A fresh look at the banking bailouts
March 2, 2011
One of the curiosities of the global bank bailout process since September 2008 has been the consensus that this episode symbolised courageous, decisive government action at its best. The nation’s economy teetered over a precipice, mere hours away from a refusal by cashpoints to dole out any more banknotes. The conventional wisdom now, almost regardless of their terms, is that the bailouts were an essential life-preserving shock to the domestic economy.
Unfortunately while this version of events contains some truth, it has diverted us from asking searching questions over the deals struck during those whirlwind weeks. As the public distaste for bankers’ remuneration and bonus payments reaches fever pitch, correspondingly little attention has been paid to the terms demanded by the erstwhile government in return for propping up the banks. It is still not clear what thought was given during the bailout process to the long term goals of government; what commercial and political principles, if any, were followed in those early days; whether this emergency action was dictated by tactical considerations alone; and if there was ever a clear strategy for the future.
In truth, the Labour government appeared to lack any coherent vision as to the route ahead. It chose rather to pursue a confused path of unconnected policy announcements dictated by the whims of public opinion, the electoral cycle and the media – a grim foundation upon which the Coalition has strived to build a credible alternative since last May.
In fact, some of the inherent flaws of the deals from those fraught weeks in autumn 2008 may help to explain why there remains to this day an overriding sense that the bankers ‘got away with it’, with the taxpayer picking up the tab. Indeed I would contend that history will view the banking bailouts as a missed opportunity – a moment when moral hazard might have been sewn into the heart of the regulatory system by making recapitalisation a deeply unattractive option.
This issue requires forensic examination and a more thorough analysis than I can provide here. I accept that I write with the tremendous benefit of hindsight about a period of unprecedented strain, when the breathtaking speed of events made mistakes inevitable. It may also prove that only the passing of a greater period of time will reveal the true worth of the deal to the taxpayer and the bailouts’ success in deterring another financial crisis of equal gravity. Nevertheless, it is worth posing some broad questions about the negotiations that preceded this colossal intervention in Britain’s economy:
While the banks undoubtedly presented the government with a crisis on a huge scale, the Treasury was nevertheless in a position of enormous strength (as is any organisation about to spend such colossal sums of money), and should have recognised immediately that the status quo no longer existed. The fact that RBS’s former Chief Executive, Sir Fred Goodwin, walked away with a pension pot of £16 million when his organisation would otherwise have been bankrupt, suggests that the government did not appreciate this.
Naturally the first priority in formulating a plan should have been to prevent systemic risk and the eventual strategy ultimately guarded against this. But beyond this task, Ministers should have asked, ‘How much money can we make out of this?’ In short, rather than view the negotiations as a bailout, they should have been looked upon as a business transaction. But instead of treating the situation as a corporate turnaround, and charging accordingly, the government provided the banks with guarantees commanding a negligible rate of return.
2. Rate of Return
The simple rule of investment is the greater the risk, the greater the return. Back then it was abundantly clear that prospects did not come much riskier than the Royal Bank of Scotland (RBS). It announced the largest loss in UK corporate history on the very same day in February 2009 that the government increased its holding in the bank from 58% to 70%.
Putting the terms of the October 2008 rescue package for RBS and Lloyds Banking Group (the product of Lloyds TSB taking on HBOS) in front of an experienced investor associate of mine, he immediately asked three questions. First, why was the most money put into the more risky instrument (with ordinary shares favoured over preference shares)? Second, why did the government pay more for the higher risk share? Third, why did the government not seek to appoint more board members?
In the case of the Lloyds Banking Group deal the government, announcing its rescue package, advised that it would purchase:
Up to £13 billion in newly issued ordinary shares, priced at 182p, and
Up to £4 billion in preference shares, priced at 38p.
Even though preference shares do not typically carry voting rights, my associate was surprised that the government favoured ordinary shares over preference shares when the latter shore up the balance sheet as effectively as ordinary, are less risky and were priced more cheaply. Compare this bailout to experienced investor, Warren Buffett’s investment in Goldman Sachs during the same period. In September 2008, Mr Buffett’s company, Berkshire Hathaway, agreed to purchase $5bn of preferred stock with a 10% dividend, with the option to purchase $5bn of common stock at any time over the following five years. That stake is now paying his company $500 million annually.
