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ISBN 9781407073651

RECKLESS BRAIN SHOT

The Rise and Fall of the City

Philip Augar

LONDON

Also by this author

The Death of Gentlemanly Capitalism:

The Rise and Fall of London’s Investment Banks

The Greed Merchants:

How the Investment Banks Played the Free Market Game

Reckless:

The Rise and Fall of the City

I

The Lord Mayor’s Banquet for Bankers and Merchants also known as the Mansion House Dinner is one of the City of London’s showpieces. It is attended by the most powerful people in finance and is addressed every year by the Governor of the Bank of England and the Chancellor of the Exchequer.

The 2007 dinner took place on the evening of 20 June. Britain was enduring its worst summer for many years but the weather did not dampen the spirits of Chancellor Gordon Brown as he made his way to the top table to the traditional slow handclap from the Lord Mayor’s 350 guests. For Tony Blair had finally agreed to stand down and in less than a fortnight Brown would achieve his long-standing ambition of becoming prime minister.

Having completed ten years at 11 Downing Street, he had been the longest-serving Chancellor in British history and apparently one of its most successful. He even appeared to have given the lie to one of his favourite jokes: there are two types of Chancellor, those who fail and those who get out in time.

Brown’s jubilation was understandable. Britain had enjoyed continuous prosperity between 1997 and 2007 and much of the credit was given to him for his prudent management of the economy. At the Mansion House that night he was not going to miss the moment, promising to ensure ‘Britain’s macroeconomic framework remains a world benchmark’ and looking back on ‘an era that history will record as the beginning of a new golden age for the City of London.’ Many of those present had been at the Mansion House the previous year when Brown had delivered a eulogy to the robust health of the British economy and the principles he had followed to get it there. He name checked Adam Smith, the eighteenth century Scottish philosopher whose work on market forces had influenced him, and Alan Greenspan, the US central banker most closely identified with free market globalisation. Brown boasted that, ‘Government debt in Britain is lower than France, Germany, Italy, America and Japan’, while growth in Britain was ‘expected to be stronger this year than last and stronger next year than this’.

His 2007 speech was also upbeat and many of his friends from the City were there to hear it. Chancellor Brown’s speech that evening lavished the bankers with praise. They were told that ‘Over the ten years that I have had the privilege of addressing you as Chancellor, I have been able year by year to record how the City of London has risen by your efforts, ingenuity and creativity to become a new world leader. . . . . The financial services sector in Britain and the City of London at the centre of it, is a great example of a highly skilled, high value added, talent driven industry that shows how you can excel in a world of global competition. Britain needs more of the vigour, ingenuity and aspiration that you already demonstrate that is the hallmark of your success.’ He quoted many statistics to back up his comments: over 40 per cent of the world’s foreign equities were traded in London, more than in New York; over 30 per cent of global currency trading took place in London, more than in New York and Tokyo combined; and more than 80 per cent of the City’s business is international.

It was an ill-advised speech under the circumstances. Although most investment experts shared Brown’s optimism, there were enough warning signs to have suggested caution and indeed the previous speaker, Mervyn King, the Governor of the Bank of England, had warned about the degree of leverage in the global financial system. He said, ‘Excessive leverage is the common theme of many financial crises of the past. Are we really so much cleverer than the financiers of the past?’. Most of those present probably thought ‘yes, we are’ but events were already proving otherwise for by June 2007 the American housing market had been on the slide for a year with falling prices and more and more borrowers defaulting on their loans. Big companies of the kind that the Chancellor and his advisers ought to have noticed were showing the pain. In February 2007 Britain’s biggest bank HSBC had warned of write downs on its US mortgage book and in April 2007 America’s largest mortgage lender, Countrywide Financial shocked the market with a 37% profits fall.

What few people understood in June 2007 was the extent to which the global financial system ultimately depended on the US real estate market. Many of the world’s largest financial institutions including most of the British banks had invested in securities linked to US mortgages and would suffer heavy losses when asset prices plunged. Worse still, what happened to US real estate would also happen in other countries including Britain. Confidence would evaporate, banks would no longer be able to rely on investors to provide the cash flow to fund their lending and a vicious circle would evolve, gumming up the world’s banking system. How did this position arise?

II

The media is now full of what Sir Howard Davies, once Britain’s chief financial services regulator and now Director of the London School of Economics, calls Harry Hindsight and the blame game is in full swing. The usual suspects include regulators asleep at the wheel; central bankers, especially Alan Greenspan, who encouraged the credit bubble by baling out markets whenever they were in trouble; ratings agencies who were too generous in their assessment of credit risk; speculators whose short selling of troubled financial stocks drove share prices down; complacent non-executive directors too close to strong willed chief executives to challenge them and greedy bankers who miss priced risk, ignored whistleblowers and made away with their riches while their companies failed.

Most of these characters played a part in bringing on the banking crisis but their actions were symptoms of a more fundamental cause. This was policy makers’ excessive faith in free market capitalism going back many decades and stretching across many countries and continents.

The events that brought the world’s banks to their knees had their origins thirty years ago when free market economics took hold in Britain and America. The break down of the post-war Bretton Woods system of monetary policy in 1971 signalled the end of the Keynesian era of interventionist economics and the world looked round for alternatives.

Into the vacuum stepped the Chicago School of economists led by Milton Friedman who argued that when governments attempted to intervene in markets they got things wrong. They picked up the ideas of Adam Smith who believed that the invisible hand of markets would cull the weak and nurture the strong, leaving the system itself fitter. Efficient market theorists weighed in arguing that the market always knows best since it prices in all known and knowable information. It followed from this that non-intervention in markets and the deregulation of industry were the best courses for governments to follow; anything else was doomed to fail.

At about the same time the creation of shareholder value became generally accepted as the primary objective for companies, following research by another American academic, Professor Alfred Rappaport of the Northwestern University Business School. Management consultancies such as the firm of Stern Stewart, with its concept of economic value added, developed these ideas into a new and complete creed for management, and investment bankers sold this hard to the corporate sector. Once the ingredient of performance-based compensation was added, a development that came with the introduction of share options in the 1980s, the stage was set for three decades in which deregulation, shareholder value and incentivisation formed the template for business in the US and its economic disciples, notably the UK.

