The FSA, RBS and the ‘pack of lies’

On page 277 of The Devil’s Derivatives, there is a short account of how the U.K. Financial Services Authority supervised the Royal Bank of Scotland in the spring of 2008. It’s only a small part of the book, but it caused me a disproportionate amount of trouble, including a legal threat from the FSA that caused me to change my U.K. publisher and delayed publication of the book by several months. Last week, compelled by U.K. parliament, the FSA published a 452-page report on RBS.

The passage in my book focuses on an FSA employee called Clive Adamson. He was what my sources called a ‘good old-fashioned bank examiner’, who had been brought over to the FSA from the Bank of England in 2000. By 2007, he was involved in supervising RBS, as part of an FSA division called ‘major retail groups’.

Towards the end of 2007, and early in 2008, as the crisis progressively worsened, Adamson is said to have become frustrated about the poor quality of disclosures that RBS was providing about its capital position. However, Adamson’s ability to act on his concerns was constrained by other forces within the FSA. In the decade since its formation, the FSA had accumulated a hierarchy of risk experts, many of whom worked on the mathematical modelling required for the Basel II regulations. RBS legally exploited Basel rules to the full in order to hold the bare minimum of capital and deliver the maximum return to its shareholders.

Adamson’s critique of RBS, the FSA risk experts said, was tantamount to admitting that the regulator had made a mistake on Basel II, in which it had invested thousands of hours of analysis and negotiation. The tensions between Adamson and the risk experts broke into the open at an FSA internal meeting in the spring of 2008, in which Adamson supposedly described the RBS Basel-mandated disclosures as a “pack of lies” and was reproved for it by a colleague I shall call X. Feeling that the senior management of the FSA was not sufficiently supportive of their position, some FSA staff took it upon themselves to informally contact the U.K. Treasury to discuss how British banks might access capital in an emergency.

The FSA told me that my account was ‘inaccurate’ and not only warned me that naming X would be defamatory, but said that FSA senior management reserved the right to sue me as well. Worse still, the FSA threatened me with criminal prosecution citing provisions in the Financial Services & Markets Act of 2000 intended to protect confidential information passed by banks to regulators. Faced with such a threat, I couldn’t take the risk. I had wanted to make more of Clive Adamson, who I thought was something of a fine fellow, but doing so would have risked either exposing me to legal action or would have exposed my sources.

Eighteen months later, the report itself does provide some indirect corroboration for the passage in my book. There is the context of light-touch, under-resourced regulation of large banks and over-allocation of resources to Basel II. There’s evidence of the poor risk disclosures and defence of the status quo which irked Adamson. We see it in an exchange over RBS’s liquidity that took place in November 2007, where the supervision head of department demanded more information, and a specialist FSA team went back to visit RBS and appears to have been fobbed off.

We also see it in the account of what the FSA calls ‘Pillar 2′ supervision — where banks and regulators engage in dialogue to determine capital levels on top of the ‘Pillar 1′ standard rules.
In late 2007, RBS’s Pillar 2 submission to the FSA was deemed to be of ‘insufficient quality’ by the supervision team, because the bank insisted on estimating capital using a 1-in-40 worst case scenario rather than the 1-in-1000 standard laid down by Basel rules. If RBS had followed the guidelines properly, it would have needed an additional £7 billion in capital, the report says. That calculation didn’t allow for the acquisition of ABN AMRO, which the FSA now admits should never have been allowed to proceed.

So why wasn’t RBS forced to increase its capital by £7 billion in late 2007? Because the FSA would have had to have admit that the Basel rules were wrong. ‘A significant departure’, the report quotes the supervisory team saying, ‘takes some explaining as to why we so massively underestimated the capital impact of the risks facing the group under Basel I’. If I was Adamson, I would have been feeling peeved at this point.

In early 2008 we see the FSA start getting slightly tougher, pushing RBS to focus on a stricter definition of capital – core Tier 1 rather than the arbitrage-friendly Tier 1 – giving the bank a year to increase the ratio to 5.25 percent (for comparison, the European Banking Authority now wants banks to exceed a core Tier 1 ratio of 9 percent).

These capital targets, incredibly weak by modern standards, were too much for RBS in the spring of 2008. In March, the bank admitted falling below the FSA required level, and did so again in April. That month, an internal FSA paper noted RBS’s ‘poor capital planning and forecasting’.

It is the first week of April when things really pick up. According to the report, the FSA’s managing director of retail markets, Clive Briault, left on 7 April, and Adamson was immediately promoted to become acting director of retail groups. Now I don’t want to be unfair on Briault, who took the blame for the Northern Rock fiasco and was forced to quit the FSA as a result. Briault rightly says that the main reason for Northern Rock’s failure was lack of liquidity, something his team was not required to regulate. A similar argument about liquidity is made in the RBS report, and it would be wrong to pin the blame on Briault for the failure of RBS.

That said, his departure and Adamson’s elevation are correlated with a striking change in the FSA’s supervision of RBS. Only 48 hours later, on 9 April, FSA chief executive Hector Sants met Sir Fred Goodwin, and demanded that RBS pursue a rights issue. It is hard to imagine a greater slap in the face for Goodwin, who up to then had thought he was walking on water, unchallenged by regulators or shareholders. After 9 April, he was offering his resignation to the RBS board (they declined to accept it) and the bank was apologising to analysts in conference calls.

The report acknowledges that the £12 billion rights issue and pledges of asset sales by RBS in April 2008 were not enough. Outside the remit of the report are the conversations that took place at the Treasury and Bank of England about RBS during this time. All the report says is that the FSA updated these authorities through the official ‘tripartite’ channels. But were there unofficial discussions between FSA staff and the Treasury as my sources suggested?

Today, Adamson is the head of supervision for the entire FSA, and he is likely to return to his old home as a prudential regulator at the Bank of England when the FSA shuts down next year. Unfortunately, many of the Basel experts whom he jousted with are likely to move over with him.