Britain’s biggest peacetime crisis had been tackled. The banking system had been stabilised in the face of a potentially devastating financial tornado. The government had put £300 billion of British taxpayers’ money on the line, equivalent to nearly a fifth of annual economic output. But had that money been effectively spent? Had the right strategy been adopted? Were the measures likely to be in the long-term best interest of the UK economy?
All those present, and most commentators at the time, believed that the best course of action had been taken in the circumstances. A nightmare hand had been played as well as it could. Market confidence had been restored. Short-term lending between banks, an essential lubricant of the financial machinery, had been secured. A bold assessment of banks’ balance sheets and the likely holes had been made, and plans put in place to ensure there were capital buffers to cover losses. The delicate balance between ambition with the scale of the response and prudence with the UK’s public finances had been retained. But in the cold light of day, had the taxpayers’ investment been well made?
The Treasury brains trust had made the critical decision not to nationalise RBS and Lloyds/HBOS but to allow the banks to continue as ‘stand-alone’ commercial entities, albeit with a large government shareholding. There were minority private shareholders with rights which had to be protected. The philosophy was to be that the banks would operate at ‘arm’s length’ from Whitehall. RBS was eventually to have an 82 per cent government stake; Lloyds/HBOS was to be just over 50 per cent state-owned. This thinking had dominated the final weekend’s efforts on the details of the individual recapitalisations. Alistair Darling’s view was that fully nationalising RBS would inevitably lead to speculation that Lloyds/HBOS would be next and then Barclays. It was argued that because the government had not quite gone to the end of the road with RBS, the line could be drawn at the edge of RBS.
One of the Treasury’s key objectives, which was made plain to the banking advisers and civil servants, was that the bailed-out banks should retain their listing on the London Stock Exchange and conduct themselves like other leading banks in the FTSE 100. The Stock Exchange listing requirement is that if any shareholder owns 90 per cent or more of a quoted company, they are obliged to make a bid for the rest of the shares. So the government had to stay below that level, with a bit to spare, to avoid any future confusion over the arithmetic.
At the time, both during the frantic first week in October and the months after that, the focus in government was on stabilising the banks and ensuring they had adequate capital. As one observer put it: ‘How do you keep them alive, not how you make them run fast?’ Discussions centred on reviving the banks and getting them to a stage where the government could start selling off their shares. The idea that RBS and Lloyds should be vehicles for boosting lending in the real economy was not at the forefront of official thinking. Mervyn King was later to argue that as the banks were, in effect, under state ownership, the Chancellor could order them to lend more to small businesses and consumers. This was an issue which would come back to haunt successive governments presiding over the prolonged saga of the bailed out banks. An increasingly loud constituency would demand that RBS and Lloyds should be used as government lending vehicles as the UK’s economic recovery struggled to gain traction. But in the autumn of 2008 this argument was not voiced in or around the Treasury and Downing Street.
Advisers were asked to structure the deals on the basis that minority shareholders were to be retained. In other words, the final package for each bank had to keep a ceiling on the state shareholding. This tied the hands of the advisers when they were calculating what taxpayers would receive in return for the capital they were injecting. RBS needed £20 billion of government money however that was engineered. And the lower the taxpayer stake, the more would have to be paid for each share.
One of the advisory team is clear that the requirement to stop some way short of outright nationalisation resulted in a more expensive bailout as far as taxpayers were concerned: ‘The UK government had to pay more for RBS shares than it might have done because of the need to keep the government stake to 82 per cent. The non-voting shares were created to allow that, and to provide requisite value to the taxpayer in return for the subsidy to allow capital to go in.’ The same adviser believed that it would have been a lot easier to arrange the deal if the government had insisted on 100 per cent ownership of RBS. But, he believes, managing a bank without subjecting it to the demands of the private sector would be hard to imagine. The existence of minority shareholders was a good check and balance to the state’s dominant holding.
The result of the drive to keep a lid on the government’s holding at RBS was that a sum equivalent to the ‘book value’ of RBS shares was paid to acquire them. This meant that the total market capitalisation of the bank, based on the government buy-in price (number of shares in issue multiplied by the price per share), was equivalent to the total net assets of the bank. They were purchased at a discount to the prevailing market price at the time of the bailout, but the price subsequently plunged, leaving the taxpayer nursing a paper loss almost from the outset. The government could have insisted on paying a lower price although this would have upset the arithmetic surrounding the upper limit for the state holding. Ministers could simply have driven a harder bargain, arguing that a state bailout was the only show in town and the taxpayer should not pay more than a token amount for a bank which otherwise would have gone bust. A senior source at RBS later reflected that ‘they did overpay, but until you knew how the bad the economy was going to turn out, it was difficult to tell at the time’.
