Tuesday, March 8, 2011

The RBS Failure was Preventable

The failure of RBS was preventable. As documented by the Telegraph, there were numerous times where adherence to the FDR Framework, specifically insuring that market participants had access to all the useful, relevant information in an appropriate, timely manner, would have prevented the failure of RBS.
... In the new year, 2006, [Sir Fred Goodwin, RBS chief executive,] made an immediate change. He responded to shareholders’ demands for better returns in the only way he considered possible – to release RBS’s until then relatively slow-growing investment bank. 
Global Banking & Markets (GBM) and UK Corporate Banking would grow their combined balance sheet over the next two years, increasing its assets from £500bn to £830bn. In 2008, excluding the distorting effects of the ABN Amro acquisition, GBM alone would account for almost half the group’s total risk-weighted assets – £195bn of a total £482bn. 
Put simply, Sir Fred had bet the bank on GBM even before he doubled down with the calamitous acquisition of ABN Amro.
This is the first time that adherence to the FDR Framework would have saved RBS.

Had RBS been required to disclose its current asset-level data, the market would have seen exactly what GBM was putting on to the balance sheet.  With this data, market participants could have analyzed the risk of these assets and the solvency of RBS given its changing risk profile.  Market participants then could have adjusted both the amount and cost of their investment in RBS debt and equity.

As risk on RBS balance sheet increased, so too would have the cost of funds to RBS.  This feedback loop is the mechanism for the market to exert discipline on financial firms and would have constrained both the profitability and the risk of this strategy.

In short, RBS would have added many fewer assets to its balance sheet as the cost of funding these assets would have exceeded the financial return on these assets.
... The expansion of a commercial and retail bank into investment banking was in keeping with the fashion of the times. Barclays was already well on the way to becoming a vehicle for the ambitions of its investment bank, Barclays Capital . And at the summit stood investment banking thoroughbreds like Goldman Sachs and Lehman Brothers, which seemed to offer those with the guts and capital to copy their models the chance to make the kind of money in a year retail banks would take decades to earn.
This is the second time that adherence to the FDR Framework would have saved RBS.

As Warren Buffett would be happy to point out, disclosure of current asset-level data on each position in the trading and investment portfolios at the end of each business day would have dramatically squash the potential profitability of this business model.

A number of years ago, he negotiated with the SEC and received permission to delay disclosure for his investment positions.

Why would he have wanted to delay disclosure?

If he was buying, he wanted to delay disclosure to minimize the price he paid for his entire position.  By not filing, he does not have to compete with investors who piggyback on his reputation and ideas. These investors would have increased the cost of his position by driving up the price of stock with their buying.

If he was selling, he wanted to delay disclosure to maximize the price he received for his entire position.  By not filing, he does not have to compete with investors who piggyback on his reputation.  These investors would have decreased his sale proceeds by driving the price of the stock down with their selling.

Clearly, there are advantages to having opacity when it comes to buying and selling securities.

Eliminating opacity in the trading and investment portfolios also has another advantage for regulators.  Regulators can now turn to other market participants, like portfolio managers and competitors, for help in analyzing what are the risk of an individual firm's trading and investment portfolio.
RBS’s fate may have hinged on that one decision over Christmas 2005, but to understand the bank’s downfall properly one has to go back to its greatest accomplishment – the NatWest takeover. To this day, the deal is considered among the greatest acquisitions in UK deal making. 
... The work that went into RBS’s offer was exhausting. Endless public documents were produced to justify the deal to a sceptical audience. Synergies and costs were verified by the accountants Deloitte. Full strategy documents were disclosed
... The deal may have been Sir George’s brainchild, but it was the making of Sir Fred. “Fred was very good at delivery. He did the integration planning. His rigorous nagging saw the deal through. We truly delivered £3bn of synergies, it was not just an accounting trick,” another director said.
Proof that the adherence to the FDR Framework works.

How ironic that to convince the market of the merits of acquiring NatWest, RBS should resort to providing the market with a significant degree of transparency.  RBS had direct experience that adherence to the FDR Framework works.
... At the height of his powers, Sir Fred was able to do pretty much as he pleased such was the support that he gained with the remarkable NatWest deal.
Then, in April 2002, in a deal brimming with ego, he demonstrated just how far he felt he could go. 
There is no obvious synergy between a mass market car dealership and a global bank but that did not stop Sir Fred – a renowned motor enthusiast – buying Dixon Motors in a £110m deal. 
“Financially, it was below the radar. But it was completely mad,” the director said. 
With hindsight the deal exposed a subtle cultural shift at the bank. First, Sir Fred’s unquestioned command and, second, RBS’s pliant board. Both came to the fore in RBS’s worst deal before its calamitous takeover of ABN Amro in 2007, that involving Charter One. 
The deal broke all the lessons learned from NatWest. Due diligence and transparency on the Charter One deal were poor. Compared with NatWest, the detail provided was so scant the numbers could barely be tested properly by analysts, let alone accountants. No one filled the role Deloitte had played with NatWest. 
“It was all done on the back of an envelope,” the director said. “If you stop reporting transparently externally, you can start fudging it internally.”
This is the third time that adherence to the FDR Framework would have saved RBS.

