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Chairman Howard Davies looks back at the financial crisis

RBS Chairman Howard Davies is giving a lecture today at King's College London entitled: ''Royal Bank of Scotland & The Financial Crisis: Ten Years On". Read the full lecture here.

"We have something of an obsession with anniversaries in this country.

For me, 2018 is principally significant for being the fiftieth anniversary of Manchester City winning the First Division Championship, and with an all-English team. Not so much as a Scot or an Irishman amongst them, and certainly no Argentinians. I have often said that 1968 will prove to have been the last time that is done. But when we have taken back control after Brexit, who knows?

But in spite of that memorable landmark, I suspect more will be written in 2018 about the tenth anniversary of the Great Financial Crisis. You can see it coming. Lectures, books – I recently reviewed a doorstop from Adam Tooze called ‘Crashed’ (ref 1) – and radio and television programmes a go go.

The underlying questions many of them will seek to address are – Could it happen again? and – Have we made good use of the crisis to reform financial markets and institutions and financial regulation?

I have some views on these questions. In shorthand, I think we have done a lot to strengthen the regulated financial system, and particularly banks and insurers. Capital is far stronger, and the incidence of failure should be much reduced as a result, if it can never be eliminated. Regulators have stronger political support and greater self-assurance. Ministers and MPs do not complain that any regulatory intervention will damage the entrepreneurial animal spirits of wealth – creators in the Square Mile, as they did in my day.

On the other hand, there are signs that in squeezing the regulated sector we are pushing risks into the shadows. I worry about new institutions and instruments. Last month the police in Beijing had to disperse demonstrations outside the banking regulator’s head office, complaining about the collapse of peer to peer lenders. I worry about cryptocurrencies, and some of the new fintech ventures. We remain addicted to debt, in Adair Turner’s phrase, and the tax system continues to favour debt over equity.

I worry, too, about the failure to address the curious structural inefficiencies in many regulatory systems. There is nothing approaching a global consensus on how to organise regulation. The US system is a particular mess. As Paul Volcker has said ”virtually every post-mortem of the financial crisis cites the convoluted regulatory system [in the United States] as a contributory factor in the financial meltdown.” (Ref 2) Yet it has not been reformed.

In Europe, too, the banking union remains, in Nicolas Veron’s phrase, ‘timber – framed’ in the absence of a Eurozone-wide deposit protection scheme. (Ref 3)

But if you want to know more on those points you will need to sign up for my course on Global Financial Regulation at Sciences Po, which began again last week. It is far cheaper than comparable Master’s programmes at King’s, I might point out. 

Today’s lecture is more narrowly focused on the RBS story, though of course that is a microcosm, and quite a large one, of the crisis as a whole.

I will try to answer three main questions: 
1. Why has the RBS recovery taken so long?
2. Why is the government very unlikely to recoup all the money it spent on the rescue?
3. What is the new shape and purpose of the bank?

It is a good moment to attempt an answer to those questions, not simply because the ten year anniversary of the rescue is approaching, but because with the very recent payment of a large fine to the US Department of Justice, for sub – prime misdemeanours in 2007 - and the simultaneous restarting of dividend payments, we can reasonably claim that the bank has turned a corner.

The circumstances of the rescue itself have been extensively discussed and debated. It happened five years after I left the regulator, and seven years before I joined the bank. I was hiding in an ivory tower at the time. Nick MacPherson may well wish to comment, but I have nothing very original to add on the events of 2008. There are, however, three points worth reinforcing..

First, the bank was rescued to save the UK financial system from collapse, not as a financial investment. That is how it was justified at the time. The point is relevant when we discuss the price at which the government should sell.

Second, it is often argued that the government would and should have taken the minority shareholders out completely, and paid far less for its stake. I can’t judge that argument well, though bankers who were involved at the time say that the government had little choice but to take the route it did, given the little time it had to act and the scale of funds required.

Third, employees of the bank, and its Board, are acutely conscious of the support taxpayers have provided and are grateful for it. £45.5 billion of public support is a massive commitment that has, particularly in recent years, been an important influence on the chosen strategy. And as Ross McEwan said recently, the government has for the most part been an excellent shareholder, even recognising that there were lively debates in the past about the direction the bank should take.

