Hubris: How HBOS Wrecked the Best Bank in Britain (9 page)

The Cultural Revolution

By the end of the 1980s the Bank’s performance was attracting attention. Pattullo had exceeded his ambition of doubling its share of the UK market and of making it the
best-performing bank, in the UK at least. Bank of Scotland’s growth – 20 per cent per annum in the previous four years
¹
–
had propelled it into the top 100 companies listed on the Stock Exchange. Its cost/income ratio, a measure of its efficiency, was 10 per cent better than any of its London competitors and was
heading lower as it continued to find new ways to increase its earnings and hold down its expenses.

Investment institutions, which a decade before had regarded the Bank as a safe but unexciting utility, were now looking on it as a growth stock. In contrast to its bigger rivals, which were seen
as poorly managed, it had strong leadership and a clear strategy for continuing to take market share from its bigger but slower London competitors.
The Times
noted that Bank of Scotland
‘still enjoys the highest prospective multiple in the banking sector, which points to a high tolerance by investors for the Bank’s flair for innovation’.
²
Professional investors were starting to focus on new measures where the Bank excelled, like return on equity (shortened by professionals to RoE and expressed as a
percentage).

The
Financial Times
’ influential ‘Lex’ comment column became a regular fan. In 1989, commenting on a profit rise of 36 per cent, it berated investors for growing
‘tired of Bank of Scotland’s refrain: strong management, even stronger balance sheet and novel strategy for growth’. Its shares had lost some of their premium over the troubled
English banks, but the newspaper added, ‘If the market thinks that the Bank has lost its deft touch in these matters, there is surely no sign of it in yesterday’s
results.’
³
A year later the Bank again posted record results, together with a sharp fall in its cost/income ratio and a return on equity
of 25 per cent. Lex commented: ‘Coming
less than 24 hours after the grim warning from Midland, Bank of Scotland is a refreshing reminder of what well-managed banks can
achieve even when times are tough.’
⁴

Before I go any further I should include a brief and very simplified explanation of bank finances. Confusingly for lay people, banks call the sums of money they hold – the deposits of
their customers – ‘liabilities’. They are liabilities because the banks do not own the cash and one day it will have to be repaid. But in the meantime they can use this money to
lend and earn profits from. The money they don’t hold – the cash they have lent out – banks call ‘assets’. They are assets because the banks expect the money to be
repaid and in the meantime it is earning interest.

‘Equity’ is the capital its shareholders subscribe for shares, plus the profit retained in the business, which belongs to the shareholders. Banks make money by lending out the funds
entrusted to them by their depositors. The equity owners, the shareholders, get the profit on this lending, but in return they take the risk. If some borrowers cannot repay – usually the case
in a recession, for example – it is the equity owners who lose their money (or should be), not the depositors. Banks need a certain minimum level of equity as a cushion against the risks of
lending. How much equity a bank needs is partly determined by what sort of business it does – some forms of lending are more risky than others – and partly by how it thinks the economy
will perform. You can look on equity as ‘rainy day’ insurance. How much you need depends on how likely you believe it is to rain and how hard.

In the days of William Paterson governments had very little to say about how much capital a bank needed to hold; it was up to shareholders and depositors to make up their own minds about the
level of risk. But numerous bank failures in the intervening three centuries have persuaded governments to specify a minimum capital level. (There will be more about government and international
regulation later, but thirty years ago it was a lot simpler than it is today.) Above this statutory minimum it is a matter of judgement for a bank’s executive and board how much equity it
needs.

There is more than one way a bank can increase its RoE. It can, of course, increase its profits (the return) by growing its business and managing it efficiently. But it can also flatter the
apparent return, thus making the ratio look larger, by reducing its equity, or at least not increasing it as fast as its lending is increasing.