One argument advanced inside Whitehall for the purchase price not being lower is that this would have driven the market price down and undermined what remained of private investor confidence in RBS shares. In other words, if the government was seen to be valuing shares well below the market price, a potentially damaging signal about the official view of prospects for the banking sector would be sent out. But others who advised the government over this period are clear that a smaller amount could have been spent on buying the shares and a higher stake obtained. This could still have allowed for a significant minority of private shareholders to continue on the register. One of the banks bailed out by the Irish government, AIB, was 99.8 per cent owned by the state and still quoted on the Dublin Stock Exchange. The outstanding 0.2 per cent of the shares remained in demand amongst market investors. One banker who had been advising the Treasury said: ‘We could have gone a lot higher – that’s one of the things I don’t quite know, how it slipped through.’
Under EU state aid rules, a government purchase of shares at 10 per cent below the prevailing market price is deemed not to be a commercial transaction and so constitutes unfair intervention and remedies are sought. The British government’s bailout of RBS was at that 10 per cent discount, so future sanctions were always going to be imposed by Brussels. So, the argument goes, if the RBS rescue was in breach of state aid rules, why not go further and pay a lot less? If you are going to be penalised anyway, why not get a much better deal for the taxpayer, say 20 per cent or even 30 per cent below the market price? Buying at an even bigger discount might even have avoided a clash with state aid rules. If a government can show that the target company is in dire financial straits and thus an extremely low price is being paid, the issue of whether a purchase is ‘commercial’ or not ceases to apply. But the same banking adviser concedes that going that far would have undermined confidence: ‘It would have triggered greater state ownership of banks, greater instability in market price with all the negative consequences for general confidence in banking system.’
The state aid sanctions that were eventually applied would later cause big headaches for the managements of RBS and Lloyds TSB. Both were required by the European Commission to sell off branches. A Lloyds deal with the Co-op involving more than 600 branches foundered, leaving Lloyds having to pursue a different course with a stock market flotation for the branches. Attempts by RBS to sell more than 300 branches to Santander had to be dropped after the prospective buyer pulled out. An auction to an assortment of private investor purchasers then dragged on. In late September 2013, a private equity consortium backed by the Church of England eventually signed a purchase agreement, although the deal was not going to result in formal separation for another two years. In both cases, there was a major distraction for management and unwelcome uncertainty for investors. Staying within the requirements of the EU state aid regime in the first place would have avoided such problems.
The UK’s bailout packages were more expensive than they might have been for taxpayers and they still fell foul of EU rules. The US bank recapitalisations were less costly for the American administration because the price paid was equivalent to below the book value of the target banks. The American approach was to tell all the major banks what capital was needed and then to insist that the state would inject that amount and take a share stake in each one. From the healthiest to the weakest, all the Wall Street banking giants agreed to take Uncle Sam’s cash. Sir John Gieve later reflected that for all their less agreeable qualities, America’s banks had done more to support the national interest than their City counterparts: ‘The American system worked better as a club than the UK system – the internationalisation of the City had destroyed that and it was less of a club than Wall Street. The US Treasury Secretary could call in all the senior bankers, who were all Americans and get broad loyalty and agreement – we found it difficult to do that.’
The problem for the UK, however, was that RBS was far bigger in relation to the economy than any of the US banks were to the American system. As a result, the British government had to put considerably more into the stricken Scottish bank than most of the others.
The question that arose in subsequent years was whether the government had erred in paying something around the full book value of RBS, Lloyds and HBOS. Had paying high in 2008 made it harder to sell off the government stakes and demonstrate fair value for the taxpayer? The answer from both City analysts and insiders at RBS is yes. A longer road back to a breakeven price for RBS has delayed the day when the sale of the government holdings can begin. Decisions made for logical reasons in the heat of battle had unexpected and unwelcome consequences which are still playing out several years after the crisis. But for Lloyds/HBOS, while there may have been a delay, the bank was back in favour by the middle of 2013 and the first 6 per cent of the government ‘s holding was sold in September of that year.
As autumn gave way to winter in late 2008, a bleak mood settled again over those in Downing Street and at the Treasury who were running financial and economic policy. Shoring up RBS, Lloyds and HBOS in October had bought time. But the underlying problems at RBS were, if anything, deteriorating. The banks’ assets looked more toxic and depressed by the week. The new boss, Stephen Hester, had been appointed to take over from Sir Fred Goodwin ahead of the chaotic weekend of the recapitalisation talks and the ‘drive-by shooting’. Hester had been chief executive of the property investment company British Land, and before that had extensive banking experience at Abbey National and Credit Suisse. He had joined the RBS board as a non-executive director in September 2008, little suspecting the scale of the storm which was about to engulf the bank. A call on the Friday evening 10 October from RBS chairman Sir Tom McKillop had made it clear the bank urgently needed a new chief executive to replace Goodwin. Hester was given half an hour to consider it. He told McKillop he would take the job subject to a government guarantee that RBS would maintain a stock market listing with some private shareholders. Hester arrived at the Treasury on the Sunday to run through the terms of engagement as Myners, Vadera and the Whitehall officials were frantically hammering out details of government investments in RBS, Lloyds and HBOS.