The difference between NatWest and Charter One was that adherence to the FDR Framework was voluntary.  This is why disclosure of current asset-level data needs to be a requirement.  There is precious little room to fudge an exposure.

By making it a requirement, it also allows accounting firms to perform a function for which they are well suited.  In this case, the firms can attest that all of the positions have been disclosed.

It is up to the market to analyze this data and turn it into useful information.
... Doubts may have been raised about his leadership but Sir Fred Goodwin was still very much in charge of RBS as 2007 began. 
Weeks earlier his advisers from Merrill Lynch had briefed the bank’s board on an audacious plan that would see RBS at the head of a consortium bid for ABN Amro that would end in the largest cross-border banking takeover in European history. 
... [UBS Banker, John] Cryan had been against RBS buying ABN from the start and had warned Sir Fred against doing the deal, telling him he was “extremely concerned” about the impact it would have on the bank, particularly its capital ratios. 
In one note, Cryan wrote to Goodwin warning him about ABN’s exposure to subprime mortgages: “There is stuff in here we can’t even value.” Goodwin replied saying: “Stop being such a bean counter”. 
This is the fourth time that adherence to the FDR Framework would have saved RBS.

Disclosing all the useful, relevant information in an appropriate, timely manner to market participants is not restricted just to financial institution balance sheets.  It also applies to structured finance securities.

Had the SEC, through Regulation AB, required that structured finance securities disclose the performance of the underlying collateral on an observable event basis, the subprime mortgage-backed securities could have been valued.
... [Johnny] Cameron [chairman of RBS global banking and markets] regularly met his opposite number at ABN, Wilko Jiskoot. However, there were limits to how much help ABN could offer as the consortium’s bid remained a hostile offer. RBS, Fortis and Santander were prevented from performing full due diligence on the bank – unlike Barclays, which had full access to the books. 
“It is always a gamble when you take on something but if you are taking on a large bank it is always useful, you would have thought, to have some knowledge of what you have bought,” Alistair Darling, the Chancellor at the time of the bail-out, said. 
This is the fifth time that adherence to the FDR Framework would have saved RBS.

With all financial institutions having to disclose their current asset-level data, RBS would have been able to perform a full due diligence and known exactly what they were buying.  As a result, they would not have overpaid for their portion of ABN.
... The lack of celebration was quickly justified as RBS bankers got their first detailed look at what the bank had bought. There was immediate concern as it appeared that Cryan’s warnings at the state of the division’s assets appeared justified. 
Once you started to look around ABN’s trading books you realised that a lot of their businesses, particularly what you would call model businesses where valuations were based on assumptions, were based on forecasts that were super aggressive,” said one senior former RBS trader. 
... In contrast to NatWest, which had been the dream integration, RBS managers now found themselves dealing with a nightmare situation of trying to value ABN’s assets amid a “freefall” in valuations, while dealing with ABN staff who, if not downright hostile, were disengaged at best. 
This demonstrates why adherence to the FDR Framework is necessary for functioning financial markets.

The reason that there was a free-fall in valuations was that there was no current information on the underlying collateral performance.  If the market had access to the underlying asset-level data, it would have been factoring in the deterioration of the underlying assets sooner and reigning in the super aggressive forecasts.

Access to the underlying asset-level data would also have anchored the price movement on the securities.  Every market participant would have known how the underlying assets were currently performing and used this as the starting point in their valuation of the securities.  This would have reduced the volatility in the price movements by narrowing the gap between buyer and seller valuations.
As the months dragged by in 2008, arguments between RBS and Fortis managers became more open as the two sides disagreed more frequently on how the separation should proceed. The strain in the relationship was not helped by Fortis’s financial difficulties as it became clear the Belgian bank was facing its own funding crunch. 
... Two days later the bank was partially nationalised, with the Netherlands, Belgium and Luxembourg authorities injecting a total of €11.2bn to prop it up. 
On Monday, Fortis staff turning up for work at the ABN headquarters in Amsterdam were barred from entering the building as the bank was forced to sell its stake in the ABN acquisition vehicle. ABN was a busted flush and RBS was left holding a whole load of nothing. The question was, could the bank survive such a hole in its balance sheet. Or would one of the world’s largest banks actually have to turn to the ultimate backstop – the Government and by implication the UK’s millions of tax payers. 
This is the sixth time that adherence to the FDR Framework would have save RBS.

