the
interest-rate setting policy and the repossessions policy. Northern Rock plc as the
administrator acts as agent for the SPV and implements the SPV’s policies100. Therefore,
when endeavouring to elicit an explanation for the policies, the Committee should be
mindful that it is Granite Finance Trustees Limited who set the policies that Northern
Rock must implement.
72. The second fundamental question is “why” those aggressive policies are dogmatically
pursued. The answer is: in June/July 2008 Granite Finance Trustees Limited required
more than £8.8 billion to redeem some of its Notes. Throughout 2008, the SPV’s monthly
Investor Reports101 stated that: “All of the notes issued by Granite Mortgages 03-2 plc may
be redeemed on the payment date falling in July 2008 and any payment date thereafter if
the New Basel Capital Accord has been implemented in the United Kingdom.” The same
notice is given on a further five Note issues alerting the investors to the same advice.
73. The condition that triggers the Note redemption is the implementation of the new Basel
Capital Accords, a condition that has been satisfied.102 Accordingly, the Granite Master
Issuer’s Notes for each of the series 2003-2, 2003-3, 2004-1, 2004-2, 2004-3 and 2005-1,
may now be redeemed. Naturally, this means that Northern Rock plc, in its capacity as
administrator and cash manager, acting as agent on behalf of the Granite SPV, must raise
the cash that will be required for such redemptions. The cost of these redemptions
amounts to £8.8 billion103.
74. Nick Ainger M.P. observed that in the half-year to June 2008, Northern Rock’s
repossessions increased 68% on the previous period, and he queried whether there was a
link between the aggressive repossession policy and the staff’s bonus incentive scheme.
He requested an explanation from Mr Sandler104, Northern Rock’s Non-Executive
Chairman. In reply, Mr Sandler admitted that the staff incentive scheme “...is designed in
the early years around the objective of debt repayment”105. Mr Ainger’s instinct was
correct and the full open and honest answer to his question is: that the incentive scheme
was designed around the objective of debt repayment because Northern Rock’s client,

100
Id at page 101, ”On March 26, 2001, each of the mortgages trustee, Funding and the seller appointed Northern Rock [plc] under
the administration agreement to be their agent to exercise their respective rights, powers and discretions in relation to the mortgage
loans and their related security and to perform their respective duties in relation to the mortgage loans and their related
security...Except as otherwise specified in the transaction documents, the administrator has agreed to comply with any reasonable
directions, orders and instructions which the mortgages trustee may, from time to time, give to it in accordance with the provisions of
the administration agreement.” (Underline emphasis added).
101
See, http://companyinfo.northernrock.co.uk/downloads/securitisation/. Granite Master Issuer investor reports
2008
102
Angela Knight of the BBA confirms the implementation of the new Basel Accords. See answer to Q171-172 “We
went from, overnight, a situation where as a banking industry we held 8% total capital as a regulatory requirement,
of which 2% was core tier one which is the expensive one, if you like, to a situation where we had to hold 8% tier
one capital of which 6% was core – a big jump”. Quoted from Treasury Committee, Banking Crisis, Uncorrected
Transcript of Oral Evidence to be published as HC 144-ii.
103
£8.8 billion is understated because it does not take account of the amount of the Notes that may have been redeemed through
2008 in anticipation that the Basel Accord would be triggered. The £8.8 billion aggregate amount outstanding on the Notes as of
31 December 2008. The total figure is calculated from: £2,618,244,672 outstanding Notes denominated in Sterling;
$3,373,079,787 Notes outstanding denominated in US Dollars (exchange rate £1 = $ 0.69096 as at 31-12-08); and €2,832,243,408
Notes outstanding denominated in Euros (exchange rate £1 = 0.97404 as at 31-12-08). Source: Granite Finance Trustees
Limited’s Investor Report available at: http://companyinfo.northernrock.co.uk/downloads/securitisation/
104
See Q431 in particular and Q425 to Q434 generally and answers thereto. Treasury Committee, Banking Crisis,
18 November 2008, Uncorrected Transcript of Oral Evidence, to be published as HC 1167-iii.
105
Id. See Q425 and answer thereto.

216
 Granite Finance Trustees Limited and Granite Master Issuer plc, requires £8.8 billion in
cash to redeem its Notes.
75. In these premises, it is submitted that the SPVs are in violation of a material term of their
legal obligations under the mortgage contracts. The SPVs’ course of conduct evidences
that they have no intention of honouring their contractual obligation to loan to the
consumer for the 25-year term. The Practitioner Panel’s calls for the Government to
support the rule of law. To that end, consumers would be assisted if the owners of the
mortgage contracts would be held to honour their contractual obligations, and/or pay
damages to each of the borrowers whom they force to remortgage.
76. The SPVs breaches of contract are not limited to the examples above. The Early
Redemption Charges (“ERC”) are also unlawful. These ERCs are often in tens of
thousands of pounds and do not reflect the SPVs reasonable costs of the redemption.
They are therefore, penalties imposed on the consumer and are unlawful because the
imposition of such excessive charges on the consumer is a violation of the FSA rules106.
Moreover, the SPVs impose the charges on properties that they have repossessed.
Notwithstanding that ERCs in the tens of thousands are unlawful in any event, the
contractual trigger for an ERC charge is when the borrower voluntarily redeems. In the
context of repossession, the borrower is not voluntarily choosing to redeem, rather it is
the SPV that demands redemption. Thus, the ERC clause is not triggered and should not
be charged. Nonetheless, in breach of contract, the SPV demands that charge and
borrowers are unlawfully forced to satisfy that non-contractual overcharge too.
77. To conclude, the Practitioner Panel’s demand for faithful observance of the Rule of Law is
welcomed. They may have intended that only those laws that benefit their members be
considered, however on review, consumers would greatly benefit if the courts would
properly construe the contracts and that judicial support for the SPVs ubiquitous and
excessive and unlawful charges are refused. The consumers would benefit if the SPV
were held to their contractual obligation to provide the loan for the 25-year term, and the
consumers would benefit if the SPVs were prevented from abusing their discretionary
powers to set interest rates. In short, consumers would benefit if the rule of law was
observed and that the principle of equality before the law had real meaning, substance
and effect.
78. In conclusion: in light of the SPVs legal obligations which are generally performed in
violation of the FSA’s MCOB rules, and generally, in breach of contract, it begs the
question whether the SPVs are lawfully repossessing the homeowner or more accurately
dispossessing the homeowner.
79. Recommendations:
• Strictly apply the rule of law. Statute law is merely words on paper until brought
to life through judicial observance, application and enforcement.
• Empower the consumer to access the law to effect the enforcement of their rights,
both contractual and statutory.
THE PERFECT STORM

106
See FSA Handbook MCOB 12.3.

217
 80. The Committee has heard the widely rehearsed crie de coeur from bankers that the
wholesale markets abruptly closed in August 2007 and that they “didn’t see it coming”.
Which means that the real question to be determined is: why did the wholesale markets
abruptly close?
81. The bankers’ explanation is that the assets became toxic. The bankers blame the source of
toxicity on the allegedly “bad” borrowers who defaulted on their loans. This universal
defamation of the borrowing public unjustly stigmatises the homeowner when in fact, in
August 2007, the default rates were no more than would be ordinarily experienced. To
accept the bankers’ allegation without question requires a gullible belief that a minority of
defaulting borrowers had the power to bring down the whole of the banking industry.
That contention is too incredulous to countenance and consequently, it is submitted that
the bankers’ explanation should be rejected.
82. A more reasonable and logical explanation for the source of the toxicity can be found in
tax law. In the Finance Act 2005, the Government took tentative steps with new tax law
targeted specifically at securitisation companies. The 2005 Act provided “interim relief
for securitisation companies”.107 Then, on 21 March 2007, H.M. Revenue and Customs
made a public announcement108 stating that legislation would be introduced in the
Finance Bill 2007 that would affect “Large companies involved in securitisation or issuance
of debt” and that the measures would have effect following its Royal Assent. The Finance
Act 2007 received its Royal Assent on 19 July 2007. It cannot be a mere co-incidence
then, that the wholesale money markets went into meltdown within a couple of weeks
apparently with the cry “toxic-assets”. On the facts, it is logical to deduce that the source
of toxicity is tax rather than the bankers’ defamatory allegation against the allegedly “bad”
borrower. The flight from funding was fear. Fear of paying tax.
83. The twist of fate turned the tide on tax policy and trumped the Treasury’s tax intentions.
The SPVs, rather than being the new contributors to the Treasury coffers became the
greatest recipients of the Treasury coffers. The consumer now pays the money-masters
twice. First directly to the banks and then indirectly through the Treasury.
84. To exacerbate these events, a further factor came into play. The banks cry for capital.
The cry was driven by the apparent immediate need to comply with the new Basel Capital
Accords. Angela Knight informed the Committee that the banks’ capital requirements
“jumped” overnight109 which naturally implies, that the banking industry was caught off-
guard. Again, this assertion is too incredulous to attract credibility. Nonetheless, this
lame excuse is the generally accepted foundation for the tax payer funding the banks’
balance sheets. The result is that the ordinary public was hit with this double-whammy of
tax policy and Basel.