Stephen Hester took over formally the chief executive’s seat at RBS in late November. But as he served out his notice with British Land in the weeks before that, he began to take stock of the state of the humbled financial empire he was about to head. Hester believed more capital should have been injected into RBS at the outset and had made that point in his first meetings at the Treasury. Within a few weeks of arriving at the bank’s London headquarters in Bishopsgate, he told ministers the bank was in a worse state than he had anticipated. It was becoming clear that the recession was going to be a lot deeper than seemed the case even the previous month. For a bank, the value of assets is closely linked to the state of the real economy – plunging activity and confidence means plunging valuations of loans and investments. For RBS, it was plain that further funding was needed and there was a realisation at the bank and at Westminster that the government would have to intervene again. But this came at a time of immense fatigue amongst Treasury staff. Civil servants and advisers had worked for a lot more hours than was good for them and at weekends for three months. Some recall the situation as ‘hellish’ with no time to see families, even newly born children. There was a desire to take a breather even in the full knowledge that more had to be done to stabilise the banks.
Whitehall insiders were initially sceptical about Hester’s doom-laden warnings at RBS. Was he, they mused, over-egging the bad news, perhaps as a newish chief executive trying the familiar tactic of ‘kitchen-sinking’ the bank? (In other words, getting all the negatives out into the open quickly so a subsequent turnaround of RBS would look even more impressive.) But as one insider put it, ‘the look on his face was one of continued shock and increased anxiety’, so it was hard to believe that Hester was really faking it. The heads of the Bank of England and Financial Services Authority, meanwhile, were discussing what to do if things got worse for RBS and HBOS. Mervyn King and Lord Turner debated whether a ‘contingent equity’ plan should be pursued. Under such a scheme, if the capital ratio fell below 5 per cent the government would automatically inject more capital to bring the ratio back up and in doing so would progressively wipe out existing shareholders. In effect, a creeping state takeover.
The debate had moved on from how to bail out banks to what needed to be done for the UK economy to avoid sliding into a depression. At the initial stage of the crisis, policymakers were reassured that they had got the key decisions right – recapitalisation and the schemes to boost liquidity and bank credit were seen as a success. In contrast in the US, TARP had been a failure at the outset. Credibility was restored for the American administration when government capital was injected into the banks. But as the immediate danger had faded, British government insiders knew that decisions had to be focussed on lending in the wider economy and the general state of consumer and business confidence. HBOS had, in effect, taken itself out of the market and was not originating any significant new lending. Losing a player that size had a significant impact; a big chunk of lending capacity had shut down, leaving many borrowers struggling to renew their loans. So policymakers’ attention inevitably turned to how to tackle the burden of bad assets and to better ensure that banks felt free to lend normally without fear of future losses on the wobbly loans.
Doubts were creeping in at the highest levels even a few weeks after the bailouts had been announced. In late October, Adair Turner and his wife were invited to lunch by Alistair Darling at the Chancellor’s official residence Dorneywood in Buckinghamshire. The eighteenth-century mansion was made available to the government after the Second World War for the use of a senior member of the Cabinet, the choice of whom being made by the Prime Minister. Dorneywood is run by a trust and the occupant is billed for its use so there is no taxpayer involvement. Traditionally, it was the residence of the Chancellor of the Exchequer, although for a brief period under Labour the deputy Prime Minister John Prescott was the occupant. Alistair Darling took the keys to the house when he became Chancellor. He did not use it for personal reasons many times, but on this occasion was entertaining friends and acquaintances with his wife Maggie.
Darling and Turner had an opportunity away from the relaxed social chit chat to reflect on the dramatic events on the previous few weeks. They took a stroll around Dorneywood’s herbaceous borders, greenhouses and lily pond to discuss where they had got to with the bank rescue package. Their attention turned to HBOS and Darling asked the FSA chairman whether it might have been better to have nationalised it. Turner was a little surprised by the question but intimated that perhaps nationalisation would have been the best option, although at that stage they were where they were. Lloyds after all was still keen to push on with the takeover. But a separation of the two banks was still possible – shareholders had not given their blessing in a formal vote at that stage. At Dorneywood that day the question of whether a takeover by Lloyds or a government-owned HBOS was best for the British economy was still lingering in the air.
For Turner, HBOS state ownership would have been a neater solution than the one which subsequently emerged with a Lloyds deal and a complex scheme involving government insurance of bad assets. Punishing the shareholders with nationalisation would send out a message – if you don’t stop your company taking unacceptable risks, this is what will happen. In other words, harsh treatment of HBOS shareholders would be ‘pour encourager les autres’ (to encourage the others). Turner felt that clarity of understanding would be best served by the nationalisation route. The government would have been in a stronger position to decide precisely what the major banks should be doing in the economy if it had a 100 per cent stake. He thought the same about RBS.