There is, inevitably, significant public interest in how and why the bank got into the position it found itself in in October 2008. Management undoubtedly carries the major responsibility (Ref 4). There have also been criticisms that Board oversight of the strategy failed to moderate the management’s ambition or properly to assess the risks they were running. The regulators have been criticised, too, notably by the Treasury Select Committee in September 2012, which described ‘a series of failures and misjudgements in supervision.’ (Ref 5)

But it is fair to point out that others shared in the enthusiasm for the RBS strategy. The Fourth Estate were impressed. Fred Goodwin was the Forbes Magazine man of the year in 2003. (Ref 6) Reuters named him best bank CEO.

Parts of academia were similarly persuaded that RBS had found a secret sauce recipe. In late 2003, after the NatWest acquisition, Harvard Business School prepared a case study, co-authored by Nitia Nohria who subsequently became Dean of the School called The Royal Bank of Scotland: Masters of Integration. It concluded that ‘RBS had undoubtedly developed a world-class acquisition integration capability… and had also demonstrated an ability to flawlessly execute exceedingly complex technical and change programs in very short periods of time.’ (Ref 7) That was less in evidence when the bank acquired the international operations of ABN – Amro.

London Business School followed up six months later with a very positive case entitled ‘Royal Bank of Scotland: The Strategy of Not Having a Strategy’ (Ref 8). Again, they were hugely impressed by the NatWest integration, noting that ‘All NatWest’s systems, for example, were moved onto RBS’s platform’. Since RBS and NatWest in England are still on different platforms, that is a surprising conclusion. The lack of a coherent strategy was, again, not a very obvious competitive advantage a few years later.

In fact the markets were not so starry – eyed. As RBS’s profits grew, its P/E ratio fell. There is a distance, however, between lukewarm investor interest and a forecast of doom and there remained strong support for the management team’s ambitions in the markets, as evidenced by the shareholder support for the ill-fated ABN-Amro takeover at the end of 2007. That acquisition left RBS as the largest bank in the world, by assets, in 2008. In retrospect we can see that was precisely the worst moment to be top of the league. We are now at number 29.

The story of the crisis has been told many times. I will not repeat it here. My own exposition, developed in 2009, was used by David Hare in his play ‘The Power of Yes’ at the National Theatre in which I appeared as a mad professor wheeling a blackboard on and off stage as the tragedy unfolded.

As prices fell, and liquidity tightened dramatically, a series of banks found themselves in trouble, some illiquid, some insolvent, depending on the scale of their involvement in the worst affected markets.

I described it as a five-act Shakespearian strategy, with the Acts subtitled Sub-prime, Liquidity, Unravelling, Meltdown and Pumping, as the central banks strove to support the system with money creation on a massive scale. It generated the descriptive acronym SLUMP.

But as the unravelling took place, RBS proved to be one of the worst positioned banks.

Keynes famously observed that ‘a sound banker is one who… when he is ruined, is ruined in a conventional way along with his fellows, so that no-one can really blame him’ (Ref 9)

RBS achieved a particularly extreme version of the Keynes ‘sound banker’ definition. It failed in all the ways other bankers failed as a result of the Global Financial Crisis, which surprised many with its speed and impact. There were many ways of running into trouble, from entering the period of disturbance with low capital, through operating a risky funding structure (both of which were true of RBS after the ABN Amro purchase) to simply bad lending. RBS managed a unique ‘full house’ of problems.

Its pre-crisis growth in some dangerous markets was remarkably rapid. One example among many is the Irish mortgage market, where Ulster Bank, partly through the acquisition of First Active, grew its mortgage lending from £2.8 billion in 2003 to £18.3 billion by 2007 – over a fivefold increase in four years. The property – related losses in Ireland were a more significant element of the bank’s collapse than is generally understood.

So the fall from grace, when it happened, was steeper and deeper for RBS than for most other banks. That is the principal reason the recovery has been so long in coming. I will put some numbers on it in a moment but let us first review briefly the strategic story since 2008.

The decade can be seen as a game of two halves, with the break coming almost exactly five years after the rescue.

That analysis simplifies a very complex story, with many twists and turns along the way, but in broad terms from 2008 – 2013 the high level objective was to maintain RBS as a full-service universal bank, with a significant global network, including a large lending portfolio in the US, and a substantial investment bank. ABN Amro’s Global Transaction Services operations required a large network, offering international cash management services rivalling competitors such as HSBC, JP Morgan and Citi. During this period, although the bank remained very large and broad a lot of progress was made. Many bad assets were sold, and extraneous businesses exited, but the shape remained recognisable.

