Hubris: How HBOS Wrecked the Best Bank in Britain

by Perman, Ray

  Bankers lent on the basis of a few simple rules, mostly based on the experience learned from crises past. For example, there was the liquidity rule:

  ‘Lend short and borrow long’,

  a lesson which might have gone back all the way to the Bank’s early struggles against the Darien Company and the Royal Bank. A run on the bank was every senior banker’s ultimate nightmare, so this rule was designed to make sure you could get your money back from those you lent to before you had to repay those from whom you borrowed it. This rule propelled banks to look for personal deposits (now known as retail deposits) because individuals were likely to be saving for long-term aims – to pay the deposit on a house, to buy a car, to pay for a daughter’s wedding or a son’s education, or just against a ‘rainy day’. Having thousands of small depositors also had the advantage that it was very unlikely they would all want their money back at the same time. It was this rule which also deterred banks from offering mortgages. They did not like having their funds tied up for 25 years and preferred to leave this market to the building societies.

  Then there was the lending rule:

  ‘Look at the borrower, not the asset’.

  The test a manager applied was whether the borrower had sufficient income to repay the loan, even if things went wrong. The value of the asset being purchased which might provide security, was secondary because a factory, or a company, or a machine tool was worth much less to a bank which had to repossess it and try to sell it again, than to the businessman who had originally bought it. This test equally applied to individual borrowers when car loans and hire purchase began to be introduced. It meant, in the words of one senior banker, that a Scottish bank manager looked deep into your soul and only when he was convinced that you did not need the money would he agree to lend it to you. A supplicant could quite often be sent away empty-handed with the manager telling him it was for his own good, but it also meant that the bad debts of Scottish banks were low.

  This was not only the result of careful appraisal before an advance was granted. If things did go wrong, Scottish banks were reluctant to call in a loan and write off a debt, particularly if that meant plunging a borrower into bankruptcy. They were prepared to accept reduced or deferred payments until such times as the borrower was in better financial shape. In this they were helped by an accounting regime which was much more lax than it is today. Loans did not have to be publicly branded as ‘non-performing’ or marked down if interest payments were not being met and they could be hidden away in a suspense account until such time as the loan was repaid or the bank finally had to admit that the money had to be written off.

  Supervision of the banking system was the responsibility of the Governor of the Bank of England, a figure held in such awe that it was said that the raising of his eyebrows was enough to deter behaviour of which he did not approve. Mergers of banks had to be agreed by the Governor, who would not sanction hostile takeovers or a bank being acquired by a non-bank company or a foreign bank not under British jurisdiction. Scrutiny of the solvency of individual banks was delegated to deputy governors and other senior officials, but their authority was also absolute. One Scottish executive complained to a Bank of England Deputy Governor that one of his rival banks was almost certainly bust. ‘It is bust when I say it is, laddie, and not before,’ was the reply.

  The primary concern of the Bank of England was to preserve the integrity of the banking system, which ultimately meant protecting depositors from loss, should a bank get into difficulties. Its authority and competence were severely tested early in the 1970s when a sudden drop in property prices following a long, unsustainable boom precipitated around 30 small banking companies into bankruptcy. These ‘secondary banks’, as they were known, had broken both fundamental rules of banking. They had borrowed short to grant long-term mortgages on homes and commercial properties and when the market plunged they were unable to get their money back. They had also been fooled by a period during which property prices had risen dramatically into believing that the value of the assets against which they had lent could not go down. When interest rates were suddenly increased to 13 per cent, borrowers could not afford their massively increased interest charges and property prices plunged.

  What concerned the Bank of England was that not only were the individuals and companies which had deposited money with the secondary banks at risk, but so were large banks, including National Westminster, which had lent to them. It stepped in to support the large banks and oversee an orderly wind-up of the secondary companies. Depositors were safeguarded and the system survived, but at a cost – and not only to the Bank of England. To ensure that the lesson was well-learned by the rest of the banking system, commercial banks were compelled to meet part of the cost. The Scottish banks felt aggrieved since the problem was mostly confined to London and the South-east, but nevertheless had to pay up. Bank of Scotland’s share amounted to £31 million.6 They had also had to meet the cost of mopping up after a more domestic failure a short time before, when the Scottish Co-operative Bank collapsed.

  Regulation and supervision was largely voluntary and relied on all the players understanding the unwritten rules and respecting the authority of the Bank of England. It worked when the participants were confined to the narrow old boys’ clubs of London and Edinburgh but became stretched when the game began to be played over a wider field. The effectiveness of the Governors’ eyebrows was tested at the end of the decade when in response to an agreed bid for the Royal Bank of Scotland by Standard Chartered, a British bank headquartered in London, but with its main activities in the Far East and in Africa, a rival counter bid was made. This came from the Hongkong & Shanghai Banking Corporation (HSBC), which although technically a British bank, was headquartered in Hong Kong, then a British colony. It did not have the support of the Royal Bank board and the Bank of England Governor made clear his displeasure – and was ignored. HSBC went ahead with its bid and looked likely to win until the Government referred both bids to the Monopolies Commission. Both were eventually blocked on the grounds that a bid would damage the ‘regional interest’ of Scotland, but it was widely believed that the real reason was to preserve the authority of the Bank of England.

