Posted on September 5, 2012 by

The Failure of the Royal Bank of Scotland: Strategy and Risk Appetite

In March 2000, The Royal Bank of Scotland (RBS) acquired the UK-bank NatWest in a £21 billion deal that was then the largest take-over in British banking history. The acquisition was considered at the time to be a masterstroke of strategy and execution. Thus began a ‘golden period’ in RBS’s near 300 year history. RBS embarked on an ambitious strategy to transition from a regional to global financial services firm and one that drove aggressive revenue growth. RBS’s stock price grew and performed well in the early years of the 2000s and by 2007 the now global financial player was viewed by most analysts as a highly successful bank. For instance:

  • From 1997 to 2007 Earnings per share (EPS) had grown from about 50p to close to 250p
  • In 2007 RBS reported a record group operating profit of £10.3bn (£7.7bn after tax)
  • RBS increased its assets by a multiple of 29 between 1998 and 2008 (assets grew by an average of 41% per year)
  • It moved from outside the top 20 global banks by market capitalization prior to its acquisition of NatWest to ninth in the world by 2007

Then the Credit Crunch and disaster: RBS essentially failed in October 2008. To prevent collapse the UK Government injected £45.5bn of equity capital (worth only about £20bn as of December 2011) and was part nationalized. Overall its stock price dropped from a high of over 700 pence in early 2007 to around 20 pence in late 2011.

The failure of RBS is one of the most notorious banking collapses precipitated by the Credit Crunch. Not only did it lead to a one-time darling of the stock market to become part nationalized, it also led to a catastrophic collapse in reputation. A 2011 study by the Reputation Institute found that the bottom ranked of 260 listed companies in terms of reputation, and by some distance, was the Royal Bank of Scotland. (Ref) Financial, market and reputational recovery will be a long, brutal road for RBS.

But what went wrong?

The UK’s Financial Services Authority’s December 2011 report The Failure of the Royal Bank of Scotland answers this question in great detail (running to 435 pages). The immediate cause of RBS’s failure was a liquidity run and although, and as we summarize, poor decision-making, especially in relation to risk, were key drivers of failure, the report did point to broader reasons: most notably:

  • The key prudential regulations being applied by the FSA, and by other regulatory authorities across the world, were dangerously inadequate; this increased the likelihood that a global financial crisis would occur at some time
  • The FSA had developed a philosophy and approach to the supervision of high impact firms and in particular major banks, which resulted in insufficient challenge to RBS’s poor decisions. The supervisory approach entailed inadequate focus on the core prudential issues of capital, liquidity and asset quality, and insufficient willingness to challenge management judgments and risk assessments
  • The capital rules which the FSA was applying were in retrospect severely deficient: they allowed RBS to operate with dangerously high leverage. This was one of the most crucial drivers of RBS’s failure
  • The erroneous belief that financial markets were inherently stable, and that the Basel II capital adequacy regime would itself ensure a sound banking system, drove the assumption that prudential risks were a low priority

Nevertheless, the report described a whole raft of poor decisions by RBS management and Board. Among the most striking was the decision to go ahead with the AB AMRO acquisition in 2007, which played a significant role in RBS’s failure. The Board decided to go ahead with the acquisition on the basis of due diligence which was clearly inadequate relative to the risks entailed. With incredulity, the report stated that, “Many readers of the Report will be startled to read that the information made available to RBS by ABN AMRO in April 2007 amounted to ‘two lever arch folders and a CD’ and that RBS was largely unsuccessful in its attempts to obtain further non-publicly available information.”

The acquisition was a primary cause of failure for this reason: RBS entered the crisis with extensive reliance on wholesale funding. Its short-term wholesale funding gap was one of the largest in its peer group, and it was more reliant on overnight funding and unsecured funding than most of its peers. The acquisition of ABN AMRO increased its reliance on short-term wholesale funding.