107
See Global Legal Group Ltd, The International Comparative Legal Guide to: Securitisation 2007, Sanja Warna-
kula-suriya and Laurence Rickard of Slaughter and May at page 117: “...under UK GAAP (as it is from 1 January
2005), significant unrealised profits and losses would have had to be recognised in the accounts of securitisation
companies and, if tax had to be paid on any such profits, there would have been a risk of securitisation companies
becoming unviable. In order to avoid this, and the effect that that would have had on the securitisation market, certain
statutory measures were introduced to allow an interim relief for securitisation companies...”, (underline emphasis
added). Source: http://www.iclg.co.uk/khadmin/Publications/pdf/1321.pdf
108 H.M. Revenue & Customs Budget 2007 BN13 available at:
http://www.hmrc.gov.uk/budget2007/bn13.pdf
109
See above, footnote no. 67

218
 85. The Government aspires to stimulate the economy which requires the revival of the
housing market. The Government appears to be in state-mate with the banks. There is
demand for property purchases, but the banks will not facilitate the buyer’s desire to buy.
Again, the Government is at the mercy of the banks. But the Government does not
necessarily need to beg the bankers to lend. It can apply the rule of law and revive and
give life to law that already exists.
86. The Law of Property Act 1925 s.95 contains a provision: “Where a mortgagor is entitled to
redeem, then subject to compliance with the terms on compliance with which he would be
entitled to require a reconveyance or surrender, he shall be entitled to require the
mortgagee, instead of re-conveying or surrendering, to assign the mortgage debt and
convey the mortgaged property to any third person, as the mortgagor directs; and the
mortgagee shall be bound to assign and convey accordingly” Emphasis added.
87. This means that the borrowers have a statutory right to assign the mortgage debt to a
buyer. The loan already exists. No new lending is required. The borrower can assign the
debt to the buyer as part of the property sale. The SPVs have made use of their statutory
rights to assign. It is now time to give life and real effect to the borrower’s right to assign.
The Government does not need the bankers, the funding is already available. The
Government can revive the housing market without the acquiescence of the bankers. If
nothing else, the threat of facilitating the public’s use of this provision would add weighty
negotiation leverage to effect the Government’s aspirations. The Government has given
the golden carrot to the bankers who have coveted that carrot to the exclusion of all. It is
perhaps time to use the stick.
88. Implementation of this provision is simple. H.M. Land Registry could create a new
Transfer Form to facilitate the mortgage assignment. For example, the TR1, transfer of
the property and TR4, transfer of mortgage charge, could be used as the basis to create a
new form to simultaneously transfer and assign both the property and the mortgage debt
to the buyer. Additionally, the HIP pack could be amended to include disclosure of the
mortgage product.
89. The Government has supported the minority, the bankers to the absolute detriment of
the majority, the public. The Government should re-focus its perspective and support the
majority. Consumers only need the Government commitment to enforce the rule of law
to empower the ordinary public.
CONCLUSION
90. Qui Bono? Who benefits? The banks and the SPVs. The banking-crisis has undoubtedly
been the greatest heist of public money at the hands of money-men wielding their power
in the guise of victimhood. In reality it is passive-aggressive intimidation. Power is
being concentrated in the hands of the few remaining banks that have successfully
dispensed with competition, leaving the public at the future potential mercy a cabal of
bankers and the attendant possibility of a concealed cartel. The golden rule will prevail.
He who holds the gold – Rules! Private foreign companies and their investors have also
done exceptionally well. The SPVs are being capitalised by the public purse through bank
consolidated balance sheets and consequently, the public purse will carry any SPV losses.
The investment paradigm appears to have shifted. Historically, investors capitalised their
companies and received high returns for taking risk and, if the risk manifests, investors

219
 lost their investment; but now, the Investors still receive high returns but, the public
capitalise their companies and guarantee the investors’ returns.
91. The intention of this memorandum is to highlight securitisation issues from the
consumer and the tax payer perspective. It is not intended to give the impression that the
securitisation process is harmful per se but it is intended to demonstrate that without
checks and balances, this financial engineering dysfunctions to the detriment of the
consumer and ultimately the economy. Transparency is essential, together with openness
and honesty from the financial institutions110.
92. The contractual relationship is not one of equals, it is one of Goliath and David without
the stone! The scales of justice are in urgent need of recalibration. To restore
equilibrium between the contracting parties the remedy is: the faithful application of the
rule of law. The failure of British courts to give effect to consumer rights makes the UK a
most creditor friendly jurisdiction (which means a most debtor unfriendly jurisdiction)
in the world attracting the highest creditor friendly rating of A1111. This high rating is
achieved not through the lack of consumer protection law, but rather through the lack of
consumer law enforcement. Consumers do not necessarily need new protection laws,
consumers need empowerment to enforce their contractual rights and the consumer laws
that exist.
This memorandum is respectfully submitted for your consideration.
February 2009

110
It is observed that the legal profession have escaped all scrutiny for their role in the banking crisis.
Without the City law firms support, bankers and SPVs may not have so confidently violated statutory
obligations nor violated borrowers’ contractual rights.
111
Contrast the U.K.’s rating of A1 with Germany and U.S.A. rated A2 and France rated B. Source:
Standard and Poor’s: http://www2.standardandpoors.com/spf/pdf/events/blr200714.pdf

220
 Memorandum from Philip Murphy

I watched the Parliament channel on TV today and watched the committee speak to various
senior staff members of banks. The subject of house repossessions was discussed and I think my
experience might be of interest to the committee.

I had a mortgage with on my Davyhulme property with Bristol and West Plc.
In recent years I was gainfully employed and encouraged by banks and credit companies to go
into ever increasing debt.
I then found myself unemployed and unable to meet my commitments.

I attempted to sell my house last year, having had it valued in July by a local estate agent at
£150,000.
That sum would have covered what I owed.
Unable to sell it, my property was repossessed by Bristol and West in October.
Last month, January 2009, B&W offered the property for sale through a local estate agent for
offers above £90,000.
That will not cover what I owe B&W and obviously therefore will not leave any to cover the other
debts I have.

I am now faced with bankruptcy.

I am homeless and the relationship I had with my seven year old son and his mother from whom
I am separated, in tatters, as a direct result of what has happened to me because it has left me
homeless.

As an ex member of the Armed Forces and having worked as a Firefighter with Greater
Manchester Fire and Rescue Service for twelve years I have worked hard, been a good citizen and
always paid my taxes.

Bearing in mind that money taken from me in tax has been used to rescue the financial industry I
am appalled and sickened at the way that I have been treated by that very industry, in particular
Bristol and West but I seriously doubt that such practices as I have seen are restricted to that
company.

They have not only taken my only asset from me but they have then, in my opinion, mismanaged
that asset. They have taken the opportunity to quickly turn that asset into a ridiculously small
sum with no regard for the short and long term negative affects that would have on me.
In doing so they have also contributed in a small but notable way to the collapse of house prices
in the marketplace.

