FSA admits to "failings" over Northern Rock

The Financial Services Authority (FSA) has published a summary of a review carried out by its internal audit division into its supervision of Northern Rock.

The review identifies a number of areas for improvement in the execution of supervision, which will be advanced urgently by the FSA's management, via a dedicated supervisory enhancement programme. This programme also includes a number of improvements already in train.

The Board of the FSA, having considered the internal audit report and the programme of work set out by the management in response, confirmed its support for the FSA's fundamental philosophy of outcomes-focused, more principles-based regulation.

It reiterated that the boards and managements of regulated firms carry the primary responsibility for ensuring their institutions' financial soundness. The Board also noted that, even if supervision had been carried out at a level acceptable to the FSA, it was by no means the case that that would have changed the outcome.

The Internal Audit review identifies the following four key failings specifically in the case of Northern Rock:

• A lack of sufficient supervisory engagement with the firm, in particular the failure of the supervisory team to follow up rigorously with the management of the firm on the business model vulnerability arising from changing market conditions.
• A lack of adequate oversight and review by FSA line management of the quality, intensity and rigour of the firm's supervision.
• Inadequate specific resource directly supervising the firm.
• A lack of intensity by the FSA in ensuring that all available risk information was properly utilised to inform its supervisory actions.

The review concluded that, overall, the supervision of Northern Rock was at the extreme end of the spectrum within the firms reviewed in respect of these failings and that its supervision did not reflect the general practice of supervision of high-impact firms at the FSA.

The main features of the FSA's supervisory enhancement programme are:

• A new group of supervisory specialists will regularly review the supervision of all high-impact firms to ensure procedures are being rigorously adhered to.
• The numbers of supervisory staff engaged with high-impact firms will be increased, with a mandated minimum level of staffing for each firm.
• The existing specialist prudential risk department of the FSA will be expanded following its upgrading to divisional status, as will the resource of the relevant sector teams.
• The current supervisory training and competency framework for FSA staff will be upgraded.
• The degree of FSA senior management involvement in direct supervision and contact with high-impact firms will be increased.
• There will be more focus on liquidity, particularly in the supervision of high-impact retail firms.
• There will be raised emphasis on assessing the competence of firms' senior management.

Hector Sants, chief executive of the FSA, said:

"This programme is the response of the management of the FSA to the weaknesses identified in the particular case of the supervision of Northern Rock. It is clear from the thorough review carried out by the Internal Audit team that our supervision of Northern Rock in the period leading up to the market instability of late last summer was not carried out to a standard that is acceptable, although whether that would have affected the outcome in this case is impossible to judge. However, I am determined through the programme of work that I am announcing today, that proper standards will apply to all significant firms supervised by the FSA.

"This represents our specific supervisory contribution to the package of measures introduced by the Tripartite Authorities to prevent a similar situation to Northern Rock undermining financial stability. That does not mean a "no failure" regime. However, together with the proposed reform of the insolvency regime for banks - and an improved deposit protection scheme - it creates a platform to strengthen financial stability and better protect the interests of consumers.

"Demonstrating our willingness to examine ourselves critically and learn lessons is central to giving the financial services industry and consumers confidence in the FSA, although, like any organisation, we cannot and do not claim infallibility, and we cannot, and should not, attempt to remove all risk from the system."

The internal audit review, commissioned late last year by Hector Sants, makes seven high level recommendations for firms' supervision in the future.

A summary of the review, the recommendations made by Internal Audit and the response of the executive of the FSA can be found on the FSA website.

Rosemary Hilary, director of Internal Audit of the FSA, said:

"The review supports the general risk-based approach and high-level framework for its application which is currently in place at the FSA. The issue is principally the manner in which it has been applied.

"Our recommendations are designed to ensure that the framework is properly applied, with good record-keeping, good information flows, the appropriate levels of challenge and the right amount of engagement and supervision of front-line staff by management. Whilst the recommendations are designed to apply to the supervision of all high impact firms, many are more generally applicable."