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Break the bank

The dramatic collapse of Barings a decade ago marked a coming of age for the British banking industry. Contrary to what many bankers believed, the Bank of England showed no inclination whatsoever to bail out the City of London’s oldest merchant bank.

During the many decades in which Britain’s banks operated a cosy market cartel, top execs led a relaxed existence, complacent in the belief that they enjoyed the support of the regulator. None of the major banks had to worry about a hostile takeover, so the mythology ran, for the Bank of England was there to ensure their invulnerability.

Barings was a special case in that it was largely criminal activity that caused its downfall – ie, the wheeling-dealing of Nick Leeson, a Singapore-based trader who took unauthorised positions in stock market futures that left the bank staring at an £830m black hole.

The ensuing 10 years have been an eye-opener: TSB, Bank of Scotland, NatWest and Abbey have all lost their independence through a combination of bad management and market forces. Nor should one forget the alarm bells that rang in 1992 when Midland, once the world’s largest bank, was taken over by what is now HSBC, formerly the Hong Kong and Shanghai Banking Corporation, without a peep from the Bank of England.

Leeson’s inept and reckless dealings aside, there is no doubt that Barings’ demise was also the result of a breathtaking lack of management controls, coupled with corporate greed and arrogance, for when the going was good and Leeson was raking in the profits, the people who should have known better turned a blind eye to what were obvious danger signals. Leeson himself states in the book he wrote about the affair: “People at the London end of Barings were so know-all that nobody dared ask a stupid question in case they looked silly in front of everyone else.”

Midland was the first to go under, following a disastrous foray into the US market in the 1980s with the purchase of Crocker. “Nobody bothered to carry out a proper due diligence,” says a former Midland executive. “They just piled in and got their fingers severely burned in the process. It was a blow from which the bank never recovered, and one that triggered a bid from HSBC which, at that time, was eager to domicile itself in the UK and thus enjoy the regulatory supervision of the Bank of England ahead of the 1997 handover of Hong Kong to China.

TSB was soon to follow after its widely-criticised £777m bid for merchant bank Hill Samuel in the late 1980s. The price (paid by what was then regarded as one of Britain’s most conservative financial institutions) amounted to nearly the entire cash pile TSB had raised in its stock market flotation. TSB, whose customers were typified by an analyst as “little old ladies sending in one pound a week to save up for their funerals, and who never missed that weekly deposit”, had exactly zero experience in investment banking, much less in running a merchant banking subsidiary. The bank promptly proceeded to fritter away the remainder of its flotation proceeds on daft acquisitions, like a gambler staking his chips on an all-or-nothing bet at the roulette wheel. From there it was downhill for TSB and its loss-making merchant bank, until Lloyds Bank spotted its opportunity and cast TSB a lifeline in the form of a takeover. But once the merger was completed, it started to look more like a reverse takeover, as many Lloyds executives began to find themselves without a job.

Bank of Scotland was perhaps one of the most bizarre cases of all. The bank was deemed as solid as the Mound in Edinburgh on which stood its corporate HQ. Management cheerfully described themselves as “Presbyterian Scottish bankers with very deep pockets and very short arms”. Yet for reasons that have never been fully clarified, the bank got into bed with the US bible-basher Pat Robertson in a marketing deal and suddenly its prestige went into free-fall.

Market forces swiftly went to work and the bank ended up in the arms of Halifax, although the merger has so far reaped benefits for both parties. “One could argue it was a merger between two banks that realised there was an ongoing process of consolidation taking place in the industry,” says Philip Middleton, head of retail banking at Ernst & Young. “It was a good fit for Halifax’s retail operations and for Bank of Scotland’s corporate and treasury businesses.”

The most blatant example of management failure was the NatWest saga. The irony is that it was management’s attempt to expand through acquisition that put the bank into play. Taking its cue from Lloyds TSB’s bold takeover of Scottish Widows (while ignoring its rival’s much higher esteem in the eyes of investors), in September 1999 NatWest launched a £10.7bn bid for insurer Legal & General. A month later there were red faces all round as NatWest backed away from the bid. The bank came under siege by enraged shareholders who interpreted the bid as a pointless and value-destroying operation, and that was the signal that triggered the opportunistic raid by the still independent Bank of Scotland, followed by a rival offer from Royal Bank of Scotland, which eventually won the day.

Analysts point out that NatWest had been making the wrong strategic decisions for at least 10 years. In 1986, it started to throw hundreds of millions at the US market to try to build up a banking franchise in the northeast, when bank valuations were at historic highs. A decade later, it was forced to beat a retreat to Fortress UK, where it followed up with a drastic downsizing operation that included reducing its SME exposure. This was all accomplished under the aegis of a chairman and chief executive who were, respectively, a top-ranking barrister and a mathematician with no banking experience.

Last to go (so far) was Abbey, which until its takeover last year by Spain’s Grupo Santander had established its credentials as the black sheep of the British banking industry in that it was the only one to report a loss. Abbey was one of the country’s most profitable building societies and knew how to squeeze a profit out of the mortgage market. But it had no business getting involved in some of its insurance activities and big-ticket corporate lending in the US, both of which went sour and dragged the bank into the red.

As for the merchant banking industry, the only sizeable participant left is Rothschild, although it recently signed a joint marketing deal with Nomura that could lead a deeper relationship. SG Warburg, Robert Fleming, Kleinwort Benson and so on, ceased to remain independent, not so much through management failings but because of a lack of scale, or an unwillingness to commit the resources required to achieve that scale.