Also they have increased the amount of irretrievable debt that other companies have on their
books because I am affectively now forced into bankruptcy.

221
My vocabulary simply is not adequate to express my anger and disgust at the greed shown by
financial institutions at their ongoing attempts to stuff their own corporate pockets with a
complete disregard for the consequences of their actions on people like me and I am sure other
members of the public that have practically had to bail them out in their hour of need.

Thank you for taking the time to read this, I hope you find it of some use in getting a rounded
view of what is actually happening to hardworking people on the ground that are suffering as a
result of the actions of the institutes you are talking to on a regular basis.

February 2009

222
 Memorandum from Manifest Information Services Ltd

Introduction
1 Manifest welcomes the opportunity to submit evidence to the Committee in connection

with its inquiry into the lessons that can be learned from the banking crisis.

2 Notwithstanding the fact that we are submitting our evidence past the published

deadline, given the nature of some of the evidence presented to the Committee in

respect of the Role of Institutional Shareholders, we hope that the Committee will not be

averse to taking supplementary, factual findings to support their deliberations.

Background
3 Manifest Information Services Ltd was formed in December 1995 to address the

operational problems faced by investors wishing to take an active role in the oversight of

their investments through the AGM process. Manifest is not an NGO, trade association

or lobby organisation and receives no funding support from political parties or special

interest groups; our entire turnover derives from subscription sales.

4 Our mission is to provide independent and impartial analysis of shareholder resolutions

and to facilitate shareholder voting through our proprietary electronic voting platform.

Our customers vary in type and size but include insurance companies, sovereign wealth

funds, local government pension schemes as well as a variety of consultants, advisors

and academics. Our clients are mostly UK and continental Europe based. Through our

partnership with a similar organisation in Washington DC, ProxyGovernance Inc., we

also service North American investors.

5 Our coverage since 1996 has been the UK Main Market and AIM and for the past 5

years we have extended our scope and coverage to include Continental Europe, Oceania

and certain global “Blue Chip” indexes.

223
6 In addition to our analysis of routine resolutions, Manifest maintains a database of, inter

alia, executive remuneration data, director biographies and board composition data, all

of which is designed to enable investors to make informed judgements on their voting

decisions. We have also been honoured to be able to work with the Department of

Business, Enterprise and Regulatory Reform, the Financial Reporting Council and the

European Commission in the provision of data and analysis on a variety of governance

reform issues.

7 A matter of relevance to the Committee is the fact that since our first proxy season of

1996, Manifest has collected the voting results from shareholder meetings in order to

assess overall voting levels as well as to be able to analyse connections between

governance issues and voting outcomes. Manifest is uniquely qualified to be able to

present these findings to the Committee as this data set represents the largest, most

comprehensive and uninterrupted database of its kind. What makes this data especially

valuable for the members of the Committee is that historically there has been no legal

requirement for the disclosure of this data; although this issue is being addressed

through the EU’s Shareholder Rights Directive for which BERR has recently closed its

consultation.

8 Using the voting results that we have collected, we wish to present the Committee with

our findings on the voting patterns in the Banks before and during the current

turbulence. In doing so we seek to be able to address, in part, the Committee’s question

relating to: ‘The responsibilities of shareholders in ensuring financial institutions are

managed in their own interests.’

Rationale
9 Having read the initial call for evidence together with the subsequent written and oral

evidence submitted to the Committee, we believe that it is necessary to put some of the

statements and answers into context, particularly those relating to shareholder

engagement and activism.

224
10 Shareholders have a number of property rights most notably the right to transfer their

shares (buy and sell) as well voting on various issues at general meetings. While selling

securities can indeed be used as a disciplining mechanism, it is not without its costs.

There is not just the spread and commission to consider there is also the wider market

impact. Selling can also be a very blunt tool in terms of flagging issues to management.

Whereas the more developed governance teams will notify a company of their intention

to vote against or abstain, any notification of a buy or sell intention would negatively

impact the institutions buy or sell strategy.

11 Asset disposal also does not have a legal impact on a company in the same way as the

shareholder vote. The UK is extremely fortunate in that shareholder votes can have a

binding effect; this is particularly helpful on issues such as the appointment or removal

of directors and dismissal of auditors. In some jurisdictions, such as the US, votes are

not mostly advisory. US shareholders are often very surprised at the relatively low levels

of dissent votes against management and shareholder-sponsored resolutions. In North

America all too often it falls to the Class Action lawyer to find a legal resolution to

shareholders concerns because the shareholder vote is that much weaker.

12 Voting has recently been described as a “fairly blunt tool” in the governance tool box. It

is, nevertheless, the ultimate sanction against management for misdeeds. Case law

clearly shows that the Courts are loath to intervene in shareholder disputes until the full

range of shareholder remedies has been exhausted. These would include, for example,

the removal of directors, the proposal of shareholder sponsored resolutions, the calling

of an Extraordinary General Meeting (EGM) or a combination of all of the above.

13 Putting it politely, there may be a cultural or societal norm which tends to lead to an

avoidance of direct conflict through the use of voting dissent. Or to be blunt, there are

widespread concerns that too much of the City’s business takes place behind closed

doors for comfort. If shareholders can demand transparency and accountability from

their investee companies, is it too much t0 ask for that process to be a two-way street?

225
14 Turning to the Investment Management Association’s written evidence, paragraph 107

stated that a number of their members had begun to exit the banking sector ‘as long ago

as 2005’. In paragraph 108 the paper states that investors not in a position to sell would

have had no alternative but to raise their concerns and ‘ultimately vote against

management’.

15 We therefore felt that it was important to test this proposition by measuring actual

voting outcomes. It is not our position to argue which should come first, the

‘engagement’ or the ‘voting’ but whichever strategy was being deployed, in theory the

results should show one of two outcomes. If it were true that non-selling, captive,

shareholders expressed their concerns by withholding voting support there should be a

higher than average level of dissent at the Bank meetings; alternatively if dissenting vote

levels remained constant then that would show that those shareholders have supported

management.

Methodology
16 We created a series of tests with the objective of comparing voting trends at Bank

meetings compared to the meetings of all FTSE100 constituent companies. The earliest

data available to us is from 1996. Although there has not always been 100% disclosure

by every constituent company over this period, since 1998 the sample is statistically

significant and response rates to our requests have consistently been in the mid to high

90% range with 100% in later years. Should the committee wish to access the underlying

data for further inspection we would be happy to share our findings.

17 Every UK incorporated company is now legally obliged to hold an Annual General

Meeting (AGM) within 6 months of its year end112. The AGM contains a number of

resolutions for shareholders to consider, on average 12 per meeting. Typically these

resolutions will be election of directors, appointment of auditors and various technical

items relating to share issues, articles of association. Since the introduction of "The

Directors' Remuneration Report Regulations 2002" shareholders have also been able to

112
Prior to 2008 companies were required to hold a meeting in each calendar year and not more than
every 15 months.

226
 voice their concerns on overall compensation policy in addition to specific

remuneration elements. This particular vote is non-binding, as is the adoption of the

report and accounts, if it is presented. Unlike much of the rest of Europe, the UK does

not require shareholders to approve the acts of management through a “Discharge

Resolution”. Some may argue that this is the UK’s loss however these resolutions can

have their own unique difficulties.

18 As part of Manifest’s standard methodology, every resolution that is entered into our

database is assigned a specific meeting business category and certain analytical rules

applied to the resolution. These rules are derived from the various national codes such

as the Combined Code, as well as best practice guidelines from organisations such as the

ABI, NAPF etc.

19 If and when the results of shareholder meetings are announced these are also entered

into our database and referenced back to the original resolution. From this we are then

able to undertake analyses based on a variety of criteria such as type of company, market

capitalisation, type of resolution etc. When looking at resolutions relating to

remuneration and election of directors we can further drill down into the characteristics

of the remuneration plans and biographical or governance structure indicators for

individual directors.

