The sorry history of the near-destruction of investment banking at RBS

ReutersGeorge Mathewson (L) and Fred Goodwin Chief Executive arrive at the Edinburgh International Conference Centre for RBS Group Annual General Meeting April 26, 2002.This week, the Royal Bank of Scotland begun getting rid of 14,000 of its 18,000 investment banking workforce.

It is an epic, global retreat from investment banking worldwide. If RBS's investment unit was a standalone investment bank, it would be regarded as a spectacular collapse. For comparison, Lehman Bros employed a similar number of bankers. When Lehman imploded in 2008 - an event that triggered a worldwide recession - it had 26,000 staffers.

The RBS collapse did not come suddenly.

It was decades in the making, and was the result of an internal culture that put the sale of questionable financial products ahead of concerns about the risk those products would create. The bank grew recklessly, overpaying for other banks that it acquired, as its balance sheet ballooned to £2.2 trillion ($3.3 trillion), larger than the entire GDP of the United Kingdom.

That growth was overseen by two CEOs who had no direct, hands-on experience of banking.

When the credit crunch hit in 2007, the bank was riddled with risky investments that imploded. The British government paid £45.5 billion to bail out the bank through 2009, ending up with an 81% ownership stake. One of its CEOs, Fred Goodwin, was stripped of his knighthood as a result.

The demise of the Royal Bank of Scotland is a sorry tale of mismanagement, "meglomaniacal" leaders and aggressive expansion that got out of control.

"RBS management and Board undoubtedly made many decisions which, at least in retrospect, were poor," said the Financial Services Authority in a report in December 2011, which was prompted by the catastrophic collapse of RBS.

"They took risks which ultimately led to failure. But if they had taken similar risks in a non-bank company, the question of whether regulatory sanctions were applicable would not have arisen. That is because in non-bank companies the downside of poor decisions falls primarily on capital providers, and in some cases on the workforce, and to a much lesser extent on the wider society."

It is little wonder that this week, RBS basically gave up on investment banking.

The rot inside the 300-year old lender started three decades ago. From the deregulation of the banking sector between 1979 and 1983 under Margaret Thatcher, to the appointment exit of Stephen Hester in October 2013, the timeline of RBS' demise is complex and riddled with management failings that the lender is still trying to put right.

However, in RBS' defence, Hester's replacement Ross McEwan is looking to put things right. Last week, McEwan delivered an impassioned speech following the 2014 results announcement, that mentions how he is on track to right the wrongs of the past.

"Let me be quite clear. This marks the end of a standalone global investment bank model for RBS," said McEwan. "What you see today is a bank on track and delivering on its plan. A bank that is determined to win the trust of its customers every day. A bank that is determined to reward its shareholders for their support."

Banking regulation and Margaret Thatcher

That meant any bank would be able to move away from vanilla retail products to offering services, such as investment banking, investment management and other forms of consumer credit.

"It was definitely in the 1980s. It wasn't just the undoing of RBS but also for most British banks," said Ian Fraser, author of the Shredded: Inside RBS, the Bank That Broke Britain, to Business Insider. "The banking system was not well regulated by the Bank of England and a lot of statutory controls were lifted in the 1980s, without any credible regulatory system being put in place. Arguably, a lot of problems can be traced back to the Thatcher era."

RBS, which was founded in 1707 and invented the "overdraft" in 1728, saw this as an opportunity to compete with the banking giants across the globe. It wanted to branch out from the high street, to Wall Street.

"In RBS' case, it lent pretty crazily during the Lawson Boom in the second half of the 1980s and was led to near bankruptcy in the UK recession of 1991-1992. At that point, it came within a whisker of being loss making, which was pretty unthinkable for that time and was pretty rare. So what they actually did needed radical reform."

The "Chairman Mao" of banking

ReutersSir George Mathewson (L) and Fred Goodwin talk prior to the RBS Group Annual General Meeting at the Edinburgh International Conference Centre April 26, 2002.The arrival of George Mathewson in 1987 as RBS' new director of strategic planning and development marked a major turning point for the bank in more ways than one.

RBS looked towards Mathewson, who had no direct experience with banking, to lead the lender into a new era. Although he was a high ranking executive, his lack of direct banking experience led to a number of key hires that also had scant hands-on financial experience.

