Would putting regulators on bank boards really stop failures?

30th September 2011

The Prudential Regulatory Authority, a new regulator in the process of being set up, is seeking new powers to sit in on board meetings and some other essential company meetings.

The current regulator, the Financial Services Authority is being broken up with its functions split between several new bodies. But here Mindful Money asks if the FSA had had such powers would it have stopped so many of the UK's big banks from needing state help.  

But first a look at the plans. The Guardian reports that "in an attempt to rectify some of the criticism it faced in the wake of the collapse of Northern Rock, the FSA is now demanding access to the inner workings of big banks and other high-risk groups as part of what Hector Sants, the chief executive of the City regulator, regards as an "eyeball-to- eyeball" approach to regulation."

"In a dramatic change in its approach to regulation, the City regulator has asked big banks and other financial firms for permission to sit in on board meetings, sub-committee meetings of boards and some divisional board meetings as it attempts to understand the goings-on at the top of what it regards as "high-impact firms".

The comment boards think this will be difficult to get right. Here we give two views.

David91 writes: "Ignoring the issue of commercial confidentiality, there's no guarantee a board will talk about anything significant while an observer is present. Passive supervision is an interesting idea but I can't immediately see how it will encourage change in companies determined to continue their reckless behaviour."

And Uppergumtree writes: "The regulators need eyeballs on all communications between those who have significant influence, it needs to see all memos and meeting agendas. Firms may simply adopt informal meetings, pre meeting and post meetings. Meetings to end all meetings? The reasons firms pose a major risk to the financial system are quite simply the human beings so can we expect better supervision when the FSA has execs on the boards? All McKinsey people no doubt, what is their record to date?"

But there may be a more fundamental question. Examining any of the big failures, scandals and losses in recent history would an FSA board presence have really have stopped the bad things from happening?

UBS

Taking UBS and its recent rogue, the bank itself certainly protests that its losses were the responsibility of one person and it is very difficult to see how any board monitoring would have stopped things.

The key question may be whether it is right to blame the rogue alone and the answer is probably not. This suggests that while the regulator might not have stopped the loss making, uncompliant trades, a regulatory presence might just have improved the compliance culture and that could have stopped the worst of the damage. But it is very difficult to know, even with the benefit of hindsight.

Northern Rock

This is the example used by the Guardian as one that might be avoided in future. The now state-owned mortgage specialist bank was nationalised following a run on the bank – it was the first visible sign of the crisis hitting the UK. Several things went wrong with the bank. First it was more reliant than most on sources of outside funding, known as securitisation (essentially selling on books of loans) to fund further lending, although to a lesser or great degree, all banks and many building societies used the strategy. Second, Northern Rock had very loose lending criteria. This was perhaps best underlined by the fact it offered mortgages that were effectively 125 per cent of the loan to value of the property. These ‘Together' loans were supposedly aimed at young professionals who were not a big risk, but in reality they available to people with low incomes who represented a much greater risk. It was the funding issue that forced Rock into the state ownership.

Someone needs to ask how the FSA not see signs that Northern Rock was an outlier from the very high share price, the concentrated business model, and the extraordinarily high level of the loans. Many people warned them. Alarm bells should have been ringing and it didn't require a board seat.

Bradford & Bingley

This is another mortgage bank, which like Rock, used to be a former building society. B&B used to offer a wide range of loans and was also a very significant financial adviser distributing mortgages and investment bonds though its branches. It also owned mortgage broker John Charcol. But in the mid 2000s, the bank changed course concentrating on selling buy to let mortgages, and sub prime mortgages i.e. loans to people with a poor credit history though its Mortgage Express subsidiary. It also bought in books of loans from other sub-prime lenders to manage. It is arguable that an FSA seat at the table might have allowed the regulator to better understand the risks being taken. However once again the model was publicly questioned, particularly the policy of buying in loans originated elsewhere. The bank is now part of Santander. The Spanish giant also owns Alliance & Leicester which also ran into trouble though not to the same extent, and Abbey National. The real worry for the PRA in future may be that the UK subsidiary might be ok, but what of the Spanish parent? It is very unlikely that the Spanish board or even the Spanish government would welcome a UK regulator turning up for the board meeting.  

HBoS.

HBoS was formed from a series of mergers, most notably between giant mortgage player and another former building society Halifax, and Bank of Scotland. At one stage HBoS was lauded for becoming the fifth giant bank and a much need source of competition to the traditional Big Four.

But it was trebling up on its property market risk. Its funding model relied on the state of the securitisation market i.e. ultimately on the quality of residential loans partly in the UK and Europe, but most importantly the US. Its co
mmercial loans business in the UK was making huge loans to businesses that relied on the property market such as house builders and estate agents. Its mortgage business routinely accounted for a third of the loans to UK residential borrowers, admittedly, some through subsidiary brands such as Birmingham Midshires (Another former building society). Certainly a board presence from the regulator could have ensured that more attention was paid to managing risk. However, first the FSA was warned about the culture by an internal compliance officer Paul Moore, as the Telegraph reports here. Second the huge market share should have rung alarm bells. Perhaps most ironically, for much of the period, the Chief Executive of HBoS James Crosby was also deputy chair of the FSA. One might argue that the FSA were already on the board!

Lloyds Banking group

Out of all the stricken banks former bosses, it is probably those from Lloyds who deserve some sympathy. At the height of the banking crisis, the board of Lloyds clearly came under huge pressure to take over HBoS. Ironically, HBoS had been a long term takeover target but competition concerns had prevented any deal. Now however, the pressure came from the Prime Minister Gordon Brown. Lloyds, actually a pretty well run bank, made a very hasty decision to take over HBoS and was forced into the arms of the taxpayer as a result. It can now repent at leisure as the poor quality of much the HBoS book becomes clear. It is difficult to imagine how a board presence for the regulator would have helped. The FSA already had to scrutinise the deal and under pressure allowed it to go through.

Royal Bank of Scotland

In the case of the second giant state owned bank, which was run for much of the crucial period by Fred Goodwin, some of the problems relate to the merger with Dutch bank ABN Amro. It is clear that RBS failed to establish that ABN was in a perilous state. RBS was accused of being seized by merger mania. It would be very interesting to see how a regulatory board presence would have affected the discussions. However, arguably, the FSA had to approve the merger anyway. Something the public don't always realise is that RBS is also the parent company of Nat West, a more successful takeover.

There have also been accusations of a bullying culture at the bank, while the quality of many loans arranged before the ABN deal have been questioned too. A regulatory presence might have made bullying more difficult.  But it is the merger that ultimately laid it low. Would the regulator really have stopped that?

The Telegraph gives a detailed account of the bank's fall from grace here.

Mindful Money's conclusion from history is that it is certainly not a foregone conclusion that a regulatory presence would have stopped any of these banks from falling into state hands or forced into shotgun mergers. However it is a very different regulator and clearly a lot of lessons have been learned so perhaps if boards have not learned from the crisis (UBS hasn't calmed such fears) then maybe the regulator has.

We'll end with one Guardian commenter thinks it wouldn't do any harm.

IReadTheArticle says: "I share everyone's cynicism about the FSA, especially the tendency of people to save formal meetings for vacuous platitudes. However, requiring employee representatives on the board has evidently been at least partially successful in Germany and similarly I can't see why giving the FSA access to board meetings is a bad thing."

More from Mindful Money:

Online ‘dragon’ Julie Meyer talks to Mindful Money on the “real issue” facing the economy

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Financial regulation: Why bother at all?

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