These ideas took hold in the US during the Reagan presidency, 1981–1989 and were adopted in Britain by the Conservative government that was elected in 1979. All four prime ministers – Thatcher, Major, Blair and Brown – who occupied 10 Downing Street, practised macro-economic policies of deregulation and non-intervention in business and markets at the strategic level. Industries such as telecommunications, utilities, energy and, of course, finance were deregulated. Previous barriers to mergers and acquisitions were lowered and the market was left to judge which companies would succeed or fail.

The effect of this on the corporate sector was electric. During the 1980s the first American corporate raiders came to the UK and triggered off a wave of industrial restructuring. Aggressive British companies such as Hanson and BTR followed their lead in picking off undervalued companies. Institutional shareholders’ relationship with the corporate sector changed from passive long-term support for management, in which disapproval was expressed in discreet meetings or in extremis by selling the shares, to a more proactive engagement. In the 1990s hedge funds transformed shareholder activism from a minority pursuit practised by maverick raiders into a mainstream activity. Fund managers, under pressure from trustees and consultants to deliver results every quarter, eagerly accepted takeover bids, cashing in today and letting tomorrow look after itself. Investors become more outspoken in their criticism of management and less tolerant of under-performance.

These conditions enabled financial institutions to grow in scale and influence, particularly the investment banks which wrapped their tentacles around the corporate sector. During two decades of anything-goes management they egged on chief executives to explore every conceivable avenue to grow earnings per share. Corporate executives listened intently. They could achieve life-changing rewards if they were able to get their company’s share price above the price of their options but if they showed any sign of weakness they were out. They redoubled their efforts to please the market using devices such as share buy-backs, buyouts, mergers, leverage and financial engineering.

The pressure the market exerted on companies can be illustrated by events at the food and beverage company Cadbury Schweppes. In 2007, two days after the American activist investor Nelson Peltz disclosed a 3% holding in Cadbury Schweppes, the company announced that it intended to spin off its beverage operations in a direct reversal of its previous comments on the subject. Anthony Bolton, one of Britain’s most respected fund managers, called this one of the ‘events that change the investment landscape – an episode that alters the relationship between shareholders and companies in which they invest.’

But in truth the landscape had changed long ago. Ever since the days of Hanson and the US activists of the 1980s, British chief executives knew that if they did not increase profits and dividends fast enough to please the market, they would be dumped and their business might get taken over. They switched their business strategy from patient long term investment, a strategy that, it must be admitted, could lapse into complacency, into chasing alpha, the City’s term for super-charged performance.

In the UK the full weight of shareholder value bore down on the banking sector. It was an intensely watched industry, and management was under constant pressure to please the stock market when it came to earnings growth. The experience of NatWest, cast off by shareholders to RBS in 2000 when it was judged to have lost its way, was a salutary reminder to banking chiefs of what happened to management that failed to perform.

III

As the British banking industry entered the 21st century it was in a finely poised position. It was in a rapidly globalising sector where the Americans were defining scale. Mega-mergers – such as those being engineered by the serial acquirer Sandy Weill who built Citigroup out of Citibank, Salomon Brothers, Smith Barney, Travelers and the British investment bank Schroders – appeared to be setting the pace in terms of product range and global reach. Shareholders said, and chief executives agreed, that British banks risked being marginalised unless they kept up with the global leaders by means of acquisitions or increasing profits through aggressive organic growth.

The British banks were at an apparent disadvantage in their attempts to become globally competitive as a result of their withdrawal from investment banking in the 1990s. The financial services reforms known as Big Bang, implemented on 27 October 1986 had been intended to modernise Britain’s investment banking and broking industry and equip it to compete in a fast globalising industry. New rules opened the stock exchange to competition and allowed investment banks to trade in markets for themselves as well as for customers. Britain’s High Street and merchant banks were allowed to buy brokers, and it was expected that this would enable them to compete with the American investment banks such as Goldman Sachs, Merrill Lynch and Morgan Stanley. Between 1983 and 1986 the big banks of the day, including Barclays, NatWest, HSBC and Midland, and merchant banks like Warburgs, Schroders and Kleinwort Benson bought, built or converted to investment banks.

But the new owners lacked the management skills to operate the new model and investment banking in the City by UK-owned firms was soon on the run, unloved by shareholders and under pressure from foreign competitors. The Americans and Europeans moved in for the kill between 1995 and 1997, when six of the City’s top investment banks including NatWest’s and Barclays’ equities businesses were sold to overseas competitors. Consequently as the banking industry entered the 21st century, none of Britain’s leading banks had a credible global investment banking arm, a situation that appeared to rule them out of the most high growth areas of modern finance.

Surprisingly, a potential opening appeared in the form of a new method of banking called originate and distribute. Traditional banking of the kind practised until the mid 1990s involved taking in deposits from savers and lending this money out at a slightly higher rate to borrowers. The amount lent was closely linked to the amount collected from depositors and by regulations designed to ensure that banks did not over-stretch themselves. There were periodic rushes of blood, leading to over-lending and write downs such as the Latin American debt crisis of the early 1980s and the British property crash a decade later, but old style banking worked well. The write-downs did not jeopardise the global financial system and the amount lent out rarely exceeded the amount on deposit. At the end of the 20th century, for example, the British banks as a group lent out slightly less than they had received as deposits.

Originate-and-distribute banking, the technique that replaced it, involved making loans and passing on the risk in them to investors. In theory if the loans defaulted, the investor not the bank would bear the brunt of the losses. Emboldened by new global banking regulations, notably the Basel banking accord of 1998, which allowed loans distributed in this way to be kept off their balance sheets, and developments in derivatives which, in the words of one leading investment bank promised to ‘transform risk’, the world’s banks went on a lending binge.

Britain’s banks could participate in originate-and-distribute banking in one of two ways. Because it was a new area, there were no established experts and few barriers to entry. Those banks that retained vestiges of investment banks, namely HSBC, Lloyds-TSB, Barclays and the Royal Bank of Scotland could use their balance sheets, debt trading and derivatives skills to become providers of the new products. In this way, they were offered an unexpected back door route into investment banking, a business they previously seemed to have missed. In addition, they, along with Britain’s retail banks, could access the new markets to expand their lending operations. It seemed to be a virtuous circle: lend to customers, get the risk off the balance sheet by issuing securitized bonds to investors and fund the business cheaply in the credit markets. By expanding the loan books in this way, banks were able to grow profits at a rate that satisfied shareholders. By 2007, the British banks – which, remember, had lent out less than their deposits base ten years before – were lending out over £500 billion more than they had on deposit.

