Policy changes needed to prevent future bank failures: FSA

A report from the UK Financial Services Authority into the failure of the Royal Bank of Scotland found that management is largely to blame, but that important policy changes are also needed to prevent future failures.

The FSA released a report Modnay that examines the failure of RBS during the financial crisis. It concludes that RBS’ failure ultimately resulted from poor decisions made by the bank’s management and its board, but that deficiencies in the global capital regime and liquidity regulations also made the crisis much more likely. Additionally, it says that flaws in the FSA’s supervisory approach “provided insufficient challenge” to RBS.

The report concludes that the failure of RBS can be explained by a combination of six factors: significant weaknesses in its capital position; over-reliance on risky short-term wholesale funding; concerns about RBS’ underlying asset quality; substantial losses in credit trading activities, which eroded market confidence; the ABN AMRO acquisition; and, an overall systemic crisis in which the banks in worse relative positions were extremely vulnerable to failure.

The report says that 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. It concludes that these underlying deficiencies should be considered as a seventh key factor in explaining RBS’ failure.

“People want to know why RBS failed and why no-one has been punished,” said FSA chairman, Lord Adair Turner. “This report aims to answer those questions. It describes the errors of judgement and execution made by RBS executive management which, in combination, resulted in RBS being one of the banks which failed amid the global crisis. These were decisions for whose commercial consequences the RBS executive and board were ultimately responsible.”

He notes that the report also describes why the FSA’s enforcement division concluded that there was not sufficient evidence to bring enforcement action which has a reasonable chance of success. And, he said it reinforces the conclusion that the global capital standards applied before the crisis were severely deficient and liquidity regulation was totally inadequate. It also concludes that the FSA was too focused on conduct regulation at the time and its prudential supervision of major banks was inadequate.

Many of the reforms required in response to the lessons highlighted in the report have already been implemented, Lord Turner notes. But in addition, he proposed two key policy areas where further significant change should be considered. He recommends that major bank acquisitions should require explicit regulatory approval, and he calls for a public debate about changes to rules, laws or remuneration policies which would ensure that bank executives and directors face personal consequences as a result of bank failure.

“The fact that no individual has been found legally responsible for the failure begs the question: if action cannot be taken under existing rules, should not the rules be changed for the future?” he said. “In a market economy, companies take risks on behalf of shareholders and if they make mistakes, it is for shareholders to sanction the management and board by firing them. But banks are different, because excessive risk-taking by banks, for instance through aggressive acquisitions, can result in bank failure, taxpayer losses, and wider economic harm. Their failure is a public concern, not just a concern for shareholders.”

“We should, therefore, debate policy options to ensure that bank executives and boards strike a different balance between risk and return than is acceptable in non-bank companies,” he said, suggesting that there are two basic ways to achieve this which could be considered: a “strict liability” approach, making it more likely that a bank failure like RBS’s would be followed by successful enforcement actions, including fines and bans; or, an automatic incentives-based approach involving either rules which automatically ban senior executives and directors of failed banks from future positions of responsibility, or major changes to remuneration to ensure that a very significant proportion of pay is deferred and forfeited in the event of failure.

“There are important pros and cons of these different ways forward, and complex and important legal issues which would need to be considered. But by one means or another, there is a strong argument for new rules which ensure that bank executives and boards place greater weight on avoiding failure,” he said. “The options for achieving this merit careful public debate. The FSA has committed to publishing a discussion paper on the options in the New Year.”