In January 2012, the Financial Services Authority published its report on the Royal Bank of Scotland’s (RBS) failure. The report is surprisingly candid. It is also a rarity.  The FSA does not usually publish its regulatory reports. However, the size and scale of the RBS failure made it a requirement.  The governance and regulatory issues it raised had to be addressed publicly. The final public report was needed to explain why the initial regulatory investigation had not identified any wrongdoing.  By contrast, the 2011 March Lehman Brothers (LB) bankruptcy report by Anton Valukas is clear and direct in assigning culpable blame.  Despite this initial contrast, the reports have important similarities.  In particular, what they show problems with the leadership, culture, the regulators. What connects all three is the same approach to risk.

What is clear in both reports is that neither organisation could survive without a government bailout.  Both failed because senior management took too great of financial risks.  The senior management teams demonstrated poor judgement with financial decisions.  For RBS it was the ABN Amro takeover decision. For Lehman Brothers, the fatal flaw was not a takeover. Instead, it was the increased holdings of sub-prime mortgage assets.  As the sub-prime mortgage crisis unfolded, LB could not sell its assets as they continued to lose value.  In the end, both were undone by the sub-prime mortgages but in different ways.

What is common to both organisations is how they arrived at the crisis point.  In both cases, we see the same failure of leadership and the wider failure of the corporate culture. What makes them interesting is that they both had the same weaknesses, with the same toxicity, in the same industry, with the same effect. Yet, they were different business models, in different market, in different organisations, and different regulators.  They should have had different approaches to financial markets, risks, and management. Yet they were overburdened with debt.  Their approach to risk proved catastrophic.

I compare the reports to draw lessons for leadership, culture and regulatory action.  Each investigation approached their respective problem differently. They created different reports.  They provided different lessons to learn.  The regulatory outcomes show the political and business establishments in each country. The leadership failures show what can happen to effective decision making when “wilful blindness” towards risk is reinforced by a corporate culture corrupted by an appetite for increased risk.

What is particularly revealing, and not well researched or analysed, is how the investigations worked.  For RBS, the United Kingdom’s Financial Services Authority conducted the review.  They were the industry regulator responsible for supervising the bank. They were responsible for the regulatory framework within which the RBS collapse occurred.  One has to read the report knowing that the FSA have an interest in how it portrays the FSA. Even though it accepts a fair part of the blame, one cannot see this as a neutral or independent report.  In many ways, its work is as much to defend itself, as it is to find out what went wrong with RBS. The FSA was explicit in criticising its approach to regulatory involvement.  (See pp 253-294). However, the FSA report cannot be considered an independent assessment of the FSA’s work. They were candid in their own failings, and the wider failings of the regulatory framework, but this has to be balanced against the political context of such remarks given that the future of the FSA as an institution was in question.  One cannot avoid the element of special pleading that hangs over the report.

The same candour is not found from the United States Security and Exchange Commission (SEC) about LB. Yet, unlike the RBS report, the LB report is explicitly independent because it serves a different purpose. The LB report was commissioned by the bankruptcy court to find out what happened and whether criminal charges are justified for any parts of the LB failure. As LB had disappeared as a viable business, the “political” pressure was not the same for the investigation as it was for the RBS and for the FSA.

1.Scope of the investigations.

The FSA, according to their statements, are limited about what they can publish about such Board Reports.  The RBS report came from an first regulatory investigation.  After the first report found that no legal action would be taken against RBS management, the larger report was prepared to explain that decision and then made public.

By contrast, when Lehman Brothers went to bankruptcy court, the court appointed an independent investigator.  The investigator was not the regulatory body, in this case it would have been the SEC. Instead, his remit was to look at the books to find out what went wrong. The report by Anton Valukas was published after it was seen by the court. In the investigation he was given the legal power to subpoena witnesses. However, he was able to get interview officers informally, rather than using an oath and transcript approach.  (Valukas report Volume 1 pp 35-37).  Every person asked for an interview, accepted, except Hector Sants of the Chief Executive of the UK Financial Services Authority. (Valukas report Volume 1 p.37), the FSA did provide a detail written response to the questions.[1]

2. Who has a stake in the investigation?

As the court appointed investigator, Valukas had no stake in the outcome.  By contrast, the FSA investigation was not intended to be made public. Although the enforcement team within the FSA were looking for activity that could be brought to court, the final report did not find any activity that could meet the legal threshold for litigation.  Both were interested in what went wrong and in doing so, they reflected their respective political, economic, and corporate establishments.  What is particularly noteworthy, as mentioned above, is how the RBS report reflected the political context created by the furore over Sir Fred Goodwin’s pension decision.  Despite the FSA having a direct stake in the investigation, unlike the SEC in the United States, neither report could be considered a political report.

