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Anatomy of a Bank Failure

The public report of the investigation by the United Kingdom's Financial Services Authority into the failure and subsequent bailout of the Royal Bank of Scotland in 2008 highlights deficiencies in regulation and supervision as also failures in bank governance. The fsa report is essential reading for regulators as well as those at the helm of banking.

HT PAREKH FINANCE COLUMN

as among the causes of the banking crisis,

Anatomy of a Bank Failure

and then focus on the last one, which has not quite received the same attention from regulators in general.

T T Ram Mohan The report is quick to dispel the per-

The public report of the investigation by the United Kingdom’s Financial Services Authority into the failure and subsequent bailout of the Royal Bank of Scotland in 2008 highlights deficiencies in regulation and supervision as also failures in bank governance. The fsa report is essential reading for regulators as well as those at the helm of banking.

T T Ram Mohan (ttr@iimahd.ernet.in) is with the Indian Institute of Management, Ahmedabad.

T
he Royal Bank of Scotland (RBS), one of the biggest banks in the world, was among the casualties in the sub-prime crisis. In October 2008, it was bailed out through public resources. Public support was extended in two forms: emergency liquidity assistance provided by the Bank of England, and infusion of capital of about £20 bn by the British government.

The failure as well as the bailout remain emotive issues in the United Kingdom (UK) to this day. They are seen as symbolising much that was wrong with the banking sector, including the whole philosophy of “light touch” regulation. In an attempt to assuage widespread anger towards the banking fraternity, the government of Prime Minister David Cameron recently thought fit to strip the former chief executive officer (CEO) of RBS, Fred Goodwin, of his knighthood.

The UK’s Financial Services Authority (FSA) conducted an investigation into the RBS failure. It has taken the unusual step of making public its findings and recommendations. The report identifies the reasons for RBS’s failure. It highlights deficiencies in regulation and supervision, and the lessons to be drawn in both areas. Finally, it attempts to shed light on failures in bank governance that should be part of any narrative of the crisis. The report is essential reading for regulators as well as those at the helm of banking.

Seven Factors

The report identifies seven factors responsible for RBS’ failure: inadequate capital, excessive dependence on short-term funds, concerns about asset quality at RBS, losses on the trading book, the acquisition of ABN Amro, loss of confidence in the banking system in general, and deficiencies in management, governance and culture. I will touch briefly on the first six factors, which are widely recognised

february 25, 2012

ception that RBS suffered a huge loss – of over £40 bn according to media reports

– as a result of which it was left with inadequate capital. Of the £40 bn, only £8 bn resulted in a reduction in regulatory capital; the rest was a write-down of intangible assets, including goodwill, which did not have an impact on regulatory capital. The total regulatory capital at RBS of around £80 bn at the time should have been adequate to withstand the loss. Why, then, did the bank go under? The report provides several reasons.

RBS was less well capitalised than its peers, so it was bound to suffer more at a time of waning confidence in banks. Second, the capital regime under Basel I and Basel II itself was deficient. The report highlights the distinction under the Basel framework between “going concern” capital, that is, capital that can absorb losses while a bank continues in operation and “gone concern” capital that absorbs losses only after a bank has failed.

The capital that is best suited to keep the bank going in the face of losses is core tier 1 (namely, equity, reserves and surplus). Under Basel 3, the minimum core tier 1 required is 4.5%, with another 2.5% if there are to be no restrictions on dividend payments; a large bank such as RBS would have to carry 9.5% of core tier 1. Around the time of its collapse, RBS had 2% of such capital, not enough to inspire confidence in the market.

Such confidence was vital given the heavy dependence of the bank on shortterm funds, with a large component of overnight borrowings. This dependence was exacerbated by the ill-fated acquisition by RBS of ABN Amro, which was financed heavily by short-term funds (nearly half of the ¼23 bn paid in cash). Ultimately, RBS was felled by a run on the bank, created not by retail depositors but wholesale providers of funds and had to seek emergency assistance from the Bank of England. Inadequate

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Economic & Political Weekly

HT PAREKH FINANCE COLUMN

capital, especially the right sort was partly responsible for this loss of confidence on the part of wholesale providers of funds.

Combination of Factors

Another factor was uncertainty as to asset quality. RBS had seen high growth in assets in the years preceding the crisis (24% in organic growth in 2004-07, with the acquisition of ABN Amro adding to this). This had created concerns about asset quality in the market, which were exacerbated during the crisis. The concerns were validated by the large loan losses that RBS showed in 2008 and 2009. The failure of RBS thus summed up in itself the three factors that underlay the sub-prime crisis as a whole: low capital (or high leverage), inadequate liquidity, and assets that were illiquid or of uncertain quality. It was not asset quality alone but the combination of the three factors that proved so lethal.

Like other banks in the crisis, RBS suffered huge losses through its exposure to securitised credit instruments. The report notes RBS’ aggressive expansion in this market and its relatively weaker distribution capability (which came in the way of its passing on deteriorating credits to others).

The report underlines that the ABN Amro acquisition, billed as the biggest in banking history, was an important factor in the failure of RBS. One reason was that RBS acted as the consortium leader for the acquisition which meant that all of ABN Amro’s assets came on to its balance sheet before they were given out to the other participants in the consortium. Although RBS did not suffer losses on the portions that were sold to others, the acquisition undoubtedly strained the bank’s capital and liquidity positions and added to the uncertainty in the market about RBS’ ability to withstand the crisis.