He was an engineer in the US at Bell Aerospace. He then returned to Scotland and, as Fraser described, and became the "macho manager" who ran the Scottish Development Agency under Thatcher from 1981 to 1987. He lectured at St. Andrews and worked in a private equity firm, 3i, but not in banking.

But after a lot of debate by the board, he became CEO of RBS in 1992, just after the recession in the UK.

"He was regarded as having led a Chairman Mao style revolution at the bank. On pretty much his first day, out of 300 top managers, he fired 100, told 100 they were on notice and that their performance would be closely scrutinised over the next year, and that 100 were safe. So, for RBS with a very old style of hierarchical management, this was an extraordinary move," said Fraser.

"He drafted in consultants McKinsey & Company and, basically reconfigured the entire bank. He removed power from, what he called, "regional" fiefdoms and centralised everything, including credit decision making. Computers were increasingly used. Branches were hollowed out, peopled with more junior, sales-oriented staff and transformed into sales outlets to sell products that were pushed from central control. At the time, this was the most radical transformation of any UK bank."

As Mathewson described it in the Scottish newspaper The Herald, he took RBS out of the "crap" and restructured the bank into an entity that could compete globally. Scotland's Sunday Herald even described him as "banking's answer to Bruce Springsteen."

Initially, it was a huge success. When Mathewson became CEO in 1992, RBS made profits of £32 million that year. By the time he retired from RBS in 2006, before the onset of the credit crisis, the bank made £6.5 billion in profit after tax.

However, Mathewson was seen by the RBS board as not aggressive enough to take the bank to the next level between 1992 and 2000.

"RBS was smaller than the likes of Midland and Natwest at the time but arguably, this is where the seeds of destruction were sown," said Fraser.

Fraser added that Mathewson, while he wanted to grow the bank through various acquisitions, he ended up being too cautious to make bids.

"Lots of the building societies were converting into the banks. The banks were buying them out and the key ones were missed by Mathewson. TSB and Cheltenham and Gloucester went to Lloyds Banking Group. So, RBS hired Fred Goodwin who, again, didn't have any direct experience as a banker."

The arrival of 'Fred the Shred'

ReutersFormer RBS CEO Fred Goodwin smiles as he leaves the Edinburgh International Conference Centre after the bank's annual general meeting in Edinburgh, Scotland in this April 23, 2008 file photo.

Fred Goodwin arrived in 1998 as deputy CEO with relatively little direct banking experience, much like Mathewson.

Goodwin was an accountant at Touche Ross that worked on National Australia Bank's acquisitions of Clydesdale Bank in 1987 and then again in 1995 for the Yorkshire Bank. However, he caught the eye NAB CEO Don Argus and was given the job of deputy CEO of Clydesdale Bank between 1995 and 1997. There he gained the reputation "as a cost cutter and a tough manager that verbally tore dissenters to shreds."

He was quickly dubbed "Fred the Shred."

He applied the same ruthless attitude to RBS when he joined as Mathewson's right hand man. Mathewson was cautious about takeovers because he thought that if he tried and failed too many times, then RBS would be vulnerable to takeover.

But Goodwin didn't have that fear. He even tried to take over Barclays, which was vulnerable at the time.

"Barclays was in disarray when Martin Taylor left (1994-1998) after Barclays lost a lot of money in the Russian default of 1998," said Fraser. "He tried to arrange a reverse takeover. It showed he had chutzpah, especially as a relatively small bank to mount such a takeover of a bank that was still seen as a citadel of British banking."

In 2000, Goodwin completed a £22 billion takeover of Natwest and this is where "the seeds of problems started to grow and set in," said Fraser.

The deal was "praised to the heavens" by the Harvard Business School, the Financial Times, and every serious financial publication, as well as by investment analysts and investors. "It only fed Goodwin's meglomaniacal character. It went straight to his head, he thought he could walk on water," he added.

In 2009, Goodwin told MPs in a hearing that he "could not be more sorry" for what happened to RBS.

"The key problem is that RBS was trying to grow too fast and too furiously," said Fraser.

Even its Ulster Bank balance sheet ballooned from £9.8 billion when RBS acquired it in 2000 to £55bn in 2007. It also took over Dutch lender ABN Amro for £50 billion in 2007.

