Hubris: How HBOS Wrecked the Best Bank in Britain (11 page)

Then in a passage which emphasised the Bank’s distinctive culture, where the institution was more important than the individual, he added: ‘Mistakes are more likely to occur in
corporate life, especially in a bank, where one individual is anxious to achieve too much in too
short a space of time. There is no substitute for good old-fashioned common
sense.’
³

The following year saw the Bank again produce record profits and a return on equity of an unheard-of 36 per cent, but the market punished it for allowing its cost/income ratio to rise over 50
per cent again – although it was still the lowest of any UK bank. Pattullo was unrepentant and upbeat. The Bank had been investing in its computer systems, refurbishing its branches and
boosting its finance house subsidiary. He stated, ‘The point is you must not fall in love with having a low cost/income ratio if there are investment opportunities and income streams to be
generated, otherwise you inhibit growth for the future.’
⁴
Lex found his bullishness hard to take, asking: ‘Is Bruce Pattullo
losing his grip?’ and pointing to the unaccustomed optimism of the legendarily bearish Pattullo and dour Peter Burt. It quoted an unsettled stockbroker as saying: ‘We are all used to
emerging from our conversations with them plunged in gloom.’ There was no gloom for the next five years as the Bank rode the boom in the UK economy and increased its profits by an average of
20 per cent a year.

If there was an outward show of optimism, it was masking deeper concerns. Despite Bruce Pattullo’s exhortation to his managers to pull in the deposits, they could not keep up with the
Bank’s success in lending. In 1978 it had been able to fund over 90 per cent of its lending from retail deposits – the savings of its customers – and a large proportion of these
were in current accounts, which did not pay interest. By 1985 the amount of lending covered by branch deposits had fallen to less than half.
⁵
This trend had serious implications, but it would not be easy to reverse.

The Bank’s deep roots in Scotland and its branches in every town and city meant that it was a natural home for the savings of thrifty Scots. Its expansion, however, had been fastest in the
south of England where it did not have a branch on every high street and was not a known and trusted brand. The success of non branch-based savings products like the Money Market Cheque Account and
HOBS, which had a savings account facility, could pull in amounts in thousands or even tens of thousands per customer, but lending, whether it was in mortgages or corporate loans, was in much
larger sums. Competition for savings was also much fiercer than it had been 20 years before. The deregulation of building societies in 1986 had
spurred a number of the larger
organisations to follow aggressive expansion policies, which included competing strongly with the banks for deposits.

Another factor was that British households were saving less. Unsurprisingly the proportion of incomes which went into savings fell during the recession of the early 1990s, but worryingly for the
bankers even in the relatively good economic position of the late 1990s the savings ratio was dropping rapidly – from nearly 12 per cent of household incomes in 1995 to less than six per cent
five years later.

The effect on Bank of Scotland was to make it much more reliant on the wholesale money market, where banks and other financial companies and institutions lent and borrowed on a daily basis.
Banks would forecast how much money they would need to meet their obligations and lend out any surplus to other banks for days, weeks or even months. Other institutions, such as pension funds and
investment managers might lend for longer periods, months or years. Brokers were also active in the market, lending and borrowing on behalf of a wide range of clients from financial institutions,
to governments, local authorities and other public agencies, private corporations and wealthy individuals. By the mid-1990s the ability to trade electronically had made this market wide and deep
– hundreds of banks and other financial companies were active across the world, trading in many currencies as well as government and corporate bonds and ‘derivatives’ such as
futures contracts and more esoteric products. The market functioned 24 hours a day and was continually liquid with untold billions (in whatever major currency you liked to name) moving hourly.

To borrow in this market you needed to be ‘a name’, meaning that you were known and trusted. Your standing determined how willing others were to lend to you and what interest rate
they would charge. The Bank, with its high capital ratios and its reputation for prudence, would have no difficulty in raising the finance it needed.