Taking HBOS under the state’s wing would, so the same argument runs, have left Lloyds ‘clean’ and better able to weather the storm and then lend more to businesses in a recovering economy. At a high of level of the Bank of England, there had been concern at the prospect of the Lloyds/HBOS deal continuing. Regulators, it was felt, could intervene to block the merger. But there were no formal high-level discussions between the Bank and the FSA on this issue. The FSA’s responsibility was to ensure that documents relating to the deal which were sent to shareholders were clear and accurate. It also had a role in assessing whether the newly merged entity would be stable. But its job was not to look after the interests of Lloyds shareholders – that was for the board and shareholders themselves. So, if it turned out to be a bad deal for Lloyds shareholders, as many of them later argued it was, that was their own collective responsibility. However, there was no denying at the FSA that if in September when the agreed Lloyds takeover was announced they had known how bad the HBOS loan book was, they would have blocked the bid and recommended government ownership of HBOS.
Whatever the reservations amongst policymakers, the Lloyds bid for HBOS stayed on the rails, heading for a destination of a legally agreed merger by early 2009. Ministers and their advisers were increasingly focussed on RBS and what to do about it. Lord Myners said of that time in late 2008: ‘Any feeling we had fixed RBS in terms of giving them enough capital began over a period of time to be severely tested by how bad we found the RBS book to be.’ It was becoming clear that Sir Fred Goodwin and his boardroom colleagues had been oblivious to what they had on their balance sheet. The need for even more funding to cover future losses was looking more pressing as each week passed. The results for the year 2008 were looking worse than anyone expected. Bigger losses would mean more capital being used to plug the holes – so the likely level of capital in early 2009 when RBS was due to report its full-year results was looking very thin.
The Treasury had by this stage taken full control of the process of handling the state-controlled banks and trying to chart a path for them. Number 10 let the Treasury get on with it and, at first, there were not too many instances of crossed wires or mutterings about interference. Myners later reflected that during those fraught days of early October he had become a minister in a manner akin to jumping onto a charging stagecoach. A couple of months later, however, with the RBS issue to be resolved, he felt as Financial Services Secretary he was more firmly in the driving seat alongside the Chancellor and in control of a significant part of the agenda.
So what were the options for RBS? One was complete nationalisation, for many of the same reasons as could be cited for HBOS. With the government share stake so high, injecting further state capital would make keeping it as a private company unsustainable. So transforming the bank into a wholly owned government corporation would be a logical step. That would involve yet more public money, a difficult step to sell to an electorate becoming ever more outraged about bailed-out banks and their apparently overpaid executives. But such a plan would not involve RBS staying on the country’s books for a prolonged period like the coal and shipbuilding industries after the Second World War. It would be a temporary move to allow RBS to be unpicked. The most toxic assets would be separated out from the higher quality loan book and put into a state-owned ‘bad bank’. (This would be the same course subsequently taken for the bad assets at Northern Rock and Bradford & Bingley, which were eventually transferred into one government-owned entity called UK Asset Resolution.) At the same time, the ‘good bank’, with the better quality assets would be groomed for a share flotation. Unencumbered by legacy loan books, the ‘good bank’, so the theory went, would be liberated and much more willing to lend just when the economy needed support.
The nationalisation idea, followed by ‘good bank, bad bank’ was strongly favoured by Mervyn King at the Bank of England. He had been pushing for forced state recapitalisation for longer than anyone at the top of the policymaking tree. King was influenced in part by the Swedish bank rescue precedent from the early 1990s. Sweden had experienced a property boom, fuelled by reckless lending, followed by a collapse leaving banks nursing collateral which was worth far less in the market than the value of their loan books. Lax regulation at that time was partly responsible for matters getting out of hand. It was an eerily familiar story and anyone outside the world of finance would have been entitled to ask why the markets failed to learn anything from it in the previous decade.
The Swedish government had taken a very hard line with its floundering banks. They were ordered to come clean about all their losses and then apply for state capital if they needed it. The price of taxpayer funding was a total wipeout of shareholders, with the government taking control of those institutions which could not raise capital from private sources. Bad assets were transferred into a stand-alone vehicle, at arm’s length from the government and supported by all the leading political parties. As the economy recovered, banks were reprivatised and the bad assets sold over the ensuing 20 years. In the end, the cost to the Swedish taxpayer was a lot less than initially predicted. One of the architects of the 1990s banking policy was Stefan Ingves who, by the time of the 2008 crisis, was Governor of the Swedish central bank, the Riksbank. He was in regular contact with Mervyn King and the Governor introduced him to ministers on visits to the UK during the autumn of 2008. Ingves, like King, was an academic economist by training so it was not surprising that the Bank of England Governor looked approvingly on him. One of the strengths Ingves was perceived to have brought to the resolution of the Swedish banking crisis was an independent mind, untainted by a lengthy career (at that stage) in financial markets or central banking.
The Treasury mulled over ‘good bank, bad bank’. It was firmly on the agenda of policy options which were considered seriously by officials. There was no shortage of investment experts who claimed to have helped devise the Swedish plan and were happy to reincarnate it for the UK. Ingves talked through the politics of going down this route with the need, in his view, to get the opposition on board to avoid it becoming a political football. Finding a culprit (for example greedy bankers) was one of his key observations – do that and a policy involving so much money can be more easily sold to the electorate.
