The failure of the Royal Bank of Scotland | FSA Board Report www.fsa.gov.uk/rbs December 2011 Financial Services Authority Board Report The failure of the Royal Bank of Scotland Financial Services Authority Board Report The failure of the Royal Bank of Scotland December 2011 © Financial Services Authority 2011 25 The North Colonnade Canary Wharf London E14 5HS Telephone: +44 (0)20 7066 1000 Website: www.fsa.gov.uk All right reserved The failure of the Royal Bank of Scotland | FSA Board Report 3Contents Chairman’s Foreword 6 Introduction 13 Executive summary 21 Annex: UKLA supervision of RBS’s market communications 36 Part 1 Why did RBS fail? 37 Part 2 Lessons for the regulatory framework and supervision, 61 and for the management of firms Introduction 62 1 Factors contributing to RBS’s failure, and the FSA’s 64 regulatory and supervisory response 1.1 RBS’s capital position and the underlying 64 regulatory framework 1.2 RBS’s liquidity position, the FSA’s regulatory 94 framework and supervisory approach 1.3 Asset quality: concerns and uncertainties 120 1.4 Losses in credit trading activities 140 1.5 ABN AMRO acquisition: ‘the wrong price, 159 the wrong way to pay, at the wrong time and the wrong deal’ 1.6 Systemic vulnerabilities and confidence collapse: 188 failure of the banks in worse relative positions 2 Management, governance and culture 220 3 Supervisory approach, priorities and resources 253 Appendices 2A Summary of recommendations 295 2B Market communication – a review of oversight by the 303 United Kingdom Listing Authority (UKLA) 2C An outline chronology 310 2D Summary of the international prudential policy framework 320 during the Review Period and the main changes in prudential policy agreed since the financial crisis Contents The failure of the Royal Bank of Scotland | FSA Board Report 4 2E Estimating Basel III capital and liquidity 330 measures for RBS 2F FSA policy on IRB model approvals 336 during the Review Period 2G Liquidity risk arising from RBS’s exposure 339 to ABCP conduits 2H RBS Board membership during the Review Period 341 2I The FSA’s management and Board during the 342 Review Period 2J Approach and processes followed by the 346 Review Team Part 3 FSA Enforcement 347 Introduction 348 1 Global Banking and Markets 358 2 The acquisition of ABN AMRO 407 3 Investment circulars 423 Appendix 3A Chapter headings of the PwC investigation reports 432 General appendices A FSA Chairman’s letter of 15 December 2010 to 434 Chairman of Treasury Select Committee B Glossary of main terms, other abbreviations and 437 other acronyms Contents 5 The failure of the Royal Bank of Scotland | FSA Board Report 6 Chairman’s Foreword RBS’s failure in October 2008 has imposed large costs on UK citizens. To prevent collapse the government injected £45.5bn of equity capital: that stake is now worth about £20bn. 1 But this loss is only a small part of the cost resulting from the financial crisis. The larger costs arise from the recession which resulted from that crisis, within which RBS’s failure played a significant role. That recession has caused unemployment for many, losses of income and wealth for many more. Quite reasonably, therefore, people want to know why RBS failed. And they want to understand whether failure resulted from a level of incompetence, a lack of integrity, or dishonesty which can be subject to legal sanction. This Report aims to provide that account. It identifies the multiple factors which combined to produce RBS’s failure. It describes the errors of judgement and execution made by RBS executive and management, which in combination resulted in RBS being one of the banks that failed amid the general crisis. These were decisions for whose commercial consequences RBS executive and Board were ultimately responsible. It sets out the FSA’s Enforcement Division’s assessment of whether any management and Board failures could be subject to regulatory sanction. It also describes deficiencies in the overall global framework for bank regulation which made a systemic crisis more likely,and flaws in the FSA’s approach to the supervision of banks in general and RBS in particular which resulted in insufficient challenge to RBS. The Executive Summary sets out the key conclusions; the full Report provides the supporting detail. I will not summarise the Report again here, but instead focus on answering two questions which I am sure many readers will ask. • First, why has no-one in the top management of RBS been found legally responsible for the failure and faced FSA sanction? And if action cannot be taken under existing rules, should not the rules be changed for the future? • Second, why was the global approach to bank regulation deficient and the FSA’s supervisory approach flawed? And have regulations and supervisory approach changed radically enough in response to the crisis? If RBS management errors led to failure, why has no-one been punished? In 2009 the FSA launched investigations into each of the major banks that failed during the 2007 to 2008 financial crisis. These investigations aimed to identify whether there had been practices which were either dishonest, lacking in 1 Based on closing share price on 6 December 2011. Chairman’s Foreword The failure of the Royal Bank of Scotland | FSA Board Report 7 integrity or sufficiently incompetent to justify the use of FSA enforcement procedures and, potentially, sanctions. Some of these investigations resulted in charges being brought and sanctions (e.g. fines and bans) being imposed on specific individuals in other banks; some are still on-going. Our investigation into events at RBS was among the most intensive of all those we conducted. After detailed investigation, however, our Enforcement Division lawyers concluded that there was not sufficient evidence to bring enforcement actions which had a reasonable chance of success in Tribunal or court proceedings. 