Bank Failures: Case Studies

Question 1

Why did RBS fail?

Answer 1

The FSA Board Report noted that the failure of RBS can be explained by a combination of 6 key factors:

1. The significant weaknesses in RBS’s capital position during the Review Period, as a result of management decisions and permitted by an inadequate regulatory capital framework. The capital regime (at the end of 2007) was deficient, in respect of the trading books where required capital for many instruments were estimated using VaR approaches. RBS did however meet Basel I & II requirements.
2. Over-reliance on risky short-term wholesale funding. The immediate driver for the failure of RBS, was a liquidity run which affected RBS and many other banks. Wholesale money market providers became unwilling to lend to RBS leaving the bank reliant on Bank of England Emergency Liquidity Assistance (ELA) from Oct 2008. FSA monitoring of liquidity risks for firms such as RBS failed to capture wholesale funding risk and funding in non-£ currencies.
3. Concerns and uncertainties about RBS’s underlying asset quality, which in turn was subject to little fundamental analysis by the FSA. RBS was particularly affected by the general collapse in market confidence because of market concerns that its loan portfolio might be of a relatively poor quality.
4. Substantial losses in credit trading activities, which eroded market confidence. RBS was highly exposed to US sub-prime credit.
5. The ABN AMRO (acquired primarily with debt rather than equity) acquisition significantly increased RBS’s exposure to risky asset categories, reduced an already relatively low capital ratio, increased potential liquidity strains and, because of RBS’s role as the consortium leader and consolidator, created additional potential ad perceived risks. The CEO’s management style discouraged robust and effective challenge, and the Board’s mode of operation followed suit. RBS was overly focussed on revenue, profit and earnings per share rather than on capital, liquidity and asset quality. Therefore questionable whether they sufficiently challenging the information presented to the board and the risk management was perhaps not sufficiently forward-looking to give early warning of emerging risks.
6. The collapse of banking system confidence in autumn 2008 resulted from belated market awareness of the risks arising from the complex interconnectedness of the banking and shadow banking systems. They were linked together in a complex web of funding and derivative exposure relationships. The failure of one bank had highly uncertain consequences for others. The bankruptcy of Leman Brothers, during which a number of other financial institutions collapsed or came near to collapse, RBS’s gradual liquidity run reached extreme proportions.

Question 2

Why did HBOS fail?

Answer 2

A report by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA) found:

1. The strategy of HBOS: The Group put itself under pressure to maintain an increasing level of income. As margins declined on all forms of lending, a search for yield pushed it towards more risky propositions. Each of the lending divisions experienced an increase in its risk profile as it sought to grow income levels. At the onset of the crisis the perception that HBOS had a highly risky strategy detonated its reputation.
2. Capital: The group reported tier 1 and total capital ratios significantly in excess of the regulatory minima. While regulatory capital ratios remained stable and looked robust, leverage had increased for HBOS and the banking industry as a whole between 2005 and 2007.
3. Liquidity and reliance upon wholesale funding: The continued growth of corporate’s balance sheet in 2007 was partly due to the completion of transactions sanctioned earlier in the year and customers drawing down on committed facilities. The ongoing closure of the syndication market meant it couldn’t sell-on large exposures that it had agreed to underwrite in full. Taking into account the proportion of loans that came to the end of their terms or were otherwise repaid in 2007, its new lending book grew. By the end of September 2008, HBOS was no longer able to meet its needs from the wholesale market and was facing a withdrawal of customer deposits. The rapid expansion of its balance sheet placed pressure on HBOS’s ability to fund itself. The structure of HBOS’s funding requirement made it particularly vulnerable to closure of wholesale funding markets. As the largest participant in the UK residential mortgage-backed securities (RMBS) market from 2003, HBOS was reliant on securitisation as a source of funding.
4. Asset quality: The losses on the Group’s lending portfolios increased markedly from Sept 2008 onwards
5. Management, governance and culture: The composition, size and structure of the HBOS Board were typical but it failed to provide effective challenge to the firm’s executive management. The ineffectiveness of HBOS’s risk management framework was a consequence of a culture within the firm that prioritised growth aspirations over the consideration of risk. The early success of HBOS in the benign economic conditions prior to the crisis also led to complacency during the crisis.
6. Banking experience: Of the 12 non-executive directors (NEDs) who served on the Board during the Review Period, only one had a background in banking and he was appointed in May 2007. The Review found a lack of debate and challenge at Board meetings around key areas of risk faced by the Group. This was compounded by a lack of experience and knowledge of banking within the executive management team.
7. Formation of strategy and risk appetite: A crucial weakness of HBOS’s strategic approach was that it was developed and pursued in the absence of a clearly defined risk appetite statement for the Group as a whole and the ability to aggregate risks at Group level.