But for ministers, the stumbling block with this course of action was always going to be the cost of nationalisation. Buying out the 15 per cent or so of private shareholders on the RBS register would have a price tag that could be met only by yet more government borrowing. Moving bad assets onto the state’s books would involve further cost. The inclusion of a nationalised RBS and its mountainous debt in the public sector accounts sent shivers down Treasury spines. At a time when the government was racking up higher borrowing to fund day-to-day spending, the idea of additional debt to deal with RBS appeared an unattractive option. The underlying priority was to preserve the UK’s top-notch credit rating and there were fears that markets might recoil from further lending to the British government. Whereas in the October bailout week, there was agreement that the UK’s balance sheet should be used to support the bank rescues, conditions had worsened by the end of the year. There were real concerns that the UK sovereign account could not afford another major financial lifeline for the banks. The fall in the value of sterling, including an all-time low against the Euro in November 2008, demonstrated that foreign investors were sceptical about the UK economy and banking sector.
Ease of execution was another priority for the Treasury. ‘Good bank, bad bank’ was seen to be a hugely complicated undertaking for an institution the size of RBS. For Northern Rock, splitting up the assets and changing IT systems was operationally challenging but in the end achievable. But at RBS a split could have taken 12 to 18 months to deliver. Valuing the toxic assets was viewed as a near-impossible task because it was so difficult to predict how much worse the economic downturn might become. Ministers feared that a transitional period that long would leave RBS in the doldrums and unable to focus on lending to households and businesses. Senior management in this scenario would be distracted from the task of reviving the bank and bogged down in the detail of dividing up the bank’s gargantuan loan book.
As the Treasury carefully weighed up alternatives, Number 10 was getting restless. Brown wanted to see more activity and demanded to know why bank lending was on a downward slide even after the mammoth infusions of public money. He instructed Shriti Vadera to study the issues and explore what new action the government might take. She personally favoured ‘good bank, bad bank’ but knew that the Treasury was against it. By Christmas the Treasury had not come up with answers and that added to Brown’s frustration. He was advised that ministers and officials were struggling to get to grips with precisely what was on the RBS balance sheet. So it was impossible to come up with a policy to tackle a problem, the scale of which had not been fully explored. But nobody across Whitehall was denying that more intervention was needed and that the initial capital infusion was not adequate in itself because the plight of the banks looked worse than it did in October. The banks themselves were on the defensive and highly suspicious of what was going on at ministerial meetings. They were fearful of the heavy hand of the state descending on them. One Whitehall source remembered that ‘there was a lot of whingeing from Lloyds’.
By January an outline solution had been reached. The hordes of investment banks allowed in through the door of the Treasury had submitted any number of bright ideas and clever wheezes. The favourite to emerge was a form of insurance scheme, drawing on the principles of the underwriting market. It was to be known as the Asset Protection Scheme (APS). The thinking behind it was that stability had to be achieved quickly if lending was to be kick-started. Bank balance sheets had to be underpinned in a way which was practical and quicker to implement than ‘good bank, bad bank’. It was assumed from the outset that APS would be much easier to establish. Some who favoured ‘good bank, bad bank’ saw the APS as a stepping stone that would, within a couple of years, trigger a full separation and sale of a ‘clean bank’. As they were to discover, it did not turn out that way.
The Asset Protection Scheme was later described as the largest private sector transaction ever entered into by a British government, bigger even than Lend-Lease, the loan from the US during the Second World War. The idea was that a bank would insure, for a fee, its dodgy loans so if they fell in value more than expected, the government (in effect the insurance company) would pick up most of the tab. The deal initially reached with RBS involved assets totalling £325 billion. If there were losses on those loans of up to £20 billion, over and above those already factored in, they would be absorbed by RBS. Anything beyond that would see the government covering 90 per cent of the bill. The initial proposal was that the fee, like an insurance premium, would be £6.5 billion. For RBS, the fee was to be paid in shares to the government. The theory was that the bank would pick up the expected losses, given the anticipated state of the economy, and the government insurance would only kick in if there was a bigger downturn. For the Treasury, the challenge was to set that first loss figure (£20 billion): high enough to provide fair value for the taxpayer. But it could not be too high in case market confidence in the banks’ ability to handle their liabilities if the climate worsened, what was known in the financial jargon as ‘tail risk’, was dented.
If anyone needed to be reminded of why RBS required a further safety net, the bank’s results announced on the same day (26 February 2009) as the outline APS framework provided it. Billed as the largest ever loss in UK corporate history, the bank revealed that in 2008 it had lost more than £24 billion, largely thanks to a sweeping write-down of the value of assets. Much of the deck-clearing was linked to the acquisition of the Dutch bank ABN Amro in 2007, just before the crisis. The Chancellor, while unveiling the APS details, admitted that the government was having to inject even more capital into the struggling Scottish bank – £13 billion in exchange for non-voting shares. That would take the government’s wider economic interest in RBS, if not the voting numbers, from 70 per cent to 84 per cent.
