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DE RUEHLO #0959/01 0931658
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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