Making It Happen: Fred Goodwin, RBS and the men who blew up the British economy

by Iain Martin

  Throughout Tiner’s tenure there was concern in the FSA about Goodwin’s assertive behaviour and the management of RBS. The FSA’s requests for individual meetings with the members of the Royal Bank board were rebuffed when the regulators wanted to test claims that Goodwin bullied the board. Goodwin, says a colleague, didn’t want board members ‘telling tales out of school’ about his behaviour, so the FSA could meet the board only as a group. The regulator complained to George Mathewson on several occasions, who responded that the board he chaired put up sufficient challenge to the chief executive. Such was the extent of the supervisors’ concerns that in October 2004 the FSA management considered ordering a ‘166 review’, in which it would hire an outside firm to conduct an independent investigation into RBS. In the event, assurances from several board members that they were not dragooned by Goodwin were enough to satisfy the FSA, which stopped short of launching a formal investigation. Goodwin, it seemed, also realised he had gone too far and urged on by Mathewson he undertook to be more helpful to the regulator after a ‘clear the air’ meeting that he held with the FSA in late 2004. After this the FSA even allowed Goodwin to soften a letter it planned to send to the Royal Bank board, which dealt with concerns the regulator had that the bank’s ‘stress testing’ was inadequate. The draft was sent to Goodwin and he amended it.

  If the FSA still had concerns, by the autumn of 2006 the regulators hoped that the arrival of a new chairman, McKillop, would mean Goodwin came under greater internal scrutiny than perhaps had been the case with Mathewson. It was also thought that Guy Whittaker, the new finance director who had come from Citigroup in the United States, was sufficiently worldly-wise to take on Goodwin if necessary. The FSA management was reassured.

  The supervision team in the FSA dedicated specifically to overseeing the Royal Bank was, anyway, very small. In 2005 only one manager and six officials were charged with scrutinising this rapidly expanding bank. A curious decision was taken in April 2006 – to keep separate the teams that looked at retail banks and those that supervised mainly wholesale financial activities. Hector Sants ran the latter while Clive Briault ran the former. There was certainly some cooperation between the two teams: ‘Clive’s lot would ask Hector’s team for advice and support when they were coming to see us, so they talked,’ says an RBS executive in GBM. Not enough, perhaps.12

  ‘What I really think they didn’t understand at the FSA,’ says a board member at RBS, ‘is that the Royal Bank was a retail bank that now had a mini, or not so mini, Goldman Sachs lodged inside it.’ Trips were made by FSA teams to Greenwich, in Connecticut, to interview Jay Levine’s staff, and there was some scrutiny of GBM’s credit and risk processes in London and elsewhere. Nothing substantial showed up, although there were recommendations that GBM improve its governance procedures, to keep track of its activities in the United States and fifty-three other countries. The FSA was then satisfied this had been done. In February 2007 the decision was taken to have ‘fewer but better’ staff looking at RBS and other banks. This left the team badly stretched. At one point there was just one staff member focused on GBM, who was also responsible for scrutinising Barclays Capital, Bob Diamond’s giant investment banking arm at Barclays.

  The main focus in the supervisory teams under Briault – including the group looking at RBS – principally involved checking that RBS’s procedures in areas such as credit and risk were in line with what was laid down in the regulations. The bigger question of liquidity – was it certain that a bank with such a large balance sheet could safely lay its hands on enough money – was not regarded by the FSA as a central concern. It was referred to at points in speeches by officials and reports, but never pounced on as a potentially fatal weakness. Anyway, there was no expectation that there would suddenly be a shortage of money. Supposedly the Value at Risk (VaR) system also meant that the banks had clearer sight than ever before of what was at risk as their balance sheets expanded. At Tiner’s management meetings participants remember almost no discussion about the safety of the banks, for good reason: it was hardly mentioned. ‘Prudential’ matters were a low priority barely touched on there or at the board. Between January 2006 and July 2007, only one topic out of sixty-one discussed at the FSA board dealt with the risks that banks were taking. In the same period, the FSA director responsible for regulating RBS and other retail banks reported 229 items to the board. Only five of them related to ‘bank prudential issues’. In Tiner’s annual report in that period, the chief executive reported on 110 items. One of them related to bank safety.

