by Iain Martin
It was in this spirit that the Royal Bank of Scotland advanced for most of its history. In England too were bankers at Barclays,1 founded by Quakers, and Lloyds,2 who operated according to exactly the same set of assumptions, although they only became joint-stock banks, with a large pool of shareholders, much later than the Royal Bank and the Bank of Scotland which had operated on that model from their inception. It was an important distinction. A bank that issued shares could use those funds to increase its activities. There was limited liability too, meaning that investors and directors were not liable for the total debts of the bank. It helped increase the availability of capital, aiding those who wanted to expand their businesses. Only from 1826, after a series of Acts of Parliament, was the model widely adopted in England. The Scots could claim, and did, that they were innovators, running ahead of their neighbours. Across Britain, savings banks and building societies established as mutuals, which were owned by those who saved with them, also proliferated.
By the end of the twentieth century the expansion of global trade had led to a transformation in the scale and complexity of what banks could do. Leverage – the amount a bank is prepared to lend compared with the amount of capital its executives think sensible to keep to guard against disaster – had been steadily increasing as bankers grew more confident that they could manage the trade-off between risk and potential reward. More lending meant more international trade by companies; more trade meant more demand for lending, subject to periodic economic downturns. Other less straightforward types of banking were prospering as well, of course: well-established American investment banks such as Goldman Sachs and Lehman Brothers, who advised companies wanting to do deals and raised the money from the markets for them, also profited on their own account by trading shares, bonds and currencies. The arrival of the computer and the creation of vast trading floors increased enormously the potential for them, and others, to make money from the wave of money now washing across continents. There was also a huge demand from corporations for the new products being invented by investment banks that might hedge against risks.
London became the leader in foreign exchange, the trading of money. It might be done on behalf of companies moving money to pay a supplier in a different country or it could be one of millions of transactions carried out for its own sake. Repeatedly slice off a slither of profit as the money flows across borders and the cumulative result might be a vast return. By 2012 the UK had an estimated 38 per cent share of the global foreign exchange market, with an astonishing daily turnover in London of $2000bn.3 In the region of 40 per cent of the global derivatives market – futures, options and contracts which derive from underlying assets – is also traded in London.4 Customers are betting that the price of a particular share price or a commodity such as wheat or oil, or an interest rate, is going to go in a particular direction. At any one time there are $640 trillion in contracts out there being bought, sold and renewed, aided by computerised trading that can facilitate rapid decision-making based on tiny movements.5
While this might seem to have little to do with the activities of a conventional and supposedly ‘boring’ British bank, such as RBS, the high-street banks were not insulated from these innovations. In fact, such was the scale of the potential rewards that some wanted to take part, even if initially it was just on the fringes. The deposits that customers put into a bank provided cheap funds for aggressive trading desks to use. The bigger profits they made could then be recycled as loans to customers or the payment of dividends to shareholders. Anyway, trading in this fashion, while risky, is potentially more exciting than the unglamorous work on the other side of banking, of managing relations with a corporate customer who wants an overdraft. It was another virtuous circle, in theory. The traders benefited from association with a solid retail bank and made profits that the conventional bankers could use in part to make more loans to businesses and those seeking mortgages. The old banks were not, initially at least, much good at this. Barclays’ early attempts to diversify in this direction were not a success, and it was arguably only with the arrival of Bob Diamond that it found a way of making proper money out of being a so-called ‘universal bank’, which does almost everything from ordinary retail banking through to complex investment banking.
Another trend was apparent in the UK. The number of banks decreased steadily after a period of marked consolidation, with takeovers and mergers undertaken in pursuit of scale and efficiencies.6 In 1960 there were sixteen UK clearing banks – so described because they can clear cheques between two parties. That sixteen has since been reduced to five. Subsumed within RBS itself are eight of those fifteen others from 1960: National Provincial, Coutts, District, Westminster, Williams-Deacon’s, Glyn Mills, National Commercial and National. Even though some of those had been minor banks, there is no doubt that by the turn of the century British banks were more concentrated, serving a far greater number of customers and engaging in a wider range of activities.
And banks grew dramatically in size. The Bank of England reported in 2010 that, collectively, the UK banks’ balance sheets were now more than 500 per cent of annual UK GDP – gross domestic product being what the country produces each year. In 1960 the combined balance sheets of the sixteen clearing banks amounted to £8bn, representing just 32 per cent of GDP. By 1990 it was 75 per cent of GDP and by 2000 143 per cent. The BoE noted in 2010: ‘Three of the four largest banks individually have assets in excess of annual UK GDP. Relative to the size of the national economy, the UK banking system is second only to Switzerland among G20 economies, and is an order of magnitude larger than the US system.’