Lloyds was the only other bank at this stage to sign up for the Asset Protection Scheme. The Treasury announced that it was to put £260 billion of assets into the scheme and cover the first £25 billion of losses on that bundle of loans. Everything beyond that, as with RBS, was to be 90 per cent absorbed by the government. There would be a fee of £15.6 billion payable in shares. The government attached an important string to this arrangement – Lloyds was required to boost its loans to households and companies. £3 billion of extra mortgage lending was pledged as well as another £11 billion of loans to businesses. RBS had been told that it had to supply an extra £9 billion of mortgage lending and an extra £16 billion to businesses. These lending agreements were said to be ‘legally binding’. The fine print of the paperwork signed with the banks also contained more strictures on executive pay with a demand for what was described as a ‘sustainable long-term remuneration policy’.
Paul Myners, who was a key player in devising the plan, described it as a ‘neat and elegant sharing of risk’. The Treasury’s main banking adviser was Credit Suisse with James Leigh-Pemberton at the helm once again. Citibank was also retained as an adviser on implementing the policy. The beauty of the scheme for the Treasury was that it did not have an immediate impact on government debt, already forced sharply higher because of the October bailouts. Even with the government stake increasing as RBS handed over shares in lieu of ‘payment’ for the APS insurance, there was no big leap towards nationalisation – a minority stake remained in private sector hands. Markets were reassured that bank capital would not be eroded as unexpected losses would almost all be picked up the government. But it was a colossal potential liability for the taxpayer and, according to a Whitehall insider, it ‘could have gone very badly wrong’. Up to £305 billion of RBS losses could, in theory, have found themselves onto the public sector’s books.
In practical terms, though, despite not being part of the government’s sales pitch when launching the scheme, there was another huge benefit for the banks from APS. If their potential losses were insured above a particular level, the value of their risk-weighted assets could fall. In other words, the risk of the whole loan book had reduced so the banks could lower the assumed value of assets for the purposes of calculating capital required on the balance sheet. It was certainly a neat way of reducing the need for capital – if potential future losses were reduced, then less funding was needed to cover them. Looked at another way, it put a ceiling on the amount of capital that the government would have to inject. And if market conditions took a nasty turn for the worse, spreading a virus further across the RBS and Lloyds loan books, the APS could always be extended to cover more assets. Even in a sharp downturn there would not be a need for more capital – the APS would take the strain. The big fear of ministers was that markets would, in the event of another economic shockwave, judge that RBS did not have enough capital which would in turn provoke another liquidity crisis. APS (in theory) took that risk off the table. For the banks and the government, then, it looked like a win-win outcome on the critical issue of capital. One cynical Whitehall observer described it as ‘sleight of hand’ that allowed the government to conjure capital out of a hat without any bill attached.
But although the political decision on APS had been announced in January, and the detailed agreements with RBS in February and Lloyds in March, this was only the beginning. The mammoth task of pulling out the assets from each bank, valuing them and then moving them into the APS stretched potentially months into the future. Staff from the banks and the tripartite authority faced the thankless task of combing through the paperwork and agreeing valuations on hundreds of billions of pounds worth of loans. Only then could pen be put to paper by the banks and the Treasury. And this was supposed to be a quicker and more stable solution than ‘good bank, bad bank’. One senior investment banker with experience of advising Whitehall was sceptical: ‘It was a monsterly complicated thing to do, trawling through the books, asking what was a loss and when it would be recognised.’ A senior regulator later expressed astonishment at ‘the terrible state of the RBS financial controls – what the due diligence revealed was that it was quite hard to substantiate the backing on the RBS balance sheet’. That view pointed away from the bad bank idea, as it was impossible to say just how bad the assets that might end up on the state books were. The job of extracting these assets from the good bank seemed daunting. The same source reflected that Sir Fred Goodwin’s reputation as a great integrator of businesses acquired by RBS was totally misplaced.
It may have been a stratospherically large potential taxpayer liability and the biggest commitment by the state beyond normal public sector activity since the Second World War, but the media and politicians made curiously little noise about the APS. Myners was later frustrated, perhaps unsurprisingly given the ordure which had been heaped on him over Fred Goodwin’s £555,000 pension, that an appearance in front of the Treasury Select Committee of MPs was dominated by the Goodwin issue. Three quarters of it was devoted to grilling Myners on why he had not spotted that the RBS chief was heading for the exit with what looked like a very generous package. The APS was barely mentioned. Myners later suspected that the Goodwin payout had been deliberately leaked by 10 Downing Street to deflect attention away from the scheme – the Prime Minister’s advisers may have been worried that the huge APS liabilities would get unwelcome media scrutiny.