  If the FSA was not robust, might the Bank of England – which still had responsibility for the overall stability of the financial system – take a lead? No. Shortly after Tiner took over at the FSA, there was a change of the guard at the Bank of England too. Sir Eddie George, the chain-smoking governor who had been its bulwark, retired at the end of June 2003 to be replaced by Mervyn King, until then his deputy. King came with a formidable academic record and a clear view of what the Bank of England should be doing. As deputy governor he had been the architect of an innovative new approach to economic policy in the UK, after the pound fell out of the ERM, the European Exchange Rate Mechanism, on 16 September 1992. That had represented the end of the government’s doomed attempt to create economic stability and control inflation by pegging the pound to the then all-powerful Deutschmark. When that failed, spectacularly, King suggested instead that the central bank, the Bank of England, should concentrate remorselessly on targeting inflation by adjusting interest rates up or down according to what the Monetary Policy Committee, which he chaired, voted for. John Major’s government bought the idea, and Gordon Brown continued the policy, even giving the bank and the MPC independence. Brown boasted that it had helped deliver an unprecedentedly long period of low inflation.

  Broader financial stability, the responsibility that had been left with the bank after the establishment of the tripartite system seemed hardly to interest King at all, compared with an obsession with perfecting his policy on tackling inflation and meeting the target set by the government. He did not present the bank’s reports on financial stability, although he did preside at the press conferences when it was time for the news on inflation. He rarely attended meetings of the Financial Stability Committee and it became, as Chris Giles the economics editor of the Financial Times later reported, ‘a talking shop’.13 In 2006, a senior civil servant, Sir John Gieve, was appointed as deputy governor responsible for financial stability, as well as being given a seat on the MPC. He was an odd choice. Gieve had had a notably torrid time in his previous post, as Permanent Secretary at the Home Office in the scandal-hit period immediately before Labour Home Secretary John Reid infamously described the department as ‘not fit for purpose’. Yet rather than him being retired, he was moved to a role that might be pivotal in the event of a financial crisis. Regarded as a decent man, it was difficult to see his appointment as anything other than him being ‘parked’ in the Bank of England after a bruising few years in Whitehall. There were suggestions that he lacked contacts in the City, and in banking, but his division was anyway looked down on in King’s Bank of England.

  Gieve made several confusing speeches in 2006, in which he touched on systemic risk. In July 2007 he seemed to sense that something potentially serious was up, as a result of the slump in sub-prime housing in the United States, although he could not quite articulate it in terms that made any impact. He concluded by being on message with the governor. The US housing market was on a downswing and there might be difficulties resulting in the boom having been combined with massive expansion in the new derivative markets. The picture, he noted, was cloudy. ‘It is our job on the MPC to work through these issues and reach a judgement on them. Our target is to reduce inflation to 2 per cent and keep it there. I can assure you that we will do whatever is needed to achieve that.’14 By then Gieve was being frozen out, anyway. Paul Tucker, the deputy governor charged with responsibility for markets, was certainly growing more concerned abou
t the impact of the decline in US housing. But this was tricky territory. The governor’s model – concentrate on the business of managing inflation and all else will follow – was malfunctioning, and King was not known for his ability to admit mistakes.

  The accountants were supposed to be another line of defence. A bank must be audited, in effect to confirm to shareholders and customers that its accounts and valuations add up and are in keeping with the law. By the eve of the financial crisis these firms themselves had been transformed too. If there had been consolidation and complexity in banking, with fewer and much bigger banks, in accountancy the trend had been even more marked. There are now only four such firms – the ‘Big Four’ – operating in the UK (Deloitte, PWC, KPMG and Ernst & Young). It is said that smaller firms do not have the resources to audit a large bank properly.