Lastly, RBS was exposed to the general deterioration in confidence in banks, particularly after the Lehman bankruptcy of September 2008. It was among the banks that were perceived to be poorly positioned in an adverse situation and, therefore, was among the worst hit.

Board Responsibility

Those are six factors that the FSA thinks together contributed to the failure of RBS. In addition, it argues that both management and the board bear responsibility for the failure although not in ways that expose either to regulatory or legal action. Since RBS made a number of questionable decisions that led to its failure, the FSA suggests that it points to deficiencies in management, governance and culture. In arriving at this conclusion, the FSA provides an account of the functioning of a high-profile board and its relationship with the CEO that should be of great interest to students of governance.

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Economic Political Weekly

EPW
february 25, 2012 vol xlviI no 8

HT PAREKH FINANCE COLUMN

Let us begin with the functioning of the board, whether it exercised its oversight function adequately. The report notes that the board had the right composition and the necessary expertise (although it may have been lacking depth in banking and investment banking). The chairman took the necessary steps to acquaint himself with various aspects of the bank’s business. The board followed the guidelines in respect of corporate governance and covered all the issues it was supposed to cover. A chairman’s committee was in place which could convene at short notice. There was no risk management committee but the audit committee handled all risk issues.

In other words, this was a board that ticked all the right boxes. So what failures can we pin on the board? The FSA comes up with the following:

  • It did not adequately challenge the bank’s focus on revenues, assets and earnings or ensure that adequate attention was paid to capital, liquidity and asset quality.
  • It linked CEO remuneration to return on equity instead of return on assets.
  • It did not properly assess the aggregate risk exposure of the bank.
  • It failed to challenge the assumptions underlying the bank’s strategy especially in light of developments in 2006 and early 2007.
  • The FSA is of the view that the board should have especially questioned the acquisition of ABN Amro. It failed to do and seems to have been content to go along with the optimism exuded by the CEO on this count. It appears that the board was swayed by the earlier successful acquisition and integration of NatWest Bank. It was also influenced by the fact that, in hostile takeovers, the information available is limited. The board should have taken into account the sheer size of the deal and the impact on customer and market confidence should anything go wrong.

    The FSA report also faults the board for not questioning the broad strategy of the bank and for not sufficiently challenging an assertive and aggressive CEO. There were shortcomings in the board’s handling of risk, such as not agreeing on an appetite for risk for the bank. These deficiencies or shortcomings were not picked up in the FSA’s supervision either.

    From the outline provided above, it should be apparent even to the lay reader why the FSA is not in a position to bring any enforcement action against the former board members. The failures at RBS that the FSA lists are hardly unique to RBS; they can be laid at the door of the board of almost any bank and, indeed, of any listed company! Had the FSA grasped this elementary truth, it may have come to different conclusions about boardroom reform.

    It does appear that the FSA, like regulators elsewhere, has a rather exalted notion of the role or contribution of corporate boards. As constituted today, boards are not in the business of challenging the CEO; they are in the business of rubber-stamping the CEO’s initiatives.

    Delusion about Boards

    The notion that boards, as representatives of the shareholders, are there to keep management on its toes is sheer delusion. Boards are not given to questioning the assumptions underlying strategy, they cannot make judgments on the aggregate risk exposure, and, yes, they reward CEOs mostly on the basis of return on equity. The entire boardroom atmosphere, with its backslapping and selfcongratulatory air, is hostile to any serious dissent, inimical to rigorous scrutiny. It is also likely that the more eminent the board members, the less they will contribute; they are apt to believe that their eminence by itself is sufficient contribution.

    Nor does the failure of boards have to do with lack of domain expertise. Board members at a bank need not get into the minutiae of risk management nor do they need great expertise in investment banking or banking in order to contribute. It suffices if they ask simple, commonsensical questions. What are the risks to aggressive growth? Has the balance sheet been subject to stress tests? Have analysts’ concerns been addressed? Asking such questions requires, not great expertise, but a willingness to rock the board. Alas, that is not a quality you

    february 25, 2012

    will find in the closed clubs that boards tend to be.

    Had the FSA recognised this, it would have posed questions other than the ones it asked. Is there something wrong with the way independent directors are defined and appointed today? Can an independent director, invited by the management and handsomely compensated, truly be independent? If not, should we change the selection of independent directors so that they represent institutional shareholders, retail shareholders and employees? Once these questions are posed, it becomes clear that the answer is not to expect great things from today’s boards but the reconstitution of boards along different lines altogether.

    Unless the constitution of boards changes radically, it would be unwise to set much store by this institution. Boards will not prevent acquisitions of the ABN Amro kind from going through; the regulator must do so, as the FSA proposes. In other words, the responsibility for preventing bank failures must lie overwhelmingly with regulators. The subprime crisis was very substantially a failure of regulation, as the FSA acknowledges, and the ongoing overhaul of regulations is the way to go. If boards can ensure full compliance with regulation, that would be an achievement.

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    Registrar, Azim Premji University

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