3. Political context was not a major factor

Neither report was shaped directly by overt political considerations.  Although both were published within a political context, where their conclusions would be politically useful, neither appears to have been shaped political needs. In the RBS case, the controversy over the decision to grant the former CEO of RBS, Sir Fred Goodwin a large pension, had political consequences.  A less dramatic political issue, although more serious, can be seen in the LB report.  To date, no criminal charges have resulted from the report. However, what is clear in both cases, at least on the surface and within the reports, was that neither the RBS nor LB failure was the direct result of politicians or government policy decisions.

4. Size, scale and intent differentiates the reports.

A further contrast, between the LB report and the RBS report was how the reports unfolded.  The RBS report was considered by the Board in November 2011 but the first announcements that no legal action was to be taken against RBS management was made in 2 December 2010. Then, in April 2011, further specialists were added to check the report. The final report was submitted to the FSA Board in November 2011.  Although experts were added to increase the investigation’s rigour, the context does give the appearance they may have been added for “political” reasons. The situation with Sir Fred Goodwin’s pension would not be raised in the report.  The LB report was submitted to the Court, then a redacted version, before the final deadline for creditors to initial legal action, and then a final unredacted version the next month.  The LB report did not receive additional experts.

The difference is that the LB report is nearly 2200 pages long stretching over nine volumes.  The RBS version, by contrast, is one 452-page volume even though both firms were roughly the same size financially when they failed.

5. Finding blame: a key difference (perhaps cultural)

The RBS report contrasts with the LB report on the blame or colourable claims. The RBS report does not find any colourable claims.  In many ways, the final report was made public to explain why no one has been charged or found to have committed anything legally wrong. (p.6-8). There are plenty of failures but no one is to be blamed.  The approach is similar to the report into the 7 July 2005 bombing where a list of failures is noted but no one is blamed.  By contrast, the LB report sets out the colourable claims for investors and regulators to take legal action against the LB directors.  The report is designed to point fingers and assign blame. The LB report, by contrast, centred on specific colourable claims that could lead to criminal charges. In effect, there was enough evidence to suggest that LB had acted inappropriately to the point where criminal charges could be brought.

The LB report focused on near senior managers to get the inside evidence against the senior management team.  They worked with people to get their help in identifying the evidence needed to go after the senior figures.  By contrast, the RBS investigation seemed at pains not to take an overly aggressive approach, and sought to review the decisions within a different context, which may have hampered its ability to draw out the wider possibilities.  Although, here we need to understand that RBS was rescued so a viable business needed to be sustained. There were no point finding skeletons if the goal was to keep RBS going.

6. Identifying regulatory shortcomings reflects different terms of reference.

The FSA report is more robust in identifying its regulatory shortcomings. The LB report does not explore that regulatory framework as it was outside the terms of reference.  However, after the report was published Valukas did give testimony to Congress about what the LB report indicated about regulatory activity. The SEC has published its own accounts of its role in regulating LB. As the Valukas report was not focused the regulator’s role, there is little to compare the reports in this area.

Leaders: taking us to the peak or over a cliff?

The RBS investigation is noteworthy for its willingness to explore the leadership, culture and governance issues that contributed to the failure.  By contrast, the LB report refers to these issues in passing so we do not have a full understanding of why things went wrong.  We know what went wrong, but we do not know, yet, if ever, why it went wrong.

In both cases, the leadership of the organisation failed in their role.  For different reasons, both organisations became loaded with debt and toxic assets that could not sold to raise capital.  Even though both had severe exposure to the sub-prime mortgage crisis, how they came to that place reflected their leadership (and respective regulators).  In the RBS report, the message is that CEO became more and more dominant as the firm succeeded.  The report explains the firm’s success increased the appetite for risk.  One could look at this issue in terms of personalities, but that would overlook the cultural and organisational issues.  The Board, and the Regulator, were willing to overlook the issue because the company was successful.  What was missing was a strong analysis, within the organisation, or regulator, to challenge the fundamental business strategy against the emerging financial system.  For example, the FSA was concerned about the RBS leadership approach back in 2003 (see paragraph 608 on page 233).  The concern, in hindsight, was that the focus on incentives that benefitted the CEO, rather than the company, might have skewed the appetite to risk.

