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Cablegate: Uk Financial Services Authority Admits Failings Re Northern

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RR RUEHBL RUEHED
DE RUEHLO #0959/01 0931658
ZNR UUUUU ZZH
R 021658Z APR 08
FM AMEMBASSY LONDON
TO RUEHC/SECSTATE WASHDC 8126
INFO RUEHBS/USEU BRUSSELS
RUEATRS/DEPT OF TREASURY WASHDC
RUEHED/AMCONSUL EDINBURGH 0912
RUEHBL/AMCONSUL BELFAST 1024

UNCLAS SECTION 01 OF 02 LONDON 000959

SIPDIS

SENSITIVE

SIPDIS

E.O. 12958: N/A
TAGS: ECON EFIN UK
SUBJECT: UK FINANCIAL SERVICES AUTHORITY ADMITS FAILINGS RE NORTHERN
ROCK

Ref: London 634; 07 London 3607, 07 London 4658

1. (U) SUMMARY: An internal report by the Financial Services
Authority (FSA) on the handling of the now-nationalized Northern
Rock (NR) details multiple failings including: high turnover of
staff supervising NR; inadequate staff; and infrequent contact with
NR management. The report recommends adding supervisory staff,
adding risk specialists to supervisory teams, and increasing contact
between senior staff and large firms. While critical of the FSA's
performance in this case, the report re-affirms the FSA regulatory
philosophy of risk-based, outcome-focused regulation. Industry
reaction is that there was a systemic failure at the FSA but that
the report goes overboard with its mea culpa. The report completes
the official inquiries into the handling of NR. The Bank of England
(BOE) emerges unscathed. END SUMMARY

Background
----------

2. (U) NR is a UK mortgage bank that grew over the past decade to
be the fifth largest UK mortgage lender. It aggressively funded
expansion through interbank short term borrowing rather than through
customer deposits. When the subprime crisis hit last August,
interbank lending dried up and NR had to ask the BOE for assistance
as the lender of last resort. A depositor run on the bank ensued,
prompting the NR crisis that ultimately led to the nationalization
of NR in February. In October 2007, Hector Sants, Chief Executive of
the FSA ordered an internal lessons-learned report on the
supervision of NR during the period 1 January 2005 to 9 August 2007.
That report was issued March 26, 2008.

The FSA Failings
----------------
3. (U) The report identified four key FSA failings in the case of
NR. The first is a lack of sufficient supervision in following up
on NR's planning for unexpected developments (stress testing) that
identified the vulnerability of the NR business model. The second
is a lack of adequate oversight by FSA line management of the firm's
supervision. The third is inadequate resources directly supervising
the firm. The fourth is the failure to ensure that available
information on the risks NR was assuming was assembled and utilized
to guide the actions of supervisors. The report concludes that the
supervisory failings with respect to the NR case resulted in it not
being classified as a high-impact firm and do not reflect the level
of supervision generally of other high-impact firms.

Supervisory Enhancements Underway
---------------------------------
4. (U) The report outlines seven supervisory enhancements that will
be undertaken immediately. The first is creation of a new group of
supervisory specialists to review the high-impact firms (those
judged to face higher levels of risk). Second, supervisory staff
engaged with high-impact firms will be increased, with a mandated
minimum level of staffing for each firm. Third, the existing
specialist prudential risk department will be upgraded to divisional
status and expanded. Fourth, supervisory training will be upgraded.
Fifth, FSA senior management involvement in direct supervision will
be increased. Sixth, focus increased on liquidity, particularly in
the supervision of high-impact retail firms. Finally, emphasis
raised on assessing the competence of firms' senior management. The
Executive Summary of the report can be found at:
http://www.fsa.gov.uk/pubs/other/exec_summary .pdf . Although the
report is highly critical of the FSA supervision of NR, it concludes
that the failings were not systemic. The recommendations relate to
a more rigorous implementation of the supervisory framework that is
already in place. The report finds no fault with the risk-based,
outcome-focused philosophy of the FSA with its principles-based
approach to regulation.

Industry Reaction: Systemic Problem or Just Poor Implementation?
----------------- --------------------

5. (SBU) At a March 28 meeting with with executives from several
leading UK banks, Econoffs were told that the FSA went overboard
with its mea culpa. They noted that FSA Chief Executive, Hector
Sants, only was appointed in July, 2007 and said the report was a
way for him to position himself with a clean sheet. While the
report concludes that the NR experience validates the FSA regulatory
philosophy, the bankers said the report points to a systemic failure
and not just to a failure of implementation and lack of resources.
In their view, the FSA system failed to move NR up the risk spectrum
as its mortgage portfolio expanded. It should have gradually been
classified as a higher risk (i.e. high impact) bank. The FSA system
failed to do this. In the case of NR, a high risk bank was assigned
a level of supervision appropriate for a low risk institution.

6. (SBU) Sants is using the report as a mandate to shake up both

LONDON 00000959 002 OF 002


the way the FSA is organized and its supervisory approach while
justifying additional resources said the bankers. Last week's
departure of Clive Briault, former Managing Director of Retail
Markets at the FSA may have been part of Sants' clean sweep.

Comment
--------


7. (SBU)While most financial service interlocutors expect it will be
years before the government is able to privatize NR and put the
crisis behind it, the FSA report marks the closing of the official
inquiries into the matter. It follows the HM Treasury consultation
in January on its review of the NR crisis. Among the members of the
tripartite agreement that oversees the UK financial system, only
Mervyn King, Governor of the Bank of England, emerges unscathed. He
was the first to testify before the Parliamentary Treasury Select
Committee and at the time, many expected he would be criticized for
not pumping liquidity into the system to rescue NR. Now, the
recommendations he made in his testimony are embodied in the HM
Treasury consultation and the FSA has admitted it failed in its
supervision of NR. The NR reviews have identified numerous
failings, but none involve King or the actions of the BOE. END
COMMENT

TUTTLE

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