On the Sunday of the ninth of September 2007 a meeting was called in the Treasury. It was, as they say, fateful – although none of the participants realised it at the time. That afternoon the course of the UK economy and political life was altered for years to come. If things had been decided differently there might have been no collapse of Northern Rock, no bank bailout, the Labour government might have emerged from the financial crisis with its reputation enhanced instead of ruined, and Gordon Brown might still be Prime Minister.
Earlier that week Northern Rock – a small but very ambitious building society turned bank – had started to run out of cash. Many thought it was a short-term problem. The bank had a strong retail business but depended on ‘wholesale’ borrowing to keep that business turning over, and the wholesale capital market had closed down as a result of the global confidence crisis. But here was Lloyds Bank, the sturdiest of the big UK clearing banks, standing by ready to buy Northern Rock. All it needed was a ‘liquidity line’ – effectively a multi-billion pound overdraft – from the Bank of England just in case things got tight.
Chancellor of the Exchequer Alistair Darling was open-minded. Hector Sants of the Financial Services Authority – the bank regulator – was all for the deal, but he fumbled his presentation and got slapped down by Mervyn King, the Governor of the Bank of England. King had failed to grasp that a full scale banking meltdown was in the offing and refused to countenance the BoE going anywhere near a private sector corporate deal (something he would have to get very accustomed to in the months that followed). “It is not our job,” said King. At that point Darling closed the discussion and said “let’s move on.” If only.
Within a week Northern Rock had collapsed, and the death spiral of the financial economy had begun. At the peak of the crisis the UK government had to commit over £1 trillion – more than half of GDP – to the banking system, and even today the actual cost of the bailout is £3,210 for every adult in the country. Yet Lloyds had been ready to step in before the rot started, potentially changing the whole trajectory of the crisis.
Wait a minute. Lloyds? Lloyds Bank, the dullest, the unsexiest, the most risk-averse of all the big UK banks? In the world of the City of London Lloyds was the least popular bank on the block, simply because of its chronic refusal to increase its risk profile, its reluctance (or inability) to grow like its rivals, and its distaste for the dark and dangerous worlds of investment banking and opaque derivatives. What was fuddy-duddy Lloyds doing bidding for one of the brashest property lenders in the business?
This is the question tackled in Ivan Fallon’s excellent book Black Horse Ride. The answer is to be found buried somewhere in the very nature of banking, a business that seems fated, almost designed, to blow up every few years. This is Fallon’s point: if you cannot trust even super-cautious Lloyds to stay solvent and keep their hands off the taxpayers’ money, then who can you trust?
The problem is simple: the core business of banking is really not a good way of making money. Taking deposits from savers and then lending the money out to investors who have good security – a house, say – is straightforward and sensible and low on risk, but not profitable. Old fashioned ‘mutually owned’ building societies used to do this and some still do, but they make a rather low return on capital – typically 10% or less. Most investors would expect to get more like 15% return on capital from a conventional business making nuts and bolts, or sandwiches.
When your bank is owned by savers, like the old kind of building society, that is fine. Big returns are not called for. But most banks are not owned by savers – in fact most building societies are no longer owned by savers – but by shareholders. Shareholders want something very different: large profits that will fuel large dividend payments, and revenue growth that will propel the share price upwards. All the big UK-based banks are shareholder-owned, and if they don’t want to disappoint these shareholder expectations, they are left with two ways to go.
They can go for retail growth, which in a mature business like banking means buying similar banks or financial services companies and bolting them on, or buying dissimilar financial companies and trying to integrate them. The strategy is essentially to buy customers, and then up the profits from them. A lot of banks went down this path, creating what were called ‘bancassurance’ businesses on the premise that once you have a banking customer, it’s easy to sell that customer other financial products, primarily insurance.
There are problems with this kind of growth. One is that different companies turn out to be a lot more difficult to bolt together than expected. Most of the profits of mergers end up coming from ‘downsizing’ or ‘rationalization’ – in plain English, job cuts. The other problem is that the sector eventually runs short of companies suitable (or even unsuitable) for acquisition.