The bank that was "out of control"

ReutersEx-RBS CEO Fred Goodwin (C) stands with Fortis' CEO Jean-Paul Votron (L) and Emilo Botin, chairman of Santander, before a media briefing at the Edinburgh International Conference Centre in Edinburgh, Scotland, April 25, 2007. Fred the Shred's journey was like Icarus. He was knighted in 2004 by the Queen but four years later, after RBS was nationalised, he "retired" from the bank and then in 2012 he was stripped of his knighthood.

In 2002 and 2003, Goodwin won Forbes' Global Businessman of the Year award for that Natwest deal. After this, he apparently cut ties with some of his former advisors and wanted to only liaise with central bankers, prime ministers and senior politicians.

"After NatWest he thought, that it didn't really matter what you paid for an acquisition, as you could always strip it down, slash costs and people and cut the fat on back office functions, at the same time as boosting revenues through cross-selling," said Fraser. "I think Goodwin believed that he had a new paradigm of banking. This paradigm was to acquire loads of banks in loads of countries and replicate what he did to Natwest."

Meanwhile, Larry Fish, who became the RBS's US CEO in 1992 after the group acquired Citizens Bank for £235 million, was aggressively "overpaying" for provincial and local banks, firstly the eastern states then in the MidWest.

"It was hubris," said Fraser.

By 2002, as Fish and Goodwin were hoovering up as many acquisitions as they could, they were cultivating, what Fraser would describe, as a "rotten internal culture."

"Rank and Yank"

In Fraser's book, he describes the "rank and yank" culture, which Goodwin encouraged across the bank.

The "Rank and Yank" appraisal system was based on individual performance and is best-known as the system General Electric boss Jack Welch introduced in the US

Traditionally in rank and yank, high performers are rewarded and staff are motivated to push sales. Low performers are fired. So the pressure built inside RBS to push and sell financial products like they were microwaves.

The system motivated people to sell more and more, which got "extreme", and encouraged groups to push financial products that would get them "points" on this performance scale.

According to Fraser, "if you dared to question the bank's approach, it would lead to a negative mark on your chart. This was irrespective of long-term consequence of the impact of the financial products."

"So, staff did what they needed to do to score highly for enhanced pay, perks and status."

Now, in 2015, RBS is still paying around £4 billion in compensation for the mis-selling of a raft of retail products, including payment protection insurance (more commonly known as PPI) and interest rate hedging products. The bank, though, has not incurred any fines for the mis-selling.

The breaking point

ReutersRBS former Chairman Tom McKillop (L) and ex-CEO Fred Goodwin arrive for the RBS shareholders meeting in Edinburgh, Scotland November 20, 2008.

It all came to a head in 2008 when the financial markets turned sour.

At the time, its balance sheet was bigger than the entire UK GDP at £2.2 trillion. This meant that when the mortgage market collapsed, the bank was unable to handle the amount of people defaulting on their loans or the value of assets becoming worthless.

RBS had to beg the government for a bailout. Over 2008 and 2009 it borrowed £45.4 billion from the taxpayer and it has yet to pay it back. The government still owns 81% of RBS.

Even today, UK Chancellor George Osborne said the government wants "to get rid of the stake as quickly as we can" after the May General Election.

The FSA, the Financial Conduct Authority's predecessor, admitted years later that light-touch regulation and supervision, as well as a catalogue of management errors brought the bank to its knees.

The CEO of the global banking & markets (GBM) division, Johnny Cameron, admitted that he didn't know what a CDO was until March 2007, even though the bank had been selling the product since 2002.

(It is a Collateralized Debt Obligation, which is a type of financial product that is backed by a bundle of mortgages, bonds and loans. The sale of these were so prolific, and their risks so misunderstood, that they had a significant role in the collapse of the global financial markets in 2008.)

"The RBS board didn't know or didn't seem to even care what was happening in its different units," said Fraser. "They weren't reining it in. It was the same attitude at Barings Bank when Nick Leeson was making huge returns and no one was looking into how and why. The board were just sitting around, smoking their cigars saying how great returns were."

2014 was a terrible year for RBS

The bank also plans to cut its corporate operations down to about 13 countries, from 38.

At the beginning of this week, RBS said it will cut about 14,000 investment bank jobs in the US and Asia by 2019. This is about three-quarters of the total investment bank workforce, which stands at 18,000. However, the bank employs 118,000 people worldwide across all units.

"We had just become far too expensive, far too bureaucratic and too difficult for our customers and employees to deal with, and that's why we embarked on a plan to be a much stronger, simpler and fairer bank, no longer chasing global market share, but instead focusing squarely on our core strengths namely our home markets here in the UK and the Republic of Ireland," said Ross McEwan during RBS' investor presentation, following the release of its 2014 results.