Eager investors from the cash generating emerging economies of Asia, Europe and Latin America snapped up these distributed loans. They offered investors an attractive income at a time when central bank rates in the developed world were being cut to stimulate the economy. The world market for securitized bonds, the product that enabled originate-and-distribute lending to work, grew from $800 billion to over $3 trillion between 1997 and 2007. Banks throughout the world lent out a multiple of their own capital, believing themselves to be safe in the knowledge that there would be a ready supply of liquidity to refinance their business when each batch of securitized bonds matured.

IV

The impact of this on the City was sensational. As Gordon Brown had pointed out during his Mansion House speech, the City was at the centre of the modern financial system and benefited from four separate but related factors. Firstly, market forces, including the growth of securitization and originate-and-distribute banking, were exceptionally favourable during these years. Secondly, good luck determined that the City was in the right place at the right time while its competitors chose a bad moment to fluff their lines. Thirdly, history endowed the City with a talent pool and an infrastructure that enabled it to seize the moment. Fourthly, the New Labour government helped the City to make the most of these opportunities.

The decade after 1997 turned out to be one of the most buoyant ever for the world’s financial services industry. Finance had been capturing ever higher percentages of output from the early 1980s onwards – Britain’s financial services industry contributed only 15 per cent of corporation tax in the 1980s; by 2005 this had risen to over 30 per cent – and this was reflected in a long boom in asset prices. As those closest to capital captured more of the value of economic activity, others turned to debt to achieve rising living standards. This is evident in the rise in total household debt, which was only two thirds of Britain’s total household disposable income at the beginning of the period but matched it by the end. Finance was all-pervasive in these years. The value of the world’s stock markets and annual share trading quadrupled in less than ten years. The global market in derivatives, around which many of the new products were based, grew from $41 trillion to an astonishing $677 trillion in these years.

Globalisation was the driving force behind this activity, and the fastest growth came in international deals that played right into London’s strengths. The world converged on free-market capitalism as communism crumbled and the stakeholder economies of France, Germany and Japan struggled. The Eurozone countries and the emerging economies of eastern Europe and Asia turned to the capital markets to fund their expansion and eventually to invest their savings. Nearly every single financial product in every single financial centre grew apace, but cross-border deals, which quadrupled in value in a decade, grew faster than any other category.

As the emerging markets boomed, London’s great advantage was that it was in the right time zone to do business with Asia. American markets were closed during Asia’s trading hours and London’s trading day straddled Asia’s close and America’s opening bell. Bankers and traders based in London were able to become the point of connection between East and West. They held the balance of power, could claim to be working round the clock and for a while were at the centre of the financial universe.

The City received another slice of good fortune from the poor performance of its competitors, especially New York. The dot.com crash of 2001–2 exposed mismanaged conflict of interest and insider dealing on Wall Street. In a backlash, Congress passed the Sarbanes Oxley Act, contributing to the 800 different regulations covering banks and financial institutions introduced between 1989 and 2005. The cost of complying with these regulations was prohibitive, rising from $13 billion in 2002 to $25 billion in 2005 for the securities industry alone, according to the Securities Industry Association. The US appeared to be litigious and bureaucratic, and according to one former senior investment banker the consequence was plain: ‘We are simply pushing people to do more business overseas.’

None of London’s closest competitors took advantage of New York’s problems. German politicians made disparaging comments about the activities of hedge and buy-out funds, thus causing these high-octane players to doubt that Frankurt would provide the level playing field they needed. Parisian attempts to win global capital markets business were undermined by the French government’s determination to cling to social market policies and national protectionism. Japan failed to develop the status it had in the 1980s as a strong domestic financial centre into an equivalent international position due to protectionism for domestic players in the corporate and financial sectors and an ailing domestic economy.

History was kind in that London already had a well-developed infrastructure (including an unrivalled offshore network of tax havens such as the Cayman Islands) and a deep pool of skills. London also spoke English, the international language of finance. It had a great ability to attract new talent in comparison with New York-based firms hampered by restrictive US immigration policies and cumbersome, unpredictable visa application procedures. London was able to take full advantage of EU freedom of movement laws and used European talent to achieve market leadership in the fastest growing and most lucrative sectors such as derivatives. A report for the Corporation of London in 2003, written by the independent think tank the Centre for the Study of Financial Innovation (CSFI), put skilled labour at the top of its list of London’s strengths: ‘The flexibility of labour practices and the depth of the talent pool are among its biggest pluses.’

The City’s established position as a global trading centre meant that it had the right financial infrastructure to support the growth. Questions about the City’s office stock were answered by the stunning success of Canary Wharf. Privatisation and digital technology had jet-propelled the UK’s telecommunications services into the 21st century, and despite lengthening delays at Heathrow, London is a global transport hub reached easily from Europe, the US and Asia. Legal, accounting and management consultancy services were in ready supply and contributed to the critical mass that goes to make up a financial services centre.

London had a good reputation for the quality of its markets, clearing and settling processes and ethical standards. The CSFI ranked the City above other European centres (but below New York) on market quality and quoted one respondent as saying, ‘In the main the culture of my word is my bond lives on.’ Another said, ‘Someone who has survived in the City is tried and tested, can be trusted, knows the language, can initiate a deal with a handshake’ – a case of perception above reality if ever there was one.

The Labour Government that was elected in 1997 put the seal on all this, proving to be even more helpful to the City than the outgoing Conservatives. Despite New Labour’s pro-market rhetoric, a few City diehards believed that New Labour would turn out to be a wolf in sheep’s clothing once it was in power. They feared it would soak the rich by raising personal tax rates on high incomes, and some wealthy individuals made contingency arrangements in case their worst fears were realised. In fact the new government’s tax policies for high earners were generous, some said to a fault, and were instrumental in drawing in talent and financial services business to the City.

The Labour government’s first Budget in 1997 contained no nasty personal taxation surprises and the 1998 Budget included the single measure that was to transform the City’s tax regime. This was the reduction in capital gains tax from 40 to 10 per cent on business assets held for at least ten, later two, years. It provided a stimulus for hedge and buy out funds and ensured that neither they nor private equity firms would be tempted by lower foreign tax rates to move their businesses overseas.