20 In our analysis we use the term ‘Dissent’. For the purposes of this report, dissenting

votes are those purposely not cast ‘For’ a management proposal and include both

‘Abstain’ and ‘Against’ votes. Dissenting votes on shareholder-sponsored proposals are

those purposely not cast ‘Against’ the proposal and include both ‘Abstain’ and ‘For’

votes. Across the various markets, local regulations treat Abstain votes in different ways;

in some they have no legal meaning. Irrespective of regulations, however, they have

become a strong indicator of shareholder sentiment to demonstrate that shareholders

do not feel able to fully lend their support. To use a sporting analogy, the Abstain or

Withhold votes (i.e. where a shareholder has positively withheld their votes, not merely

omitted to tick the box) are treated as a ‘Yellow Card’ and an Against Vote a ‘Red Card’.

We would generally say that a dissent level of greater than 5% should be cause for

227
 concern for a company, and 10% would constitute what the press would be apt to call a

‘Shareholder Backlash’.

21 The Committee may wish to bear in mind that although voting levels in the FTSE100

constituents are now 63% of shares in issue113, this has not always been the case as a

decade ago that same figure would have been circa 40% with voting levels of around 30-

35% at the time of the Cadbury Report. This is an impressive improvement in numerical

terms, especially given that the proportion of shares held by UK institutions has fallen at

the expense of increased overseas ownership. As at 2006 it is estimated that foreign

investors held 2/5ths of UK shares. For further detailed information relating to the

ownership of bank shares we would refer the Committee to the ONS114. It is worth

noting that ONS estimates that Banks themselves own around 3% of all UK shares, the

highest recorded level since 1963.

22 Looking at the percentage turnout figures together with the ownership figures, there is a

wider question as to whether all UK institutional shareholders are exercising their

franchise. Although this represents an interesting question it is outside the scope of this

paper due to time and resource constraints.

23 While we can measure for quantity of voting, there is no simple metric for the quality of

the thought processes and due diligence behind the scenes. In our sales activities we

meet investors with a wide divergence of views from those who devote considerable

effort and resources to those for whom voting is a non-value-adding operational

annoyance to be avoided at all costs. Even within organisations with a commitment to

the active oversight of their shares there will be different styles and approaches from

those where the governance team is fully integrated into the investment process and

others where it is a ring-fenced activity with a narrow remit.

113
Source: The Manifest Pan-European Voting Review 2008, page 13
114
Source: http://www.statistics.gov.uk/cci/nugget.asp?id=107

228
24 To challenge the proposals that shareholder concerns about Bank governance would be

expressed through votes, we designed 4 tests of voting activity looking at the voting

results from UK Banks and the constituents of the FTSE100 over the same period. The

tests looked at:

• Overall Dissent: Was average overall voting at Banks materially different from

companies of similar size?

• Share Schemes: Did shareholders have greater concerns about share-based incentive

pay at Banks in comparison with other FTSE100 companies?

• Remuneration Reports: If concern was not expressed against the share scheme

resolutions, would dissent be shown through the report on the remuneration report?

and lastly

• Director Elections: Ultimately, if shareholders were concerned with management

strategy and board oversight they would have had the right and opportunity to

either cast a vote of no confidence or remove directors, executive and non-executive.

Would we see any correlation of votes with the wider public comments about bank

boards?

Detailed Findings

Overall Dissent
25 In the first test, we measured overall ‘Average Voting Dissent’ in the Banks vs. the

FTSE100 constituents. That is to we assessed every resolution at every company to

discover how much support or dissent management received. The results are as follows:

Figure 1: Average Overall Dissent

229
 Average Voting Dissent
Banks vs FTSE 100

5.0%
4.5%
4.0%
3.5%
3.0%
Dissent

Banks
2.5%
FTSE 100
2.0%
1.5%
1.0%
0.5%
0.0%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Year

26 UK companies tend to receive unstinting support from their investors with over 95%

approval in nearly all instances. Overall, the average dissent for voting at Banks is

marginally lower (0.27%) than for FTSE100 companies in general. Dissent only

exceeded the average in 4 out of the 11 years under review and then, at most, by 1.73%

in 2008. A detailed breakdown of the results can be found in Table 1 on page 239.

230
27 To understand which issues attracted dissent we drilled down further into the data.

Looking at the four years where Banks showed higher than average dissent we

discovered the following:

27.1 2002: Significantly above the all time average and 0.53% ‘extra’ dissent. There were a

number of resolutions requiring shareholder consent to approve EU Political

Donations which attracted very significant dissent. The regulations on EU Political

Donations were generally not very well understood at the time of their introduction

and were confused with donations to national political parties.115 116 117 Resolutions

relating to the election of directors at Bradford & Bingley and Standard Chartered

Bank are particularly notable. The director-related dissent can largely be attributed to

an enthusiastic implementation of director independence criteria, most notably

relating to length of service. Please see Table 2 on page 240 for details.

27.2 2004: Total dissent is still below the all time average but we see 0.13% extra dissent in

comparison with the FTSE100 overall. Remuneration issues at Bradford & Bingley

and Standard Chartered provoked a sharp shareholder reaction.

27.3 2007: Slightly above the all time total dissent average with 0.86% extra dissent. Two

proposed M&A transactions, Barclays with ABN Amro and Standard Chartered with

Temasek, plus two remuneration-related resolutions at Royal Bank of Scotland

provoked a significant reaction. Manifest’s analysis of RBS’ 2007 Executive Share

Option Plan highlighted our serious concerns regarding the possibility of excessive

levels of rewards that could be granted to senior executives.

115
Political Parties, Elections and Referendums Act 2000
http://www.opsi.gov.uk/ACTS/acts2000/ukpga_20000041_en_14
116
http://www.telegraph.co.uk/finance/2746759/Political-donations-back-on-the-agenda.html
117
http://www.parliament.the-stationery-office.com/pa/cm200001/cmstand/deleg2/st010130/10130s01.htm

231
27.4 2008: There is a marked increase in voting dissent with almost double the level of

average dissent. On further inspection we can see that this is attributable to four

shareholder-proposed resolutions at Northern Rock attracting dissent levels of over

65%; capital raising resolutions from Barclays and remuneration related dissent.

Please see Table 5 on page 248 for a detailed breakdown.

Long Term Incentive Related Votes

28 In Figure 2 below we are looking at a comparison of the overall dissent on the adoption

of performance share plans. Table 6 and Table 7 on page 252 show the detailed

breakdown.

Figure 2: LTIP Dissent

Average Dissent Banks vs FTSE 100

(Long-term Incentive Arrangements)

30%

25%

20%
Dissent

Banks
15%
FTSE 100

10%

5%

0%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Year

29 With a dissent rate of double that of the rest of the FTSE100, 2002 is the year of highest

variation from the mean. However this relates to a single resolution proposed by

Bradford & Bingley which attracted 27.40% dissent. In 2004 there were three resolutions

that attracted consistently above average dissent; 2008’s uplift related to two resolutions.

There is a common theme across all years with Bradford & Bingley consistently

attracting dissent on a variety of resolutions.

232
Remuneration Report Related Votes
30 In Figure 3 we see that the average dissent on votes to approve the Remuneration Report

in the Banks largely tracks the FTSE100 with a more noticeable trend away starting in

2007.

Figure 3: Remuneration Report Dissent

Average Dissent Banks vs FTSE 100

(Remuneration Report)

18%
16%
14%
12%
Dissent

10% Banks
8% FTSE 100

6%
4%
2%
0%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Year

30.1 As can be seen in the associated Table 8 and Table 9 on page 252, in overall terms we are

only looking at a difference of 0.01% between dissent towards Banks and the whole of the

FTSE100. In 2002 there is around half as much concern with Bank remuneration and it is

not until 2008 that dissent is 3.3% above the norm.