For a time this strategy looked potentially successful. Markets improved in 2010 and all investment banks recovered. But that provided to be a false dawn and other problems weighed on the bank’s balance sheet – larger loan losses than expected, and a wave of unexpected conduct costs, at a time when capital requirements were growing, much more than had been predicted. Those higher requirements meant that the bank did not have enough capital to support all its activities, and the largest shareholder had no appetite for investing more. That also meant that many marginally profitable business lines became loss-making.

So by 2013 the case for a new approach became overwhelming. Critics argued that the right approach was to set up a ‘bad bank’ to hold the most troublesome assets which still weighed down the balance sheet. In November 2013 the Treasury rejected that idea, after a review (10). The new management, under Ross McEwan, therefore set out a new strategy with Treasury and UKGI support to refocus the bank on its core UK and Irish business, exiting a lot more businesses and activities. In particular, the investment bank would be downsized, the GTS business closed down, and Citizens Bank in the US sold. A Capital Resolution division would manage the wind down of £47 billion of high – risk, poorly – performing assets, a kind of internal bad bank.

There has been, since then, a determined and consistent focus on executing the revised strategy, which has attracted near – universal support from investors, including the private sector stock holders as well as the government. But the near – term consequence was further losses, as losses on disposal of assets and restructuring costs passed through the Profit and Loss Account.

During that period the government has reduced its stake from 84.4 per cent to 62.4 per cent, largely through two sizeable sales, in the summer of 2015 and again this June.

The share price has, however, languished during this period. In part that is attributable to factors which go beyond RBS. European banks are generally unpopular with investors and UK banks have also been affected by the uncertainty surrounding Brexit and the associated risks for the UK economy. But RBS continues to trade at a discount to book value, along with Barclays and Standard Chartered.

Here we get to the nub of the second of my three questions – why is the government unlikely to recoup its investment in full? The ‘in ‘price is generally assessed at around £5 a share, ignoring funding costs in the interim. Even if the discount to book price could be eliminated, the total Net Asset Value per share is now around 287p, down from 363p five years ago. (Slide 13) Why has this happened?

One way of answering that question is by analysing the bank’s losses over the last decade. (Slide 14) The slide shows that during the period from 2008 to 2017 the core operating business of the bank made cumulative profits of around £65 billion. The main franchises of the bank, notably the NatWest mortgage and commercial lending businesses, have held up well. Indeed, our share of the mortgage market has grown. But those profits have been more than fully consumed by losses, and the net position during that period was of £63 billion of losses. So the bank has lost almost £130 billion during the period. That amounts to around four and a half times the bank’s current market capitalisation.

The largest items were loan loss provisions of £49 billion, £20 billion of which related to property and construction, and £12 billion in Ireland. The losses in Ireland alone amount to around 40 per cent of the current market value. The next biggest item is losses on M&A totalling £30 billion, from ABN Amro and Citizens. The third is the conduct and litigation provision, the largest parts of which relate to sub – prime mortgages in the US – the most recent settlement, and to PPI.

It has also been costly to shrink the bank. We have incurred restructuring costs of £15 billion. And more recently we have had to cope with ring-fencing, following the Vickers Report. That has cost around £1 billion in systems changes, and has increased the funding costs of our markets business.

There has also been another significant drag on the bank’s book value which is not captured in these figures.

The government rescue was deemed to be State Aid by the European Commission, and the then Competition Commissioner, Neelie Kroes, imposed a series of approval conditions to offset the adverse impact on competition in a number of markets. Conditions were imposed on other banks in receipt of state support – Lloyds was required to dispose of TSB, for example, but the RBS conditions were very extensive.

The bank committed to a major balance sheet reduction, and specifically to the sale of its insurance activities, now DirectLine, its Sempra commodities business and the business now known as Worldpay (11). The receipts from these sales were material.

Sempra raised $1.6 billion. The 20 per cent stake in Worldpay brought in £2 billion. DirectLine was sold in two tranches for a total consideration of £3.2 billion. The subsequent (in the case of WorldPay which was acquired in 2017 and is no longer traded), and current values of these assets are considerably higher. WorldPay is currently valued at £8.1 billion and Direct Line at around £4.6 billion for example. So the disposals materially reduced RBS’s market value.