According to one hedge fund manager this change had a major impact: ‘London became the place to be, to set up businesses. Historically, people did not leave big organisations and start up on their own, but with 10 per cent taper relief it became possible for a new generation of entrepreneurs or individuals who were willing to take risk to set up on their own, and basically risk their careers but possibly make a fortune. The pay-off slope changed. The tax situation meant that the threshold hurdle for taking risks came down.’

The rise of action-oriented hedge and buy out funds added a sharp edge to London’s capital markets. It is perhaps too simplistic to say that the success of these funds and their obsession with alpha persuaded banking executives to be equally gung ho but their influence was considerable. Standard hedge and buy out fund techniques such as leverage- using borrowed capital to grow- and shareholder activism had a profound impact on corporate behaviour, encouraging chief executives to copy their growth strategies and reminding them of the consequences of failure.

One of Gordon Brown’s first actions as Chancellor was to reform regulation of the financial services industry. The Bank of England’s regulatory role was reduced, the UK’s myriad of financial services regulators were merged into one new organisation, the Financial Services Authority (FSA), accountable to Parliament through the Treasury. The relationship between the Bank of England, the FSA and the Treasury were loosely defined – events were to prove too loosely defined – under a set of arrangements known as the Tripartite Agreement but to all intents and purposes the FSA was the lead regulator.

Regulators all over the world came to regard the FSA as setting the benchmark in effective and proportionate regulation. In 2007 New York senator Charles Schumer and the city’s mayor Michael Bloomberg commissioned a study from the consulting firm McKinsey to address the issue of New York’s global competitiveness, a study that was littered with references to London’s success. London’s regulatory system was particularly praised. It was held up as an example of light-touch, principles-based regulation and contrasted with what financial services practitioners alleged was the heavy-handed, rules-obsessed approach of US regulators. The McKinsey study reported evidence from interviews with a wide range of senior financial executives and their customers: ‘For many executives, London has a better regulatory model: it is easier to conduct business there, there is a more open dialogue with practitioners and the market benefits from high-level, principles-based standards set by a single regulator for all financial markets.’

British financial services practitioners also liked the FSA’s approach. The CEO of one US securities firm said, ‘The FSA is open to discussing issues constructively and resolving problems quietly, without penalizing you for coming forward when you see a potential problem. The multiple US regulators and enforcers, by contrast, play a different game entirely.’ One of London’s leading hedge fund managers described the FSA as ‘a pleasure to work with’, and the global head of compliance at one of the big investment banks described ‘a very close and personal relationship with the FSA. I would not dream of going to the US regulators to discuss an issue without taking a lawyer with me; in the UK it is a very different environment.’

This cosy relationship was no accident. The Financial Services and Markets Act of 2001 prescribed the FSA’s remit and reads more like a mandate to protect the UK’s financial services industry than to regulate it. The regulator was not to discourage the launch of new financial products and had to avoid erecting regulatory barriers, terms of reference that gave it a mission to be as friendly to the firms it regulated as it was to the industry’s clients. Just in case it was in any doubt as to where its loyalties lay, it had to consider the international mobility of financial businesses and avoid damaging the UK’s competitiveness.

The FSA certainly got the message and prioritised persuasion above compulsion. It said, ‘Our preference is for working with the industry to find solutions to market failures and to intervene only where the benefits of doing so are likely to outweigh the costs.’ It maintained an easy dialogue with the industry and practitioners soon realised that it was in their interests to cooperate.

V

At the beginning of the 21st century, the British banking sector consisted of two groups: the High Street banks and the former building societies that had become mortgage banks. HBOS, the product of a merger between the Halifax building society and a large regional bank, the Bank of Scotland, was a hybrid of the two groups. Both groups were on a fast ride. Global forces produced an apparently endless supply of liquidity; encouraged by stable economies and low interest rates borrowers had an apparently equally endless demand for credit; global derivatives developments and banking regulations enabled banks to lend without penalty; Britain’s regulators had a mandate to encourage innovation and the growth of the country’s financial services industry; executives were incentivised to grow as fast as possible and were on pain of death if they failed; and fast talking, well informed and richly resourced investment bankers were selling complex financial instruments as hard as they could.

The consequence was that the banks became more and more adventurous, seeking to expand their businesses by lending increasing amounts and making acquisitions. They lent to a wide range of consumers and corporations, stimulating the housing market on both sides of the Atlantic and encouraging the corporate sector to borrow to expand. Britain went on a credit binge, borrowing at low interest rates to buy houses, cars, consumer goods and holidays. Household debt exceeded the nation’s Gross Domestic Product for the first time in 2000 and during the Brown Chancellorship the country’s household financial deficit rose to record highs, larger even than at the height of the Lawson boom in the 1980s.

The mortgage banks were particularly vulnerable to the complex forces shaping the global banking industry at this time. Following legislation in 1997, Alliance & Leicester, Halifax, Northern Rock, and Bradford & Bingley converted from being member owned mutual societies to public listed companies between 1997 and 2000. The timing was unfortunate. The individuals running these banks ran slap bang into financialisation in its pomp. Originate-and-distribute banking was all the rage. The investment bankers claimed to have ‘transformed risk’ through their new credit derivatives, off-balance-sheet vehicles and securitisations. Governments and regulators were easing off the brakes in respect of capital adequacy, disclosure and intervention. Benign economic conditions and low interest rates encouraged leverage and risk-taking.

All of this happened while the chief executives of Britain’s mortgage banks were finding their feet as listed businesses. They saw other financial institutions including the clearing banks and the US investment banks growing earnings through aggressive financing schemes, and their shareholders pressed them to do the same. Banking regulations encouraged flexibility, and national regulators seemed unconcerned. Objective, independent advisers had been replaced by deal hungry whizz-kids, and shareholders wanted results and they wanted them now.

In order to please shareholders, Britain’s public listed mortgage banks changed their business model and became heavily reliant on originate-and-distribute banking. They lent fast and furiously using the global credit markets to source funds and punted the housing markets in Britain and America to boost profits. The economist John Kay, who was on the board of Halifax until 2000, regards ‘the day it was decided that treasury [the department that organised the bank’s funding] should be a profit centre in its own right rather than an ancillary activity’ as the defining moment in that organisation’s history, and this is a fitting comment on the entire sector.

