Publications
Feature
FSA: Report into the failure of the Royal Bank of Scotland
An article by Norton Rose LLP|
Contact: Katie Wise Date: 19 Jan 2012 |
Print page | Email |
1 Introduction
On 12 December 2011, the Financial Services Authority (FSA) published the FSA Board’s Report into the failure of the Royal Bank of Scotland (RBS). The Report follows investigations initiated by the FSA in 2009 into a series of bank failures during the 2007 to 2008 financial crisis. The investigation into events at RBS was among the most intensive of all those the FSA conducted but its Enforcement Division concluded in December 2010 that there was not sufficient evidence to bring enforcement actions which would have a reasonable chance of success against senior individuals at RBS. In July 2011, the FSA decided to produce a summary account of its enforcement investigations and to supplement this with a more comprehensive report on the reasons for RBS’s failure.
With a review period extending from early 2005 to 7 October 2008, the day on which RBS first received Emergency Liquidity Assistance from the Bank of England (the Review Period), the Report considers the factors that led to RBS’s failure, identifying in addition any key deficiencies in FSA regulation and supervision and explaining the reasons that led Enforcement Division to conclude against enforcement action.
In this article we summarise the Report’s key findings, the reasons why the FSA decided not to take any enforcement action and its recommendations for policy and other regulatory changes.
2 Why RBS failed
The Report concludes that the failure of RBS can be explained by a combination of six factors:
(a) RBS’s capital position and the underlying regulatory framework – The Report considers that crucial to RBS’s failure were the significant weaknesses in RBS’s capital position resulting from a combination of severe deficiencies in the global regulatory capital framework and poor management decisions. The Report recognizes that the Basel II rules applied by the FSA and other regulatory authorities across the world, which were at the time considered ‘sophisticated’ and ‘appropriate’, were, in hindsight, ‘severely deficient’ and ‘dangerously inadequate’, allowing banks to operate with inadequate capital and excessively high leverage.
(b) RBS’s liquidity position and the FSA’s regulation and supervision of liquidity – In the pre-crisis period, RBS had relied extensively on risky short-term wholesale funding, particularly following the acquisition of ABN AMRO. The Report acknowledges that RBS’s over-reliance on short-term wholesale funding was permitted by the FSA’s inadequate approach to the regulation and supervision of liquidity for major firms in the pre-crisis period.
(c) RBS’s underlying asset quality – In the period 2007-2010, RBS suffered significant losses as a result of its highly-leveraged balance sheet, with a particular concentration in commercial property.
(d) Losses in credit trading activities – Following RBS’s decision to expand its structured credit trading business in mid-2006 and the subsequent acquisition of ABN AMRO, RBS became largely exposed to such assets just as the market had started losing confidence in credit trading activities. The Report concludes that both RBS’s strategy and the FSA’s supervisory approach underestimated how bad losses associated with structured credit might be;
(e) The ABN AMRO acquisition – RBS’s leading role in the consortium that acquired ABN AMRO is regarded by the FSA as one of the key factors that increased RBS’s vulnerability, by increasing RBS’s reliance on short-term wholesale funding, eroding its capital adequacy and increasing RBS’s exposure to structured credit; and
(f) Systemic vulnerabilities – The Report concludes that RBS’s weaknesses in terms of capital adequacy, liquidity and asset quality had made it extremely vulnerable to the overall systemic crisis. As a result, RBS was one of the banks most affected by the loss of market confidence that followed the collapse of the Lehman Brothers.
Deficiencies in global regulations and flaws in FSA’s supervisory approach - It is clear from the above that some of the factors that are considered to have led to RBS’s failure were systemic and common to many banks, resulting primarily from deficiencies in global capital and liquidity regulations and from flaws in FSA’s supervisory approach. In relation to the latter, the Report acknowledges that the FSA frequently operated within the context of political demands for ‘light touch’ regulation which were aimed at promoting the competitiveness of UK financial firms.
RBS’s management, governance and culture - The Report also suggests that the multiple poor decisions undertaken by RBS indicate that there were likely to have been underlying deficiencies in the management, governance and culture of RBS which made it prone to make poor decisions and which could be considered as a seventh factor in explaining RBS’s failure. Putting aside the board’s decision about the ABN AMRO acquisition, which the Report clearly identifies as defective, the Report concludes that, although certain aspects of RBS’s management, governance and culture (such as the board’s operation, the CEO’s management style and remuneration package, and RBS’s risk management policies) raised questions as to the effectiveness of RBS’s management operations, it is difficult to be certain how such aspects affected the quality of decision-making. Once more, the FSA’s supervision into these issues proved to be insufficient.
3 Why the FSA has not taken enforcement action
In the foreword to the Report, Adair Turner, Chairman of the FSA, addresses the decision by the FSA’s Enforcement Division not to pursue enforcement action against RBS or specific individuals, citing the following crucial points of principle:
(a) absence in the relevant law and the FSA rules of a concept of “strict liability”. The fact that a bank fails does not make its management or board automatically liable to sanctions. He points out that a successful case needs clear evidence of actions by particular people that were incompetent, dishonest or demonstrated a lack of integrity; and
(b) errors of commercial judgement are not in themselves sanctionable unless either the processes and controls that governed how these judgements were reached were clearly deficient, or the judgements were clearly outside the bounds of what might be considered reasonable. Mr Turner adds that the reasonableness of judgements has to be assessed within the context of the information available at the time, and not with the benefit of hindsight.