Once the behemoths of Wall Street like Goldman Sachs and Merrill Lynch launched their offensive in Britain, it was only a matter of time before the City’s boutique investment banks were taken over by the global players.

No other sector lived such a blinkered existence. Warburg is a case in point: with UBS closing in for the kill, the bank still employed a graphologist to evaluate the suitability of prospective job applicants.

Britain is left with half a dozen players of a serious size, and the question on everyone’s mind is whether the process ends here or if the process of cross-border consolidation kicked off by the aggressive Spaniards will make further inroads in the UK. “Thirty years ago, banking was a mechanical process,” says John Reeve, a partner at Deloitte. “Banks did things roughly the same way as in Victorian times. They were about bringing in computers to do calculations for them, like adding up at the end of the day. It was run by junior-level people who kept the business moving. The world changed around them and they had to grow, meet competition and take on new products. They had no mechanism for doing that. They evolved these mechanisms and now the quality of management has improved.”

Given the highly profitable business that evolved from that process, Reeve believes that foreign competitors will probably try to come in and buy UK banks. “When you look at cross-border acquisitions you have to look not so much at the target but what’s happening in the acquirer’s economy,” he says. “In the US, they’ve been mopping up little banks and growing their own economies of scale. When this process is finished they’ll have got to the point where they will have to look abroad for further acquisitions and mergers.”

Robustness, according to Middleton, is the interesting thing about UK banks. “The banks are so profitable because Britain is the world’s fifth-largest economy, because UK business and consumers are quite sophisticated, and because the economy has been doing well for 10 years, which means that demand is rising and provisioning levels are down.”

Middleton sees three possible scenarios ahead for the UK banking market. “The first are in-fill acquisitions through the takeover of some of the smaller banks such as Bradford & Bingley or Alliance & Leicester,” he says. “Second, there is the possibility of a tie-up between a UK bank and a US or European bank. Then there is a chance that under a future government, people will realise we need a national champion, and so a merger between major domestic incumbents can’t be ruled out. A merger involving the big six would be good for UK plc as well as the shareholders of both banks concerned, and it would not be to the detriment of customers either, although in the short-term employees might be affected by staff cuts. I’m confident that something will happen within the next year.”

In spite of the swings and roundabouts that UK banks have endured over the past decade, corporate customers are still enjoying a more advantageous relationship with their lenders than are their peers across the Channel. A corporate FD and chief financial officer needs to have a bank that is responsive, high quality and profitable, and it is in the company’s interest to work with an efficient and competitive banking sector.

“UK plc has access to attractively priced financial services and banks that are eager to get their hands on companies’ business rather than state-regulated institutions,” says Philip Middleton, head of retail banking at Ernst & Young. “European corporates have not enjoyed as much support from their banking sector as is the case in the UK. In Britain, corporates are fortunate in having efficient banks competing for their business.”

The redrawing of the UK banking map has not had a significant impact on corporate customer relationships, with one or two exceptions. The NatWest saga is the one outstanding case in which mid-cap customers have suffered a deterioration in their banking relationship, inasmuch as Royal Bank of Scotland’s strident cost-cutting brought a tightening up of credit rules. NatWest ceased to be an independent bank to become merely a brand in the high street, with strategy planning transferred to Edinburgh.

“The worst effect of these takeovers is the cost-cutting they involve,” says Norman Bernard, director of bank consultancy First Consulting. “It inevitably means a lower standard of care and fewer account managers as they are spread over a larger universe of corporate accounts. Mid-cap customers may suddenly find they are not getting the attention they are accustomed to when trying to finance their investment programmes.”

The mergers that have involved the likes of Bank of Scotland, Midland, Abbey and TSB have had little or no knock-on effect for corporates. In the Halifax-Bank of Scotland deal, the businesses were sufficiently different to avoid any traumatic cost-cutting, while Midland’s customers arguably benefited from the aggressive expansion of its new parent, HSBC. Abbey is not a corporate lender and, when it tried to be, it went about it the wrong way through its treasury arm and got itself into terminal trouble. The jury is still out on whether Lloyds or TSB was the acquirer in that transaction, but neither bank had a corporate loan book the size of NatWest’s or Barclays’ to deal with. Barclays, meanwhile, is perceived by the market as a safe bet for corporates, having set the business back on track after several aimless years.

The bad news for corporates is that the rationalisation process has had almost no impact on lending margins, despite ferocious competition among the newly merged players. The accounts of UK banks that recently reported their 2004 results revealed little tightening of corporate lending margins. Inertia is probably the main problem, as banks don’t make it easy for customers to move their accounts or have multiple banking relationships. In this sense, Don Cruickshank, the former head of the London Stock Exchange, who five years ago conducted a review of banking services on behalf of the Treasury, may well have a valid point to make when he charged that the banks operate a cartel. Cruickshank recently alleged that this situation has not shown much improvement since 2000. “Sustained and high profitability is an indication that they (the top UK banks) are operating in a monopoly,” he says.

The good news is that there are a raft of investment banks happy to serve their capital markets needs. With the markets on the upswing, the bulge bracket players have turned their backs on mid-cap customers. But second-tier players such as BNP Paribas and ABN AMRO have dedicated mid-cap teams, while further players such as Singer and Friedlander or Close Brothers are prepared to have representation in Birmingham or Leeds, for instance, to pick up business from customers outside the FTSE-100.

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