Building societies that had started life recycling members’ savings to help other members buy houses became complex financial institutions. They were hailed as pioneers of the knowledge economy. If you had been asked in the spring of 2007 to nominate one company that summed up Britain’s successful transformation from a manufacturing to a service economy, Northern Rock would have been a reasonable choice. Originating as a self-help movement for artisans in the heavy industrial heartland of north-east England, it became an IT-enabled finance house, filling the vacuum left by that region’s industrial decline and offering well-paid jobs in modern air-conditioned offices to 6,000 employees. These children and grandchildren of miners and shipyard workers had learned new skills as members of Britain’s growing financial services army.

Northern Rock was much admired. After the company was listed on the stock market in 1997 its profits and share price soared, and economic liberals hailed the invigorating effect of market forces on a boring old mutual society. Left-wing critics of demutualisation were placated by Northern Rock’s strong regional identity and philanthropic work: its charitable foundation paid out £175 million (5 per cent of pre-tax profits) between 1997 and 2006 to support good causes in the north-east and Cumbria.

The company’s success appeared to justify the government’s faith in the financial services industry. As readers of its 2005 annual report were told, this was not just a domestic building society located in a remote corner of England: ‘Northern Rock is a global company in terms of where it raises funds, a national company in terms of where it lends but a regional company in terms of where it mainly employs people.’ This was exactly how modern finance was meant to work. The wonderful world of Wall Street and the Wharf had enabled Northern Rock to transform itself and help regenerate a moribund regional economy. The benefits were there for all to enjoy including rich pickings for those at the top, cheap mortgages for customers and secure employment in a safe environment for the workforce.

In order to meet the stock market’s growth expectations Northern Rock developed a new mortgage product branded Together. It enabled customers to borrow 125 per cent of the value of their home plus up to six times their annual income, thus rolling up their existing debt and mortgage into one package. With interest rates so low in the early years of the 21st century, it was a winner, particularly with young professional couples, and helped Northern Rock raise its share of the residential mortgage market from 6 to nearly 20 per cent over ten years.

The company’s loan book grew at a rate of 20 per cent per annum between 1997 and 2007, rising from £16 billion to £101 billion, 85 per cent of which was in residential mortgages. Profits and the share price raced ahead, and Northern Rock became a member of the FTSE 100 index of the UK’s largest companies in September 2001. Under the leadership of the newly appointed Adam Applegarth, the second youngest chief executive of a FTSE 100 company, Northern Rock was the epitome of a forward-looking, go-getting financial services company. Over the next five years it did not disappoint, profits more than doubling to £415 million and the share price reaching a heady £12–52 at the beginning of 2007. Just ten years after it had come to the stock market, this little building society from the north had become Britain’s eighth largest bank.

What the stock market had not noticed, however, was a major change in Northern Rock’s business model. In the early days all the money lent by building societies came from members’ deposits, but as they became more commercial the societies discovered a new way to make money for their members. They borrowed cheaply in the wholesale banking markets, marked up the interest rate and lent on to retail borrowers at a nice premium. Provided that they matched the maturity of their assets and liabilities it was money for old rope. Northern Rock was active in this market, and at the time of flotation customers’ deposits covered two thirds of its loan book and the other third was borrowed from the wholesale market. All building societies did it, and there was nothing exceptional about the scale of Northern Rock’s wholesale borrowing or the ratio between its wholesale borrowing and retail deposits. But in 1999 it changed the structure of its liabilities. Previously it had been holding the loans it made to maturity, the traditional method of banking called originate and hold.

In the 1990s, as outlined above, banks developed the new originate-and-distribute model. Instead of holding the loans to maturity, banks originated loans – in Northern Rock’s case residential mortgages – and then sold them on to investors through securitisation.

Northern Rock went for securitisation hook, line and sinker. It did its first securitisation deal in 1999, a relatively modest £600 million representing less than 4 per cent of the bank’s total loan book. Over the next two years it securitised nearly £5 billion more, and at the end of 2001 Northern Rock had securitised 22 per cent of its £22.8 billion mortgage loan book. Over the next five years the pace accelerated still further with securitisations averaging £10 billion a year, so that at the end of 2006 £60 billion of Northern Rock’s £101 billion loan book had been securitised or converted to covered bonds, a form of mortgage-backed securities similar in purpose to securitisation.

Northern Rock’s share price started weakening in early 2007 once the problems of the US sub-prime sector began to spill over into the wider credit markets. From a peak of 1,252 pence in February, the shares had already fallen to 1,000 pence on 27 June 2007, when the company surprised the City with a trading statement. It admitted to having been ‘caught out’ by higher funding costs and the share price plunged a further 12 per cent to 834 pence. A month later the company revealed flat first-half profits but made optimistic comments about a positive medium-term outlook and an improving environment for bad consumer debts. The stock market remained doubtful and investors maintained the selling pressure despite Northern Rock’s announcement on 20 August that it had sold almost £500 million of its commercial property loan book and that it had no exposure to US sub-prime mortgages.

The market was right to be sceptical because by then Northern Rock’s senior management was aware that it was in deep trouble. Its traders reported to senior management a ‘dislocation in the market’ for its funding on 9 August 2007. It was worrying news because Northern Rock had a big securitisation to do in the middle of September and the market appeared to be seizing up. Matt Ridley, Northern Rock chairman, and Adam Applegarth discussed the problem on Friday 10 August, reflected over the weekend and reported it to the FSA on Monday 13 August. The following day, senior officials from the authorities involved in the tripartite arrangement – Hector Sants, the FSA’s new chief executive; Sir John Gieve, deputy governor of the Bank of England; and a Treasury official – met to discuss the matter, informing the governor of the Bank of England about the situation later that day and telling the Chancellor of the Exchequer on 15 August.

Discussions between Northern Rock and the three regulators continued for a month, during which time conditions in the markets tightened considerably. Banks stopped lending to each other and securitisation deals ground to a halt. As the mid-September deadline approached, it became clear that Northern Rock’s big securitisation would not get done, and the search for alternative solutions was stepped up.