2 Why has the FSA not taken enforcement action? Many people will find this conclusion difficult to accept. If harm has been imposed on society, surely someone can and should be held responsible? Part 3 of this Report, ‘FSA Enforcement’, therefore seeks to explain the legal reasoning which led to Enforcement Division’s conclusions. The crucial points of principle are that: • There is neither in the relevant law nor FSA rules a concept of ‘strict liability’: the fact that a bank failed does not make its management or Board automatically liable to sanctions. A successful case needs clear evidence of actions by particular people that were incompetent, dishonest or demonstrated a lack of integrity. • Errors of commercial judgement are not in themselves sanctionable unless either the processes and controls which governed how these judgements were reached were clearly deficient, or the judgements were clearly outside the bounds of what might be considered reasonable. The reasonableness of judgements, moreover, has to be assessed within the context of the information available at the time, and not with the benefit of hindsight. The implication of these points is that an investigation can identify evidence of numerous poor decisions and imperfect processes, without that establishing a case for enforcement action which has reasonable prospects of success in Tribunal or court proceedings. This Report describes many such poor decisions by RBS management and Board. Among the most striking was the decision to go ahead with the ABN AMRO acquisition. That acquisition, for reasons described in Part 2 of the Report, played a significant role in RBS’s failure. And the Board decided to go ahead with it on the basis of due diligence which was clearly inadequate relative to the risks entailed. 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’ 3 ; and that RBS was largely unsuccessful in its attempts to obtain further non-publicly available information. But while the Board can certainly be criticised for proceeding with such inadequate due diligence, the professional judgement of the FSA’s Enforcement lawyers is that an enforcement case for inadequate due diligence would have minimal chances of 2 See www.fsa.gov.uk/pages/doing/regulated/law/pdf/enf_procedure.pdf for a description of the FSA’s enforcement powers and procedures, the role of the Regulatory Decisions Committee, and the right of referral to the Upper Tribunal. 3 In addition to this material, information on LaSalle (which RBS did not ultimately acquire) was provided via an online data room (for details of the acquisition, see Part 2, Section 1.5 and Part 3 of the Report, in particular paragraphs 215 to 221 of the latter which cover the information on ABN AMRO made available to RBS). Chairman’s Foreword The failure of the Royal Bank of Scotland | FSA Board Report 8 success, given that there are no codes or standards against which to judge whether due diligence is adequate, and given that the limited due diligence which RBS conducted was typical of contested takeovers. Enforcement Division also reached similar conclusions in relation to the other issues that it investigated. Part 3 of this Report explains the factors which led it to those judgements. Those judgements could of course be questioned. But I am confident that the FSA’s Enforcement Division decisions were based on intensive investigation of the evidence, and driven by a strong determination to bring enforcement actions if evidence could be identified which justified it. Starting four years ago, the FSA’s Enforcement Division has transformed its approach to enforcement, pursuing cases far more aggressively. The number of major cases brought has significantly increased: the level of fines has more than trebled in the last three years. The same team which has led this change has concluded that there are not sound grounds to bring enforcement action in respect to RBS. While it is possible that new evidence will become available which could support future FSA enforcement action, the current position is therefore that enforceable breaches of FSA rules have not been identified. 4 The crucial issue that this raises, however, is whether the rules are appropriate: whether the decisions and actions which led to failure should ideally have been sanctionable, and whether we should put in place different rules and standards for the future. Should the rules be changed for the future? This issue deserves extensive public debate and Parliamentary consideration. Key to that debate should be a recognition that ‘banks are different’, and that society has a strong interest in bankers taking a different attitude to the balance between risk and return to that which applies in the rest of the economy. RBS management and Board undoubtedly made many decisions which, at least in retrospect, were poor. They took risks which ultimately led to failure. But if they had taken similar risks in a non-bank company, the question of whether regulatory sanctions were applicable would not have arisen. That is because in non-bank companies the downside of poor decisions falls primarily on capital providers, and in some cases on the workforce, and to a much lesser extent on the wider society. The ABN AMRO acquisition illustrates the point. The due diligence conducted was