Royal Bank of Scotland, Northern Rock and Lloyds Banking Group - Treasury Contents


Examination of Witness (Question Numbers 80-99)

MR STEPHEN HESTER

12 JANUARY 2010

  Q80  Mr Fallon: But you are telling us you want to grow the profitability of your investment bank and if you get it wrong, we have got to pick up the tab again?

  Mr Hester: No, actually. Not at all. What I thought I was saying to you is that I am 100% behind all of the different streams of measures that should allow banks in the future in times of crisis not to call on the public purse. At the moment my great effort is to make RBS safe again, to serve our customers and allow the taxpayer to get his and her money back, not the other way around. So far our balance sheet has gone down by £500 billion. That is £500 billion of assets no longer at risk in RBS that were at risk a year ago.

  Chairman: You mentioned the hundreds of different ways. We have established a "too important to fail" inquiry to bring clarity to this issue, so if you could go back, think of 100 different ways, and give us two or three ways that you want banks to be safe and sound, then we will be delighted to receive that evidence, Mr Hester.

  Q81  John Thurso: I wanted to ask a couple of questions on the "too big to fail issue" but can I go back first of all to what was touched on with Mr Fallon, which is the question of narrow banking? I respectfully disagree with your view that there is no evidence in the financial crisis to support a contention that narrow banking would be helpful, but I want to put that to one side and concentrate on one point, which goes back to what your capital is doing and it goes back to why bonuses are paid. That is that historically, if you go back, investment banking, merchant banking, came out of a partnership model. Each member had their total wealth involved and therefore they had an acute sense of and, I would suggest, ability to manage risk. The problem, those companies having been acquired by larger companies or having been listed, is that they now have other people's capital but they are taking the identical reward. Is that not one of the core problems, that if people are to have massive reward, then they must personally be taking the risk? That is absolutely fine. If people want to do that, that is great. But if you are using other people's capital, namely shareholders, government or anybody else, then you cannot be expected to have that same return. Is that not the cultural divide and is that not the cultural problem that got us into so much of the difficulties we are in?

  Mr Hester: Respectfully, I do not think so but let me try and explain why. As I have said already, I believe very strongly that highly paid people in all walks of life should have a significant alignment between that pay and the future of their institution and how well it does. That is why we have introduced share-based payments and clawback and all these things. To that extent I completely agree. However, if you look at the evidence of the crisis, the two investment banks with the highest percentage of employee ownership, Lehman Brothers and Bear Stearns, went bust. Investment banks with the lowest proportion of employee ownership, like Credit Suisse, my old employer of some years ago, had a good crisis as these things go, so there simply was no correlation that you could draw between the extent to which the employees felt their personal wealth was at risk and what happened to the institution. So although I happen to agree with that alignment, I do not think it has the outcome that you would look for and—

  Q82  John Thurso: If I may just interrupt, there is a great difference between getting a telephone number salary, 70% of which is in shares, but your personal wealth which you have acquired over several years is elsewhere, and having your entire personal wealth at unlimited risk in a partnership where you and your colleagues are making decisions. There is a world of difference between the two.

  Mr Hester: But you know, then when you look at the Bradford & Bingleys, the Northern Rocks, the Wachovias, the Washington Mutuals, the Fannie Mae and Freddie Mac, AIG, if you look at some of the companies that have lost large amounts of money, these are not companies that you would be advocating a partnership model for but they are companies that managed to lose a lot of money.

  Q83  John Thurso: We will agree to differ on that. Considering the RBS business model, what do you believe is the relationship between the size of the bank and risk? This is the "too big to fail" question. To what extent is the size of RBS relative to the risk that it poses to the system?

  Mr Hester: I think that sometimes when people think about this issue they are making an implicit assumption that I am not sure goes, and that is to say that only one bank fails at a time. Of course, if only one bank fails at a time, then you want lots of little banks but if we actually look at this crisis, were it not for government intervention, all banks would have failed, so it did not matter how many you had. You could have had one mega-bank or a million tiny banks and you would have had the exact same problem on your hands. In fact, the smaller number of banks made it easier to deal with because you have less people to deal with to save things. So I do not think you can actually say that more banks is safer than less banks as a public policy issue when you are dealing with systemic crises as opposed to one-offer banks, which are not the ones that worry people. As it relates to RBS, I do think that RBS became too big but the issue was not size; it was in a sense relationships; it was how big the balance sheet was relative to the capital resources; it was how unstable the funding was; it was how many disparate things that RBS was in that were not good; it was how good the management culture was. There are other banks, like HSBC, that were bigger than RBS that came through very well. So again, I think size is a red herring in positive and negative. It is how well something is managed and its inherent commercial merits. The thing that I would really hope everyone appreciates and the thing that makes me still optimistic after a difficult year, my first year at RBS, is that the core businesses of RBS are really good businesses. They serve customers well, they are worth rescuing, and they will provide the wherewithal to pay back the taxpayer.