It was now clear that Northern Rock would only survive with some kind of support from the Bank of England but the Old Lady was playing hardball. In August 2007 the British banks asked the Bank of England to provide additional liquidity to the banking system without penalty. Other ideas were for the Bank to lend for longer terms and to increase the range of collateral against which it would lend. Taking a harder line than the European Central Bank, which smoothed the timing of its supply of credit to help the crisis, and the US Federal Reserve, which cut the interest rate charged to banks and extended the term of inter-bank financing, the Bank of England refused requests for system-wide measures. Mervyn King still believed that the banking system was strong enough to withstand the credit crunch and wanted to allow market forces to re-establish valuations of asset-backed securities. There was also the issue of moral hazard: if central banks were too ready to help in a crisis, commercial banks might assume that they would always be rescued if they got into difficulties, leading to more risk-taking and bringing on the next crisis.

Refusing system-wide support at a time when no single institution was in danger was one thing, but the imminent risk of an individual bank failing was altogether more serious. If Northern Rock was declared insolvent, depositors would be guaranteed only the first £2,000 of their funds and 90 per cent of the next £33,000. There would probably be a bureaucratic logjam before any money was returned to depositors and a total loss of confidence in the UK banking system. Under these circumstances moral hazard would be the least of the authorities’ worries, and at a meeting on 3 September 2007 Alistair Darling, Mervyn King and FSA chairman Sir Callum McCarthy agreed to give support to Northern Rock if securitisation and takeover failed.

Ten days later Northern Rock formally requested such help from the Bank of England. Full disclosure to the stock market was required because Northern Rock was a public company, and it was planned to make an announcement on Monday 17 September. But on the afternoon of Thursday 13 September rumours in the market started and the share price fell to a new low of 634 pence. The Court of the Bank of England met that evening; the terms of the funding facility were agreed in the early hours of the following day and at 7 a.m. on Friday 14 September it was announced that ‘The Chancellor of the Exchequer has today authorised the Bank of England to provide a liquidity support facility to Northern Rock.’

However, by the time the announcement was made it was already old news. The BBC’s business editor Robert Peston was onto the story and it was first reported at 8.30 p.m. on Thursday 13 September on BBC News 24. A run on the bank started immediately, with Northern Rock’s online customers bombarding the company’s website as they tried to make withdrawals. The Internet site crashed repeatedly – the company blamed the premature leak for stymieing their plans to increase the available bandwidth – and customers panicked. Queues began forming outside Northern Rock’s seventy-two branches but the bank was ill prepared. There were only four branches in London; most of the rest did not normally do much business over the counter; and all were too small to cope with the volume of traffic.

The queues persisted over the weekend and into Monday 17 September. The risk of the panic spreading to other banks was growing by the hour, and at 5 p.m. that afternoon the Chancellor of the Exchequer called a press conference to announce that the government would guarantee all the existing deposits in Northern Rock during the current instability in the financial markets.

The announcement had the required effect. Panic subsided and the run on the Rock was over but the credit crunch was only just beginning. It was driven by events in the US, where in a devastating demolition of the theory that originate-and-distribute banking and derivatives had reduced risk to below systemic levels, continued weakness in the housing market caused the global financial system to unravel between September 2007 and October 2008.

The mortgage default rate continued to rise and house prices continued to fall in the final quarter of 2007 and throughout 2008. The flow of interest payments from borrowers on which mortgage-backed securities depended was interrupted; the market value of mortgage-backed securities and derivatives fell; the investment banks wrote down the value of the assets they carried and poured money in to support their struggling investment vehicles. It turned sour very quickly. Suddenly they needed cash and called in their loans to hedge funds and other borrowers, who then had to sell assets in order to repay them. This wave of selling further depressed mortgage-backed markets. Banks tried to reduce their leverage ratios and stopped lending to each other except on an overnight basis, accepting only blue-chip collateral such as US Treasury securities. This forced mortgage lenders to cut back on loans, further depressing house prices, increasing default rates and weakening the market value of mortgage-related assets.

A string of interest rate cuts in America, Britain and Europe and various liquidity support schemes from central banks failed to restore confidence. Iconic American institutions such as the investment banks Lehman Brothers, Merrill Lynch and Bear Stearns, the country’s biggest mortgage finance companies Fannie Mae and Freddie Mac and the giant insurer AIG, in effect failed and had to be baled out by competitors and the government. Citigroup, whose predecessor and constituent companies had invented mortgage-backed securities and pioneered securitisation, and whose expansion by acquisition under Sandy Weil had epitomised post-modern capitalism, had to be rescued by the US government. Its share price had been in freefall, sinking from $22.50 to $3.50 in the space of twelve months under the pressure of write-downs and funding difficulties, and it had to accept a US Treasury investment of $20 billion in high-yielding preferred stock and a government guarantee on $306 billion of its domestic assets in order to survive.

In the UK, a decisive move was made in October 2008 with the government-backed recapitalisation of the country’s banks. This was announced on the morning of Wednesday 8 October 2008 and aimed to tackle the two issues that threatened the banks’ ability to survive: the adequacy of the capital cushion they had to protect themselves from asset write-downs and the funding gap between their deposits and loans. Under the plan the government would provide up to £50 billion of capital to raise banks’ tier-one capital – equity capital and reserves, defined and measured by regulators – to help absorb any future losses. Half of this would be available to Britain’s eight largest banks and a further £25 billion would be obtainable by other eligible financial institutions. Government stakes in participating banks would be in the form of preference shares, and the banks that accepted government funding would have to accept restrictions on dividend payments and influence on senior executive compensation.

One after another, the British banks sought refuge in the government’s recapitalisation scheme. The closure of the credit markets and the deteriorating housing market had eventually led to the nationalisation of Northern Rock and part of its rival, Bradford & Bingley but the most surprising collapse was that of HBOS, the hybrid mortgage and High Street bank. Under the leadership of James Crosby, HBOS borrowed cheaply in the wholesale markets, expanded its loan book aggressively, lending to homeowners, businesses set on expansion and buccaneering private equity moguls. It was so sure of global liquidity and asset prices that it invested billions of borrowed capital into US mortgage-backed assets. It was a wonderful business model while HBOS could source the money it wanted to lend from external markets and while asset prices continued to rise. James Crosby was widely admired in the City and in Westminster and he was knighted for services to finance after he left HBOS in 2006 at the age of 50 to pursue a portfolio career. When asked whether looking back on his time at HBOS he would have done anything differently, Crosby said: ‘Now I know what I know, I wish I’d been bolder.’ In fact Crosby had been quite bold enough. By September 2008 it had lent out £200 billion more than it had on deposit, could not fund itself in the credit markets, had to write down the value of its portfolio and had to be rescued by Lloyds-TSB, a conservatively run High Street bank that had restricted its exposure to mortgage-backed securities, and Her Majesty’s Treasury.