For these reasons, it was concluded that, notwithstanding the numerous poor decisions and imperfect processes identified, there was not sufficient evidence to establish a case for enforcement action which had a reasonable chance of success in Tribunal or court proceedings.
4 Recommendations for further changes
(a) Policy changes
Whilst the Report concludes that no enforceable breaches of FSA rules have been identified, it also acknowledges the difficulty that many people will have in accepting the lack of accountability for the wider economic harm that RBS’s failure has imposed on society. The crucial question which, therefore, arises is whether the existing rules are appropriate or new rules and standards are required for the future. The Report flags this issue as meriting careful public debate and argues that key to that debate should be a recognition that ‘banks are different’. Unlike non-bank companies, where the downside of poor decisions falls primarily on their shareholders, the failure of banks can have wider financial and social implications and, therefore, there is strong public interest in bankers taking a different attitude to the balance between risk and return to that which applies in the rest of the economy.
The Report identifies the following policy changes which could ensure that bank executives face “different personal risk return trade-offs” than those which apply in non-banks:
- a legal sanction based approach, introducing a "strict liability” of executives and board members for the adverse consequences of poor decisions, and making it more likely that a bank failure like RBS’s would be followed by successful enforcement actions, including fines and bans; or
- an automatic incentives-based approach, involving either rules which automatically ban senior executives and directors of failing banks from future positions of responsibility, or major changes to remuneration to ensure that a very significant proportion of pay is deferred and forfeited in the event of failure.
The Report acknowledges that these options carry pros and cons which merit careful consideration. In particular, a “strict liability” approach is likely to result in expensive and contentious legal processes and, in some cases, the large personal liability involved might act to deter high quality people from working in banks. The “automatic incentives approach”, on the contrary, would not raise the same complex legal issues, but may prove insufficient to produce the desired shift in personal incentives. By one means or another, however, the Report concludes that there is a strong argument for new rules to ensure that bank executives place greater weight on avoiding downside risks.
(b) Further regulatory changes
Appendix 2A to the Report consolidates the lessons for the FSA’s regulatory framework and supervision identified from the review of the regulation of RBS. It outlines lessons previously identified (where actions in response to the need for change are underway or have already been completed) and recommendations for further changes. Recommendations made in the Report include the following:
- Issues for boards to consider: A number of issues are set out for the boards of banks and other financial service firms to consider following consideration of the management, governance and culture at RBS, including whether:
(i) the board has the right size, composition (including its NED component), skills, experience, external advice (where appropriate) and ability to “step back” to assist executive management by challenging the assumptions underlying strategy, strategic initiatives (such as acquisitions), risk appetite and exposures and the key areas of the firm’s focus;
(ii) the board considers the appropriateness of delegation by its CEO;
(iii) the board has a risk committee, separate from its audit committee, which is able to identify and bring to the board’s attention the major risks facing the firm, including in aggregate; and
(iv) the chief risk officer participates in the risk management and oversight processes at the highest level within the firm.
- Board reviews: The chairman or, if appropriate, the senior independent director, should discuss with their FSA supervisor the outcome of any externally facilitated effectiveness review of the board which should be undertaken at least every two or three years, and the action they propose to address any issues identified.
- Board and committee meetings: In order that boards can demonstrate that proposals from the executive have been met with appropriate discussion and challenge, the Report recommends that the minutes of board and sub-committee meetings outline the substance of the views expressed and record key elements of the debate and challenge provided, as well as the conclusions for each agenda item. The record need not be verbatim nor, unless requested at the time by a board member, include individual comments.
- The regulatory oversight of large bank takeovers: The FSA did not formally consider whether the risks in the ABN AMRO acquisition were acceptable because RBS did not have to seek the FSA’s regulatory approval for the contested takeover of ABN AMRO. The FSA argues that there would be merit in making it a formal requirement that banks obtain regulatory approval for major acquisitions. The term “major” would be defined by reference to the target firm’s size relative to the size of the acquiring bank.
- The provision of independent advice in respect of major acquisitions by regulated firms: The Report recommends that the FSA should consider whether and how the board of a firm considering a major acquisition should obtain independent advice from an adviser whose remuneration is not linked to the successful completion of the transaction.
5 What can Building Societies learn from the Report?
Clearly the business models and ethos adopted in the mutual sector are very different to those of global banking institutions such as RBS. Indeed many involved in the mutual sector contrast the differing fortunes of those building societies such as Northern Rock, Halifax, Bradford & Bingley, Alliance & Leicester and Abbey National which choose to demutualise, with those which decided to retain their mutual status. However, it would be wrong for Building Societies to ignore the findings of the Report or to believe that they will be unaffected by changes resulting from its recommendations. The introduction of a strict liability regime for bank executives may, for example, extend to Building Society directors and this is an issue which the sector may want to lobby against. There are also a number of points to consider in the way that the board of Building Societies is to operate.
On a more practical level, the FSA's proposed approach to the preparation of board minutes is clearly out of line with the approach currently adopted by most Building Societies and, indeed, corporates. The prevailing view is that what should be recorded is the final view reached by the board as a whole and not the individual views of the directors which led to that final decision. Hence, it is not clear whether this suggestion by the FSA will be adopted and so secretaries of Building Societies should monitor whether current practice alters in line with the FSA's suggestion and determine whether as a consequence their approach to the preparation of board minutes should also change.