233
Director Elections
31 Turning our attention to the election of directors, because the directors are the elected

agents of shareholders and in theory accountable to them for their actions, we might

expect to see some relation between concern about the boards’ strategy and oversight

and shareholder voting turnout or dissent. The detailed breakdown of these results can

be found in Table 10 and Table 11 on page 255.

Figure 4: Director Election Dissent

Average Dissent Banks vs FTSE 100

(Director Elections)

5.00%
4.50%
4.00%
3.50%
3.00%
Dissent

Banks
2.50%
FTSE 100
2.00%
1.50%
1.00%
0.50%
0.00%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Year

31.1 The dissent relating to Bank director elections is clearly significantly lower that the

FTSE100 average. The difference is especially marked from 1998 to 2004, the time during

which it is said that some shareholders raised doubts about the future strategy of the

Banks. Even after this time, although the margin has narrowed, the votes do not bear any

relation to the subsequent, alleged shareholder dissatisfaction with and animosity towards

certain individuals as reported by the media.

31.2 There is a peak in dissent in the period between 2000 and 2003, but this applies equally to

the FTSE100 group as well as to Banks. This uptick is related to a period of new

disclosures by issuers and shareholder concerns regarding non-executive director

234
 independence. Looking at the individual resolutions on director re-elections we see a clear

trend toward Combined Code related compliance issues. Further details and drill down

are available on request.

Conclusions
32 The role of institutional investors in the real “ownership” of quoted companies is the

subject of many column centimetres (or inches) and we do not to intend to revisit the

theory in this short submission. For those shareholders wishing to be actively involved

there are many barriers to contend with including the opacity of disclosures and the

compressed time frames that they have to work within. Please see Figure 5 below for the

impact of ‘Peak Season’. It is also clear that there is a significant variation in the resource

allocation for the governance professionals, many of whom are not fully integrated into

the investment process, and that is not necessarily out of their own choosing.

Figure 5: UK Proxy Season

AGM & EGMs in the UK

2008
120

100

80

60

40

20

0
04-Nov-08

18-Nov-08
01-Jan-08

15-Jan-08

29-Jan-08

03-Jun-08

17-Jun-08

01-Jul-08

15-Jul-08

29-Jul-08
12-Feb-08

26-Feb-08

11-Mar-08

25-Mar-08

08-Apr-08

22-Apr-08

06-May-08

20-May-08

12-Aug-08

26-Aug-08

09-Sep-08

23-Sep-08

07-Oct-08

21-Oct-08

235
33 There is an education and understanding issue in parts of the City where voting and

shareholder democracy is seen as a time-wasting, administrative burden which is

irrelevant because either “the shares are going up” or “if we don’t like them we sell”. For

long-term beneficial owners it is not clear that this approach is sustainable. If our stock

markets are nothing more than respectable casinos then perhaps not, however we are

always mindful of the fact that we are often dealing with the life savings of modestly

remunerated individuals who have put considerable trust in the expertise of their

investment managers.

34 There are also administrative issues for shareholders such as the problems associated

with the way that Custodian banks, for their own administrative and P&L preferences,

have forced shareholders to hide their share ownership through pooled nominee names.

This also leads to anti-competitive bundling and network access practices which have

meant that shareholders are not at liberty to vote their shares by more efficient means

resulting in numerous lost votes and missed deadlines. Nor can they correlate their

voting instructions directly with those received by the company.

35 At the outset we said that we wanted to test the assertion that Banks were held to

account by their shareholders through the shareholder vote. Taking 2005 as the point at

which sentiment is said to have turned against British banks with a subsequent

abandonment of their share registers, the data shows no evidence of excess shareholder

dissent at Bank meetings in the 3 year run up to this sentiment sea change. There

certainly a marked change of voting outcomes in 2008, but these changes are

attributable to a very small number of resolutions against one specific company which it

could be argued, was a doomed attempt to shut the door after the horse had bolted.

236
36 Would a change in legislation on shareholder oversight bring about the changes that are

needed? Possibly, but we would be cautious about a rush to legislation as the unintended

consequences of hurried regulation can, as has been seen in other jurisdictions, be far

removed from legislations original intention. Taking the US example, the ERISA

Guidelines for pension funds mandate voting at shareholder meetings. Lord Myners at

one point suggested their introduction to the UK but he was counselled against this on

the basis that much of the voting by ERISA funds had become little more than a box

ticking exercise with more emphasis on compliance with the letter of the law than its

spirit. It also resulted in a massive outsourcing of the due diligence process as many

fund managers had little appetite for the chore.

37 In 1996 we asked the Financial Services Authority why proxy voting was not included in

their Conduct of Business Rules. Our rationale was that votes, in law, are no different

that transferability rights and as such their exercise should be the result of a careful

fiduciary process. The FSA was not moved by our arguments and to this date the buying

and selling of shares is tightly regulated but the after market is not. This is a sad

reflection on a market which is said to have the highest governance standards and most

comprehensive shareholder protection regime in the world. However until the entire

shareholder ownership process comes under the scrutiny of the compliance department

it is unlikely to receive the widespread resource allocation it requires.

37.1 For further information please contact:

Sarah Wilson – Chief Executive; or

Alan Brett - Head of Research

Telephone: +44 (0)1376 503500

Web: http://www.manifest.co.uk

Email: sarah.wilson@manifest.co.uk or alan.brett@manifest.co.uk

237
Appendix: Supporting Tables

Table 1: Overall Average Dissent

Year Banks FTSE 100 Difference

1998 1.46% 2.63% 1.16%
1999 1.20% 3.02% 1.82%
2000 1.42% 2.54% 1.12%
2001 2.41% 3.39% 0.98%
2002 4.42% 3.89% -0.53%
2003 3.71% 4.53% 0.81%
2004 2.66% 2.53% -0.13%
2005 1.85% 2.08% 0.23%
2006 2.04% 2.16% 0.11%
2007 2.82% 1.96% -0.86%
2008 4.06% 2.33% -1.73%
Period Average 2.72% 2.73% 0.01%
Table 2: 2002 High Bank Dissent Votes > 10%

S/H Poll % % % % Total

Name Type Title Narrative
Res? ?118 For Discr.119
Abstain Against Dissent
To authorise political
Royal donations and expenditure
Bank of by Direct Line Group Ltd in
AGM 18 No No 51.50% 46.47% 2.03% 48.50%
Scotland terms of the Political
Group Parties, Elections and
Referendums Act 2000
Bradford To approve amendments to
AGM 8 No No 66.99% 5.60% 12.35% 15.05% 27.40%
& Bingley the Performance Share Plan
Standard To re-elect as a director, Mr
AGM 5 No No 81.23% 0.33% 16.20% 2.24% 18.44%
Chartered C A Keljik
To authorise the Company
Northern to make EU political
AGM 8 No No 78.99% 2.85% 10.17% 7.99% 18.16%
Rock donations and/or incur EU
political expenditure
To authorise Standard
Standard Chartered to make EU
AGM 13 No No 83.48% 0.34% 12.17% 4.01% 16.18%
Chartered political donations under
the Political Parties,