At root, this is why George Mathewson at the Royal Bank of Scotland and his rival Peter Burt at the Bank of Scotland fought so hard for the chance to buy NatWest in early 2000. The consensus was that with banks enlarging themselves, smaller banks had to catch up or face obliteration in a financial revolution. The idea that one or other might choose to carry on at roughly the size they were – making a healthy profit sensibly and employing people – went unmentioned as shareholders cashed in, selling their shares when a decent offer came along.
It was recognised internationally that the expansion of finance in countries such as the US and the UK brought dangers for the banks, the bedrock of the financial system, and for the rest of us who depended on them. How might these increasingly intricate and enormous institutions be regulated to ensure they were not going to blow up with potentially catastrophic consequences? This dilemma exercised regulators and central bankers when various scares in the 1970s demonstrated how internationally ‘interconnected’ banks had become. In the 1980s, in the unprepossessing Swiss city of Basel, bankers and regulators had a first proper attempt at regulation. They understood that the risks apparent in a bank run were magnified many times when one factored in the size of banks and the potential for a cross-border emergency. A run at an important institution, one with operations in other countries and a web of links with other international banks, might destroy confidence and damage the global economy. What they agreed eventually – although they were actually bounced by the authorities in New York and London – sounded plausibly as though it would deal with the problem. In Basel I, in 1988, and then in Basel II, published in 2004 although never fully implemented, minimum standards were laid down for how much capital banks must keep.
Big banks are often reluctant to keep more capital than the bare minimum. They are under pressure from some shareholders to hold as little of it as necessary because they would rather that as much of the profits as possible go to them. The Royal Bank under George Mathewson and Fred Goodwin adopted a policy known as ‘efficient capital’, which meant running capital a little lower than might be ideal on the basis that their business was historically sound and they knew what they were doing. When Tom McKillop asked about this he was told by Goodwin: ‘Our investors like it.’
Under Basel a bank’s assets were rated, in five categories, according to how risky they were. Banks had to hold roughly 8
per cent of the total value in capital, and a lower number for what was termed ‘core tier 1’ capital, of ultra-safe assets. It was appreciated that the value of the bank’s assets could deteriorate unexpectedly and rapidly. But how might a bank keep track of this? The stock market crash of October 1987, when markets in London, New York, Hong Kong and elsewhere fell dramatically, concentrated minds. If banks had enormous portfolios of all kinds of assets on their books – loans, bonds, securities, stocks, derivatives – they needed a way of being able to measure at close of business each day how it was looking. Increasingly complex risk management systems were evolved in banks to monitor the extent of the exposure and flag warnings, particularly in trading. A lot rested on the adoption of something called VaR, Value at Risk, which teams of risk managers and risk committees inside the banks used to assess, according to various formulae, how much a bank might lose on a particular asset in an emergency.7 It was supposed to be an early warning system. It had been developed by a team at J. P. Morgan in the early 1990s and computer-assisted modelling was integral to the process. VaR was pivotal to the expansion of banks, and what was to follow, because it created a sense of reassurance and confidence. The teams of risk professionals that managed the process checked that the traders were acting within the VaR guidelines set for the bank, and if they were then all was probably fine. Risk was being measured, modelled, every day, constantly.
The increased complexity of banking did not make life easy for national regulators, who still had oversight of their country’s banks even though it was hoped that international agreements had made the system safer. After the Big Bang of 1986, Margaret Thatcher’s government had relied on a network of committees to try to police the City, in a system of self-regulation, with bank supervision overseen by the Bank of England.8 When Gordon Brown became Chancellor in 1997 he wanted a much simpler system and a beefed-up single body modern enough to cope. In the event, after his row with the Governor of the Bank of England, a messy compromise was agreed. Instead of the Bank of England losing its traditional oversight of bank regulation entirely, the ‘tripartite’ system was established in which the Financial Services Authority (FSA) handled the day-to-day monitoring, the Bank of England was supposed to consider the stability of the overall financial system and the government, in the shape of the Treasury, kept in touch with both. Howard Davies, a technocrat who had worked for the Treasury and the Foreign Office, ran the CBI and would go on to the top job at the London School of Economics. He set up the FSA as executive chairman then left in 2002. Later the organisation was criticised for its performance in that period in the run-up to the collapse of Equitable Life, England’s oldest insurance provider.
The successor to Davies as chief executive in September 2002 was John Tiner, a high-flying accountant who had been hired the year before to oversee the insurance side of the FSA’s activities. Tiner had a gift for timing his exits. He had left the auditor Arthur Andersen in 2001, only months before it collapsed in 2002 over its involvement in the Enron scandal, and he later departed the FSA in July 2007, hailed at the time for the good job he had done regulating financial services. Arriving at the FSA’s offices in the North Colonnade of Canary Wharf, Tiner was no greenhorn when it came to banks. He had led the team at Arthur Andersen hired by the Bank of England to investigate the collapse of Barings Bank when it was brought down by the activities of the trader Nick Leeson in 1995. Tiner knew about bank runs and how quickly a piece of exotic trading could go wrong.