But the wholesale market was capricious. Interest rates could vary widely and the perception that a bank was becoming dependent on it could affect both its credit rating and its share price.
Analysts began to ask questions about the Bank’s strategy and whether it could sustain the remarkable record it had achieved in increasing its lending. The question mark over how the Bank
would fund itself in
the future became a weakness and in the minds of Pattullo, Burt and the board it made the Bank vulnerable to takeover and the possibility of losing its
independence just as it was celebrating its 300th birthday.

These fears were heightened by the shock decision by Standard Life in May 1996 to sell the one-third stake in the Bank it had acquired a decade previously from Barclays. Up to this point the
Bank had been able to ignore the threat of takeover, confident that its close relationship with the life assurer would protect it. The two companies were twin pillars of the Edinburgh establishment
and had representatives on each other’s boards. Any potential acquirer of the Bank would have to deal with Standard Life and it was tacitly assumed that nothing would be done to jeopardise
the independence of Scotland’s largest company.

But times were changing and the ‘squalid Scottish stitch-up’ which Tom Risk had been able to pull off ten years before was no longer possible. Local loyalties and the necessity of
avoiding embarrassment in the New Club, the exclusive gentlemen’s club overlooking Edinburgh Castle in Princes Street, cut no ice with the professional fund managers running Standard
Life’s equity portfolio. The insurance company had done well out of its Bank of Scotland shares, but it represented a disproportionate element of its equity holdings and if the Bank’s
performance in the future faltered, the shareholding could drag down the fund’s return. The announcement came without warning and immediately promoted speculation that the shares might be
sold to a potential predator, such as one of the London Big Four or a foreign bank wanting to enter the UK market. The
Financial Times
Lex column declared that the decision had ‘put
Bank of Scotland into play’
⁶
and the share price jumped on speculation of a possible future bid.

The decision caused uproar in Scotland and spilled over from the business world to the political. The day after Standard Life’s announcement Bruce Pattullo met Michael Forsyth, Secretary
of State for Scotland in the Conservative government, who issued a statement emphasising the importance of the Bank to the Scottish economy and saying that he hoped there would not be a hostile
bid. Alex Salmond, leader of the Scottish National Party, called on the Government to refer any future bid to the Monopolies and Mergers Commission. Pattullo was embarrassed and angry that he had
not been given prior
warning and to show his displeasure at the way the announcement had been made, he immediately quit the board of Standard Life, delivering his resignation
letter in person to their offices. He said he had been affronted at the way the news had been allowed to become public and he owed it to the 18,000 employees of the Bank to show where his loyalties
lay.

The speculation continued in the Scottish newspapers for a month until Standard Life placed its shares in the stock market, selling them in small lots to many different buyers rather than as a
lump to a single purchaser.

There was relief on The Mound, but it did not answer the underlying problem of what to do about the increasing reliance on wholesale funding. The Bank commissioned the management consultancy
McKinsey to report on its strategic options, but it confirmed what was already feared. If it carried on growing at the rate it had been, increased reliance on the inter-bank market – and
therefore increased vulnerability – was inevitable. The alternative of putting the brakes on growth could have the same effect: the share price would fall, making the Bank an easier target.
The only answer was to get access to a new, large source of deposits and do it quickly.

In 1997 the Bank signed an agreement with the supermarket chain Sainsbury’s to create Sainsbury’s Bank, which offered savings products devised and operated by the Bank, but branded
and sold by the supermarket to its customers. There were no branches, customers used the telephone (and later the internet) to access their accounts and carry out transactions. It was the first
such venture in the UK and within months it brought in several hundred million pounds in deposits which Bank of Scotland effectively lent to itself – useful, but not nearly enough.

So Pattullo and Burt began a series of journeys through England talking to building societies, which typically had high deposit ratios, trying to interest them in being bought or entering into a
merger. Burt joked that he had eaten a ‘rubber-chicken’ lunch or dinner in every sizeable town from Bristol to the Scottish border. But again the Bank’s cautiousness held it back.
It was not the only suitor looking for a mate and the Bank balked at the prices being paid, so found itself standing on the edge of the dancefloor while others swept away the most attractive
partners. Lloyds took over the Trustee Savings Bank (TSB) in 1995 and Cheltenham & Gloucester Building Society in 1997; in the
same year Bristol & West Building
Society was taken over by Bank of Ireland and in 2000 Barclays bought the Woolwich. The Royal Bank had also tried to form an alliance with the Midlands-based Birmingham Midshires society, only to
find itself jilted when Halifax, the largest former building society and now a retail bank, bettered its offer and made off with the prize.

