Why Did Royal Bank of Scotland Fail? The FSA Speaks
Sarah Jane Leake | Bloomberg Law
After an investigation that has spanned some 33 months, the UK Financial Services Authority (FSA) has published its much anticipated report on the failure of the Royal Bank of Scotland (RBS).
The FSA attributes RBS’ failure to a wide array of factors, including over-reliance on short-term wholesale funding. Not surprisingly, deficiencies in RBS’ management, governance, and culture are also cast as having played a significant contributory factor in causing the bank’s collapse. Moreover, the FSA admits that flaws in its own supervisory approach provided insufficient challenge to RBS, and, indirectly, facilitated poor decision-making at the bank.
The detail of the report seeks to underpin and explain the FSA’s rationale for deciding last year1 that there were no grounds for pursuing enforcement action against the bank or its former top executives with a reasonable chance of success.
In October 2008, at the height of the financial crisis, RBS failed and became part-nationalised. From 7 October, it became reliant on the Bank of England Emergency Liquidity Assistance for funding and, six days later, the Government announced it would inject up to £20 billion of new equity to recapitalise the bank. Owing to subsequent increases in funding, the Government eventually provided a total of £25.5 billion in support.
As well as playing an important role in exacerbating the financial crisis, which led to one of the worst recessions the country has faced in the last century, the bank’s failure also imposed significant direct costs on the nation’s taxpayers. Given the strong public interest in RBS’ collapse and recovery, the FSA considered it necessary to investigate and explain what happened in the run up to the bank’s collapse, and identify, as far as is possible, who was responsible.
The Six Key Factors
— Capital Position
While the direct cause of the bank’s failure was a liquidity run, concerns regarding its capital adequacy were also fundamental to its failure.
Although the FSA found no breaches of the regulatory minimum requirement in place at the time, it nonetheless identified several worrying deficiencies in RBS’ capital position. In comparison with its peers, the bank chose to be lightly capitalised and made greater use of lower-quality forms of capital. In retrospect, RBS’ capital before the crisis was “grossly inadequate to provide market assurance of solvency.”
Moreover, the FSA admits that its supervision of capital before the crisis was “mainly reactive.” As part of its strategy to develop and apply a more rigorous capital regime, it pushed RBS, in April 2008, to make a large rights issue. While the £12 billion rights issue seemed large at the time, it was, in hindsight, insufficient to maintain market confidence in the midst of the 2008 funding crisis. As such, the changes to the FSA’s capital regime “came too late to prevent the developing crisis.”
— Wholesale Funding
Compared with its peers, RBS was over-reliant on risky short-term wholesale funding, in particular overnight funding and unsecured funding. The acquisition of ABN AMRO by a consortium led by RBS increased this dependency, thereby making the bank more vulnerable to a collapse in confidence and a consequential run on its funds.
The FSA concedes that its regulatory and supervisory framework for liquidity in place at the time was insufficient; it was unable to identify and limit RBS’ reliance on this type of funding, in particular its heavy use of non-sterling short-term wholesale funding.
— Asset Quality
In the years leading up to the crisis, amidst a period of rapid growth in credit extension across the banking sector, RBS’ balance sheet and leverage increased significantly. As its loan portfolio expanded in several divisions, significant loan losses were incurred; between 2007 and 2010, RBS’ losses on credit trading activities exceeded £17.7 billion. The full extent of these losses would not, however, have been clear to market participants in the autumn of 2008. As such, uncertainties concerning the scale of RBS’ future losses, and about the asset classes it held, “contributed to the loss of confidence in the firm at that time.”
The FSA acknowledges that its supervisory approach before the crisis involved little fundamental analysis of balance sheet composition or asset quality. It was therefore unable to identify and help rectify RBS’ growing asset quality problems.
— Credit Trading
In the lead up to the crisis, RBS had accumulated considerable exposures containing credit risk in its trading portfolio, which were amplified by its acquisition of ABN AMRO at a time when credit trading activities were becoming less attractive. As structured credit markets deteriorated during the course of 2007, it was inevitable that RBS, holding a dominant position in this market, would suffer some loss. RBS, however, was less effective than its peers in managing its positions through this period of decline. In consequence, it incurred substantial losses, which heightened its vulnerability and undermined market confidence in its business.