In the LB report, the focus is less on leadership and management team. The reasons for the crisis are not explored as well as the immediate cause.  What is clear, though, is that the business context, seeking larger deals to maintain status within the field, fuelled an appetite to risk. The market is competitive which means that each firm seeks an advantage, but most importantly, the appearance of advantage in landing clients. The concern for appearance drove much of the LB leadership decisions, especially when the financial crisis became publicly clear in 2007.  LB found it increasingly difficult to sell its inventory of assets because their value was substantially less than promoted.  As a result, the firm turned to Repo 105 transactions to offset this problem and maintain the appearance of its poor inventory of financial assets.  (See Volume 3 of the LB report).

What is clear, though in both cases is that the leadership was not exercising a wilful blindness to the risks and problems in each firm.  Instead, they understood the risks, to some extent, but ignored them or believed they could overcome them.  In this regard, the leaders were different from a Rupert Murdoch or a Tony Hayward seeking avoid what was evident to everyone else.  In the News of the World, the ethos created the phone-hacking scandal.  At BP, the wilful blindness was to the safety concerns raised repeatedly. In RBA and LB, the issue was more than leadership. The leadership flourished within a culture culture that allowed their views to be challenged or assessed against an external standard to regulate their behaviour.

Culture: profits before prudence means risk can never be avoided

The leadership issues exist within a culture that encouraged risk taking and reinforced the leadership style.   What was going wrong at the end was the culture that created the problem could not fix it.  The problem is that the leadership rewarded and created in both organisations a culture that accepted risk beyond what was prudent.  In LB, this is understandable, to an extent, given its business as a deal maker.  What is not as understandable, though, is how this same culture emerged in RBS. One could simply explain this by saying both firms suffered from the successful market syndrome. As long as the market improved, their failings, the underlying performance issues, and their culture, were not a problem.  As such, that becomes a truism that does not help us to understand the deeper issue.

The deeper issue is that both firms reflected their leadership and embodied and encouraged a culture that embraced more and more risk. At the same time, they did not develop a culture that looked at the fundamentals to argue against the grain. Instead, the leadership encouraged a culture where employees were encouraged to go along to get along.  The same approach was working across the industry as the market continued to improve with each year.  Why oppose what appeared to be working?  Yet, even the regulators in 2003, according to their claims, were concerned about the leadership at RBS. (One wonders how much of this is based on a defensive hindsight.) If the regulator could see the problems, and yet not do much beyond report their concerns, it makes sense that others across the industry had the same concerns.  Although the FSA was quick to accept that its voice was not heard and it could have done a better job, it does not reflect adequately on why its regulation failed.  What remains unanswered is why the regulator was not heard in 2003.

The reason the regulator was not heard was that it could not use risk to its advantage.  For the same, but inverted reasons, the market sputters because it cannot use risk to its advantage.  What this means is that the market still does not understand risk, what causes, and how to cut its effect.  Instead, the industry believes, quite incorrectly, that risk can be conquered and if not conquered managed through exotic and complicated financial instruments that “insure” against risk.  The culture that created RBS and LB was (is) the false belief, the dangerous belief, that risk can be conquered. The mind-set towards risk that created the culture at RBS and LB is still dominant in two different but related ways across the industry. The first way was the belief that riskier and riskier situations can somehow be saved with an amazing long-shot success. In 2008, it was the idea that somehow the market will rebound.  The second was that risk cold be calculated and managed through complex mathematical formulas that “removed” risk.  In this approach, almost the micro version of the macro long shot risk, the companies believed that risk could be managed by effective mathematical modelling. The problem, though, was that this only displaced the risk, it shifted the consequences to someone else.  In effect, they externalized the risk. In doing so, they made the system riskier. The other firms sought the same solution so that when the risk had to be paid, the system unravelled.  Firms sought to cash in their insurance only to find that everyone else was cashing in at the same time.

What is needed is for regulators to have a stronger belief in risk. They need to remember the aphorism Naturam expellas furca, tamen usque recurret (You can drive nature out with a pitchfork, but she always comes back).  The regulators need to use risk to their advantage to restrain the companies and avoid the same mistakes.  The challenge though is that the market perpetuates the consistent belief that risk can be conquered so even greater risks can be taken.  What is needed is to learn the fundamental lessons of the market and not attempt to avoid them. Only then will we begin to develop cultures and leaders that can work within risk and not try to conquer it.

Postscript: As I just finished this post, after 3 weeks, I came across this link to a report by Kerr and Robinson on RBS leadership, in particular Fred Goodwin, and the management style of fear which contributed to the collapse.  Although they raise interesting points, I could not incorporate them into my piece.

http://www2.le.ac.uk/offices/press/press-releases/2012/june/rbs-mangement-style-used-2018economic-violence2019-to-wield-power-that-led-to-banks-failure-new-study-suggests

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