RBS had kept well away from broad scale investment banking in the 1980s and 1990s, focusing instead on corporate lending, interest-rate trading and foreign exchange dealing. But when it acquired NatWest, the deal included an American bond dealing business named Greenwich. RBS then embarked on what it described as ‘a careful plan for its Global Banking and Markets division’. It used its position as a large commercial lender to sell other services to clients and to broaden its geographical reach. The UK was obviously its strongest area but it built up its operations in France and Germany by lending to private equity groups, becoming the biggest player in European leveraged finance. In the US, Greenwich’s product range was broadened by senior recruits in areas such as investment-grade corporate bonds and asset-backed trading. When considered alongside its leveraged finance business, RBS was building a large exposure to the activities that were to be at the heart of the global banking crisis of 2007–8.

This expansion enabled its markets division to average growth of over 17 per cent per annum in the six years to 2006. The division was led by a well-connected Oxford graduate named Johnny Cameron, who had joined RBS in 1998 from the investment bank Dresdner Kleinwort Benson. Cameron appeared more like the traditional British clearing banker than his dynamic counterpart Bob Diamond at Barclays but appearances can be deceptive for RBS was aggressively building a global debt trading business and by March 2007 the division accounted for 40 per cent of group profits.

RBS’s chief executive was Sir Fred Goodwin, known as ‘Fred the Shred’ for his ability to buy a bank and transform profits by stripping out costs. Under Goodwin’s leadership, RBS had conducted an aggressive acquisition strategy, including the hostile takeover of NatWest and participation in the consortium break-up of ABN AMRO in 2007. This was achieved on the back of thin capital ratios and a leveraged balance sheet. The strategy had worked well in benign markets but the sea change in 2007 exposed the risks that had been run in the markets division and the high-rolling nature of an acquisition-led strategy. ABN AMRO was the deal that broke the camel’s back. RBS paid a top-of-the-market price for a second-grade investment bank. The acquisition transformed RBS’s global markets division from an aggressive and focused debt trading business into a diversified global investment bank. ABN AMRO’s investment bank was not a member of the bulge bracket in terms of client reputation or profitability yet its headcount was equal to that of the industry leaders. The timing of the deal could not have been worse, coinciding with falling markets, mortgage-related write-downs and difficult funding conditions, all of which have been described previously. By December 2008 the market capitalisation of the entire British banking sector was little more than the price RBS and its consortium partners had paid for ABN AMRO in 2007. After £6 billion of write-downs, a £12 billion rights issue and a gap of £165 million between its retail deposits and loans, the falling share price showed that shareholders had lost confidence in RBS management. The government had to rescue RBS and the incoming chief executive Stephen Hester, a well-regarded banker from his time at Abbey National prior to its sale to Santander, said, ‘the bank had overextended itself and got caught up in a bull market culture’.

At the time of writing, only two High Street banks have avoided state aid. Barclays had kept its debt and currency trading businesses out of the sale of the rest of the investment bank in 1997. In 1996 it had recruited a forty five-year-old American named Bob Diamond to head up debt trading. Barclays’ retreat from equities had not been planned when Diamond was hired, but he shrugged off any doubts he may have had about the bank’s commitment to markets and pressed on with developing the business, renaming its investment banking division Barclays Capital – BarCap for short.

Diamond’s US style of management contrasted with Barclays’ more gentlemanly tradition, and initially things did not go well. In the summer of 1998 the Russian debt crisis caught Barclays holding £340 million of Russian debt and securities, mostly within BarCap. In the first week of September Barclays warned that it would have to make a charge of £250 million to cover potential losses and warned of a further £75 million of trading losses. Later that month Barclays contributed $300 million to the bail-out of the failed US hedge fund Long Term Capital Management, and there was a storm of press and investor criticism of the firm’s strategy, dragging down the share price by more than 50 per cent in six months.

After the debacle of 1998, BarCap caught the rising tide of markets, and profits grew rapidly at a rate of 25 per cent a year between 2000 and 2007, based on areas such as underwriting bond issues, hedging commodity exposures, principal investments and private equity, securitisation and equity derivatives. Diamond became one of the most powerful and written-about people in the City. He was appointed to the bank’s main board in 2005, was paid nearly £23 million in 2007 and widely acclaimed for rebuilding Barclays’ presence in investment banking. Very few people inside or outside Barclays questioned the wisdom of the bank’s growing dependence on securitisation for a proportion of its profits and funding.

In 2008, the collapse of two large investment banks, Lehman and Bear Stearns, and the availability of another, Merrill Lynch, for a cut-price merger, provided Barclays with an opportunity to round out the investment banking business. It looked hard at Bear Stearns when that firm was in trouble in March 2008 but decided that it would not be ready in time and watched it go to J. P. Morgan. It then identified Lehman as a possible candidate, Barclays’ chief executive John Varley told analysts in September 2008, ‘We thought some months ago that it was possible this opportunity might arise but we were clear we would only be interested in pursuing it at the right price’.

It narrowly missed buying the whole business, but after Lehman had filed for Chapter 11, on Tuesday 16 September Barclays agreed to buy the bulk of the US operations. It looked like a good deal for Barclays. It had paid $1.75 billion for the core business of a group that had been worth $45 billion on the stock market in early 2007. It had avoided the most toxic part of Lehman’s balance sheet, and the assets it took on had been written down by Lehman and pored over by Barclays’ own people. There would be integration issues and some redundancies to eliminate overlaps, but Barclays had pulled off a coup in achieving a presence on Wall Street in one fell swoop at what looked to be the bottom of the market.