With hindsight, the FSA recognises that its supervisory approach before the crisis was inadequate. As it undertook little fundamental analysis of trading book inventory, and did not focus on valuation issues, neither the FSA nor RBS were able to predict the true extent of loss subsequently incurred as a result of RBS’ credit trading activities.
— Acquisition of ABN AMRO
The acquisition of ABN AMRO, the largest cross-jurisdictional acquisition in history, greatly increased RBS’ vulnerability. The report explains that RBS proceeded to bid for the company without giving full consideration to the risks involved, and with inadequate due diligence. RBS’ decision to fund the acquisition primarily with short-term debt significantly eroded its capital adequacy and made it more reliant on short-term wholesale funding.
The FSA admits that it was “not sufficiently engaged” when informed of the bank’s intention to make a bid, in terms of testing in detail the potential capital/liquidity implications as well as challenging the adequacy of RBS’ due diligence. This, however, reflected the FSA’s supervisory approach at the time, when supervisors were encouraged to rely on the assurances given by firms. The FSA confirms that its approach to major takeovers is “now considerably more intrusive” and proposes that, going forward, major bank acquisitions should require explicit regulatory approval.
— Systemic Crisis
Given the intensification of market uncertainties in 2008, compounded by the collapse of Lehman Brothers, banks were inevitably extremely vulnerable to failure. While the rights issue initially placed RBS in a strong capital position, in hindsight, its true loss-absorbing capital was actually very weak. In view of the bank’s capital position, reliance on short-term risky short-term wholesale funding, and poor asset quality, RBS was consequently seen as one of the most vulnerable banks in the UK. According to the FSA, “there was little, if any, action that could be taken to improve RBS’ deteriorating position.”
Management, Governance & Culture
While many of the causes of RBS’ failure were systemic, the FSA concludes that poor decision-making by RBS’ board and senior management in 2006 and 2007 were “crucial” to the bank’s failure. In the FSA’s view, there were underlying deficiencies in the bank’s governance arrangements, particularly concerning its attitude towards balancing risk with growth. Of the many criticisms made, the FSA argues that the bank was overly focused on revenue, profit and earnings per share, rather than on capital, liquidity, and asset quality.
Who is Accountable?
The FSA’s decision not to bring an enforcement case against the bank (on the basis that it would be inappropriate to sanction a bank that had already failed) or against its former top executives (as there is no clear evidence of personal culpability) has sparked considerable controversy.
Many, like Professor Bob Garrett, visiting professor at London’s Cass Business School, take issue with the fact that the report “fails to tackle the issue of director and senior liability.” To Garrett, “[t]he odd thing is that according to Report and the Government’s lawyers no-one can be seen as accountable and liable.” In his view, this is “patent nonsense.”2 Some have gone further, expressing dissatisfaction that senior executives at the FSA remain unpunished for failing to sufficiently supervise and regulate RBS in the lead up to the crisis.
Introducing Strict Liability
In his foreword to the report, Lord Turner, chairman of the FSA, stresses the importance of ensuring that bank executives and boards “strike a different balance between risk and return than is acceptable in non-bank companies.” To this end, bank executives should, he argues, face different personal risk return trade-offs compared with non-bank directors and boards. This could be achieved, for example, by the introduction of a strict liability regime for the adverse consequences of poor decisions. Adopting such an approach would, however, give rise to a wide array of complex legal and human rights issues and could potentially discourage top talent from working within banks in the future owing to the high degree of personal liability involved.
The FSA’s Approach
In hindsight, it is clear to the FSA that its supervisory approach in the run up to the crisis was deeply flawed. It admits that it focused too heavily on conduct regulation, and that its prudential supervision of the country’s major banks was inadequate. In the FSA’s view, this approach “reflected widely held, but mistaken assumptions about the stability of financial systems.”
The report stresses that the FSA is a completely different organisation now, with a greater focus on capital, liquidity, and asset quality. The creation of the Prudential Regulation Authority, with a clear focus on the prudential regulation of some 2,500 banks, insurers, and the larger, more complex investment firms, will also help ensure that a focus on prudential risk is maintained at all times.
Moreover, the FSA argues that the prudential regulation in force before the crisis was “severely deficient.” Banks across the globe, not just RBS, were operating on levels of capital and liquidity that, in retrospect, were far too low. Since the onset of the crisis, national and global prudential regulatory standards have, however, been, radically reformed, particularly with the introduction of Basel III.
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