Hubris: How HBOS Wrecked the Best Bank in Britain (8 page)

He intended to tackle the English retail market by a twin-approach of getting other people to sell Bank of Scotland products, and pioneering direct sales channels which did not need bricks and
mortar. Before long the Bank was providing credit to customers of Marks & Spencer, the clothing retailer C&A, Renault cars, the Henley Group car dealership, British Rail and the motoring
organisation the AA. Banks had got over their fear of mortgages, realising that although the loans were granted for 25 years, many people moved house and redeemed their debts long before that. The
average life of a mortgage was less than a third of the nominal length. Bank of Scotland processed home loans centrally, but marketed them in this pre-internet age through newspaper ads all over
the country. It also launched a Money Market Cheque Account, aimed at people with above-average incomes or wealth – the first account in the UK to offer near-market rates on credit balances
above a minimum level. The address of the Bank’s Threadneedle Street branch in the City of London was on each cheque, but the account was run from a computer centre in the Edinburgh council
estate of Wester Hailes.

Innovation was now the Bank’s guiding principle and this was dramatically illustrated by the introduction in 1985 of HOBS – the Home & Office Banking
System, the first electronic banking system in the UK. It was initially run on Prestel, an early electronic network. For the first time customers could see their account balances and move money
between deposit and current accounts from a screen on their desks or on their home televisions. We now take this for granted with internet banking, but at the time it was revolutionary. The Bank
was freed from its dependence on a branch network largely confined to the most northerly quarter of the country and customers did not have to telephone their branches or visit them to find out what
their balance was. HOBS brought Bank of Scotland tens of thousands of new accounts, but it failed to make the most of it. ‘We still had a Presbyterian culture,’ Pattullo remembered
later. ‘We didn’t believe that we were that much ahead of any other bank. It was a great success, but we could have expanded the account base twice as fast if we had thrown everything
at it.’

Other electronic developments followed: an internal network which allowed any manager to access the account details of any customer – another ground-breaking system – and an
international payments system which was used by the Government to pay pensions and other benefits to British citizens living abroad.

There was financial innovation too. In the early days of North Sea exploration, when the Bank began participating in oil field financings, it had learned new skills by being able to forecast
cash flows and structure lending deals. Archie Gibson, one of Pattullo’s closest allies, and Gavin Masterton, Gibson’s young protégé, began to apply these techniques to a
new corporate phenomenon – the management buyout.

In boom times big corporations had often acquired companies without obvious logic and diversified conglomerates became fashionable. As the economy tightened in the early 1980s, these same big
groups began to sell off unwanted subsidiaries, often to their managements, who understood the business and recognised its potential to grow if freed from the burdens and restrictions imposed by
the parent group. Unlike later leveraged deals, these were usually companies in basic industries, with long track records and predictable cash flows. The Bank realised that the companies could
afford to borrow a large proportion of the purchase price, with the loans being repaid a few
years later when the firm was either bought by another trade buyer or floated on
the stock market. It set up a unit to specialise in management buyouts (MBOs) and quickly became the leader in the field, topping the league table of lenders ahead of banks many times its size.
Crucially, it began to gain a UK rather than just a Scottish reputation as a shrewd corporate lender and its younger managers got to work on bigger and more complex deals than they would have done
had they worked for one of the big London banks.

The core retail market in Scotland was not neglected. In 1984 Pattullo launched the ‘Friend for Life’ campaign, an attempt to shake off the Bank’s ‘stuffy and dour’
image and replace it with an attempt to provide ‘the most friendly, efficient and constructive service of all the banks’. The advertising was backed up with staff ‘training and
retraining’, to ensure that the actual service experienced by customers lived up to the hype.
²
The Bank also supported the Institute of
Bankers, and put any of its managers it believed had potential through the Institute courses and exams. Exceptionally talented people were sent to Harvard to take the Advanced Management
Programme.

In 1985 Pattullo presented figures to his senior managers at an internal conference. Over the past year the Bank had increased its pre-tax profit by 35 per cent, marginally behind its old rival
the Royal Bank, but well ahead of any of the English clearers. Over five years the record was more impressive: the Bank was well ahead of the pack with an almost doubling of profit. Over ten years
it had achieved an increase of 474 per cent, beaten only by Lloyds. Its return on equity – a measure increasingly looked at by professional investors – was running at 23–25 per
cent in the late 1980s, a very high rate of return for a bank which was still regarded as well capitalised and not unduly risky. In 1989
The Economist
magazine’s survey of the
financial sector resulted in the Bank being voted by its peers as ‘the most admired bank’ for its technical innovation, and the Institution of Electrical Engineers asked the Bank to
deliver the annual Faraday Lectures, under the title ‘Electric Currency’.

For all his willingness to try new things, Pattullo remained innately a cautious man. While trumpeting to a management conference that the Bank was now ‘advances led’ – that is
its growth was being propelled by its success at lending – he exhorted them to match this by bringing in more deposits. Although he sanctioned large corporate
loans, he
wanted to be sure that there was a near-certain chance of the money being repaid and he often expressed his belief that banks ‘should not be in the risk business’.

The philosophy that the Bank was a custodian of its depositors’ funds lay behind its governance structure. In addition to the main board, there were area boards in the East and West of
Scotland and in London, whose members included the responsible senior executives of the Bank and non-executives, usually the heads of prominent local businesses. Another board shadowed the
international department. They would scrutinise lending propositions, using their business expertise and local knowledge to challenge the executives. The main board also discussed lending proposals
in a process known by the Victorian term ‘homologation’. The board, drawn from the captains of the various industries with which the Bank dealt – oil, property, engineering,
shipping, investment – would closely question executives on what they were doing. ‘The idea,’ remembers one board member, ‘was not to second-guess the executives, but to
make sure we understood what they were proposing and also to make sure they understood it too.’