  Q84  John Thurso: Last question, if I may. In the Turner review a whole variety of things are discussed: minimum capital requirements, living wills, Tobin tax, all sorts of things. What is your view as to the direction in which countries and regulators should be going to have the best opportunity of ensuring that any banking institution does not pose a risk to the system? I know that cannot be eliminated but to minimise it.

  Mr Hester: We have attacked this in two or three different ways and I think the answer is complicated but necessary, and so there are a whole series of different streams. You are inviting me to comment. I will give you some examples. Clearly, counterparty risk can be mitigated by moving a series of transactions on to exchanges by using security and netting agreements and a whole series of things, which is a series of global initiatives. Clearly, liquidity risk can be dealt with by requiring banks to hold a lot more liquidity and have a different funding structure. Capital risk by more capital. I do think that there is a role ... What I would search for is what I might call a Chapter 11 for banks; in other words, is there a way that you can reconstruct a bank's capital structure and apportion loss to creditors whilst having the bank's day-to-day functions of payments in ATMs and so on carry on undisturbed? All of these are what you might call a living will, so I think there are multiple strands that together will get us to the right place but there is no one single measure—

  Q85  John Thurso: There is no silver bullet?

  Mr Hester: No, I think that is right, and I think this will take a decade but it is very important work.

  Q86  Jim Cousins: If we look at the Asset Protection Scheme, these represent assets that are sufficiently risky to require a government guarantee but if the government guarantee were ever drawn on, there would obviously be considerable reputational damage. If we look at these things that have been placed under government guarantee, we see things like a €30 billion commercial property; €50 billion of loan facilities, largely outside the UK; over €30 billion of derivative contracts, largely outside the UK. Do not the people running these things have you over a barrel?

  Mr Hester: The people who were responsible for getting us into bad situations that we regret now have been fired. Of course, there are still troops around, if you like, but the generals have been fired. All of our unwanted assets have been put into a separate division where they can be separately managed, either by the restructuring group that I referred to earlier where we are trying to restore companies to health, or by what I will call rundown specialists whose only job is to get us out of something as opposed to the people who got us into it. It is true that the way we manage the people in our non-core division is very different. We are asking them, in a sense, to do themselves out of a job, and that is a specialised management, and in fact, one of the things I was fortunate about in my career is on a couple of previous occasions I have used the same device, most recently in Abbey National in the early 2000s, and have some experience in it, but we therefore try and do it, if you like, completely away from the line and the workplace that that was brought on. So I cannot think of any instance in the management of those assets where I would describe us as being "over a barrel" to the people managing them.

  Q87  Jim Cousins: Are those rundown specialists being paid bonuses?

  Mr Hester: The assumption will be yes but obviously the merits of their goals are not about putting on new positions or making profit. Their goals are about risk reduction, and then they would be paid competitively whatever that particular job is to other jobs that they could otherwise have. In fact, interestingly, one of the things that the Treasury insisted on in the Asset Protection Scheme is that the RBS people working on those assets were not disadvantaged in pay terms against anyone else, and I was of course pleased to accede to that.

  Q88  Jim Cousins: Do forgive me. The Treasury insisted that the people running the assets placed with the Asset Protection Scheme should not be disadvantaged in terms of access to bonuses?

  Mr Hester: Correct.

  Q89  Ms Keeble: There was a kind of deal that was made with the government, more importantly with the taxpayers, with our constituents, that in return for bailing out the banks, the banks would deal with the bonuses and reach certain lending targets, increased lending. This morning you have given us very cogent, sanguine arguments about the fact that you intend to carry on paying bonuses, as do the other banks, and you have given very cogent arguments about why you have not been able to reach the lending targets. The British Bankers' Association figures on lending are actually quite grim and those are probably a bigger source of grievance for the public actually in some ways than the bonuses. Are you not concerned that this failure to deliver on your side of the deal, as it were, is a real source of grievance for the public and also probably presents the biggest constraint on public policy towards financial services going forward of anything?

  Mr Hester: I think that anything that can give rise to controversy in the eyes of the public or our customers is something that I should be concerned about, so the simple answer to your question is yes. However, I am also bound to say that I do not regard us as having not met our commitments. In fact, I am absolutely adamant that we have met our commitments, and if you are someone in search of a mortgage, nine out of ten times we will say yes to you. I think that is an appropriate statistic and eight and a half times out of ten we will say yes to you if you are asking for a small business loan. I am afraid to say to you that I think that those are absolutely hard evidence that we are meeting our commitments. We have something like £30 billion of undrawn overdrafts available to UK businesses, that at any time they could get that money if they needed it without any more negotiations with us or conditions or anything. So we are absolutely clear. I have a legal obligation to meet those commitments on behalf of RBS and we have, but do I worry about what our customers think and the public think? Absolutely, I do worry.