In the 1980–90s Bank of Scotland was achieving high levels of RoE, but not by reducing its equity cushion. The Presbyterian ethos of the Bank prevailed and as its
business increased it had no hesitation in going to its shareholders to raise new capital to maintain its capital ratio, which was already higher than many of its rivals. This was not a reflection
of the riskiness of its lending – its bad debt levels were low – but of its cautious approach. The 1980s had seen recession as well as economic boom and the Bank ran its business on the
assumption that between the good times there would always be bad ones. After declaring record profits and an increased dividend in 1984, the Bank raised £41 million, another £81 million
the following year and a further £191 million in 1991. ‘This is a capital-hungry business,’ Pattullo explained. ‘I believe the strong are going to get stronger and the weak
are going to get weaker.’
⁵

The Bank was riding high, but instead of gloating or greed there was a rectitude bordering on Calvinism. In 1991, with a recession starting to take its toll and the first reverse in profits for
years, senior executives and the non-executive board decided to take no pay increase. Of the other British banks only Midland, then in its last difficult days of independence, followed suit.

It also had a policy of supporting its customers through bad times, particularly industrial and commercial customers who had been with it for a long time. In the Bank this was known as
‘staying at the table’, a metaphor derived from gambling which seems inappropriate for an institution still characterised by its moral rectitude. Justifications for this policy were
varied and sometimes vague. There was a feeling of social responsibility: if the Bank forced a company into receivership, jobs might be lost and communities might suffer. There was also a more
pecuniary motive: by supporting a company through hard times the Bank might be able to get more of its money back than it would by an immediate default. But occasionally there was also a loyalty to
the business owner which seems naïve by today’s standards. One executive explained it to me at the time: ‘It would be very hard for someone who had been a loyal customer for years
to see his business transferred to someone else because the Bank had called in the Receiver.’

This policy was not without its critics. Where Bank managers could defend it by pointing to flourishing businesses which would not exist had the Bank not held its nerve when things were
apparently going wrong, others could assert that had the Bank called in the receiver
earlier a business which had eventually collapsed might have been saved by a new owner
with fresh ideas and new capital.

Whatever the motivation, sometimes the Bank stayed ‘at the table’ too long and it acquired an odd assortment of businesses by default during the 1980s and 1990s, including office
blocks, a half-completed golf resort which it went on to finish before selling it, a part-share in the Magnet Joinery business, and the Balmoral Hotel at the end of Edinburgh’s Princes
Street, which it let to the management company of Rocco Forte for five years before selling it to him. In fact, at one stage it was said to own so many hotel rooms that wags named it ‘the
largest hotelier in the UK’. This practice of supporting customers was not unique to the Bank; its main rival, the Royal Bank of Scotland, acquired the airline Loganair by the same process
and operated it for 15 years before selling.

Progress at the Bank was being watched not only in London, but much nearer to home too. During the 1980s Royal Bank of Scotland had struggled with many of the same problems of poor management
and an unwieldy structure which had hobbled the Bank a decade before. Despite being larger than Bank of Scotland and having a greater presence in England through its subsidiary Williams &
Glyn’s, it lagged in efficiency, innovation and performance. Several of the Royal’s non-executive directors were becoming concerned that its slumping share price could make it
vulnerable to collapse or takeover and persuaded the board that new blood was needed to bring new energy and ideas. Sir Robin Duthie, chief executive of the tent maker Blacks of Greenock, had been
chairman of the Scottish Development Agency (SDA), and pushed the name of its Chief Executive, George Mathewson.

Mathewson was not a career banker. He had been born in Fife and after studying electrical engineering at university to doctoral level, he had worked in the US for an electronics company and
taken an MBA degree there. He came back to Scotland at the beginning of the oil boom to work for the investment bank ICFC (now called 3
i
), rising to become a main board director based in
London responsible for a portfolio of a thousand companies. He returned to Scotland as the second chief executive of the SDA, and transformed a bureaucratic government body into a nimble, dynamic
organisation focused on industrial investment, urban regeneration and the attraction of investors from the US and Japan. At the end of his five-year term he
was considering
an offer to run the New Zealand electricity company when the call came to move to the Royal Bank.