It was certainly complicated and not easy for the media and politicians to digest. In February 2009, when unveiling the scheme, Alistair Darling told the House of Common: ‘Together, these measures will help restructure and rebuild RBS, making one of the UK’s biggest banks also a stronger bank, better able to serve the people and businesses of this country.’ But for the Liberal Democrats, Vince Cable denounced APS as ‘a disgrace and a betrayal of the taxpayer’s interests’. Cable argued that the government should purchase more shares in the banks even if that meant nationalisation in all but name. Opposition elsewhere seemed muted.
What was not known at the time was that Mervyn King was deeply opposed to APS. He had been very frustrated that ‘good bank, bad bank’ was not adopted but would only make that public four years later. King had other things on his mind in the spring of 2009. He and his colleagues at the Bank of England were in the process of launching an unprecendented stimulus for the UK economy. This involved the creation of new money which was then pushed out into the economy in exchange for Government bonds (gilts) held by investors. The idea was that the investors would receive cash for their bonds which they would in turn spend on other riskier assets (such as shares) and in so doing support economic activity. Known officially as ‘quantitative easing’, as noted earlier, some critics branded it ‘printing money’ and £375 billion was eventually created.
Like Banquo’s ghost, Barclays hung in the air throughout the debate about ‘good bank, bad bank’ and the APS. It was the one bank that was not physically present but was uppermost in policymakers’ minds. Since John Varley had sat in Canary Wharf on the fateful weekend in October that had seen the ‘drive-by shooting’ at RBS, Barclays had endeavoured to stay well clear of ministers or anyone connected with government. The tall, paternalistic, bespectacled Barclays chief executive had set himself on keeping his bank out of the hands of civil servants and clear of any state shareholding. And as the autumn crisis gave way to winter’s nervous chill, Varley had sorted out his capital requirements without a penny of government funding. Qatari and Abu Dhabi investors had been approached and agreed to put up £7 billion, but at a price – Barclays paid hundreds of millions in fees to arrange the financing.
As the Asset Protection Scheme was being launched, there was much speculation in government and amongst financial regulators as to whether Barclays would be obliged to join. The downward adjustment of market expectations on the economy and the impact on banking which had battered the RBS balance sheet was raising questions about Barclays. Exposure to commercial property loans which might turn sour was by no means confined to RBS and HBOS. Ministers were not entirely convinced by the way Barclays marked assets in its accounts. The ‘marks’, are supposed to be a bank’s best up-to-date guess on what loans might be worth relative to their original value. The lower the ‘marks’ the more realistic a bank’s balance sheet is perceived to be. Critics believed they were too optimistic.
The Barclays board predictably said no to the government’s offer to join APS, but the bank had to enter into prolonged talks with the Financial Services Authority and submit to a stress test of its balance sheet. Barclays was required, under rules for the industry at that time, to hold core capital of 4 per cent of the ‘risk-weighted’ assets (the value of all the loans adjusted for varying degrees of risk). That was the benchmark the FSA had to work to as it scoured the Barclays balance sheet to see if there was enough capital. The government, however, had gone a little higher with the state-controlled RBS and Lloyds and demanded a 5 per cent ratio. There was some resentment in the Treasury and Downing Street that Barclays was being tested against the 4 per cent floor.
All this was crucially important for Barclays: fail the 4 per cent stress test and the bank would have to either raise more capital, extremely difficult in the circumstances, or join the APS. Varley and his boardroom colleagues were understandably desperate to pass. A war of nerves was being played out with some in government keen to get Barclays into APS and the bank itself determined to stay out. The simmering resentments burst out into the open with a leaking battle in March 2009. The first edition of the Financial Times on 26 March ran a story with a headline suggesting Barclays had failed the stress test. Barclays chiefs were furious. They had heard that day, unofficially, from FSA staff that they had passed the stress test although the Agency had pointed out the decision still had to be ratified by the tripartite authority. So the FT story looked odd at best, malicious at worst. The bank’s press team went into overdrive, phoning senior editorial figures at the newspaper. The second edition had a totally different headline, suggesting Barclays had passed the test.
The headlines soured the atmosphere even further. Barclays noted that the first edition of the story had been written at Westminster by a political correspondent. The bank suspected that briefings by 10 Downing Street or others in government had been put out to destabilise Barclays and indirectly put pressure on members of the tripartite who would have the final say on the test. Some government sources were disappointed with the second edition headline, believing that Barclays, having only just scraped through the 4 per cent barrier, was trying to pre-empt the tripartite discussion. The bank looked, to some in government, to be telling journalists that the FSA decision was final and would not be overturned. Whitehall officials considered going on the record to say that Barclays was wrong. But in the end they and the FSA decided it would destabilise Barclays too much if the FT story was contradicted.