  Just as bankers and regulators had Basel, auditors in the UK from 2005 put faith in their version of the International Financial Reporting Standards (IFRS) which allowed a generous way of calculating what provisions banks should make to cover potential losses on loans. This had the effect, argue critics, of making bank profits bigger, or look bigger, and of increasing the bonuses linked to profits. It contributed to banks being able to take on greater leverage and lend more. And then the auditors would sign their accounts off, and enjoy higher fees as they had to audit banks that were getting larger. This put the auditors in a highly profitable and ethically questionable bind.

  RBS was not entirely straightforward to audit. Goodwin was instrumental in removing the old auditors, PWC, and in the spring of 2000 Deloitte won the contract. Goodwin, it is said by former RBS executives, wanted an auditor which would be much more cooperative, and Deloitte was Goodwin’s alma mater. Touche Ross, where Goodwin had risen so fast, had become part of the firm in the UK. The senior partner in Deloitte was his old mentor John Connolly, who had talent-spotted Goodwin as a rising star at Touche Ross, and then helped make him the firm’s youngest partner. As a result Goodwin and Connolly were often bracketed as friends, although it was more complicated than that. Goodwin as RBS chief executive was intensely demanding of Deloitte staff and as a result the Royal Bank was regarded by Connolly’s team as a ‘pain in the arse’ client that paid well. Connolly himself was a blunt, sharp-elbowed, racehorse-owning boss, a fanatical Manchester United fan and friend of Sir Alex Ferguson, who ran his firm extremely hard, for the maximum profit. The relationship with RBS was a valuable global contract for the firm and Goodwin, a tricky customer, had to be attended to.

  Initially, Deloitte moved a senior partner to its Edinburgh office, in the city’s George Street, who reported to headquarters in London. Albert Hazard (appropriately named for an accountant) was installed so that RBS could have a senior man on hand to minister to Goodwin. It was a worthwhile investment for Deloitte. The Royal Bank’s growth was good business. When the audit contract began in 2000 it was worth £5.5m in fees to Deloitte, but as the Royal Bank expanded and its structure became more complicated, the auditor could earn much more. By 2006 the contract was worth £9.9m and in 2008 £38.6m. On top of the audit fees, Deloitte was also awarded other work for advice on tax or corporate finance. In 2008 it amounted to £20.1m. In the year of the financial crisis alone Deloitte’s connection with Goodwin had paid off to the tune of almost £59m.

  Surely the auditors in this period were at least maintaining a proper dialogue with the regulator, the FSA, to flag up any concerns they might have? Again, not really, no. Auditors have protection in law, allowing them to raise privately with a regulator anything they discover that they do not like the look of. When the Bank of England ran regulation there was such contact. Once the tripartite system was established after 1997 it seems that it dwindled to almost nothing. As the FSA later admitted: ‘The regular practice of auditor-supervisor meetings fell away gradually following the transition from the Bank of England to the FSA as banking supervisor.’ In 2011 the House of Lords Economic Affairs Committee inquiry into the power of the big four15 found that: ‘In 2006 there was not a single meeting between the FSA and the external auditors of either Northern Rock (PwC) or HBoS (KPMG), and only one meeting between the auditor of RBS (Deloitte) and the FSA; and that in the whole of 2007 there was only one FSA/auditors meeting with each bank auditor.’ In 2008, with the financial world ablaze, there were no meetings between the FSA and Connolly’s firm Deloitte about RBS. The auditors and regulators were not communicating. Another line of possible defence against disaster was full of holes.

  None of this seemed apparent in 2007. In July of that year, Tiner left the FSA and said: ‘This seems to me to be the right time to pass on the baton, with the FSA set firmly on the road to more principles-based regulation.’ Next, he was appointed to write a report for the government on the corporate governance of the National Audit Office. It was as though there was an establishment ‘revolving door’. Ed Balls, then the Economic Secretary to the Treasury, Brown’s friend and most trusted adviser, also praised the FSA in generous terms. When the National Audit Office published its review of the regulator, Balls welcomed the findings: ‘The report shows that the FSA is working well, and is a world leader in a number of areas – which can only be good for the competitiveness of the UK financial services sector.’ At a meeting with Gordon Brown on 30 April 2007, the chairman of the National Audit Office said that the FSA was ‘an institution that the UK can be proud of’.16