The Bank board of the 1970s–1980s, exclusively male – white, middle-aged, middle-class with the occasional member of the aristocracy – would not pass muster today. ‘It
was non-PC,’ remembers one executive, ‘but it worked.’ In a small country like Scotland conflicts of interest must also have occurred frequently, with board members sitting in
judgement on the business plans of their competitors. But standards then were different. Directors were expected not be partisan or further their own interests and trusted not to do so.

In the UK, the Bank’s success in oil and management buyouts was increasingly bringing it into London – although with typical Edinburgh disdain Tom Risk categorised it as ‘an
inefficient place to do a day’s work’. In the late 1980s came the ‘Big Bang’. The deregulation of financial services allowed clearing banks to move into previously
prohibited activities. There was a wholesale rush of banks buying stockbrokers, fund management firms and merchant banks. Names which had been a fixture of the City for decades or even centuries
disappeared into huge financial conglomerates and the city gents who had been partners in these firms retired with wealth unimagined even by their accustomed comfortable standards. In their place
came a new breed of younger, sharper, better educated and more aggressive
operators. ‘My word is my bond’, the motto of the Stock Exchange, gave way to
caveat
emptor
. Long lunches gave way to sandwiches at the trading screen. Bank of Scotland stayed aloof from this movement, preferring to stay as a pure banking operation and in a statement of its
defiance, contributed to a capital-raising by Cazenove, the Queen’s stockbroker and the most conservative of the city institutions, which had decided to remain independent. The Bank and
‘Caz’, led by its senior partner, the patrician David Mayhew, appeared to share a similar ethos.

The Bank also refused to be drawn into the increasingly fashionable proprietary trading of derivatives or other complex financial instruments which were forming a growing large part of
banks’ profit-generating strategies. A treasury dealing room had been set up in London, but Pattullo always regarded the operation, which lent and borrowed in the inter-bank market, as a
service department. Its job was to ensure that the Bank always had sufficient liquidity – that it never ran the risk of running out of cash. If there was a shortfall in customer deposits,
Treasury had to make up the deficiency as cheaply and effectively as possible by borrowing on the wholesale market. It also bought and sold currencies on behalf of the Bank’s customers. What
it was not there to do was take unnecessary risks – which the Bank’s board regarded as gambling – even if this meant it might miss out on profitable opportunities.

There was one fashion, however, which it did not shun. The Bank’s entry into the mortgage market at the end of the 1970s had been a great success. There was an increasing demand from
couples to own their own homes and the Conservative Government, headed by Margaret Thatcher, encouraged the trend and offered a tax incentive which made mortgage interest payments more attractive
than paying rent. By 1984 home loans made up 10 per cent of the Bank’s lending
³
and its advertising campaigns were producing more leads
than it could handle. This was low-risk business. Borrowers knew that they could lose their homes if they failed to meet the repayments and would tighten their belts elsewhere rather than default
on the monthly mortgage. The Bank carefully screened applicants to satisfy itself that they had steady incomes and could meet the repayments even if the economy turned down. It also took security
over the house, or over an endowment life assurance policy. Besides the loan, there were other gains for the Bank: it insisted that mortgage customers open a current
account
to channel their monthly payments and tried to sell them insurance, on which it earned a commission. The loans themselves were very profitable: the Bank not only charged a premium on the interest
rate, but a set-up and administration fee as well. The problem was that home lending was growing much faster than the Bank could attract deposits. It wanted to do more, but how was it to find the
money to lend?

The answer was to sell the loans on to someone else, a process now known as ‘securitisation’. The Bank formed syndicates with other banks and they parcelled up thousands of mortgages
together. They now represented a very large amount of lending, which was being repaid in regular and predictable instalments. The risk was low, partly because the Bank had taken care to vet the
borrowers, but also partly because of the diversification effect of this huge portfolio which was spread over different parts of the UK, different ages and types of homes and borrowers, whose
occupations and incomes were different. It was very unlikely that many of them would default at the same time. These packaged mortgages could be sold to life assurance and pension companies which
had cash to invest and needed predictable, reliable incomes to meet monthly pension payments.

The Bank kept the fees it had charged to borrowers and took a small share of the interest payments to cover the cost of continuing to administer the loans, collect the repayments and process any
early redemption of loans when borrowers moved house. It also kept the risk and undertook to buy back any outstanding loans at the end of seven years.

Borrowers were oblivious to any of this. As far as they were concerned, their loans were with Bank of Scotland, to whom they continued to make their repayments and to whom they addressed any
queries. But with the money it received from selling the mortgages, the Bank was able to make new loans, collecting set-up fees and a margin on the interest payments each time. As long as the
demand was there it could carry on doing this indefinitely.

Had he been able to see 300 years into the future, William Paterson would have approved; this was near to his ideal of a bank benefiting from interest on money it was creating out of nothing.
Some of the Bank’s board, however, did not approve.

‘Who were these mortgages being passed on to and what responsibility did we have?’ one director remembers wondering. ‘We asked
these questions, but they
were never satisfactorily answered.’ The non-executives were uneasy about the whole process. Their concerns were quietened by assurances that the Bank carefully vetted the borrowers, retained
the risk and would buy back any outstanding loans at the end of the process, but doubts remained. ‘If you can pile up loans and get them off your balance sheet and believe you have no
responsibility for them, whereas the people who took out the loans believe you are still responsible – that is not good business. However, it became very fashionable and everyone was doing it
the same way, so we did it.’

The practice did not last long. The Bank decided that mortgages were to become an important part of its lending and should stay on the balance sheet. It would be years before securitisation was
attempted again.