The bank was also obliged to effect the disposal of 5 percentage points of market share in SME lending. At the time it was not expected that the net cost of that disposal would be significant. Indeed in 2009 RBS said it ‘expects the EC will require it to dispose of some market share in SME lending in the UK, but it considers that the financial impact is unlikely to be material for shareholders’ (12).

In the event, the attempt to stand – up a separate Williams and Glyn entity proved very costly indeed and ultimately abortive. The recent difficulties of TSB show how complex and disruptive systems transitions can be. RBS incurred costs of £2.4 billion on the exercise, and the replacement scheme, of incentivised customer transfers, involves payments of £775 million to competitor banks. So the total impact is around £3.2 billion.

It seems clear that, in aggregate, the cost of these remedies to the bank and its shareholders was very much greater than could reasonably have been forecast at the time. It is another important reason why the book value of the bank is not greater than it is today.

So where are we now?

The transformation of the bank on the lines set out in 2013 is more or less complete. The share of assets now represented by the UK and Ireland commercial and retail banks has grown from 69 to 85 per cent over the last five years. Almost all of the non – core assets have been sold and the losses taken.

The bank’s capital position is very strong. Core Tier one capital is over 16 per cent, and continues to grow along with earnings. We are more strongly capitalised than the other big UK banks.

After 8 years of losses we became modestly profitable in 2017, an important moment for the bank, and made a profit in the first half of this year, even after settling the DoJ sub-prime fine, which cost us £1.1 billion of top of our pre-existing provision.

For what it is worth 48 per cent of the 21 brokers who cover us now rate us as a ‘buy’. They are particularly focused on the surplus capital we have, over and above our target of a 13% CET1 ratio. There are currently no ‘sell’ recommendations in the market. That suggests something of a dislocation between the views of the Buy and Sell sides.

But numbers are not everything. We still have reputational problems to overcome. The bailout casts a long shadow, and recent CMA data on customer satisfaction rank RBS (as a brand, not the Group) at or close to the bottom of the league. But our most important brand, NatWest, is around the middle of the pack, and the brand is in fact highly rated by commercial customers. Undoubtedly, though, we have more to do on customer service. The focus on survival over a decade has had a cost.

On the conduct side we have resolved the great majority of our outstanding cases, through PPI remediation continues, courtesy of Arnold Schwarzenegger.

For the last few years, since the Tomlinson report, there has been an ongoing investigation into the activities of our Global Restructuring Group. At the end of July the FCA finally issued its verdict. The regulator was critical of the way the bank handled the affairs of a number of distressed companies, which moved into resolution during and after the last recession. The relevant area was overwhelmed by the caseload and was in some cases insensitive and over-hasty. Communication was poor, and unreasonable and complex fees were sometimes charged. But the FCA also concluded that its review “found no evidence that RBS artificially distressed or transferred otherwise viable SME businesses to GRG to profit from their restructuring or insolvency” (12)

We have set up a focussed scheme, under a retired High Court judge, to address specific complaints including claims for consequential loss. That scheme is paying out material sums, within an estimated provision of £400 million. The exercise should complete in 2019. Certain complex fees have been automatically refunded.

With the resolution of most of these outstanding regulatory issues the return of RBS to full private sector ownership is now an entirely realistic ambition for the government, and the Treasury has planned to receive receipts of £3 billion per annum during this parliament. The timing and quantity of sales are a matter for HMG, not the RBS Board. But it is possible that the company could contribute to the sell down by using some of its surplus capital to buy back shares, as part of a wider offer. To do so would require shareholder approval, but the logic is clear. A smaller, less risky bank does not need the size of capital base it had in the past.

So looking at the core purposes of RBS in today’s market they are, first, to provide efficient banking services to its retail customers in the British Isles, in a way which matches their preferences and lifestyle. That increasingly means faster responses, delivered digitally, 24 hours a day. And second, to recycle savings to productive enterprises which will drive future economic growth. These essential purposes were submerged pre – crisis under ever more complex trading transactions, whose link to the underlying purposes of the bank became ever more tenuous, fuelled by growing leverage which in good times magnified returns, much of which found its way into the pockets of the bankers concerned.