In return for the government’s investment in LBG, potentially representing 44% of the proposed merged bank, it was given the opportunity to appoint two independent board members. The board, however, comprised thirteen seats, giving the government a representation of 15% for its 44% share.
Similarly, the terms of the rescue package announced in October 2008 as they applied to RBS were that the government would purchase:
Up to £15 billion of ordinary shares and
Up to £5 billion of preference shares.
In return for that investment, the government would appoint three independent board members out of twelve, i.e. 25% of an organisation in which they owned 63%. No doubt the political imperative of being seen to take a hands-off approach was assumed to be of greater import than being able to hold greater sway over RBS’s overall direction. It might also be asked who controlled the other 37% of RBS and how much was paid for that stake when the government only got 63% of a bank which, had it not been for state intervention, would surely have imploded.
It is worth examining who was advising the government during this fraught period. Did they hire experienced investors with a track record of driving hard business deals and did they consider who would pursue the best return for the taxpayer?
It seems instead that the ‘usual suspects’ made hay. Since Northern Rock faltered in late 2007, the government spent £107 million on professional fees for the banking bailouts. Lawyers Slaughter and May picked up £32.9 million for commercial legal advice, Credit Suisse £15.4 million for financial advice with PricewaterhouseCoopers, Ernst & Young, KPMG and Blackrock taking an aggregate of £35 million for advice on the Asset Protection Scheme. Understandably the National Audit Office has called into question some of the Treasury’s practices in employing professional advisers who were awarded retainer contracts without any clearly defined criteria for success.
4. Criteria for Success
Since the bailouts took place, politicians have defined success as ‘returning money to the taxpayer.’ This is almost unbelievably unambitious. As I have described, we should have approached the bailouts as a business agreement with our aim, beyond preventing systemic risk, to strike as good a deal for the taxpayer as possible. Had this happened, and the taxpayer were aware year-by-year of the forecasted value of its stake, the debate on the future of banking would surely have been shaped entirely differently.
Instead, there has been a sense that the biggest risk takers extricated themselves from the crisis scot-free with the rest of the banking fraternity being able to carry on as before. The result has been for politicians to try to placate the public with a potentially damaging PR campaign against the financial services sector and its employees, grandstanding on bonuses, cash/share splits and the efficacy of the 50% higher rate of income tax. In essence, the previous government had no coherent strategy on banking after the bailouts, laying a foundation upon which it has been difficult for the Coalition to build a credible alternative.
5. Lessons Learned
I doubt any institution would wish happily to go down the path of recapitalisation again. Yet the fact remains that the government stands ready as the lender of last resort to depositors at the very least. History demonstrates that the terms of any bailout should not be as unattractive as they might be. Had a hard bargain been driven by the government, with no option of a golden goodbye for the most discredited Chief Executives, the fear of bailout could have served as a far better regulator of behaviour than reams of new laws and fresh bodies in place to police the system.
Beyond the prevention of systemic collapse, in future the government’s negotiating teams might ask a few simple questions: what are our guiding principles during these negotiations; what long term goals are we pursuing; what are our commercial, economic and (as ever) political objectives? In short, how do we want the financial system to look in the future?
The last government’s success in preventing an immediate collapse in the banking system should not disguise its failure to articulate any overarching strategy for our financial services during and after that time of economic emergency. Its insistence on pursuing a weak, ill-defined and ad hoc path left only a bitter taste in the mouths of banker, businessman and taxpayer alike alongside a messy inheritance for this coalition government. Whilst no one should anticipate with too much relish the next economic downturn, we should at least hope that today’s problems and the path to their solutions will be in the minds of many who are charged with fixing it next time round.
Nothing can change the original terms negotiated during those 2008 bailouts, but they really must hold lessons both for now and the future. Beware the vested interests or entrenched mindset of the expert. Be sure to exact terms in line with the risks taken. Most importantly, robustly and continually define the strategic objective in the general national interest.