Banking Crisis - Treasury Contents

Further memorandum from Gavin Fryer


  Following my letter to you of 7 February and your acknowledgement, you can imagine that in the light of events I am "seething". I believe that from the line of questioning last week, some of which I witnessed through the television broadcast, this was going along the right lines.


  It concerns me that the Financial Services Authority assessed the uncertain position of HBOS and probably found itself ill-equipped to change the likely course of events. Why have some banks of today effectively failed?

  Building Societies had a stable lending activity founded on a business model that served them well for many decades. This was despite the overturning of the convent ion "you do not borrow short to lend long". The key reason for this in the case of building societies was the extent and quality of the confidence that depositors placed in the societies' conservative business model. Those "friendly societies" had been regulated under legislation different from the Companies Acts and operated on a very conservative basis. Thus they survived for a very long time, distinct from the skewed model in the USA. Were depositors' confidence to be undermined, the consequences of overturning the convention would result in disaster, vide Slater Walker for which the Bank of England found they had indeed borrowed short to lend long. That is part of the root of the problem we have encountered. Owing to a mistaken perception and entry into the banking arena as a bank, distinct from traditional building society activity, these entities took the initiative to access the wholesale money markets without the diligence and know-how to assess and manage the associated risks. The mistake seems to have been the urge to seek massive additional money from short-term international sources to re-lend for long-term mortgages.

  One cannot make sense of the attitude that a bank recruits at board level, or just below, an expert in retail selling to expand the loan book. Anyone with the remotest contact and experience of international finance would tell you that. The risks are a hundred fold greater. How is it that this attitude prevailed at board level? Did the directors honestly examine the risks and consider what experience they had to deal with them? There were plenty of individuals who could at least have explained why such a course for expansion would be risky. But what experience did the directors have to even consider this prospect? Entry into the wholesale finance markets is totally different from what one might term traditional borrowing from depositors who had a number of long-standing relationships with their building society that gave them a great deal of confidence. That confidence was the basis of the trust between the parties. It evaporated once the scale of their borrowing expanded outside these depositors to encompass the risks inherent in the international money markets.

  In my view the directors should have never gone down that road even if their entity took on the status of a bank. Those directors did not understand what they were doing: in particular the directors did not understand the way the traditional confidence of depositors that underpinned a conservative building society business would alter once the convention that "you do not borrow short to lend long" was turned on its head. Without a broad sweep of confidence, operating a business in opposition to that convention and involving international counter-parties was bound to lead to big problems, if not destruction. Look to the USA and to the experience of Fannie Mae and Freddie Mac. Indeed, some years ago the entire mortgage activity in the US fell on its head when interest rates rose above the government imposed ceiling for lending rates in the personal mortgage market of 13+ % pa. That arbitrary waterline could never hold out in a flood.

  It seems that some investment banks broadened their business activity into personal lending on mortgages, an area of business their directors knew little about, while building societies experienced in this type of lending for 100 years and more moved the other way by taking on huge exposure in the wholesale markets. Neither sets of directors understood the difference between these activities.


  Last week you and members of your Committee rightly focussed on the experience of the directors of the British banks being interviewed and how much relevant experience they had of banking. The answer given was economical and time should have been made to pursue these questions far harder. If these directors did not have banking experience, one has to ask why they did not act cautiously and adopt a conservative business strategy. Instead they clearly thought that having directed a substantial business they were equally qualified to run a bank in the deepest pools of international finance. Added to which, they authorised commitment of their bank to huge exposure in complicated transactions in money instruments, securitised debt, in the deepest currency markets and extended the time intended to elapse in such contracts. The combination of all those factors and the changing relative strength of the counter-parties makes for a myriad of consequences. I expect that they had hardly any clue as to how such contracts operate in fair weather or foul. Once outside factors turned against them the value and hence the price fell faster than they could imagine. But that is the nature of markets when things get tough, as they will sooner or later.


  One can be forgiven for thinking that these directors forged ahead regardless of the risks, despite so much current attention to establishing and implementing correct corporate governance, even through Company Law. Did these directors think they were somehow above the law and current convention? What did they think was the point of all the work involved even for the smallest entity, not necessarily in a business, that now goes through due diligence to protect itself against claims later? I was a part of a "house" that specialised in advising on corporate governance, advising individuals intending to take board positions and present workshops for directors or persons expecting to assume such positions both in the UK and Europe, even in Russia. I know that there is no excuse whatever.

  Before taking strategic and tactical business decisions, what regard did the board have for the various groups of stakeholders in their bank? What factors did they consider on behalf of the depositors, the counter-parties with which business deals were done, creditors, the shareholders, the money market, the interests of the UK banking sector and other wider public interests including the regulators and government, and not least the entity's reputation and ability to maintain a sustainable activity into the future. Indeed, what were the non-executive directors saying? Were they the appropriate people to have on the board of a bank?


  These factors should be examined closely to understand how the people holding responsibility for the actions of each bank allowed the situation to get so completely out-of-hand. It seems that the directors did not have relevant experience, did not seek and obtain advice that was applied to their entity's situation and acted out of total disregard for the consequences.