Managing risk for sophisticated and complex clients will remain a skilled activity, incurring a range of bespoke transactions. But we must not lose sight of their ultimate purpose.

Against that backdrop, the focus of the Board and management is changing rapidly. Our agendas are increasingly dominated by new technology – driven initiatives. There is not time today to describe most of them. One recent launch, Esme (slide 20) offers extremely rapid loan approval for SMEs, on a platform which has the look and feel of a P2P lender. There will be more initiatives of this kind over the next two years.

So the future for RBS looks very different from the past. No ambitions for world domination, but still stretching and challenging. Finding a new role for a big bank in the new world where Fintechs and GAFAs are eyeing our lunch will not be straightforward. But we have a large and still very loyal customer base, which is an important asset. We are trusted to keep their money safe and to handle their information securely. So we can see a viable future for a private sector RBS, even in a more competitive market.

There could, however, be a rather different future, at least in terms of ownership, if not in terms of the type of business we undertake. The Labour Party commissioned a review from GFC Economics on investment, monetary and banking policy. The final report was published in June and was warmly welcomed by the Shadow Chancellor.  (Ref 13)

The most eye – catching feature was the plan to move most of the Bank of England to Birmingham and for it to set a target for productivity growth. (Mervyn King, an Aston Villa supporter, must think the idea has come fifteen years too late). One deputy governor would be responsible for both interest rates and UK banking supervision and would be able to use credit guidelines and varied risk weights to direct lending to investments which may best contribute to enhancing productivity.

There would also be a Strategic Investment Board, a National Investment Bank and a National Transformation Fund. The NIB on the report says, would ‘act as the lending entity to RBS [which] will be specifically mandated to support the SME market… This assumes that the RBS is still publicly controlled. The RBS would be akin to a development bank’ (Ref 14) ‘in the absence of the RBS taking on this role, the NIB would need to build out an SME lending operation and a regional presence.’

That would amount to a significant change of emphasis for the bank, through not as dramatic as the scheme proposed in the last Labour manifesto, which envisaged RBS being broken up into over 100 regional banks. That was a genuinely alarming idea. The Williams and Glyn experience showed that breaking up is hard to do. And banks heavily dependent on a small geographical area are almost inevitably fragile, as has been demonstrated in the US. Charles Calomiris’ book, Fragile by Design, is a powerful analysis. (15)

If this Parliament runs its full term, the point may be academic, as the government’s shareholding would then be well below 50 per cent. If not, then the precise role of RBS in the SME market will probably not be the subject of the first post-election Strand Lecture. (The series might in any case have to move to the Bull Ring). The fundamental reform of the Bank of England’s role and operations may well attract rather more immediate interest.

For now, we are leaving high politics aside and concentrating on creating the most efficient, reliable and sound bank we can. We are well on the way to achieving it. With that sound foundation in place we can work on rebuilding the trust of our customers, and of the country as a whole, which has been greatly damaged by the last painful decade. Our aim is to repair that damage."

1.      Crashed. Adam Tooze. How a decade of financial crisis changed the world. Penguin Random House 2018.
2.      Reshaping the Financial Regulatory System. Volcker Alliance. April 2015
3.      Europe’s half a banking union. Adam Posen and Nicolas Veron. Bruegel. September 2014.
4.      The failure of the Royal Bank of Scotland: Financial Services Authority Board Report. December 2011
5.      The FSA’s report into the failure of RBS. Treasury Select Committee. 16 October 2012.
6.      Forbes Global. 6 January 2003.
7.      The Royal Bank of Scotland: Masters of Integration. Harvard Business School. Nitin Nohria and James Weber. 18 august 2003.
8.     Royal Bank of Scotland: the Strategy of Not Having a strategy, London Business School. 2 June 2004.
9.     The consequences to the Banks of the collapse in monetary values. J.M.Keynes 1931.
10.   RBS and the case for a bad bank: the Government’s Review. H.M. Treasury November 2013.
11.   Restructuring of RBS. European Commission. 14 December 2009
12.   Statement on the Financial Conduct Authority’s further investigation steps in relation to RBS GRG. July 2018.
13.   Financing Investment: Final Report. GFC economics and Clearpoint Advisors.  June 2018.
14.   Ditto. Page 112.
15.   Fragile by Design: The Political Origins of Banking. Charles Calomiris. Princeton University Press. 2014.
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