At the time the US investment banking sector imploded, the UK’s largest bank, HSBC had just wound down its latest attempt at organic growth in investment banking. It had spent some time explaining its slimmed-down strategy and an investment banking deal in the US would be an extremely tough sell to shareholders. HSBC’s senior management must have debated the problem for some time. They knew that it was difficult if not impossible to achieve the required scale in investment banking through organic growth, and they knew that if an investment bank was to be purchased it was better to do so at the bottom of the market than the top. But would the bank look ridiculous if it reversed its strategy less than two years after cutting back in investment banking? In the end it played safe and did nothing in 2008. Despite writing down almost $40 billion on sub-prime and other loans and facing a potential $1 billion hit from its exposure to Bernard Madoff ’s failed US investment fund, it ended the year with one of the strongest capital ratios in the sector and its chief executive Michael Geoghegan was able to afford the luxury of pontificating on the plight of his competitors and the risks of moral hazard: ‘There is no question that guarantees have been given to failed managements. I hope these guarantees don’t last too long because they may create the wrong type of behaviour by managements in those banks.’

VI

It now seems obvious that running a large funding gap and relying on wholesale markets and securitisation to fill it was running a massive liquidity risk. Bankers have become the villains of the piece. I have no wish to apologise for their behaviour but I do understand it. The environment of the time was unashamedly bullish, shareholder value was the only game in town and Britain’s banks were players in a new financial system designed and run by Americans. It would have been practically impossible for a public quoted bank in the UK to have resisted the trend. When Morgan Stanley’s chief executive Philip Purcell tried to follow a low-risk strategy he was hounded out of office by shareholders who wanted a more aggressive approach. It is very doubtful whether the shareholders of British banks would have tolerated a low-growth strategy in the 21st-century bull market.

A case in point is Andy Hornby, the much-criticised chief executive of HBOS from 2006 to 2008 and a man I have never met, spoken to or dealt with in any way. Hornby is the son of a Bristol headmaster, had a distinguished academic career at Oxford and the Harvard Business School, and was considered a rising star by Asda and then his bosses at HBOS after he moved there in 1999. As retail director he played his part in growing HBOS’s consumer lending business and was appointed chief executive during a raging bull market for housing in which HBOS was the market leader. Now he might have said to shareholders, ‘Wait a minute. This money market funding thing could disappear and the housing market could slump. I am going to shrink market share, build up deposits, and earnings per share will halve. Is that OK?’ But if he had, he would probably have got a pretty rude answer. This young man in his first chief executive’s job would have needed to turn the world on its head and tell the market, ‘You are all wrong.’ Adam Applegarth at Northern Rock had longer at the top of his organisation but he faced similar pressures. Even Sir Fred, at the time he was fighting Barclays to buy ABN AMRO, will have had an eye on events at HSBC where an activist shareholder with just 0.3% of the shares, was trying to whip up support to oust the management. This was not the failure of a handful of individual executives; it was a system-wide failure.

Hubris of course played a part. The banks had been so successful for so long they believed they were infallible. Boards of directors including the non-executives who were meant to offer objective counsel got sucked in. The last time the capital markets had faced meltdown was during the oil crisis of 1973–4, before the careers of most 21st century bankers, fund managers and chief executives had begun. The journalist Christopher Fildes defines the moment of maximum economic danger as the point at which the last person to have lived through the last recession retires, a telling description of the situation in the opening years of the 21st century. Financial services practitioners, non-executive directors who sat on their boards and regulators all forgot that liquidity is what keeps markets going. They were blinded by their own genius. It is significant that two of the banks that survived the 2008 crisis best were J. P. Morgan and Goldman Sachs, both hit heavily in the bond market crash of 1994 and who learned the lessons by introducing strong risk management systems and analytics.

One of the most puzzling aspects of the period is why no fully formed alternative to market capitalism was debated in the political mainstream. Washington has long been in the thrall of Wall Street and for thirty years British governments of the left and right listened far too much to extreme economic liberals and those with a vested interest in maintaining the system and not enough to writers such as Will Hutton, John Kay and John Plender, all of whom warned well in advance of the crisis of the risks of relying too heavily on markets. Labour, like the Conservatives it replaced in 1997, listened far too much to the City and its vested interests. The government believed in what the City was doing, became overly dependent on its earnings and listened to its threats to move off shore if taxes and regulation were increased. The FSA’s terms of reference led to a complacent state of mind and became an accident waiting to happen. It is unfortunate for the UK that it its cutting edge industry was financial services for this was the industry most in need of regulation not deregulation.

It is too early to be sure whether we are in 1929, the year the Great Depression started, or 1933, the year Governments began to get a grip. Government stakes in financial institutions of the size and importance of Citigroup in the US and RBS in the UK have created an extraordinary opportunity to redesign the global financial services industry. Politicians are talking tough but the precedents for equally tough action are not encouraging. A similar and only slightly less inviting opportunity to reform the system was missed by US regulators in 2003. The crisis in corporate governance at the time of the crash of Enron and the dot.com implosion had some of the same elements as the credit crunch including option-based compensation, off-balance sheet financing, banking hubris, and a belief that the good times would carry on to the end of time. When it all blew up, the regulators’ response was to toughen up the rules at the micro-level but to leave the system intact.

Tinkering with the rules did not work in 2003 and it is doubtful whether it would make a lasting difference in 2009. Market forces, global co-ordination of regulation and new rules covering banks’ capital will doubtless constrain leverage, discourage risk-taking and ration capital for a certain period, but they will not address the risk of over-mighty finance reappearing to threaten the system. This would require radical action to curtail the range of activities permitted to the financial institutions in which they would have to choose whether to be investment banks that underwrote and traded securities or whether to be banks that took deposits from savers and lent to borrowers. Banks making loans would keep the risk on their balance sheets and would need to deal with investment banks on an arm’s length basis if they wished to hedge risk or offer clients other services as agents.

Investment banks would become providers of liquidity as pure trading houses. They would be able to trade for themselves as well as for clients but they would not be allowed to give advice to clients. That role would be reserved for advisory firms working for a fee and covering all asset classes and corporate advisory services.

Such a system would be transparent and free of conflict of interest. The risk of one component contaminating another would be minimal. Under this model, financial markets might be less liquid than institutions have come to expect and the cost of capital might rise but neither outcome is certain and in any case we have seen in recent years what excess liquidity and cheap capital can do to the world.

The larger British financial institutions such as Barclays and HSBC would have the opportunity to float off their markets businesses. Their remaining banking businesses would be conservative and solidly based. The return of objective advice for investors and corporate chief executives would improve the quality of decision-making and reduce their pressure to transact. The financial services industry would probably turn out to be a smaller part of the UK economy and the markets culture that has permeated British society for the last quarter of a century would dissipate. Who is to say, given the events of 2008-9, that this would be a bad thing?