  The 1970s were not an easy time to make money in banking. The British economy lurched from boom to bust under the Conservative government of Edward Heath, the Labour governments of Harold Wilson and James Callaghan and Mrs Margaret Thatcher’s first Conservative administration. Inflation rocketed reaching 22 per cent in 1975, interest rates were high and the Labour Chancellor was forced to seek a loan from the International Monetary Fund (IMF). Ministers changed policies often. Heath placed restraints on lending, then removed them. Thatcher taxed deposits and abolished exchange controls. Economic growth was sluggish and companies found it hard to move forward.

  The high rate of inflation took its toll on bank costs, which were predominantly wages and salaries. High interest rates gave the banks the opportunity to widen their margins, but high costs and a poor economic outlook did not encourage customers to borrow. In 1978 Bank of Scotland reported a pre-tax profit of £16.7 million, the same in money terms as it had achieved five years earlier. When inflation was taken into account the Bank was going backwards rather than forwards, a conclusion confirmed by the fact that its rivals, the Royal Bank and Clydesdale Bank were achieving much higher returns on their equity.7

  The 1970s was a decade dominated by oil. In 1973 came the first ‘Oil Shock’ when Arab oil-producing countries imposed an embargo on supplies in protest at US support for Israel in the Yom Kippur War. When supplies were resumed, prices were increased dramatically, sending growth rates in Western countries plunging. Further effects took a while to materialise, but in the meantime Burmah Oil, a Scottish-based international oil company, got into trouble and had to be rescued and restructured. Bank of Scotland lost the account, which had been one of its biggest.

  Not all the news was negative. In the early part of the decade oil was discovered in t
he North Sea, bringing dozens of oil companies to Scotland, and in their wake more than 30 international banks looking to finance new developments. The London banks, seeing their international competitors getting near to the action, tore up the century-old ‘Gentlemen’s Agreement’ and opened offices in Edinburgh and Aberdeen. This was initially treated with dismay by those in the headquarters on The Mound who saw only the downside.

  Oil field financing was far outside the Bank’s experience, but it began to get calls asking if it was participating in this or that and younger executives began to press the senior management to take action. In 1972 the Bank recruited its first expert from the oil industry and in the same year, Bruce Pattullo, a 34-year-old manager, persuaded the Treasurer (as the Chief Executive was still called) to allow him to organise an oil conference in London. The event, ‘Scottish North Sea Oil’, held at the Savoy, branded Bank of Scotland as the ‘oil bank’ and led to it being invited to participate in the financing of BP’s Forties oil field.

  By the standards of the time, the total sum to be raised was massive at £360 million, to be split between a consortium of banks. The deal tested the Bank in a number of ways: the structure was complicated, the margin was finer than the Bank had been used to on industrial lending, but also it challenged one of the fundamental lending principles. The lenders would have no recourse to BP, despite its huge assets and strong cash flows from elsewhere in the world. They were to be repaid from the profits of the field and so had to make their own assessment of how much oil it held, how much of it was recoverable and at what price it could be sold. They were being asked to lend against the asset, not the ability of the borrower to repay. Despite its inexperience and misgivings, the Bank was the first to sign up, a move which cemented its reputation in the industry. Forties turned out to be one of the largest, longest-lasting and most profitable of the North Sea fields.

  The Bank went on to part-fund a number of other oil developments, to open an office in Houston, Texas, the US oil capital, and to look at financing elsewhere in the world. At home North Sea business was also boosting its industrial customers in engineering, shipping and construction and providing opportunities for its clients in the investment sector. But in taking up the chances offered, the Bank also crossed another line – it took equity stakes (that is, it owned shares) in some ventures as well as providing loans. The Bank had previously maintained that providing both debt and equity opened it to the risk of conflict of interest. As a pure lender a bank had only one concern – to get its money back – but when it also became a part-owner its loyalties could become divided. It comforted itself by saying that these were exceptional circumstances, that its participation was small and that none of its customers objected; it overturned centuries of practice, but the Bank took the risk nevertheless and mostly did very well out of it.