  Q90  Chairman: Since the bonuses are discretionary, on what basis did you decide to pay the record amounts to some of these executives in the investment bank?

  Mr Hester: As I mentioned earlier on, there have not been any decisions made to pay anything.

  Q91  Chairman: You have paid people. It is just that you are not reporting it until a couple of months' time.

  Mr Hester: No, no, no. The bonus decisions have not been made.

  Q92  Chairman: You mean at the end of the calendar year that finished in December you do not have an idea?

  Mr Hester: They cannot be done until after because you need to know the results, which you do not know until you have the books.

  Q93  Chairman: You know roughly. Come on.

  Mr Hester: As the timetable currently looks—it might move—I would expect in late February our people will be told whether they will get a bonus and, if so, what it would be. That is what I expect the timetable to be, and then the bonus would be made available to them over the ensuing three years according to the vesting schedule. That is what I expect. To answer a different bit of your question, you are asking on what basis. For each individual there are in effect two processes that go on. Part of it is: what did you and your team and your area do this year and how does that compare to what we asked you to do? Is it better or worse? You get some sort of balanced forecast because obviously everyone has different objectives that you set them. Secondly: what is the market rate for that sort of a job? Because, as I have said many times, I do not want to pay a penny more than we need to and so I need to understand what we need to as well as what is deserving, and to bring those two things together, and then of course that is scrutinised by very many people. That is the process but it will not be until late February that any of our people know what, if any, bonus they have.

  Q94  Chairman: Yes, but you have a fair idea what is happening at the moment as you come to us. Have institutional investors raised concerns or given you directions on bonuses?

  Mr Hester: My summary of the position as I understand it from our institutional investors is that they are all highly conscious of the very difficult challenges that exist in turning RBS around successfully and making them money. They believe that we need highly qualified and motivated people to do that and to compete against people, and they want to make sure we have that. Subject to that, they would like the biggest profits possible and therefore the lowest bonuses.

  Q95  Chairman: So the answer to my question is they have not raised concerns or given you directions?

  Mr Hester: They want us to optimise the balance between having the lowest possible expenses—

  Q96  Chairman: I think it is a very simple question, Mr Hester. Have they raised concerns or given you directions? That is all I want. Just a simple answer.

  Mr Hester: They have raised concerns about our ability to keep and motivate good people. They have raised plenty of concerns about that, and the institutional shareholders all continue to have rules as it relates to remuneration on the other side.

  Q97  Chairman: You said that a safer banking system will reduce the pace of economic growth. You said that here. Do you think the City has woken up to the fact that the rest of the economy may value stability more than innovation and the spirit of breakneck growth that we have seen in the past few years?

  Mr Hester: It is hard for me to comment on the City in general but I certainly would offer you my personal observation, which is, in general, banking is a mature industry and should experience single digit growth rates. Part of the problem was that banking started to think that it was a growth industry, with double digit growth rates and revved the engine too fast and, by the way, economies made exactly the same mistakes and banks were the mirror image of what was going on in the economy. But I do think that banks will be better managed if they are managed appropriately for a mature industry rather than in a dash for growth.

  Q98  Chairman: The investment bankers, the traders and the top management whose actions have contributed to this crisis seem to be getting telephone number bonuses still but the vast majority of bank employees get a fraction of that. What does that say about the way that banks value their employees or the penalties that exist for failure?

  Mr Hester: Clearly, there are very important matters of political philosophy as it relates to income distribution and I think it is probably not my place, and it is not the right time anyway, for us to go into those. With respect to how people in banks are paid, I submit to you I think it is very similar to how you would pay people in accounting firms or in any other walk of life, which is to say that individual jobs are compared against other comparable individual jobs and there is a wage rate and, obviously, the more diverse a company, the more diverse you will have those wage rates—

  Q99  Chairman: It is not your place to comment on public policy but have you gone into this issue in your own institution regarding income distribution, particularly in light of the job losses of over 20,000 that have been postulated at the moment?

  Mr Hester: I do not have a political goal for a particular range of income distribution in RBS. My goal is to help RBS recover, to serve our customers well and to rebuild the share price, I want us to be as efficient as possible, and I want our costs to be as low as possible, in each case subject to having good and motivated people in our different businesses. That is what I am trying to do.



 
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