118
% Turnout calculation methodology was not the same in earlier years so has not been included to avoid confusion. Vote outcome was not routinely recorded at
this time.
119
Discr. = Discretionary votes. Votes which the chairman has been granted authority to vote.
240
 S/H Poll % % % % Total
Name Type Title Narrative
Res? ?118 For Discr.119
Abstain Against Dissent
Elections and Referendums
Act 2000
To authorise Standard
Chartered Bank to make EU
Standard political donations under
AGM 14 No No 83.52% 0.65% 12.13% 3.70% 15.83%
Chartered the Political Parties,
Elections and Referendums
Act 2000
Standard To re-elect as a director, Mr
AGM 7 No No 84.43% 0.33% 9.12% 6.11% 15.23%
Chartered A W P Stenham
Bradford To elect as a director, Steven
AGM 3 No No 82.42% 5.46% 9.47% 2.65% 12.12%
& Bingley Crawshaw
Bradford To re-elect as a director,
AGM 5 No No 82.73% 5.49% 9.13% 2.65% 11.78%
& Bingley Keith Greenough
To authorise political
Royal donations and expenditure
Bank of by Ulster Bank Ltd in terms
AGM 21 No No 88.49% 7.99% 3.52% 11.51%
Scotland of the Political Parties,
Group Elections and Referendums
Act 2000
Royal To authorise political
Bank of AGM 17 No donations and expenditure No 88.52% 7.99% 3.49% 11.48%
Scotland by Coutts & Co in terms of
241
 S/H Poll % % % % Total
Name Type Title Narrative
Res? ?118 For Discr.119
Abstain Against Dissent
Group the Political Parties,
Elections and Referendums
Act 2000
To authorise political
Royal donations and expenditure
Bank of by Lombard North Central
AGM 19 No No 88.53% 7.99% 3.48% 11.47%
Scotland in terms of the Political
Group Parties, Elections and
Referendums Act 2000
To authorise political
Royal donations and expenditure
Bank of by Angel Trains Ltd in
AGM 20 No No 88.53% 7.99% 3.48% 11.47%
Scotland terms of the Political
Group Parties, Elections and
Referendums Act 2000
To authorise political
Royal donations and expenditure
Bank of by National Westminster
AGM 16 No No 88.54% 7.99% 3.47% 11.46%
Scotland Bank in terms of the
Group Political Parties, Elections
and Referendums Act 2000

242
 S/H Poll % % % % Total
Name Type Title Narrative
Res? ?118 For Discr.119
Abstain Against Dissent
To authorise political
Royal donations and expenditure
Bank of by The Royal Bank of
AGM 15 No No 88.54% 7.99% 3.47% 11.46%
Scotland Scotland in terms of the
Group Political Parties, Elections
and Referendums Act 2000
To authorise political
Royal donations and expenditure
Bank of by the Company in terms of
AGM 14 No No 88.63% 7.99% 3.38% 11.37%
Scotland the Political Parties,
Group Elections and Referendums
Act 2000
Standard To re-elect as a director, Sir
AGM 6 No No 89.53% 0.33% 6.08% 4.06% 10.14%
Chartered Ralph Robins

243
Table 3: 2004 High Bank Dissent Votes > 10%

S/H Poll % % % % Total

Name Type Title Narrative
Res? ?120 For Discr. Abstain Against Dissent
Bradford To approve the report of the
AGM 2 No No 71.50% 4.22% 15.28% 9.00% 24.28%
& Bingley Remuneration Committee
Alliance & To re-elect as a director, F A
AGM 7 No Yes 80.19% 4.39% 15.42% 19.81%
Leicester Cairncross121
Alliance & To approve the report of the
AGM 11 No Yes 81.95% 13.62% 4.43% 18.05%
Leicester Remuneration Committee
Northern To approve the report of the
AGM 8 No No 82.61% 10.74% 6.65% 17.39%
Rock Remuneration Committee
To approve the Bradford &
Bradford
AGM 13 No Bingley Executive Incentive No 83.66% 4.30% 2.08% 9.97% 12.05%
& Bingley
Plan (2004)
Standard To approve the report of the
AGM 3 No No 89.66% 2.81% 7.54% 10.35%
Chartered Remuneration Committee
To amend the rules of the
Standard
AGM 18 No Standard Chartered 2001 No 89.98% 1.70% 8.32% 10.02%
Chartered
Performance Share Plan

120
% Turnout calculation methodology was not the same in earlier years so has not been included to avoid confusion. Vote outcome was not routinely recorded at
this time.
121
Length of service issues identified.
244
Table 4: 2007 High Bank Dissent Votes > 10%

S/H % % Total
% Outcom Poll % %
Name Type Title Res Narrative Abstai Agains Dissen
Turnout e ? For Discr.
? n t t
Royal
Bank of AG To approve the 2007 Executive 73.96
16 No 66.31% Passed Yes 4.63% 21.40% 26.03%
Scotland M Share Option Plan %
Group
To approve the waiver in respect
of the requirements to enter in
Standard
AG to fixed-term written 79.60
Chartere 21 No 68.92% Passed Yes 19.66% 0.74% 20.40%
M agreements with Temasek and %
d
its associates in respect of
ongoing banking transactions
To approve the waiver in respect
of the reporting and annual
Standard review requirements in respect
AG 79.60
Chartere 20 No of ongoing banking transactions 68.92% Passed Yes 19.66% 0.74% 20.40%
M %
d with associates of Temasek that
the company has not been able
to identify
To approve future ongoing
Standard
AG banking transactions with 79.68
Chartere 22b No 68.85% Passed Yes 19.58% 0.74% 20.32%
M Temasek and its associates, %
d
including the waiver in respect
245
 S/H % % Total
% Outcom Poll % %
Name Type Title Res Narrative Abstai Agains Dissen
Turnout e ? For Discr.
? n t t
of the requirement to set an
annual cap
Standard To ratify past ongoing banking
AG 79.74
Chartere 22a No transactions with Temasek and 68.85% Passed Yes 19.53% 0.73% 20.26%
M %
d its associates
Standard To adopt the remuneration
AG 81.39
Chartere 3 No report for the year ended 31 68.92% Passed Yes 3.50% 15.10% 18.60%
M %
d December 2006
Royal
To adopt the remuneration
Bank of AG 85.28
2 No report for the year ended 31 66.31% Passed Yes 5.49% 9.22% 14.71%
Scotland M %
December 2006
Group
To approve the proposed merger
with ABN AMRO Holding NV,
to increase the authorised share 87.81
Barclays EGM 1 No 59.32% Passed Yes 2.01% 10.18% 12.19%
capital and to authorise the %
directors to issue shares in
connection with the merger

246
 S/H % % Total
% Outcom Poll % %
Name Type Title Res Narrative Abstai Agains Dissen
Turnout e ? For Discr.
? n t t
Subject to the passing of
resolution 1 and the merger
becoming effective, to increase
88.87
Barclays EGM 2 No the authorised share capital, to 59.32% Passed Yes 2.12% 9.02% 11.14%
%
authorise the directors to issue
preference shares and to amend
the Articles of Association
To approve the passing and
implementation of resolution 2
at the Extraordinary General
89.53
Barclays Class 1 No Meeting relating to the 57.97% Passed Yes 2.18% 8.29% 10.47%
%
preference shares and to consent
to any resulting change in the
rights of ordinary shares
To approve a general authority
to the directors to dis-apply pre- 89.55
Barclays EGM 4 No 59.32% Passed Yes 0.28% 10.18% 10.46%
emption rights on the issue of %
shares for cash

247
 Table 5: 2008 High Bank Dissent Votes > 10%
S/H % Poll % % % % Total
Name Type Title Narrative Outcome
Res? Turnout ? For Discr. Abstain Against Dissent
Subject to the passing
of resolution 1, to
replace the directors'
existing authority to
Defeated
Northern issue shares on a non
EGM 2 Yes 37.45% (Insuff Yes 66.10% 33.90% 66.10%
Rock pre-emptive basis
Majority)
with an authority to
issue a lower number
of shares on a non
pre-emptive basis
To delegate powers to
Defeated
Northern the Board to effect the
EGM 4 Yes 37.25% (Insuff Yes 66.01% 33.99% 66.01%
Rock resolutions adopted
Majority)
by the meeting
To amend the
Articles of
Association in
Defeated
Northern relation to the
EGM 3 Yes 37.25% (Insuff Yes 65.96% 34.04% 65.96%
Rock prevention of
Majority)
disposals or
acquisitions of assets
by the Company

248
 S/H % Poll % % % % Total
Name Type Title Narrative Outcome
Res? Turnout ? For Discr. Abstain Against Dissent
To replace the
directors' existing
authority to allot
Northern
EGM 1 Yes shares with an 37.24% Passed Yes 65.91% 34.09% 65.91%
Rock
authority to allot a
lower number of
shares
To approve a specific
authority to the
Barclays EGM 2 No 60.81% Passed Yes 76.72% 10.17% 13.10% 23.27%
directors to issue
shares
To approve the issue
of shares at a discount
Barclays EGM 4 No of 25.3% to the 60.81% Passed Yes 77.77% 10.48% 11.75% 22.23%
closing share price as
at 30 October 2008
To approve a specific
authority to the
directors to dis-apply
Barclays EGM 3 No 60.81% Passed Yes 77.85% 10.44% 11.71% 22.15%
pre-emption rights
on the issue of shares
for cash