  The Oil Shock had other repercussions for the banks years later. Higher oil prices meant that the governments of oil-producing countries, companies and individuals, particularly in the Middle East, accumulated huge financial surpluses and began to deposit them with banks in the US and Europe. The question for the banks was where to lend this money profitably. The economies of the developed world were still suffering the effects of the oil price rises and the demand for borrowing was weak, so they turned instead to the developing world, and especially Latin America. Governments there were desperate to borrow and willing to pay high rates of interest. These were not the sort of customers Western banks would normally consider taking on. Their governments tended to be unstable and short-lived, their economies were erratic and corruption and inflation were endemic. But the banks’ executives clung to a belief that countries, unlike companies, could not go bust – the IMF would step in to prevent a default. Third World lending therefore looked like a one-way bet; your money was guaranteed and margins were much higher than you could get anywhere else. Loan officers from US and European banks began touring Central and South America pressing cash on willing borrowers.

  This proposed a dilemma for Bank of Scotland. Lending on the large scale required by governments was done by consortia of banks. The Bank was too small to be part of the leadership of any of these groups, it had no international network of branches and offices and its experience of currency lending was confined to meeting the export needs of its domestic customers. Nevertheless some of the Bank’s executives in the newly formed international division wanted to be part of the action – the margins on offer, even for those lower down the food chain as the Bank would be, were too fat to ignore. Barclays, which had a big shareholding in Bank of Scotland, was also pressing the Bank to take part in consortia which it was leading. The board was cautious about ‘taking crumbs from other men’s tables’, as one board paper put it,8 but nevertheless, the Bank did lend.

  The total debt of Latin American governments quadrupled over eight years while at the same time economic recovery meant that interest rates rose. Inevitably some countries could not meet their interest charges and repayments and panic ensued when first Mexico, then Argentina and Brazil teetered on the edge of default. The consequences for the banks were dire. The total capital of some US and London banks would have been wiped out had they been forced to write off all their lending to the region. The IMF did have to step in, but the sums were so large that all it could do was extend debt terms to allow banks time to write off their loans. Bank of Scotland had the least exposure of any UK clearing bank, but had it had to write off the lot in one go, it would have lost more than a quarter of its capital.

  The international rescue bought time and although the Bank wrote off some debts, it adopted an innovative solution to others. David Jenkins, the Bank’s Economist, was pressed into a new role, travelling South America to negotiate debt-for-equity swaps which saw the Bank acquire, among other things, a hotel on Copacabana Beach in Rio de Janeiro, a tomato-paste factory in north-east Brazil, and a stake in the country’s third-largest paper producer.9 Jenkins, short, bald, dapper, with a wry wit and ready smile, must have cut an unlikely figure touring some of the more remote areas of Brazil and Chile. He turned his adventures into a series of humorous articles for The Scottish Banker magazine.

  4

  Cometh the hour, cometh the man

  At the end of the 1970s a quiet revolution occurred at the top of Bank of Scotland. The appropriately named Tom Risk was appointed one of two deputy Governors.1

  Risk was a corporate lawyer who had been a director of the Bank for some time. Importantly, he had chaired its corporate banking subsidiary, initially named Bank of Scotland Finance Company, but later relaunched with the old British Linen Bank name. His chief executive there had been Bruce Pattullo, the manager who had led the Bank to raise its profile in the oil industry. Risk was a strategist and a shrewd judge of character. Along with some of the other board members he was concerned that the Bank’s lacklustre performance over the previous decade made it vulnerable to a takeover. With the retirement of the Treasurer (Chief Executive) looming, he persuaded his fellow directors to leap a generation, ignore the potential candidates among the general managers and promote Pattullo, who was made Deputy Treasurer and Chief General Manager in 1979 and promoted to the top post the following year at the age of 41.

  It was not only Pattullo’s youth which was unusual. His background made him a very strange animal in clearing banking on either side of the border. Whereas most recruits had joined the Bank from state schools, Pattullo had been educated at prep school, Rugby and Hertford College, Oxford. There he had developed an interest in economics and fancied a career in finance, but while his university contemporaries might have gone into stockbroking or one of the blue-blooded London merchant banks, he opted to join Bank of Scotland as one of the first of a handful of candidates on its new graduate programme. Recruiting from university was a radical departure for the Bank, but any difference to its usual method of training stopped there. Pattullo was still required to work in a branch ‘passing money over the counter’ and to study for the Institute ex
ams, although having acquired the habit of studying on his own at Oxford, he opted for correspondence, rather than night classes. He won the Institute’s first prize in his exam year. As with other recruits, the Bank moved him around, so that by the time he reached the top nearly 20 years later he had acquired a broad experience of practical banking.

  Pattullo was intelligent, rather than clever, thoughtful rather than impulsive. By temperament he was a quiet, cautious man, not given to overstatement. I had known him for a couple of years by the time he was appointed to the Treasurer’s position and I interviewed him for the Financial Times. I asked him his ambition and was surprised by the answer:

  ‘To make this the best-performing bank.’

  ‘The best-performing bank in Scotland?’ I asked.

  ‘The best-performing bank anywhere,’ he said.