RBS faced a question about its solvency.  In the absence of disclosure of current asset-level data, market participants were left to guess whether the market value of the assets on its balance sheet exceeds its liabilities.  Because investors did not know if RBS was solvent, it was susceptible to a run on the bank.
Over the summer of 2007 as the battle raged for ABN Amro very strange things were happening in the credit markets. 
Back in February, HSBC had been the first bank to openly signal the problems it was having in the US subprime market and had fired the head of its US mortgage business as losses hit $10.5bn. 
Investors had to guess the value of the subprime securities and their related CDOs on RBS's book.
... The main area of worry for RBS was its huge leveraged finance and commercial real estate lending businesses. The market for leveraged debt had already shut and what the managers did not contemplate was what would happen if they were unable to fund the lending books. 
Add in leveraged finance and commercial real estate lending.
In early September the ABN in-house funding team held a conference call to discuss the increasing difficulty the bank was having in securing financing and were surprised when they realised they were financing themselves at a lower rate than their soon to be new owner, RBS. In plain English, it meant RBS was having a harder time sourcing funding than they were. 
And they were in real trouble. Like all investment banking businesses, ABN and RBS’s wholesale banking arms were funded in large part through a mixture of short-term loans, often overnight borrowing from other banks, and corporate deposits and the cost of these was rising daily. 
... Even without the problems in the credit markets, funding such a large balance sheet would have been a major headache for RBS, but as the wholesale businesses were combined, the bank began to breach the risk limits of many of its corporate depositors, leading to a steady outflow of increasingly scarce funds. 
The cost of attracting new funds was rising and combined with the losses the bank was now facing on many of its wholesale banking assets, RBS’s core tier 1 capital, already taken to the dangerously low level of 4pc through the acquisition, was entering emergency territory.
With the problems on its balance sheet, corporate depositors had even more reason to withdraw funds.
[Gordon] Brown, who valued Vadera’s knowledge of finance industry, asked her to begin thinking about solutions to the problems that were appearing and said he thought it was important that banks become more open about declaring their losses. 
“In December and January it was becoming clear that the system was clogging up and that people were sitting on huge losses,” one Whitehall source said. “There was a fear that no-one could really test what was on each others’ books.” 
Such a lack of information astonished the Government. “The situation raised important questions,” Darling said. 
“One of the things that was a real problem was that neither the FSA nor the Bank nor any of their American or European counterparts could pull out a file and say 'here’s a health check on such-and-such a bank’. It did surprise me. But looking back now three years later, what is equally surprising is that there wasn’t a sheet that could be pulled out by RBS. 
“If you look at the FSA – the emphasis over its first few years of operation was consumer protection and that is what it occupied itself with. And if you look at the Bank of England it was monetary policy and it wasn’t financial security for which it always had responsibility.” 
Until disclosure under the FDR Framework is required, the financial system still faces this problem.

Without current asset-level disclosure, it is impossible for banks to know what the true financial condition of their competitors are.

This is why Jamie Dimon, Peter Sands and Bob Diamond highlighted the need for this information to be disclosed at Davos.
... Cameron realised the funding of the wholesale business was becoming critical. Over the summer a decision was taken to put most of the division’s product sales staff on to deposit gathering duties with bottles of champagne now handed out for landing large deposits in the same way they had once been for hitting sales targets. 
We literally had a taskforce out there trying to convince corporates not to take their money away,” says one former senior RBS investment banker. 
Had there been current asset-level disclosure, there would have been no need to convince corporates not to take their money away.  They could have seen for themselves or hired independent third parties to do the analysis for them whether RBS was solvent or not.

In the absence of disclosure, these corporate depositors had a strong incentive to avoid loss and withdraw their money.
Treasurers at rival banks were also alarmed by what they were seeing happening at RBS as overnight borrowings increased day by day and the bank was forced to replace deposits with short-term funds. 
“It was like you could see this wall of water coming towards you. We had a meeting internally about pulling back our risk limits on RBS because there was clearly something going horribly wrong,” said one head of treasury at a major UK bank. 
Naturally, knowing what they knew about their own exposure to subprime mortgage-backed securities, leveraged lending and commercial real estate, banks did not want to lend to each other.
.... Crisis landed at Royal Bank of Scotland on Tuesday October 7, 2008. One day earlier, a giant oil group had taken billions of pounds out of the bank in a single transaction. It was the biggest withdrawal RBS had suffered in recent memory and foreshadowed the disaster that would cripple the bank. Unlike Northern Rock, where queues formed at branches that trailed around the street, RBS was suffering a “virtual” run by its corporate customers. 
On that Tuesday morning, RBS shares crashed 20pc as what little confidence remaining evaporated on rumours of a run. 
In the absence of data showing RBS to be solvent, it succumbed to the fear that it was not.

From the very beginning, had current asset-level data been available, the result for RBS would have been different.

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