Cable on Northern Rock and Banking Reform

12.27.00pm GMT Tue 11th Mar 2008

[Mar 10] Vincent Cable: I start by congratulating the Chairman of the Select Committee, the right hon. Member for West Dunbartonshire (John McFall), and his colleagues on producing a timely and substantial piece of work.

Perhaps most remarkably, given the wide dispersal of political views on the Committee, they reached a consensus while being hard-hitting. That was a substantial outcome. Rather than go back over who said what to whom when, and who was to blame, it might be useful to be more forward-looking. I shall first ask some of the questions that I do not think the Select Committee asked, and that it certainly did not answer. I shall then turn to the policy implications of its conclusions.

There were two important sets of questions on which the Select Committee did not focus properly. The first was the nature of the assets of the bank that we have taken over. The major theme of the Committee's criticism, which was right as far as it went, was that the bank's managers and directors made one massive mistake: over-relying on international wholesale markets. The Committee stated that the Financial Services Authority was negligent in failing either to pick that up or, if it did pick it up, to do anything about it. That criticism is fair. However, the Committee largely seems to have taken at face value the assumption that the bank's assets were basically sound. In paragraph 13 of "The run on the Rock", the Committee approvingly cites a quotation from Mr. Sants, stating that Northern Rock had had

"high quality assets-there is no suggestion here that this is an organisation taking on poor quality assets".

Northern Rock also got a glowing testimonial from the Governor of the Bank of England, who is quoted at some length. Among other things, he said:

"What I would say about Northern Rock...is that most of the staff that worked...on the lending side, all the evidence shows, did an excellent job in appraising the loans that they were making, and that they monitored very carefully and did not lend money to people who should not be borrowing from them. The lending side was handled extremely well."

The issue is left there.

I wonder how that came to be accepted. I have worried about this from the outset of the Northern Rock affair. The worry centres on the so-called Together mortgages, which are one of the main products of the bank. We know that there are 200,000 of those out of 900,000, which is a big chunk. Those mortgages varied, but the basic principle was that they were well over 100 per cent. of the value of the property-they were usually something like 125 per cent. It seems that the bank was lending a fairly conventional 95 per cent. mortgage to its borrowers and adding on a 30 per cent. unsecured loan, which was typically £25,000. A lot of that happened when the housing market was at its peak last year.

I wonder how that could possibly have happened. The Governor of the Bank of England and the chief regulator concluded that this was straightforward and uncomplicated and that the assets were perfectly sound. That does not ring true. The Select Committee pointed out that managers were asked to undertake a stress test to see what would happen if house prices fell by 40 per cent. and concluded that the bank was safe and would have survived. I cannot understand how it could possibly have passed that test. Nothing we know about the bank leads us to believe that it would have survived that test, but it has become written into the orthodoxy that it was perfectly sound and secure.

Kevan Jones (North Durham, Labour): Is it not correct that there are two separate items in the mortgage book? There are traditional long-term mortgages, and I know from once applying for a Northern Rock mortgage that they are very difficult to get. There was also the activity described by the hon. Gentleman. His point was backed up by my constituents who worked in the Sunderland processing centre; in the last 12 months, mortgages were being given without any reference to payslips or anything else simply to get the market share up, which was Mr. Applegarth's key thing to boost the share price.

Vincent Cable: The hon. Gentleman makes exactly my point, but he has developed it in a very helpful way.

John Redwood (Wokingham, Conservative): The way that some might look at it is that what matters is the person's ability to pay the interest and to repay the capital. As long as they do not lose their jobs or mess up their family budgets, it will be quite possible for them to service those debts and repay them even if house prices have fallen. I understand the hon. Gentleman's point that it is not helpful because the security is undermined if there is a big reduction in the market value of properties. In such conditions, it is more likely that people will lose their jobs, but 40 per cent. of the mortgages will not go wrong just because house prices have fallen by 40 per cent.

Vincent Cable: That is a helpful correction. However, the point in answer to both the right hon. Member for Wokingham (Mr. Redwood) and the hon. Member for North Durham (Mr. Jones) is that we now know that over the past few months the Northern Rock management has refused to accept any individual voluntary arrangements. Northern Rock is the only bank that has refused to do that. It is clearly worried about the security of the people who have been lent to. There have been complaints from the Insolvency Service that that is bad practice and against policy. Northern Rock is the only bank that is taking that extremely aggressive approach towards the people who have borrowed from it, as it is worried about conditions such as those described by the right hon. Member for Wokingham.

