Sorry is the hardest word

In its final report on the near-collapse of Northern Rock, the Financial Services Authority (FSA) says that in future its supervisors should watch out for ‘dominant or aggressive individuals’. No names, no pack drill – and no comfort at all to the 2000 staff expected to lose their jobs over the next three months as the lender tries to halve its £110 billion mortgage book. But In an admirable display of candour the FSA has confessed to major failings in its handling of Newcastle-based Northern Rock.

The FSA disclosed that supervision of the bank amounted to just eight meetings in the two years before it imploded, and was “at the extreme end of the spectrum.” The report revealed a high turnover of FSA staff monitoring Northern Rock, and a consequent lack of experience and expertise. It seems clear that FSA’s hapless supervisors forgot about Northern Rock and, on the few times that they did recall it, failed to ask the right questions or keep a proper record of the meetings that they did manage to hold. But of course the greatest failure was one of FSA management.

The report found that FSA managers did not act with sufficient rigour in following up on its 2006 ARROW risk assessment visit with a proper risk-mitigation programme (RMP). Instead the decision was taken to supervise Northern Rock on a “close and continuous” basis. This means regular supervisory contact and challenge at all levels – but not in this case. Management failure, it seems, went to the very top: the report found that FSA directors had not monitored their department heads and they had not monitored their minions.

The blunders bravely identified in the report are a shocking indictment of FSA management at all levels, and if a major firm regulated by them were similarly afflicted the FSA would have shut it down several years ago.

It is ironic then, that despite the manifold failings of its personnel the FSA’s fundamental supervisory model is perfectly workable. The philosophy of principles-based regulation at the heart of the regulator’s approach is basically sound. The questions raised in the report are much more about regulatory practice than the principle that underlies it. Proper application of the existing supervisory framework may well have uncovered Northern Rock’s systemic weakness. But it is doubtful, however vigilant and well-ordered, that the FSA could have forestalled the bank’s denouement last year.

The FSA report outlined several recommendations to improve its regulatory procedures. Crucially, the supervisory teams, who have often been regarded as the least glamorous and most routine department, are to be strengthened and cease to be treated as the Cinderella of Canary Wharf. The teams are to get more, better trained staff and greater input from FSA senior management. There is to be a drive to improve the calibre of staff by paying them more: a budget increase of £15 million is being earmarked to attract City high-flyers. It is expected that this extra gravitas will allow the FSA to expand its risk department and increase the supervision of ‘high-impact firms’. But will people with high-value skills see any prestige in public service? The FSA is however right that without a healthy leavening of talented insiders who know how modern finance works, regulation can never be as effective as it needs to be. On the plus side, the likelihood is that any new City-wise supervisors will be less willing to accept given explanations and become increasingly challenging when asked to approve unconventional business models.

The banking sector has so far welcomed FSA proposals to enhance supervision. There are suggestions, though, that it is the smaller banks and building societies that should be the focus of attention. The signs are that the regulator will be allowed to both reform itself and behave far more assertively than in the past. But no amount of rules and supervision can prevent some financial institutions from failing or turn bad managers into good ones. Overly intrusive regulation will encourage a risk-averse business culture which is hardly desirable, and would probably result in the relocation of some financial institutions overseas.

The market will always innovate and regulators will inevitably run half-a-mile behind. The FSA will never be perfect and continuing reforms will not and should not aim to produce a ‘zero failure’ regime. However good the cadre of bankers persuaded to join up, the FSA will necessarily remain a financial regulator somewhere behind the cutting edge of financial innovation, and we must position our expectations accordingly.

Simon Morris is a partner at CMS Cameron McKenna