Barclays, then, stayed out of the Asset Protection Scheme. John Varley and his fellow directors were delighted to steer clear of a structure that had the smell of a government bailout device. It was all in keeping with the bank’s strategy since the previous autumn of avoiding what the board saw as the stigma of state intervention. Never mind the fact that some of its major investors included members of the Qatari and Abu Dhabi royal families, the bank had escaped the clutches of the British government. But Barclays had the best of both worlds. It benefitted from the APS without actually being in it because investors regarded the whole UK banking sector as safer after the policy was announced. Once the markets saw there was a government insurance scheme that any bank could join, they judged there was a backstop for the whole sector. On the back of that funding costs for all banks fell, with Barclays like others a beneficiary. And for Barclays, that bonus came without an APS membership card and the subscription to go with it.
In late March there was a reminder, if one were needed, that the banking crisis had not been entirely the fault of high-rolling casino bankers. And not all of the victims were institutions that had gorged themselves on fickle wholesale funding. Sometimes it was plain old-fashioned bad lending which was the problem, and that was the case at the the Dunfermline Building Society. Armed with new resolution powers created in legislation only the previous month, the tripartite swooped on the Dunfermline and forced a sale of much of the society to Nationwide. About £1.5 billion of bad assets were taken under the wing of the Treasury. Regulators argued the Dunfermline was dangerously exposed to commercial lending which was turning sour. The fact that it was Scotland’s largest building society, close to the constituencies of both the Prime Minister and the Chancellor, added a political twist to the debate about the intervention of the authorities.
As summer dragged into autumn, progress with APS was slow. Headhunters were hired to recruit staff, interviews took place but for months there were no senior appointments. The Treasury had a streamlined team of talented and prodigiously hard-working civil servants but it lacked the numbers of people to deal with all the immensely complex problems that had arisen from the banking crisis. They were still fatigued, some close to burnout, and now they were faced with the gargantuan task of dealing with up to £600 billion of questionable bank assets. They did not, entirely understandably, have the skills or experience to assess loan books. They had retained banking advisers from Credit Suisse, Citibank and Blackrock to work on the complicated task of calculating the value of the assets. But these experts complained that, despite their best efforts, they could not get proper access to the loan books at RBS and Lloyds. One source said ‘diligence was terrible, the numbers were all over the place’. The banking advisers told the Treasury about the problems but officials did not feel able to press the case.
Another complication lay in pinning down Lloyds. Its membership of the APS had been announced in March but negotiations had become tortuous over the summer. The bank’s board made it increasingly obvious it wanted nothing to do with the scheme and was set on going it alone. Spurning the comfort blanket of the APS meant that Lloyds would need to raise more capital and it was desperate to do just that. So, in November 2009 it launched the biggest ever cash-raising exercise (known as a rights issue) seen in the City of London, with the aim of tapping the markets for £13.5 billion to shore up capital buffers. A further £9 billion was to be raised from bondholders. Lloyds shareholders backed the deal and took up 95 per cent of the shares on offer. The board billed it as a vote of confidence by the private sector in the bank, though the major shareholder, HM Government, had a large part to play in the success of the share issue by buying all it was entitled to – the final publicly owned stake was to be 43 per cent. After paying a £2.5 billion fee to the government for the implicit support gained by Lloyds since the scheme was announced, the bank was allowed to say farewell to APS.
The Lloyds board’s decision to plough its own furrow in the markets and shun the government’s scheme soured its relationships with Whitehall. Ministers had been keen for it to join the scheme, even if at a lower level of involvement than had been outlined in February. But Lloyds was defiant, seemingly hell-bent on avoiding APS at all costs because of the perceived stigma which went with the scheme. Staying out of the scheme would also help the bank keep the government stake below 50 per cent. On the government side there were suspicions that the Lloyds chief executive Eric Daniels was making derogatory remarks about APS to shareholders, turning them against the scheme. Some commentators have since argued that the rights issue was a less sensible outcome for shareholders as, for those who did not take up their rights to buy, it diluted their interest in the bank. Joining APS, on the other hand, would have helped its capital position without the begging bowl being handed around shareholders. But senior Lloyds sources say they asked the Government not to exercise its right to buy shares. The bank’s directors were confident they could raise all the money from private investors and if this had been allowed to happen billions of pounds of tax payers’ money would not have been needed. Lloyds’ chiefs suspected that, for political reasons, the government did not want its stake to fall.
For RBS, though, there was no escaping the Asset Protection Scheme. The terms were revised by the Treasury to provide better value for the taxpayer. The first loss to be taken by the bank was revised up from £40 billion to £60 billion and the total pool of assets put into the scheme reduced to £282 billion. Yet more government capital was injected into the bank with taxpayers writing out a cheque for £25.5 billion. By this time it was possible to work out the total bill for the bank bailouts. Government investments in the two banks since October 2008 totalled £65.8 billion (£62.7 billion net of fees paid back to the Treasury). In return the state had taken an 84 per cent interest in RBS and 41 per cent of Lloyds. The taxpayer liability of course did not stop there. There were hundreds of billions of pounds worth of lending being underwritten by the credit guarantee scheme and the Bank of England’s Special Liquidity Scheme. The die was cast, the taxpayers’ billions committed. But the question of whether the extraordinary policy decisions of 2009 would heal the banking system and get credit flowing properly around the economy was far from clear.