We also know that whenever borrowers have got into any kind of difficulty-for example, when they have failed to make one month's mortgage payment-the bank has immediately come in to get a first charge on the property. That behaviour is much more aggressive than that of any other bank around, so why is it doing that? There is clearly a lot of worry in the bank about the quality of its assets.

The question then arises of what happened to all those mortgages. The answer is that we do not know. They may have been dealt with entirely separately, as the hon. Member for North Durham said. One possibility is that they were bundled together and sold, through the Granite vehicle, on the market. A more likely possibility that follows on from what the hon. Gentleman said is that the mortgages were separated, with the good, traditional mortgages being sold off through Granite-sold through intermediation into markets-and all the unsecured loans being left behind in Northern Rock, which is now a nationalised bank. If that is what happened, the outcome is worrying. It has been worrying all along, both when Northern Rock was nationalised and when it was not, but that is what we are left with.

I have been trying to secure a proper, independent audit, as have hon. Members from different parties. Clearly, the FSA failed in that task. We need to get a proper understanding of how good the assets really are. The honest answer is that we do not know. I hope that the Select Committee goes further into the issue in future.

Mark Field (Cities of London & Westminster, Conservative): I agree with much of the hon. Gentleman's careful analysis. He made the point that ultimately we do not know the quality of the asset book, but he suggested that the fact that Northern Rock was being very aggressive in relation to arrears was somehow a reflection of poor security. It may actually be a reflection of good market practice; it may be ensuring that it protects its interests. That may reflect well on its approach for the future-a subject that I am sure he will come to later in his speech.

Vincent Cable: It may well do so, and as we now own Northern Rock, it may be protecting the taxpayer by taking that approach. None the less, an awful lot of people in distressed situations are being treated far more harshly by the bank than other borrowers. We simply have to take note of that. The hon. Gentleman is quite right: we do not know the answers, and I hope that the Select Committee will go further into the subject.

There is another set of questions to which we still do not really know the answer. They are about the Granite vehicle. As many hon. Members will remember, the issue surfaced in the last stages of debate on the Banking (Special Provisions) Bill. The Select Committee refers to the issue in its report, and it obviously heard evidence on the subject, but there are big outstanding questions about what is really going on and how Granite will operate in future.

My first major group of questions is: what are the circumstances in which the Granite vehicle will have to be topped up in future with new mortgages from Northern Rock bank? How will that happen? What mortgages will go into it, and what is the scale envisaged? How will that affect the nationalised company that we have acquired? The other question that I have is: in the documentation relating to Granite, what is meant by the "pass-through event"? I have no idea what the phrase means, but it refers to circumstances in which Granite is effectively closed down and has to pack up. Presumably, in those circumstances, the bondholders lose their money and a complicated set of legal and financial processes are engaged. I hope that in its future work, the Select Committee will help us to understand the issue, because the Government have not been very enlightening and the Select Committee does not say much on the subject.

Those are two sets of questions that we ought to pursue further. Then there are the policy issues that arise from the Select Committee's work. The Committee is rightly damning about the FSA, but I am left asking, "What does it mean for the future of the FSA and the way in which it carries out regulation?" If it has been excessively indulgent in supervising the bank, what will it do in future if it sees banks behaving in a rather high-risk way? Is it supposed to intervene to stop them immediately? Is it supposed to issue a formal instruction, such as, "You must stop lending"? Is it supposed to have a quiet word in the ear? In future, will much more explicit, complex, prescriptive rules be applied to banks through the regulator, as the hon. Member for Sevenoaks (Mr. Fallon) suggested, and will we have a much more regulated system? If the system were much more regulated, what would it mean for the concept of banking as we have traditionally known it? Banking would then become much more like supplying electricity and water; very tightly controlled conditions would apply. That raises the question of what the banking system is for-something that the right hon. Member for Holborn and St. Pancras (Frank Dobson) mentioned. It is fine to criticise the FSA and its failures of regulation, but I am still not clear what the implications of doing so are for the way in which the FSA operates in future.

The second set of recommendations by the Select Committee, and probably the most important, relate to deposit protection. There is general agreement that there must be proper deposit protection, that the American model in general is the best available, that it must be, in practice, 100 per cent. protection up to a limited sum-£50,000 seems about right-and that that is the direction in which we will proceed. I have one worry about that, which was not dealt with by the Select Committee; that is, what happens to competing institutions, such as insurers, who do not have the same quality of compensation? They are competing with banks in many respects. There is the outstanding problem of Equitable Life, whose investors were just as exposed as investors in Northern Rock and who have not been compensated and presumably will not be. Why should one set of financial institutions have a fundamentally different type of compensation mechanism from others?