The FSA boss, supported by the organisation’s new chairman Callum McCarthy, subscribed to a then fashionable theory. If the banks had become so intricate, with vast risk-management teams and access to the cleverest thinking and computing, then no state regulator or state employee could hope to outsmart them. There was no point in the regulator tying up bankers in complicated sets of specific rules, when they already had to comply with Basel and the laws governing accounting. Better to set broad principles on conduct to which the banks could sign up. Eventually, he and his colleagues hit upon the idea of rewarding those who cooperated by granting a ‘regulatory dividend’ of lighter scrutiny. This was termed ‘principles-based regulation’. Much of the rest of the FSA’s work was in consumer protection, examining the products that banks or other financial services providers sold, while the teams dedicated to monitoring the conduct of the individual banks were small.9
Says one of his colleagues from the FSA: ‘John is a very nice man who just happened to get it completely wrong.’ Tiner’s thinking was certainly very much in line with the mood of the age. The bankers, in charge of such large organisations, now had an extraordinary degree of privileged access to senior politicians who shared the prevailing view that regulation should be ‘light touch’. Chancellors had long invited in groups of bank chief executives for conversations, to get a sense of what was happening on the ground in the economy. Now bankers were treated more like dignitaries and ushered into private un-minuted individual meetings in Number 10 and Number 11, and invited to sit as experts on government ‘taskforces’. It was hoped that the innovative, expansive spirit of banking would imbue other areas of economic and national life.
The Conservative opposition, having initially issued some warnings about the dangers of the tripartite system, generally came to accept the situation. After all, in regard to the City, Blair and Brown were continuing the work started by Margaret Thatcher and Nigel Lawson, which had been designed to make London once again a world financial capital. By 2007 the financial services sector in the UK was paying the Exchequer £67.8bn in taxes, which accounted for 13.9 per cent of the overall tax collected by the government that year.10 In such a climate, bankers who complained to the Prime Minister and Chancellor about regulation found that their concerns were taken seriously. Even the much heralded ‘light touch’ was deemed too heavy. On 26 May 2005 Tony Blair made a speech in which he attacked excessive regulation: ‘Something is seriously awry’, he told the Institute of Public Policy Research, ‘when the Financial Services Authority that was established to provide clear guidelines and rules for the financial services sector and to protect the consumer against the fraudulent, is seen as hugely inhibiting of efficient business by perfectly respectable companies that have never defrauded anyone.’ Callum McCarthy, the chairman, was so stung by the criticism that he wrote to Blair, assuring him that regulation was proportionate. Brown in particular found that Fred Goodwin was particularly persistent in complaining about the FSA. Much later Brown started to wonder if this, the chance to lobby him on regulation, had been the main reason that Goodwin was prepared to spend so much time with him in meetings and at dinners. At the time Brown was clear what he wanted, however. On 24 May 2005, at the launch of his Better Regulation Action Plan, he said: ‘The new model we propose is quite different. In a risk-based approach there is no inspection without justification, no form-filling without justification, and no information requirements without justification. Not just a light touch but a limited touch.’
Even without such pressure, the Royal Bank itself was not an easy bank for the FSA to regulate when Tiner took over. Goodwin’s personality saw to that. According to his colleagues, the RBS chief executive initially had difficulty taking the FSA seriously, seeing it as an unsophisticated, bureaucratic organisation that caused unnecessary problems without really understanding what modern global banking was about. Its focus was certainly more on consumer protection and less on the scrutiny of high finance and the stability of large banks. Indeed, the deputy chair from 2004 to 2007 was Dame Deirdre Hutton, known by some newspapers as the ‘Queen of the Quangos’, because she made a career out of serving on public bodies. After a spell at the Glasgow Chamber of Commerce, she sat on ten quangos in three decades. She had run or chaired, variously, the National Consumer Council, the Scottish Consumer Council and the Personal Investment Authority Ombudsman Bureau. Until June 2005 she was also a member of the government’s ‘Better Regulation Task Force’, which Gordon Brown had established with the aim of limiting b
urdens on business.
If the extent of Hutton’s banking expertise was questionable, there were others on the FSA’s board who did have more relevant experience. McCarthy, the beekeeping chairman, had worked in senior positions at Barclays, and before that at Kleinwort Benson, as well as spending time as an official in government. Fellow board member Hector Sants was a career investment banker who had switched to regulation. He became head of the unit in the FSA that monitored wholesale activities, which included investment banks. Astonishingly, one serving board member of the FSA actually still ran a bank, a retail bank. James Crosby was the chief executive of HBOS when he was appointed to the FSA board in January 2004. The bank Crosby presided over had a particularly aggressive attitude to lending, as would later become apparent at the height of the financial crisis. When a whistleblower, Paul Moore, attempted to warn his colleagues at HBOS that the bank was taking excessive risks on property and commercial lending he was fired, by Crosby.11
