House of Commons - The FSA's report into the failure of RBS

The FSA's report into the failure of RBS - Treasury Contents

1 Introduction

1. On 2 December 2010, the Financial Services Authority (FSA) released a 298-word statement announcing that it had completed its supervisory inquiry into Royal Bank of Scotland Group (RBS). It said that:

The issues we investigated do not warrant us taking any enforcement action, either against the firm or against individuals. [...] The FSA cannot publish the content of the RBS review as information gathered from the bank during the course of the review remains confidential under the Financial Services and Markets Act 2000 (FSMA).[4]

2. In the light of the scale of the failure of RBS and the widespread public interest in understanding the reasons for that failure, the Treasury Committee regarded the statement of the FSA as wholly inadequate. On 13 December 2010, the Chairman of the Treasury Committee wrote to Lord Turner, Chairman of the FSA to request that the FSA reconsider its decision not to publish the findings of its investigation.[5]

3. In response, Lord Turner wrote to the Chairman of the Committee on 15 December and agreed that the FSA would prepare a report for publication.[6] In March 2011 the Committee requested that this report by the FSA, summarising RBS's failure and the FSA's actions in relation to it, be subject to independent external review. Lord Turner, in a letter on 28 March, confirmed that the FSA accepted the need for such a review which would "add value to this process, specifically by providing external assurance that the FSA is being brutally honest about any of its own failings."[7] Sir David Walker and Bill Knight were appointed as specialist advisers to the Committee to undertake independent external review of the FSA's Report in May 2011.[8]

4. On 25 May, the Treasury Committee published a Statement of the Purposes of the Committee and Terms of Reference relating to the independent review of the FSA's Report.[9] The Statement of Purposes set out the expectations of the Committee as to what the FSA's Report would contain:

The FSA Report will include analysis of the causes of RBS's failure; a summary of the findings of the FSA investigation into matters relating to RBS's decisions, risk controls and governance processes; and an assessment of the FSA's regulation and supervision of RBS, identifying any deficiencies and actions taken by the FSA subsequently.[10]

The Terms of Reference for the independent review by Sir David Walker and Bill Knight stated that the purpose was:

To review and report on the extent to which the FSA report is a fair and balanced summary of the evidence gathered by the FSA and PricewaterhouseCoopers during their review of the failure of RBS, and whether it fairly reflects the findings of the FSA's investigation.
To review and report on whether the FSA's report is a fair and balanced summary of the Authority's own analysis of its regulatory and supervisory activities in the run up to the failure of RBS.[11]

5. On 12 December 2011 the FSA published 'The failure of the Royal Bank of Scotland: Financial Services Authority Board Report'. The Report sets out what the FSA considers to be the primary causes of RBS's failure, and also examines deficiencies in the FSA's regulation and supervision of the firm. It includes a summary of the main points contained in two reports produced by PricewaterhouseCoopers (PwC) in relation to the enforcement investigations conducted by the FSA into RBS, and a summary account of the reasons why no enforcement action was taken.

6. Box 1 provides a summary of what the FSA takes to be the key explanatory factors in the failure of RBS. Box 2 shows extracts from the outline chronology given in the FSA Report to give a timeline of the key events described in the Report. Box 3 summarises the Report's conclusions with respect to RBS's performance, management and culture. On these matters, the Committee notes the similarities between the problems discovered at RBS and the problems with Barclays' board and culture that caused the FSA great concern in early 2012.[12] The FSA Report admits, however, that the degree of supervisory intensity that it applied to RBS's management, governance and culture before the crisis was less than it would now consider appropriate.

7. On the same day that the FSA's Report was issued, the Committee published written evidence on that Report submitted to us by our two specialist advisers.

8. We subsequently took evidence from Sir David Walker and Bill Knight on 24 January 2012 and from Lord Turner (Chairman), Hector Sants, (Chief Executive) and Margaret Cole (Interim Managing Director, Conduct Business Unit) of the FSA on 30 January 2012.

9. We reiterate here our thanks to the Committee's specialist advisers Sir David Walker and Bill Knight, for the immense amount of time and effort they put into reviewing the FSA's Report.[13] We would also like to thank our specialist adviser Richard Andrews for his assistance during this inquiry.

BOX 1: EXTRACT FROM THE EXECUTIVE SUMMARY OF THE FSA REPORT OUTLINING THE KEY EXPLANATORY FACTORS IN RBS'S FAILURE[14]

Why did RBS fail?: poor management decisions, deficient regulation and a flawed supervisory approach

The failure of RBS can be explained by a combination of six key factors:

significant weaknesses in RBS's capital position during the Review Period, as a result of management decisions and permitted by an inadequate regulatory capital framework;
over-reliance on risky short-term wholesale funding;
concerns and uncertainties about RBS's underlying asset quality, which in turn was subject to little fundamental analysis by the FSA;
substantial losses in credit trading activities, which eroded market confidence. Both RBS's strategy and the FSA's supervisory approach underestimated how bad losses associated with structured credit might be;
the ABN AMRO acquisition, on which RBS proceeded without appropriate heed to the risks involved and with inadequate due diligence; and
an overall systemic crisis in which the banks in worse relative positions were extremely vulnerable to failure. RBS was one such bank.

Although poor capital and liquidity regulation made it more likely that there would be a systemic crisis and thus set the context for the failure, and while a flawed supervisory approach provided insufficient challenge, ultimate responsibility for poor decisions must lie with the firm. The multiple poor decisions that RBS made suggest, moreover, that there are likely to have been underlying deficiencies in RBS management, governance and culture which made it prone to make poor decisions.