inadequate to assess the risks. But it was typical of all contested takeovers, and in non-bank sectors of the economy launching a bid on the basis of limited due diligence might be a reasonable risk to take if the Board believed that the upside opportunities justified it. If the acquisition went wrong, shareholders would suffer, and it would be for them to decide whether to sanction the management or Board by firing them. 4 There is a separate issue of whether disqualification proceedings could be brought against any former directors of RBS. The responsibility for bringing proceedings under the Company Directors Disqualification Act 1986 lies with the Department for Business, Innovation and Skills (BIS). The FSA passed the underlying evidence base received from PricewaterhouseCoopers to BIS in February 2011 so that it could decide whether to start such proceedings. Chairman’s Foreword [...]... Royal Bank of Scotland | FSA Board Report Introduction 19 and had held meetings with RBS and other interested parties The specialist advisers’ terms of reference asked them to report on the extent to which, in their view, the FSA report is a fair and balanced summary of the evidence gathered by the FSA and PwC during their review of the failure of RBS, whether it fairly reflects the findings of the FSA’s... its opinion, the Report represents a fair and balanced summary of the evidence gathered by the FSA and by PwC during their review of the failure of RBS, that it fairly reflects the findings of the FSA’s investigation and that it is a fair and balanced summary of the FSA’s analysis of its regulatory and supervisory activities in the run-up to the failure of RBS 24 The Board also noted that the executive... sub-group of the Board s non-executive directors, chaired by Brian Pomeroy.8 The sub-group had been set up by the Board for the purpose of providing direct Board- level scrutiny of the Report and of the independence and objectivity of the process by which it had been produced The Board also noted that in May two specialist advisers had been appointed to advise on the preparation of the Report The advisers... on the ability of the Review Team or Enforcement Division to conduct their work and, having investigated the subject matter of the injunction, we are confident that it is irrelevant to the story of RBS’s failure The failure of the Royal Bank of Scotland | FSA Board Report Executive summary 21 Executive summary 1 This Executive Summary sets out: • our conclusions on why RBS failed RBS’s failure amid the. .. possible, and thus addressing the key priority of ensuring that RBS was adequately capitalised The failure of the Royal Bank of Scotland | FSA Board Report 28 Executive summary 30 There were, however, a number of points on which, while agreeing that the decision taken was in line with the prevailing practices or, in the case of the acquisition of ABN AMRO, that there was no precedent, the Review Team questioned... investigated by Enforcement Division was the conduct of Mr Johnny Cameron, Chairman of RBS’s Global Banking and Markets (GBM) division, in respect of key decisions made and potential control failings within The failure of the Royal Bank of Scotland | FSA Board Report 32 Executive summary GBM This focus reflected the significance of GBM’s losses in the failure of the bank Losses incurred by GBM (excluding... extensions of changes already in hand The executive management of the FSA has agreed that these further recommendations will be taken into account in the design, in collaboration with the Bank of England, of the Prudential Regulation Authority and, as appropriate, of the Financial Conduct Authority 38 Two recommendations, however, merit highlighting • The first relates to the regulatory oversight of large bank. .. have the capital resources to meet large and uncertain risks We believe, however, that there would be merit in making it a formal requirement that banks obtain regulatory approval for major acquisitions (relative to the size of the acquiring bank) The failure of the Royal Bank of Scotland | FSA Board Report Executive summary • 31 The second relates to the provision of independent advice in respect of. .. Basel Committee), the European Union and the UK authorities in the development and enforcement of prudential rules relating to capital and liquidity See Part 2, Section 1.1 for detail of the point, relating to the confirmation of RBS’s precise end-March 2008 capital position The failure of the Royal Bank of Scotland | FSA Board Report Chairman’s Foreword 11 of imperfect implementation of the FSA’s defined... on the key prudential issues of capital, liquidity and asset quality The creation of the Prudential Regulation Authority, focused exclusively on prudential issues rather than spanning both prudential and conduct concerns, will ensure that that focus is The failure of the Royal Bank of Scotland | FSA Board Report 12 Chairman’s Foreword maintained even when most of the world assumes, as it did before the . The failure of the Royal Bank of Scotland | FSA Board Report www.fsa.gov.uk/rbs December 2011 Financial Services Authority Board Report The failure of the Royal Bank of Scotland Financial Services. A). Introduction The failure of the Royal Bank of Scotland | FSA Board Report 16 • Part 2, ‘Lessons for the regulatory framework and supervision, and for the management of firms’, analyses the causes of failure. detail of the point, relating to the confirmation of RBS’s precise end-March 2008 capital position. Chairman’s Foreword The failure of the Royal Bank of Scotland | FSA Board Report 11 of imperfect