Greg Hands (Hammersmith & Fulham, Conservative): The hon. Gentleman referred to the US style of deposit insurance enacted by the Federal Deposit Insurance Corporation, which was mentioned earlier. Is he aware that the system in the United States is not exactly parallel, and that in the States there are still more than 1,000 deposit-taking institutions? Some of those are very small, and the concept of deposit insurance may be far more relevant-for example, at the Montana state bank-than it would be at Lloyds in the UK. The hon. Gentleman is comparing apples and oranges. There is a case for deposit protection, but the US example is not quite all it is made out to be.

Vincent Cable: If the banking industry in this country develops in the way that it could develop and as some of us feel it ought to develop, which means becoming much more competitive and having a much wider range of deposit-taking institutions, the models would become closer and the analogy would be more directly applicable.

Greg Hands (Hammersmith & Fulham, Conservative): In the States, the movement is more in the opposite direction. As banking consolidation happens in the States, more and more people are questioning the need for the FDIC to be there for very large institutions.

Vincent Cable: No doubt we could continue this conversation all afternoon. The one conclusion that we drew from the events of last year is that if there is no such structure, the old system of compensation was not adequate, partly because it did not cover 100 per cent. but more particularly because it was not timely-the payouts were not rapid enough. That is the lesson that was learned, and my understanding of it is that the American system is much better in that respect. Clearly, there are differences and we should be careful about blindly copying that system, but I am trying to make the more general point, reinforcing the views of the Select Committee.

John Redwood (Wokingham, Conservative): If the problem of compensation can be resolved or the answer improved, one of the options to look at is what the Department of Trade and Industry, as it then was, used to do with insurance companies when it was the insurance regulator. If it felt that an insurance company was over-trading or not liquid enough, it would stop it writing all new business and put the company into run-off, which meant that the assets and the liabilities both had to be managed in the interests of all the counterparties to try and salvage as much as possible.

Vincent Cable: We are talking about slightly different things. Is not the purpose of deposit protection to prevent a panic run on the industry? That is what it is designed to achieve. The right hon. Gentleman is right in saying that if the institution itself gets into difficulties, there are various ways of handling it, including closure. I entirely understand his point.

The third set of questions that arise from the conclusions of the Select Committee are about how banks should be regulated in the broadest sense of liquidity. There was an interesting passage in "The run on the Rock" which I had not understood previously, about what happened when the Northern Rock bank managers discovered that they had excess capital-that they had over-complied with the capital adequacy requirements. As I understand it, they simply blew it on a big payout to their shareholders.

That raises the question what those capital adequacy ratios are for. Common sense suggests that in a boom period, as those bank managers were, with a massive expansion of lending and a booming housing market, the requirement should have been tightened rather than relaxed. Similarly, a period like the present, when the market is going down, should be the point at which it was relaxed. I ask, and I do not know the answer, whether it is possible to design a system that is counter-cyclical, and whether that is compatible with the rules of the European Union, under whose auspices these institutions now operate. That is the kind of mechanism we should consider.

Albeit from different standpoints, the right hon. Member for Holborn and St. Pancras and the hon. Member for Sevenoaks have both asked what banks are for in the new world and what they should look like. Mr. Don Cruickshank raised those questions seven or eight years ago, when he pointed to the apparent anomaly that the industry is ultimately underwritten by the state but makes well above average profits in terms of the rate of return on its capital over a long period of time, which, from his point of view, is unacceptable.

There are two ways to resolve that situation. The first is to treat the banks as utilities by making them highly regulated and highly controlled. That would directly or indirectly control their profits, which is what the right hon. Member for Holborn and St. Pancras wants. The alternative is to say that provided deposits are protected, the banks should compete and the industry should be treated like any other. I am more sympathetic to the latter approach, but getting there will be difficult. We need a clear understanding and commitment from the Government and the Financial Services Authority about which of those two models they are going for, because simply adding a new layer of regulation to the existing system will not help.

Frank Dobson (Holborn & St Pancras, Labour): I understand the hon. Gentleman's point, but it assumes that if banks were allowed to go broke, subject to looking after the depositors, they would behave differently without further regulation of their activities. I am not confident that that is the case in view of the number of apparently reputable banks that have lost a fortune either directly or indirectly in the sub-prime mortgage scandal in the United States.

Vincent Cable: If some of the banks were to go bust, lessons would be learned. Historically, banks, like any other set of companies, have short memories, so the pattern returns after a generation. However, I take the right hon. Gentleman's point.