  Avoid being drawn into technical detail. The picture is so large and so many people are affected by the consequences of only a few hundred individuals in the UK "taking their eye off the ball". Similar numbers, pro rata to national GDP, would probably be found in other countries. Also remember that no bank or company can take action of itself. For any course of action, or inaction, one has to have people to take decisions and implement them. A corporation is not self-propelled.


  If the point is proved, then quite serious consequences should follow. It matters not whether they are executive or non-executive since they are all equally responsible under company law. If the directors did not understand these transactions and their implications, how could they recognise a mistaken strategy adopted by senior managers. Why and how did the directors and senior managers in this entire saga of the last five months not stop to consider the consequences of their chosen business strategy. It seems to me that a case could well be made for pursuing the Directors for not acting prudently. When one boils all this down, it comes to acting without due care and attention, regardless of the consequences. Persistent questioning may well reveal responses that show aspects of "gross negligence". Insofar as that finding is the case for some individuals, grave consequences will follow.

  I cannot see why those individuals who received huge remuneration should not be required to repay in cash the last year's total remuneration to their employer for the benefit, say of junior staff pension finds. That way these individuals would experience some pain. Furthermore, to the extent that culpable individuals on the Boards of directors of British banks that are regulated by the Companies Acts should be addressed by the Secretary of State for Business, Enterprise and Regulatory Reform, Those against whom findings have been delivered that they acted without due care or acted in a grossly negligent manner should be disqualified as a director. Such disqualification should apply to the individual to prevent him or her from ever again acting as a director of an entity that falls within any of the UK corporate regulatory control.


  As regards the Financial Services Authority (FSA), their chairman and directors should be questioned by your Committee. What were they doing to control the banks, especially those that changed their activity from a building society to an authorised bank? Why were these entities permitted to change their business and authorisation, and of course fall within different legislation from that previously applied to them? Why did these changes go through without extensive interviews and assessment of the know-how and understanding by the directors of the risks inherent in international banking, derivatives, etc.? Were such assessments carried out after an initial vetting? Why were no ceilings or other controls imposed upon those entities, at least until their directors could demonstrate to their regulators that they would be in full control of the risks of their business? There are a lot of questions here.

  In my view the FSA has a lot to answer for. There seems to be an assumption that Banking entities and dealing enterprises can be allowed to operate without any controls and provided they are earning lots of money for shareholders and "everything in the garden seems fine". For the key regulator, that will not do. In the light of events last year lack of effective regulation is a catastrophe.


  Now we see that the FSA directing banks not to pay bonuses but to defer settlement in the form of share options or a similar manoeuvre. That needs to be questioned. It looks like a wet response to a very serious problem. The banks say have felt that they need to retain executives because their skills must be retained. Well, the international scene is telling us that as most countries in the Western world have run into the banking crisis, these so-called "skilled people" are not about to migrate to a competitor.

  Payment of these bonuses to any employee earning say over £45,000 should be eliminated forthwith. It very much looks as though entities, banks and FSA to take examples, are taking swift action to dispose of cash that may well not rightly be theirs to dispose, so that the "deed is done" and cannot be reversed. Taxpayers are not in a generous mood to fund bonuses for actions that have lead to such a widespread disaster. Any bank in the taxpayers' ownership, partly or wholly, relies on taxpayers' funding. Furthermore, we have been told that the UK taxpayers may find that it will take until 2030 to pay for all this damage. On no grounds whatsoever should bank executives or directors be paid other than for a wholly satisfactory delivery of work, not work the hours and be paid double for attending the office consistently.


  Again, the FSA want the public to believe that it is appropriate, in the light of events and the above factors and FSA's own failings, for FSA to pay a huge sum from their own resources by way of bonuses, covered by a sugar coating of "for services in dealing with the banking crisis". No, Sir! This is taking us into the "Looking Glass World" of Alice. The FSA was established as the regulatory authority to protect the public's involvement in investment and banking, as well as insurance, etc. Can it honestly hold up its head in public and say on one hand banks must defer payment of bonuses, that ought not to be paid anyway, while on the other it says "we will pay ourselves in cash for immediate settlement". This surely surpasses the understanding of most people. Any remaining credibility or reassurance the public have in the regulators is being dissolved. Also to say that, on behalf of the public, Britain's investigators should not go too far on a "witch hunt" because this will destroy overseas perception of British banking, well that has been done quite perfectly by the directors of these banks in the first place and possibly by others in the second. Is no one going to take a grip of this problem?


  In my view your Committee has a big task on its hands. Will the Committee be able to set aside sufficient time to address these problems, to find out why they occurred, and what can be done (a) to address the outcome to those responsible and (b) make proposals for dealing with the future? An Inquiry should be carried out swiftly with a published outcome for the public to read, digest and discuss.

  If it is not possible for the Committee to set aside the time needed, I believe that the government must appoint a Royal Commission or similar all-party Inquiry that quickly goes to the root of these problems, and reports within six months. The Jenkins Committee on Company Law many years ago produced a marvellous Report that was a model of clarity in all aspects. For many years that Report was a standard reference for a wide range of complex points in Company Law. It was also very well-written in English. Your Committee owe it to the public to carry out such enquiries and report or recommend an alternative mechanism to do so.

  Meanwhile, until those findings and recommendations have been received by the government and been published, no bonuses or other precipitate action should be taken that might not otherwise be capable of reversal.

15 February 2009

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