The final part of the work day yesterday was an interesting discussion with Stephen Hester, Chief Executive of the Royal Bank of Scotland (RBS) and Martin Wolf of the Financial Times.
Here’s a summary of what he said, not verbatim and slightly interpreted, but near enough to be accurate:
Martin: Why did you join RBS in their time of need?
Stephen: There are often few new things in life to learn in terms of business lessons. When I was catapulted into this job in November 2008, my judgement at the time was that like many similar corporate failures, although not many at this scale, the inherent businesses with RBS were strong. That meant it could be brought back to health. If you don’t start with that bedrock, you have a problem, but the businesses within RBS inherently had a strong raison d’être and therefore could be saved.
Secondly the issues that had weakened the bank did not infect every piece of the bank. They were largely mistakes made at the top layer of management at the bank, and therefore could be rectified as they weren’t infecting the whole business.
Martin: How big a bank are we talking about?
Stephen: RBS employed just under 200,000 people at the peak, and with derivatives had over £2 trillion on the balance sheet. The bank was operating in 51 countries with 40 million customers, and touched anything up to a third of all financial transactions in the UK.
Although a significant component of that scale was excess that we have pulled back, the underlying heart of it is a good business.
Martin: So what have you done to scale back?
Stephen: The plans we have followed are timeless plans that many would follow. The starting point is to ask: what is good or could be really good and competitively advantaged in the future? Our aim then is to get rid of anything that isn’t like that.
Oh, and by ‘good’, I mean that it has to have four things: the business needs to be operating in large customer markets; it has to have proportionate risk reflecting that customer driven activity; it must be able to make returns greater than the cost of capital; and it should be connected to other parts of our business that are strategically important.
For example, the payments business is huge for us. We are one of the top five operators in the world. It has huge linkage with the other parts of our bank and the shareholder returns we want to deliver. So that’s an area we would invest in.
From that rationale of concentrating on doing things you are good at and do them better, we can then put the things that were responsible for our weakness to be professionally managed out as divestitures and run-off.
That has freed the majority of people in RBS to focus upon doing the core of what they do well.
Martin: That sounds simple. What were the problems you had to face therefore?
Stephen: One of the major issues was around leverage and so we have focused upon restoring our capital ratios back to being the best in the world. By capital, I also only have one measure which is equity. Our aim is to achieve greater than 8% core Tier 1 capital, and we’re now over 10%.
Another factor is leverage and the gold standard for banks is to have just 1:1 loan:deposit ratios. That still leaves you using wholesale markets for non-loan trading, but it avoids the leverage being from over thirty times, as we were, to under twenty times. Again, I think the gold standard is 15 times leverage ratio here.
One of the mistakes politicians, regulators and media makes here, is that the regulatory rules that establish these ratios is not the only route to safety. To my mind, regulation should be much broader and establish a minimum level, but not just judge the business by ratios.
Martin: On this level, should the bank be rationalised? I mean, should you be a ‘universal bank’?
Stephen: RBS is a universal bank, as we have retail, corporate, investment banking, wealth management and payments. We cover all the main areas except proprietary investments and asset management, which we exited.
Martin: Is proprietary trading a bad thing then?
Stephen: On proprietary trading, there is no trading that takes place that is not proprietary. One has to take one side of a deal and find someone to take the other. That is proprietary by nature. However, the way that it can be more usefully thought about is whether your primary goal is to facilitate customer activity, as in connecting those who want money with those who have it, or is your main goal to purely make speculation on future price movements which is what asset managers do. There was a blurring of those lines, and it is important to be clear as to how and why you are making money. Is it through servicing customers or betting on markets? They are different and should be thought about differently.
Martin: So prop trading caused this crisis?
Stephen: No. In that sense, this had nothing to do with the crisis in the markets. The crisis was caused by bad loans and mortgages. The process was flawed between basic lending and securitisation of those loans.
Martin: And when the crisis hit, was the government bailout the right thing to do?
Stephen: Regardless of your ideology, in no country did any of the governments bailing out the banks see it as desirable, which is why they only offered temporary support. The question was how to set up state support such that it could be withdrawn profitably as soon as possible. That is why there was an injection of capital from the government but no-one from government was placed on the board. In all respects, from our listing and governance therefore, we are a private business. That is what the government wanted to ensure, so that they could withdraw profitably when the time is right. For example, the sale of our shares, when it happens, will actually fund the NHS for almost a year. That’s how important this is.
However, the issue it does raise is that we are in the public eye. That process is wearing. It is wearing on our people.