249
 S/H % Poll % % % % Total
Name Type Title Narrative Outcome
Res? Turnout ? For Discr. Abstain Against Dissent
To approve an
increase in the
Barclays EGM 1 No authorised share 60.81% Passed Yes 78.13% 10.39% 11.48% 21.87%
capital of the
Company
To adopt the
HSBC remuneration report
AGM 2 No 36.32% Passed Yes 81.75% 7.53% 10.71% 18.24%
Holdings for the year ended 31
December 2007
To adopt the
remuneration report
HBOS AGM 10 No 43.98% Passed Yes 82.94% 6.89% 10.17% 17.06%
for the year ended 31
December 2007
To approve the
amendments to the
Bradford
AGM 15 No Bradford & Bingley 31.26% Passed No 81.36% 1.74% 13.85% 3.05% 16.90%
& Bingley
Executive Incentive
Plan 2004
HSBC To amend the rules of
AGM 10 No 36.44% Passed Yes 84.23% 6.63% 9.14% 15.77%
Holdings the HSBC Share Plan

250
 S/H % Poll % % % % Total
Name Type Title Narrative Outcome
Res? Turnout ? For Discr. Abstain Against Dissent
To authorise the issue
of shares to
shareholders in lieu
of a cash interim
dividend for the year
ended 31 December
2008, including to
Bradford
EGM 5 No increase the 38.86% Passed No 85.11% 2.73% 12.16% 14.89%
& Bingley
authorised share
capital of the
Company, to reduce
the share premium
account and to
approve a specific
authority
Royal To adopt the
Bank of remuneration report
AGM 2 No 59.85% Passed Yes 88.39% 3.24% 8.37% 11.61%
Scotland for the year ended 31
Group December 2007
To adopt the
Standard remuneration report
AGM 3 No 73.43% Passed Yes 89.41% 4.45% 6.14% 10.59%
Chartered for the year ended 31
December 2007

251
 S/H % Poll % % % % Total
Name Type Title Narrative Outcome
Res? Turnout ? For Discr. Abstain Against Dissent
To adopt the
Lloyds
remuneration report
Banking AGM 2 No 45.96% Passed Yes 89.57% 9.30% 1.13% 10.43%
for the year ended 31
Group
December 2007

Table 6: Long Term Incentive Arrangements Dissent Votes (Average)

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

s 2.57% 9.21% 4.37% 14.54% 27.40% 4.51% 10.13% 5.73% 3.69% 8.33% 1

100 8.06% 7.34% 11.74% 15.87% 13.47% 11.04% 5.75% 5.64% 6.55% 7.96%

rence -5.50% 1.87% -7.37% -1.33% 13.93% -6.53% 4.37% 0.10% -2.86% 0.36%

Table 7: Long-term Incentive Arrangements Dissent Votes (Banks)

Name 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Period Average

Alliance & Leicester 22.19% 4.53% 2.51% 6.85%

Bank of Scotland 31.50% 31.50%
Barclays 5.66% 1.90% 3.15%
Bradford & Bingley 27.40% 12.05% 16.90% 18.78%
Halifax Group 3.63% 7.31% 5.47%
252
HBOS 4.37% 4.21% 4.29%
HSBC Holdings 3.00% 3.33% 15.77% 6.28%
Lloyds Banking
0.63% 7.71% 2.52% 8.31% 4.81% 4.80%
Group
Northern Rock 2.57% 18.08% 3.80% 5.77%
Royal Bank of
9.21% 5.17% 12.03% 4.66% 26.03% 11.42%
Scotland
Standard Chartered 6.94% 11.86% 6.49% 10.02% 4.57% 8.34%
Yearly Total 2.57% 9.21% 4.37% 14.54% 27.40% 4.51% 10.13% 5.73% 3.69% 8.33% 16.34% 8.15%

253
 Table 8: Remuneration Report Dissent Votes (Average)

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Period Average

Banks N/A N/A N/A N/A 4.74% 12.82% 10.79% 5.98% 6.57% 7.75% 10.64% 8.95%

FTSE 100 N/A 8.47% 12.65% 8.49% 8.84% 17.05% 9.55% 6.63% 6.14% 7.11% 7.31% 8.94%

Difference -4.10% -4.23% 1.23% -0.65% 0.43% 0.64% 3.32% 0.01%

Note: Prior to 2002 a number of companies elected voluntarily to propose their Remuneration Report to the vote. No banks chose to do so, hence three
years of null data.

Table 9: Remuneration Report Dissent Votes (Banks)

Grand
Company 2002 2003 2004 2005 2006 2007 2008
Total
Alliance & Leicester 16.63% 18.05% 2.94% 2.93% 3.63% 2.74% 7.82%
Barclays 17.51% 6.65% 4.92% 5.93% 5.75% 6.27% 7.84%
Bradford & Bingley 8.09% 24.28% 9.77% 13.28% 5.32% 8.15% 11.48%
Egg 1.55% 2.01% 0.37% 1.31%122
HBOS 21.44% 6.62% 1.50% 1.45% 3.06% 17.06% 8.52%
HSBC Holdings 21.69% 8.15% 5.60% 4.84% 4.99% 18.24% 10.59%
Lloyds Banking Group 4.78% 7.08% 6.31% 6.14% 7.45% 10.43% 7.03%

122
Egg is 79% owned by Prudential plc therefore 1.3% of 21% free float represents a true dissent level of 6.2%
254
 Northern Rock 5.49% 7.73% 17.39% 16.13% 10.78% 6.25% 10.63%
Royal Bank of Scotland Group 3.99% 16.11% 7.27% 7.84% 7.60% 14.71% 11.61% 9.88%
Standard Chartered 12.70% 10.35% 4.44% 6.18% 18.60% 10.59% 10.48%
Grand Total 4.74% 12.82% 10.79% 5.98% 6.57% 7.75% 10.64% 8.95%

Table 10: Director Election Dissent Votes (Average)

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Banks 1.29% 1.01% 1.22% 2.71% 3.30% 3.55% 2.03% 1.08% 1.13% 1.38% 1.52%

FTSE 100 3.68% 3.55% 3.31% 3.51% 3.83% 4.67% 1.93% 1.45% 1.63% 1.55% 1.90%

Difference -2.39% -2.54% -2.09% -0.81% -0.53% -1.12% 0.10% -0.38% -0.50% -0.17% -0.39

Table 11: Director Election Dissent Votes (Banks)

Company 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Grand Total
11.53
3.85% 3.87% 5.63% 2.44% 5.47% 0.94% 0.50% 0.75% 0.80% 3.68%
Alliance & Leicester %
Bank of Scotland 0.24% 0.20% 0.25% 0.23%
Barclays 0.54% 0.62% 0.95% 0.76% 1.20% 1.92% 1.74% 1.34% 2.21% 1.57% 1.26% 1.38%
Bradford & Bingley 1.29% 9.32% 2.39% 1.47% 1.37% 1.10% 0.70% 1.08% 2.30%
Egg 0.46% 0.04% 0.20% 0.04% 0.23%

255
Halifax Group 1.71% 1.06% 0.78% 1.15%
HBOS 0.59% 1.10% 0.74% 0.39% 0.58% 1.36% 0.81%
HSBC Holdings 0.44% 1.47% 2.97% 2.26% 4.16% 2.27% 1.17% 0.76% 1.41% 0.75% 1.76%
Lloyds Banking Group 0.27% 0.58% 0.30% 1.07% 0.57% 1.29% 0.66% 2.37% 1.61% 1.48% 0.98%
NatWest Group 0.61% 0.61%
Northern Rock 0.87% 1.20% 1.12% 0.94% 1.81% 2.89% 0.92% 0.86% 3.27% 6.78% 2.17%
Royal Bank of Scotland Group 2.50% 3.27% 4.18% 0.71% 1.69% 2.92% 0.56% 0.75% 1.53% 1.20% 1.94%
Standard Chartered 2.89% 0.42% 4.64% 9.16% 9.79% 1.03% 2.07% 0.89% 0.64% 0.67% 2.94%
Grand Total 1.29% 1.01% 1.22% 2.71% 3.30% 3.55% 2.03% 1.08% 1.13% 1.38% 1.52% 1.82%

256
257
 Memorandum from Phil Bale

Re: Submission to the Treasury Committee's Investigation on the Banking Crisis - Member
Empowerment in the UK Mutual Sector

I am writing to you as an ordinary member of several mutual businesses in the United

Kingdom and as a former Member of Britannia Building Society’s Members’ Council. I
hope that this submission will assist members of your Committee when making their
recommendations to the Government, with its particular focus on member owned
businesses.