BOX 2: KEY EVENTS IN RBS'S FAILURE AND THE FINANCIAL CRISIS[15]

Timeline of key events

Date Event

2005

1 January Start of Review Period

24 February RBS announces £6.9bn pre-tax profit for 2004

2006

28 February RBS announces £7.9bn pre-tax profit for 2005

May RBS decides to expand GBM structured credit business

2007

1 March RBS announces £9.2bn pre-tax profit for 2006

19 March Barclays announces intention to bid for ABN AMRO

27 March RBS decides to bid for ABN AMRO

29 April RBS receives due diligence information from ABN AMRO

20 July Hector Sants appointed as FSA CEO

August RBS VaR models start showing significant back-testing exceptions

9 August Short-term money markets freeze; 'crisis period' begins

10 August 94.5% of RBS shareholders in favour of the proposed ABN AMRO acquisition

14 September Northern Rock receives liquidity support from Bank of England

5 October Barclays withdraws offer for ABN AMRO

17 October ABN AMRO acquisition is completed

November RBS added to FSA Watchlist

December 2007 - February 2008 Several major investment banks announce significant write-downs on structured credit assets

2008

18 February Supervision Director meets RBS CEO: agreement that capital position is tight

28 February RBS announces £9.9bn pre-tax profit for 2007 (including ABN AMRO)

19 March RBS Board agree plan to raise core tier 1 capital ratio

10 April RBS confirms to FSA that it will proceed with a rights issue

21 April Bank of England launches Special Liquidity Scheme

22 April RBS announces capital raising of £12bn

12 May - 2 June 2008 RBS share price falls by 35%

16 July RBS share price reaches a low of 165 pence

Mid-July Evidence of deterioration in available wholesale funding maturities for major UK banks

8 August RBS announces half-year pre-tax loss of £691m after credit market write-downs of £5.9bn

15 September Lehman Brothers files for bankruptcy; Bank of America announces purchase of Merrill Lynch

18 September Lloyds TSB and HBoS announce merger

20 September Adair Turner takes over as FSA Chairman

25 September Collapse of Washington Mutual

28 September Benelux governments announce Fortis bail-out

29 September RBS share price falls by 13%; government announces guarantee arrangements for B&B

30 September Irish government announces deposit guarantee for six banks

6 October RBS share price falls 39%; S&P downgrade RBS's credit ratings

7 October RBS fails, requiring emergency liquidity assistance; End of review period

BOX 3: EXTRACT FROM THE FSA REPORT EXECUTIVE SUMMARY: RBS'S MANAGEMENT, GOVERNANCE AND CULTURE[16]

24 Some of the causes of RBS's failure were systemic—common to many banks or the consequence of unstable features of the entire financial system. And a deficient global framework for bank capital regulation, together with an FSA supervisory approach which assigned a relatively low priority to liquidity, created conditions in which some form of systemic crisis was more likely to occur. But with hindsight it is clear that poor decisions by RBS's management and Board during 2006 and 2007 were crucial to RBS's failure.

25 Individual poor decisions can result from flawed analysis and judgement in particular circumstances: many of the decisions that RBS made appear poor only with the benefit of hindsight. But a pattern of decisions that may reasonably be considered poor, at the time or with hindsight, suggests the probability of underlying deficiencies in: a bank's management capabilities and style; governance arrangements; checks and balances; mechanisms for oversight and challenge; and in its culture, particularly its attitude to the balance between risk and growth.

26 It is difficult, from the evidence now available, to be certain how aspects of RBS's management, governance and culture affected the quality of its decision-making, but the Review Team's analysis prompts the following questions, in addition to the conclusion (discussed in paragraph 19) about the ABN AMRO bid:

Whether the Board's mode of operation, including challenge to the executive, was as effective as its composition and formal processes would suggest.

Whether the CEO's management style discouraged robust and effective challenge.

Whether RBS was overly focused on revenue, profit and earnings per share rather than on capital, liquidity and asset quality, and whether the Board designed a CEO remuneration package which made it rational to focus on the former.

Whether RBS's Board received adequate information to consider the risks associated with strategy proposals, and whether it was sufficiently disciplined in questioning and challenging what was presented to it.

Whether risk management information enabled the Board adequately to monitor and mitigate the aggregation of risks across the group, and whether it was sufficiently forward-looking to give early warning of emerging risks.

27 Potential areas of concern about RBS's management, governance and culture were identified by the FSA Supervision Team during the Review Period. The degree of supervisory intensity applied to these issues, however, while consistent with the FSA's prevailing practices and approach, was less than the FSA now considers appropriate.

4 "FSA closes supervisory investigation of RBS", FSA Press Notice, 2 December 2010 Back

5 Letter from Chairman of the Treasury Committee to Chairman of the FSA, 13 December 2010 Back

6 Letter from Chairman of the FSA to Chairman of the Treasury Committee, 15 December 2010 Back

7 Letter from Chairman of the FSA to Chairman of the Treasury Committee, 28 March 2011 Back

8 Relevant interests of specialist advisers are as follows:

Bill Knight:

Chairman, Financial Reporting Review Panel

Director, Financial Reporting Council. RBS 2007 Accounts were reviewed by the Panel and FRC corresponded with HM Treasury regarding the Asset Protection Scheme.

Sir David Walker:

Nil Back

9 "Independent Review of Financial Services Authority's report on The Royal bank of Scotland-Terms of Reference", Treasury Committee, 25 May 2011, "The FSA and the collapse of RBS-Statement of the Purposes of the Treasury Committee", Treasury Committee, 25 May 2011 Back

10 "The FSA and the collapse of RBS-Statement of the Purposes of the Treasury Committee", Treasury Committee, 25 May 2011 Back