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
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
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
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
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