Never mind the apologies – what went wrong and why?

It’s not every day you get to watch the heads of two once-powerful UK banks defend themselves to a Treasury Select Committee. I was expecting the hair-shirt act and the apologies, and we got them, but I also expected a clearer description of what went wrong. After all, the four in disgrace – Lord Stevenson and Andy Hornby, chairman and chief executive respectively of HBOS, and Sir Tom McKillop and Sir Fred ‘The Shred’ Goodwin, who occupied the same roles at RBS – can have had little else to think about for the last few months.

Yet once the ‘sorrys’ were out of the way, MPs had to keep asking whether the bankers were really remorseful, so quick were they to blame the wholesale funding markets, the stress-tested models, the fall of Lehman Brothers, the ratings agencies – in fact anything and everything but their own incompetence. On that the bankers were united. Their industry commands the very best talent and they stood at the top of that pyramid of excellence.

There was just one problem. They didn’t have a single banking qualification between them. Lord Stevenson, who needed the dictionary description of a bank read out to him twice, had been an entrepreneur; Hornby, a grocer; Sir Tom, a mathematician and pharmacist; and Sir Fred was a lawyer and accountant by trade. It also transpired that the head of risk control at HBOS had no previous experience at the job, while the prior head of risk, Paul Moore, had been fired for suggesting that the bank was growing too fast and taking on too much risk. Moore, who claimed there had been “a total failure of all key aspects of governance”, was removed by Hornby’s predecessor Sir James Crosby. Hornby, a board member at that time, voted in favour of Moore’s removal. Later, as CEO in 2007, he replaced the then head of the residential mortgage business for losing market share to none other than Northern Rock.

But what the committee really wanted to know was how the banks failed and how to stop it happening again. So HBOS and RBS shouldn’t actually have been in the same room. Sure, both failed for the same basic reason: they had insufficient capital to see them through the next downturn, even if it had been significantly milder than the one we now face. But they both followed quite different business models.

HBOS had little truck with sub-prime securities. Who needs rubbish US mortgage debt, when you can load up on the British stuff? Hornby clung to the mantra that HBOS was felled by the totally unexpected collapse of the wholesale funding market (exacerbated by the bank’s ‘excessive’ exposure to residential property). Yet unfortunately none of the Treasury Committee thought to ask whether this was really so.

Because HBOS’s fate is not without precedent. A heavy reliance on wholesale funding is a common, nay typical, feature of a pre-crisis debt bubble and the natural consequence of banks lending more than their deposit base. Japan, Sweden, Norway and Finland all relied on wholesale funding (supplied by more conservative foreign banks) in the run-up to their banking crises in the 1990s. Why were Hornby and Stevenson not aware of this? Hadn’t they been in banking in the 1990s? Oh, of course not. They’d been pursuing their prior careers. Surely then they’d have listened to wise counsel at least? No. They fired any voices of experience that warned of over-leverage and reliance on short-term wholesale funding, replacing them with sycophants as inexperienced as themselves.

RBS on the other hand looks much more like a typical international commercial bank. RBS’s problem was that it won the race against Barclays for Dutch bank ABN AMRO. Sir Tom admitted that the £10bn price tag had been all but wiped out. But while buying ABN at the top made RBS’s capital position untenable, we are still very early into the downturn. Other banks may yet fall prey to what RBS has done to its capital to asset ratio.

Sir Fred blamed his bank’s failure not on the wholesale funding market, but on AAA-rated securities which, despite “stress-testing” their models, had actually ended up worth just 5c or 10c on the $1. RBS apparently did its own risk assessment of such securities, which also presumably somehow failed to pick up on the unlikely event of an impoverished, possibly jobless sub-prime borrower being unable to make mortgage payments before the initial ‘teaser’ period of low interest rates was up. Unbelievable.

Sir Fred seemed unaware even now that the originate, securitise and distribute model, which was meant to take risk off the balance sheet and spread it widely, did nothing of the sort. Instead of packaging low-quality loans into securities mis-labelled as AAA-rated and selling them on, RBS did what so many other banks did; it started believing its own hype and buying the stuff itself. Between 2003 and summer 2007 marketable securities on RBS’s balance sheet ballooned from £38bn to £164bn, while capital, in the form of shareholder equity, only grew from £29bn to £46bn. Rule Number 1 in the drugs world for dealers is: don’t get high on your own supply. Sir Fred would have made a lousy drugs dealer; ex-pharmacist Sir Tom should have known better.