Mathewson was fiercely competitive and combative – he played club rugby into his fifties – but also a team builder. One young subordinate remembers fierce arguments which would get
steadily more heated up to the point where ‘George would remember that he had hired you and that he was never wrong, so maybe you had a point’. He was also an inspirational leader with
strong self-belief. Another manager remembers coming away from a meeting at which George Mathewson had set a seemingly unachievable goal and had inspired the team to believe they could reach it by
saying: ‘I will get there and I have never failed.’ It was only after the meeting that the manager had remembered all the instances in which George had failed. ‘But at the time he
said it he believed it to be true and we all believed him too.’

He had managed the transformation of the SDA with a small group of bright young men, mostly recruited from outside the agency. When he moved to the Royal Bank as strategy director he brought the
team with him. These were not time-served bankers, but intelligent, ambitious people, many with postgraduate degrees and the arrogance which comes with being young and highly educated. Their
analysis of the problems of the bank showed contempt for the ponderous management structure and complacent attitudes. Society and business had changed rapidly, but banking had not kept pace with
it. With a handful of like-minded second-tier executives from within the bank, Mathewson began a series of weekly meetings to plot an internal takeover and oust the senior management.

Their chance came with the recession of the early 1990s, which cruelly exposed the bank’s poor lending record. At the end of 1991 the Royal’s bad debts soared and group profit
collapsed by over 80 per cent. The retail bank managed a contribution of less than £6 million, but only by finding every legal means it could to flatter its accounts. Bank of Scotland also
suffered from the economic downturn, but still managed to increase its pre-tax profit to £140 million.

Mathewson was helped by the fact that George Younger had recently resigned from the Cabinet as Defence Secretary to become chairman of the Royal Bank of Scotland. The two men had worked closely
together when Younger had been Secretary of State for Scotland and had given Mathewson the political cover he needed
to run a successful interventionist industrial policy at
the SDA which ran counter to the ethos of Mrs Thatcher’s government. The move had paid off. Reversing the pattern of decades, Scotland had started to do better in the league tables of
economic performance and prosperity than many of the English regions. When there were riots in English cities in protest at the harsh austerity being imposed from Westminster, Scottish cities had
remained calm.

Younger’s relaxed manner and urbane charm disguised a decisive mind and a shrewd judge of character. The two men were to become as effective a combination as Tom Risk and Bruce Pattullo at
the Bank. Mathewson and his team made a presentation to the Royal’s directors and argued that only a radical transformation could save the bank. The board decided in his favour. He was
installed as chief executive shortly afterwards and cleared out the old guard from the top jobs.

The effect on the Royal was dramatic, but the most radical changes were yet to come. Mathewson split the bank into three – a wholesale bank to service corporate customers, retail for
smaller businesses and personal customers, and an operations division, to provide shared services such as property, computer services, now renamed ‘Information Technology’, and
personnel, which was renamed ‘Human Resources’ following the fashion of the time. The 17,000 staff were also divided into three – those whom the new management wanted to keep,
those whose attitudes or skills did not fit the new regime and those who were to be given the chance to change.

The retail bank went through fundamental change. Under the code name Project Columbus, Mathewson’s team identified numerous failings, including poor organisational design, poor-quality
people in key positions, lack of vision and investment in IT, unreliable lending and pricing policies, unimaginative products and low priority given to customer service.
⁶
The solution, it was decided, was to reinvent branch banking and it called in the international management consultancy McKinsey to help it.

Hundreds of branch managers now found themselves either facing early retirement or having to be interviewed for their own jobs. ‘The golf courses of Edinburgh were full,’ quipped
Mathewson. Compared to the gradual evolution which Pattullo had encouraged at the Bank, the upheaval at Royal Bank was more like Mao’s Cultural Revolution. It was a shock not only to the
Royal’s staff, but to the whole of
Scottish banking, which had regarded entry into one of the banks at the age of 18 as being the passport to lifelong employment. From
now on people ‘who had done nothing wrong’ could find themselves out of a job.