Bank of Scotland already had working arrangements with Halifax– a team of 20 from the Bank had been seconded to the building society for a year to help sort out problems in its commercial
property lending business and the Bank, through its successful credit card processing operation, provided the back office for Halifax’s Visa Card. Trying to build on this relationship,
Pattullo and Burt had on two occasions tried to interest the building society’s management in a closer tie-up, but both had come to nothing. On the first, Jim Birrell, chief executive of
Halifax until 1993 and a dyed-in-the-wool building society man, dismissed any idea of a merger with the Bank. His successor Mike Blackburn, a former banker, did see the logic in putting
Halifax’s huge savings base to work with Bank of Scotland’s skill at lending, but could not get his board to see it the same way.

In the end Pattullo had to admit defeat – all the lunches and dinners had been for nothing. He retired at the annual shareholders meeting in 1998 at the normal Bank retirement age of 60.
In nearly two decades at the top he had transformed an inefficient and complacent company into one which was admired for the quality of its management, its talent for innovation, its growth and its
prudence. The final set of results he presented to shareholders delivered another 20 per cent increase in dividends – the 26th consecutive annual increase – and showed that costs were
again below 50 per cent. The Bank’s shares had been the best-performing in the FTSE 100 over 1997, having achieved an 85 per cent rise in the year.

In his valedictory message he warned: ‘The fast ongoing rate of change in the volatile financial services sector means that success can only flow from a pragmatic blend of opportunism
tempered with experience. We are particularly wary of grandiose designs. The corporate scrapheap is already littered with other players’ comprehensive blueprints that were found to be
inappropriate even before they could be implemented.’
⁷

He set three challenges for his successors: stay independent, with a
headquarters in Edinburgh; be judged the best, even by your competitors; and ‘evolve and develop
the business in such a way that future generations of management always inherit the stewardship of a sound and stable business organisation with further capacity for ongoing expansion’.

A dark land – we need to pray for them

Pattullo’s place as Governor was taken by Sir Alistair Grant, who had been on the board for five years. Grant had been born in Scotland at Haddington, a village in East
Lothian a short way south of Edinburgh, but had grown up in Yorkshire. After school he had entered the retail industry and had risen to become the right-hand man of the Scottish entrepreneur Jimmy
Gulliver at Argyll Foods. While Gulliver provided the energy, flair and single-minded drive, Grant was credited with bringing competence and unflappability to the relationship and with tempering
his partner’s impetuousness and irascibility. The two were beaten by Guinness in the highly controversial takeover of the Distillers Company, but their consolation prize was the purchase of
the British arm of the Safeway supermarket chain. When Gulliver left, Grant took over as chief executive and turned it into one of the most successful retail brands in the UK.

Grant’s business life had mostly been in London and his years at the top of Safeway had made him a familiar face in the City. This was one of the qualities which recommended him as
Governor. Now that the Bank no longer had the comfort of knowing that a third of its shares were owned by a friendly Edinburgh life assurance company, establishing good relationships with financial
institutions, fund managers and stockbrokers’ analysts would become essential.

The Bank’s shares were still more highly valued than those of other banks, but the shine had come off them and investors did not immediately see how it was going to overcome its funding
problem and continue its phenomenal rate of growth. The
Financial Times
Lex column had reprimanded the Bank: ‘If you cannot be bothered to explain, you can hardly complain if people
don’t understand. Bank of Scotland’s sub-par rating is a legacy of years of neglecting investors when Standard Life owned nearly a third of the shares. That position
has changed and the Bank has been talking more, but the message still has not been getting through.’
¹