That led a lot of banks down the other route, which is expansion into the worlds of investment banking and corporate finance. The trouble here is that that these businesses are very cyclical – corporate finance is a feast-or-famine business, which is why banks are often either crazily hiring or crazily firing people, and even investment banking has a rather low return on capital over the medium term. And these businesses are risky – the free-wheeling culture of investment banking is quite alien to the retail business – and so difficult to understand that the people at the top of banks frequently have absolutely no idea what is going on in the offices below the boardroom.
While other banks went for international acquisitions, proprietary trading (ie gambling), and creating and selling complex derivatives, Lloyds stuck with low-risk domestic expansion. Through the 1980s and 1990s it bought up building societies big and small, and the insurer Scottish Widows. The wilder shores of investment banking and property finance it never visited. And it did well.
Only, other banks did better. Lloyds slipped down the size and profitability rankings. The great deal that would propel it back into the top tier eluded it. Lloyds tried to buy RBS, Midland Bank, Standard Chartered, all unsuccessfully. There were plenty of foreign opportunities, but they always seemed too risky for the bank that never gambled. The City was not impressed – in the eight years to 2005 the treasured Lloyds share price halved. A falling share price makes acquisitions more difficult to finance; all the while the Lloyds board was acutely aware that in banking if you don’t do takeovers, then takeovers get done to you.
And so it was that in the collective Lloyds mind a fatal narrative developed. Lloyds had to grow, even in the grip of a financial meltdown it had to grow. But Lloyds didn’t do risk. It was as if whatever it did to grow couldn’t be, wouldn’t be high risk, almost by definition. So when not long after missing Northern Rock, Lloyds was offered on a plate the chance to buy the stricken Halifax Bank of Scotland (HBOS), a deal Lloyds had been chasing for years, it was just too tough to say no.
The HBOS deal began to unravel even before it was signed, but unfortunately for Lloyds it unravelled slowly. If the disastrous state of the HBOS lending book had been apparent quickly, Lloyds might have backed out. As it was, by the time the deal was finally settled Lloyds was effectively a government-controlled business, bailed out to the tune of nearly half its market value while it digested the roughly £40 billion in HBOS losses it had bought for itself, its reputation for caution vaporised.
Ivan Fallon is sympathetic to the position of the top people at Lloyds, and some other banks, who were pushed ruthlessly into corners by the Treasury. Yet even on Fallon’s own account most of these financiers seem to have been permanent residents on the Planet Zog. When the Lloyds top men were called to the Treasury to be told that they were going to be part-nationalised whether they liked it or not, their main concern was – you guessed it – preserving the executive bonuses. Then there was Andy Hornby, the hapless chief executive of the collapsing HBOS, who spent the high days of the crisis alternating between blue funk and plaintively asking ‘is there anything for me?’ in the new dispensation. The reader is tempted to think that a stiff term of community service is what should have been in it for Hornby – but no, that is not how banking works. The former HBOS man wangled himself a consultancy job at Lloyds, for a mere £60,000 a month. The chief executives of HSBC and Barclays (which avoided a government takeover thanks to some very costly Qatari money) were no better and arguably worse, responsible between them for investments and lending at lunatic levels of risk.
But the chief baboon of Planet Zog was undoubtedly Fred Goodwin, painted by Fallon as the vainglorious bully who drove RBS to destruction. One day in October 2008 Goodwin stood up to address a banking conference in London and spoke about the fabulous ‘opportunities for growth’ for a bank that his audience knew full well was done for. In the 30 minutes that Goodwin was on his feet the RBS share price fell 35% and was suspended twice. Even then he didn’t accept that the jig was up, and eventually had to be dragged from his post kicking and screaming, pension intact.
Fallon has no sympathy for the unpleasant Goodwin, but he is far too kind to too many of the other top bankers, and especially too kind to Sir Victor Blank the urbane chairman of Lloyds who should have called time on the HBOS merger but didn’t. The Lloyds line on this is that legal and time restrictions meant they could not know the true extent of the HBOS black hole until after they bought it, but if you don’t understand something then you shouldn’t buy it. That’s the first rule of value investing.
Black Horse Ride is a readable, pacy account of very complex events. Fallon is very well informed but never gets bogged down in the detail. Anyone who is interested in the people and the politics behind what one hopes was the biggest financial disaster of the age will learn a lot.
Black Horse Ride: The Inside Story of Lloyds and the Banking Crisis. Ivan Fallon, The Robson Press, RPP £20.