By early 2007, RBS had accumulated significant exposures containing credit risk in its trading portfolio, following its strategic decision in mid-2006 to expand its structured credit business aggressively. The acquisition of ABN AMRO increased RBS’s exposure to such assets just as credit trading activities were becoming less attractive. This increased the firm’s vulnerability to market concerns.

Structured credit markets, of course, deteriorated from spring 2007 onwards. RBS, like many others, was by then holding positions which were bound to suffer some loss. The crucial determinant of how much loss was the extent to which a firm could distribute its existing positions, or was willing to take losses earlier by hedging or closing those positions out. RBS was among the less effective banks in managing its positions through the period of decline, according to the report.

It is evident that in pursuing its aggressive strategy RBS was exposed to a plethora of high risks. The FSA analysis raised serious questions about the effectiveness of the RBS Board’s role in relation to strategy. ”Given the scale of RBS’s ambitions for growth, in particular during 2006 and into 2007, it is reasonable to expect the Board to have assured itself that the growth strategy was accompanied by a very high degree of attention to the associated risks. In retrospect, this was not clearly and demonstrably the case,” the report stated. This is a sample of the evidence cited in the report:

  • The ‘Board, Remuneration Committee and Nominations Committee Performance Evaluation 2005’ report said that a quarter of the Board disagreed that the Board’s review and evaluation of strategic issues in relation to the Group’s present and future environment was satisfactory, that directors would like more time to consider and debate strategy, and that a number of them felt that there should be a formal report or discussion of risk appetite when the budget was reviewed. The 2006 report said that directors felt there was insufficient input to and review of risk appetite at Board level, that the Board needed to articulate its risk appetite and that a third of them did not appear to be satisfied with the Board’s role in defining and developing strategy.
  • Strategy documentation provided to the Group Board for Global Banking and Markets (GBM) did not include detailed analysis of the relevant markets to support the aspirations for growth or of the key risks involved. The risk impact was typically summarized in a bullet point for each initiative, with no information as to how the various risks identified were to be addressed or mitigated. There was no evidence of any significant challenge by the Risk function to the proposals.
  • Feedback from an adviser who contributed to the RBS executive programme that RBS was unique among major banks in having many ‘hill climbers’ but almost no ‘hill finders’. The bank was seen as exceptionally strong in people who would reliably implement agreed strategy but relatively much weaker in its capacity for strategic thinking.
  • The relevant risk functions within RBS were not heavily involved in the process of strategy formulation and they did not carry out a risk assessment until after the strategy had been presented to the RBS Board. When the strategy was presented to the RBS Board in June 2006, the key risks were identified as ‘Market risk from newly evolved products and model complexity’. The FRS found no evidence to suggest that this brief description was expanded on to provide more detail as to the nature of the risk, how and when it would crystallize, and what steps would be taken to minimize it.

Overall, the report stated that within the RBS board and executive team there was pattern of decisions that may reasonably be considered poor, suggesting the probability of underlying deficiencies in: a bank’s management capabilities and style; governance arrangements; checks and balances; mechanisms for oversight and challenge; and in its culture, particularly its attitude to the balance between risk and growth.

FSA highlighted to RBS the need for it to have best practice risk management systems including, in particular, to make improvements in stress-testing to show that it would be able to withstand a severe economic downturn; and for the RBS Board specifically to consider and debate its risk appetite and establish appropriate limits.

Based on the above and other evidence, The RBS Group Internal Audit report delivered to the Chairman in July 2008, said: ‘Based on our review and meetings with Board members, discussions of strategy could be expanded to include more analysis of strategic options and their associated risks. These discussions would also be supported by appraisals of current risk levels versus risk appetite’ and ‘this should include the nature and scale of the risk that the Board is prepared to take’

Finally, risk and, in particular risk appetite, had become an agenda item for the Board of RBS.

Notes

*This case study is based on the report The Failure of the Royal Bank of Scotland by UK’s Financial Services Authority, December 2011 and some additional materials.

** This case study appears in the forthcoming book, Risk-Based Performance Management: The New Agenda by Andrew Smart and James Creelman, Palgrave Macmillan, UK, 2013).