Whilst the Committee will be focusing its attention primarily upon the failings in the UK
banking sector, in this submission I would like to focus on the UK mutual sector. In
particular, I wish to advance a number of ways in which the Government could strengthen
governance arrangements in the financial mutual sector.

I would therefore be grateful if the Treasury Committee could address the three key issues
highlighted below as part of its final report.

1. Member Representation – National Level

2. Member Representation – Member Business Level
3. Building Societies – The lost generation

1. National Member Representation:

Support a ‘Mutual Members’ Association’ (MMA) in the United Kingdom

1.1 Despite the significant and growing role of mutually owned businesses across the United
Kingdom, there is still no one organisation which exists to represent the interests of
ordinary members.

1.2 Shareholders in public companies have benefited from the establishment of the UK
Shareholders Association in 1992. Likewise, financial mutuals have the support of their
own trade associations, which include the Building Societies Association (BSA) and the
Association of Mutual Insurers (AMI). However, these bodies exist to represent the
interests of their member businesses, not members themselves, in the various sectors in
 which mutuals now operate.

1.3 It is therefore vitally important that the Government works with members to develop
such a body, so that the voice of members is better represented at a national level. The
creation of a new member led (MMA) body would be extremely helpful in addressing
this historical imbalance.

1.4 If the mutual sector had an equivalent organisation to the UK Shareholders Association,
then it is likely that the debate over the large scale demutualization of Building Societies
in the 1990’s would have been much less one sided. This could have reduced the number
of Building Societies which pursued such strategies, which in turn may well have reduced
the need for substantial taxpayer support for the demutualised banks.

1.5 The role of a new national member advocate group could include;

• Promoting greater awareness and participation in the democratic process in mutual

businesses and assisting in the development of good corporate governance in the sector.
• Supporting education and training on the mutual model, including working with schools
and colleges.
• Facilitating national forums to encourage member debate and awareness of the issues
facing particular types of mutuals. (The first industry wide ‘Mutual Forum’ was held in
December 2008 but no such event exists for ordinary members)
• Improving the scrutiny of management and highlighting poor business performance
• Undertaking and commissioning new research and member surveys
• Providing increased opportunities for member involvement in consultations with
regulators as well as an input into government policy formation.
• Inclusion on the Board of Mutuo, along with employee representatives, to provide an
enhanced tripartite arrangement to promote mutuality.

1.6 It is worth highlighting at this point the potential impact of the Building Societies
(Funding) and Mutual Societies (Transfers) Act. The recently announced merger
between Britannia Building Society and The Co-operative Group, may well herald the
start of further cross-mutual consolidation in the financial industry. This will inevitably
encourage greater co-operation and in some instances, mergers between trade bodies as
well.

1.7 If members remain ineffective in monitoring the use of this new legislation, then there is
a real danger that some mutuals will begin to expand into more complex (and potentially
unsuccessful) business combinations, supported by a smaller number of more influential
trade body groups.

1.8 This development has the potential to undermine member understanding of their
businesses and the required scrutiny of management in the sector going forward.

259
1.9 I would therefore urge the Government to take decisive action to ensure that ordinary
members are properly represented at all levels within the mutual sector.

2. Member Business Representation:

Recommend the appointment at Board level of a ‘Member Advocate’

2.1 There is a case for the Committee to consider the merits of legislation which would
require a customer/member representative to be appointed to the Board of Directors of
Building Societies (and perhaps even our banks as well).

2.2 This representative could produce their own Member Report as part of the Annual
Report & Accounts and could hold specific responsibilities for member engagement and
consultation, for example over branch closures. Some Societies do already advertise and
invite applications for Board candidates from their members but successful candidates do
not have any special customer owner responsibilities.

2.3 I would also recommend that this Board level ‘Member Advocate’ was also accountable to
a panel of members, similar to Britannia’s Members’ Council, but with clearly protected
rights and responsibilities which cannot be manipulated by senior management. Such
bodies do already exist at some Societies, but their powers and remit vary considerably.

2.4 The Nationwide Building Society for example, prefers to hold ‘Talk Back’ sessions for its
members across the country as a means of listening to their grassroots membership.
However, there is no reason why such road shows could not take place alongside a
permanent body of members.

2.5 The ability of a member to monitor management is of course helped considerably when
they are able to do so in a formal framework, over a three or four year period, and with
access to the same information as the Chief Executive. This is why such changes can only
be implemented by Government as management themselves are unlikely to promote
member engagement strategies which undermine their authority.

2.6 There are a number of Building Societies which now appear to have followed strategies
which have left these businesses poorly positioned to deal with the rapidly deteriorating
economic climate. One can only speculate what the outcome of such practices would
have been if such strategies had been allowed to continue unchallenged and unchecked
by the current recession.

2.7 The election of a customer member to the Board of a financial mutual would help to

260
 assist in promoting a challenging culture within Boardrooms.

2.8 Furthermore, if an ordinary member who has been elected to the Board cannot
understand or becomes increasingly concerned by the direction being followed by
management, then that would in itself act as a useful warning to excessive risk taking.

2.9 The Government should also move quickly to end the practice of Executive Directors
sitting on Nomination Committee’s, which then select the Non-Executive Directors who
are supposed to monitor their own performance.

261
3. Building Societies: The lost generation

Promote a new breed of Building Society based on important social and economic
principles rather than geographic spread

3.1 The long term decline in the number of mutual mortgage providers in the UK must be
addressed in the Treasury Committee’s Report.

3.2 The last new Building Society in the UK was the Ecology Building Society in the early
1980’s. There are now significant barriers to entry to the market which must be
addressed.

3.3 The BSA has failed to take a lead in this important area and concentrated on the priorities
of their last remaining member societies. However, now is just the time for the
Government to encourage greater consumer choice through smaller, locally run and
accountable mutual lending and savings providers.

3.4 The long term consequences for competition in the mortgage market, as a result of the
consolidation or complete withdrawal from the UK market, of significant numbers of
participants should not be underestimated.

3.5 Furthermore, the dominant position of the Nationwide, relative to its peers, currently
exposes the entire sector to an excessive degree of risk. If the Nationwide were, for
whatever reason, to loose the confidence of its members then the viability of the entire
sector would be called into question. This risk would be reduced if the Nationwide’s
size, relative to the whole sector can be reduced over time.

3.6 This can be achieved through the promotion of a new breed of Building Society which,
like the Ecology, is focused upon important social objectives rather than any geographical
spread. Such an approach would not only capture the current climate for socially
responsible business but would also provide an incentive for members to invest the levels
of new capital required. These capital requirements should be reviewed to ensure that
they are no longer viewed as a barrier to entry for the sector.

*************

I do hope that you have found the points I have raised of interest to your enquiry. I shall
now await, with interest, your final report but in the meantime if you have any further
questions, please do get in touch. I would welcome the opportunity, in partnership with the
London Centre for Corporate Governance & Ethics (LCCGE), to expand upon any points
raised and to assist you more generally in any way possible.

February 2009

262