  Two months after Tiner left the FSA and handed over to Sants in the summer of 2007, the FSA was then blindsided by the run on Northern Rock, when credit markets froze. Deirdre Hutton also left the FSA as deputy chair in 2007, and was soon appointed by the government to chair the Civil Aviation Authority. She remarked shortly afterwards: ‘I don’t know anything about aeroplanes.’17 She had thought about this, however, and concluded that she had skills, developed in many quangos such as the FSA, that were transferable: ‘My main interest, I realise after quite a long time working, is making organisations work properly.’ Hutton was replaced at the FSA by Crosby, the former boss of HBOS who had been on the board since 2004. He had left HBOS in January 2006 on ‘a high-note’ recorded the Financial Times. A knighthood followed. Later, only months before the banking system failed, and Crosby’s old bank HBOS had to be bailed out, he was appointed by the government to lead a taskforce looking at the workings of the mortgage industry.

  When it came to HBOS and more importantly the much bigger RBS, a bank that had grown from minnow to mammoth in just seven years, there was little in the way of searching scrutiny. The regulatory authority was pursuing light-touch, ‘principles-based’ oversight. In the case of RBS, the auditor Deloitte was doing well out of a difficult client. The Governor of the Bank of England was focused narrowly on managing interest rates and had little regard to what was going on in RBS or any of the other banks, whose balance sheets now dwarfed the rest of the UK economy. And the Chancellor who had presided over an extraordinary boom – marked by an explosion in levels of personal indebtedness – was getting ready to move next door and become Prime Minister.

  On the evening of 20 June 2007, Gordon Brown turned up to make his last speech as Chancellor at the Mansion House. This annual address is when a Chancellor gives the grandees of the City, assembled for dinner, his assessment of the prospects of the UK economy. That night an excited Brown was only a week away from realising his ambition of making it to Number 10. He fizzed with the possibilities of what lay ahead and spoke of ‘a new world order’ unleashed by global trade. He was, he said, ‘more optimistic than ever about the future of our islands, just one per cent of the world’s population, in this new era of globalisation’. The City had shown the way to the rest of the country, Brown claimed. Together, as Chancellor and City, he told his audience, they had been involved in creating what he considered an ‘era that history will record as the beginning of a new golden age for the City of London’. Britain was, Brown said, ideally placed to capitalise: ‘While never the biggest in size, nor the mightiest in military hardware
, I believe we are – as the City’s success shows – capable of being one of the greatest success stories in the new global economy. Already strong in this young century, but greater days are ahead of us.’ Stability must remain the watchword, he observed. After all, Britain was a ‘world leader in stability’, and Brown promised to ‘entrench that stability, by ensuring Britain’s macroeconomic framework remains a world benchmark’. This would very soon be proved to be Panglossian propaganda for a doomed experiment. It was delusional drivel.

  That same month, Mervyn King’s pivotal role was also being celebrated, in a fitting location. The Society of Business Economists hosted a private dinner to mark the tenth anniversary of Gordon Brown granting independence to the Bank of England, with King as the guest of honour. Economists and various dignitaries, including former Governor Eddie George, who was now Lord George, gathered in the City for drinks and then a convivial discussion over dinner. It was a chance for King to relax among friends and reflect on the achievements of recent years. The Governor was a little worried, belatedly, about the exuberance of the markets. He had mentioned it in his speech the evening of Brown’s last address at the Mansion House as Chancellor. But inflation was low and growth had been strong, with only minor deviations, for almost a decade and a half. The venue for this private dinner had been booked by RBS’s chief economist. It was held at 280 Bishopsgate, on the twelfth floor, in the dining room just along the corridor from Sir Fred Goodwin’s office. Goodwin sent his apologies. He would very much have liked to be there, but he was too busy in meetings about RBS’s attempted takeover of the Dutch bank ABN Amro.

  12

  Double Dutch

  ‘We face 2007 with confidence’

  Fred Goodwin presenting the annual results on 1 March.