So government support can be a source of strength – we wouldn’t be here without it – but it can be a source of weakness too, as it is wearing on our people.
Martin: And when will the government sell your shares?
Stephen: They could sell them tomorrow in my view, the sooner the better, but there are one or two obstacles. In particular, the share sale must ensure that there are no losses to the taxpayers and we are within spitting distance of achieving that.
Martin: There is this big hullabaloo about lending. What is your stance on lending in Britain?
Stephen: There is excessive critique about unsafe lending. That is what caused this crisis and yet the political criticism could be encouraging us to do that again. We take the view that we are guided by our goals, which is to support customers to be safe and reward our shareholders appropriately. Therefore, if part of what our customers need is lending and if our customers can pay us back, why wouldn’t we be lending to them? That’s why all day, every day, we are trying to lend provided it can be done safely and commercially. We don’t need encouragement or being told to lend in an inappropriate way or repeating lending in that way, we just need to do it appropriately and securely.
Martin: Does the government agree with that approach?
Stephen: The UK government set up this agency – UK FI – to manage our shares with an explicit charter, as it relates to the government shareholding, that they would act as an engaged shareholder.
Martin: What about bonuses. Are big bonuses in banking a bad thing?
Stephen: Regarding bonuses, I see it as a no-win discussion. It is impossible to win this one, but there are dimensions of truth to both sides of the argument. I mistakenly was quoted, although I did give the quote, that my parents think it is inappropriate to remunerate with such high pay. But let’s be clear, 90 percent of our people do not work in these high pay areas. They are in retail and commercial banking, and they all get characterised with this, but only a small part of the industry has high pay and bonuses.
Furthermore, the amount of customer income that goes to people in investment banks is not that much different to the amounts that go to the people in the retail bank. The only difference is that there are a lot of low paid people who service customers, whilst the investment bank has a small number of people who are highly paid specialists.
Martin: What about too big to fail? Should we stop banks becoming too big to fail?
Stephen: I do not take the view that size is the issue. I think people misunderstand the principle mechanism that drives these markets which is not size. It is confidence. There are secondary mechanisms around the connectivity between banks and more, but confidence is the primary mechanism that manages the markets.
Greece would not be too big to fail if you said nations of a certain GDP should fail, but Greece was not allowed to fail because it related to confidence. Allow Greece to fail, and Europe might fail. That’s why we do not allow banks to fail. It has nothing to do with the scale and size of the bank, but confidence and the issue of confidence it would create if it were allowed to fail.
Martin: So how do you measure that confidence and ensure it is there?
Stephen: Well, the difference between financial institutions and other industries is the dynamics of failure in our industry. When industrial companies get into trouble, the factories are allowed to continue whilst the balance sheet is sorted out. That’s how chapter 11 works in the States, as can be seen with the recent situation with General Motors and so on.
Banks don’t have that luxury because you cannot separate the balance sheet from the factory. Therefore, the whole discussion about resolution regimes and bailing out is the way to go. In other words, to create mechanisms that smoothly and efficiently can sort out a bank’s issues over a weekend, that would take other business months to sort out.
The alternative is what we saw where the cliff edge of administration is massive value destruction, where we saw Lehmans lose 85% of their value overnight. It should not be that way.
Martin: So is that where regulators should focus?
Stephen: It is getting exactly to the issue that made Lehmans disastrous to let go, and to create a situation where a large bank could be liquidated in an orderly manner if it is necessary.
I think it will take ten or twenty years to get the right answer to that question but, if we do that, I think it will be viewed as an incredibly important step forward in building a more robust system.
There was then an open Q&A with various questions about bank bashing, who RBS competes with, the ethical banking initiative and more.
I asked a question about the European Commission’s action, where they have forced RBS to sell off strategic assets, and Stephen said they had to live with regulatory and legal developments, but that it wasn’t clear whether the action was taken to encourage competition or to punish RBS.
Martin translated Stephen’s answer as: “we have to live with the action but it doesn’t make any sense”.
There was also a question about how RBS will be servicing its customers in 2050 from a guy from Oracle. This got a laugh as Martin said that no-one from the audience would be around to see if Stephen’s answer was right or not.
But Stephen more gracefully answered that banking hasn’t been changed dramatically by new patents or inventions in the way that medicine or other industries have been. In 1970 you could not see the technology developments that we have today, but the basics of how we operate remains the same in terms of matching people with money with those who need money. He believes that banks will still be doing that in 2050.