RBS

Ross McEwan joined in 2013. McEwan is radically different to his predecessor Stephen Hester, who ran the bank from 2008 to 2013. He managed to shrink the bank's balance sheet down by £900 billion and cut costs. But huge litigation problems, loss making investment banking divisions and ongoing restructuring meant the government was not ready to try and sell its stake in RBS.

McEwan, by contrast, seems more in tune with what the government wants; a retail bank that is on the path to privatisation.

However, McEwan has a lot work to do. He said he is focussing on putting the customer, particularly in retail, first and that all issues at the moment are historical, not current.

"Banks love to categorise their problems as legacy issues as from a PR perspective it suits them. However a culture change is required," said Fraser. "The way the bank treats [small and medium sized business] borrowers at the moment, let alone in the past, does not show a great deal of change in attitude and culture. There is absolutely no doubt that from 2008 and credit crisis era that RBS was engineering defaults in companies and acquiring assets under their property group through RBS' Global Restructuring Group."

Battles with SMEs and retail customers

"Following the reckless lending leading up to the financial crisis, dramatic falls in property prices meant that the bank's shareholders and customers lost billions of pounds on bad loans. Tens of thousands of our customers saw the value of their assets plummet and their businesses struggle. Many ended up in serious financial difficulty.

"GRG helped minimise losses where it could, and successfully turned round the vast majority of businesses it worked with, advancing hundreds of millions of pounds of new lending and saving hundreds of thousands of jobs. As a result, fewer than 10% of these struggling SME customers ended up in insolvency.

"Due to the sheer number of cases involved there will undoubtedly be times when customers did not receive the level of service they deserved or would receive now. But the allegation that this bank, systemically and institutionally, set out to artificially distress otherwise viable businesses was extremely serious and hugely damaging. That is why we commissioned Clifford Chance to independently review this matter. Clifford Chance's investigation made very clear that it found no evidence to support this allegation.

"The FCA is now conducting its own review concerning how the bank works with financially distressed customers. We are cooperating fully with this review."

But Fraser thinks this is indicative of how the culture still hasn't fully changed from the years of Goodwin.

"The bank is in denial about it and I have actually seen some pretty convincing evidence from ex-insiders that this was true That suggest that this was and perhaps remains a rogue bank, not just a few rogue traders," he said. "When Ross McEwan talks about putting the customer in the centre of everything they do, it doesn't sit comfortably with what they are doing to some of their business customers right now."

"Many SMEs (small and medium sized enterprises) and customers have done very little wrong but have been hounded, persecuted and abused through the courts by the bank. It seems brazen and hypocritical for a bank to do that at the same time as presenting itself as cuddly and nice via its TV commercials and public relations."

RBS still faces major lawsuits from GRG "victims" and shareholders that invested in the bank before its 2008 rights issue. In that rights sale, investors were offered £12 billion in new, additional shares. Investors who bought them lost over 90% of their money.

Google FinanceThe 12,000-strong RBS Shareholder Action Group launched a £4 billion lawsuit in 2013 against RBS and former RBS executives Fred Goodwin, Tom McKillop, Johnny Cameron, and Guy Whittaker. The group accused RBS and the former executives of "misrepresenting the underlying strength of the bank and omitting critical information from the 2008 Rights Issue prospectus."

RBS told Business Insider: "While RBS and its former directors made some business decisions that have been criticised, this does not mean that they misled investors or acted illegally. We believe we have strong defences to the claims that are being brought against the bank and that is why we intend to defend these vigorously and to protect the interests of our shareholders including UK taxpayers."

There are also ongoing cases surrounding the mis-selling of interest rate hedging products and of course global investigations into its potential role in currency market manipulation.

RBS told Business Insider: "We have worked in line with the FCA agreed process to ensure that all customers mis-sold these products get fair and reasonable redress. In each case, the decision is approved by the independent reviewer to ensure that redress is fair and reasonable. We have provided redress offers to all of our customers and are now either awaiting their response or working through remaining consequential loss claims. Once the review has concluded we would expect that it will be subject to a thorough evaluation which we will participate in so that lessons can be learned from the process."

McEwan has a long, long way to go in turning around this lender. The good news is, he appears to be turning it into a different bank entirely.

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