How Britain's bankers lost the plot - The once great Big Four banks make huge profits in spite of inept management, says Stephen Fay, but their practices are now being called to account.
Sir Brian Pitman, chairman of Lloyds TSB, is England's most successful banker. Measured by market capitalisation, Lloyds ranks no less than third among the world's banks. For this achievement, Pitman is lionised by the stock market, admired by his competitors and feared and respected by his staff. His conceit is to claim he could have done better. Speaking recently to a group of bankers, 68 year old Pitman said one of his few regrets was that he had not set the hurdles for his management team high enough. That's partly why his colleagues refer to him as a bit of a thug. It's a pity there are not more like him.
The story of what Pitman did right helps to explain what Barclays, NatWest and Midland, the other English banks that make up the old 'Big Four', did wrong in the past decade. Each has been the victim of bad management and inept boards of directors on a scale that should have been a national scandal. Between them, the four recently reported pre-tax profits of £8.87 billion in 1998, up £1.75 billion in a year; but these prodigious sums mask the true record, for they are based on a well-padded cushion provided by rich pickings from the high-street branches.
These are now under scrutiny by a Treasury inquiry headed by Don Cruickshank. Ominously, his brief is to decide whether the competitive structure of English banking provides decent services to small business and disadvantaged communities. Gordon Brown evidently thinks not, and Tony Blair seems to agree.
For bankers merely to talk about failure only erodes trust and is, therefore, imprudent. Consequently, bankers do not encourage public debate about the culture that drove management to reach far beyond themselves, and to lose billions of pounds for their banks. In those years, they thought that, somehow, the customary standards of measurement did not apply to them.
Barclays and NatWest, especially, had grown used to thinking of themselves as 'states of the realm' rather than businesses. Delusions of grandeur didn't encourage prudent decision-making.
In fact, the Big Four is now really a Big Six, following the conversion of Abbey National and Halifax from building societies into banks. There are two, perhaps three, very competent banks in Scotland, and the market is now resilient and open enough to embrace most of the building societies, as well as Sainsbury's and Tesco. Old cultures are finally dying, although, with hindsight, the extraordinary thing is that they lasted so long. Before competition in the high street changes the Big Four clearing banks for good, it is worth asking what went wrong, and what Pitman did right.
Only 10 years ago, it was said by young Turks in banking that no clever, experienced graduate would think of accepting a job at Barclays. The dominant culture there was still the independent-minded, country banking families that had come together to form the bank in the 19th century, and it was run by decisive characters who took their autonomy for granted and abhorred bureaucracy. The style worked and Barclays was top of the Big Four league until 1989. On committees of fellow bankers, the man from Barclays was, as often as not, the 'Honourable this' and 'Fortescue that'. A feeling of superiority was literally inherent.
Barclays did not limit itself to these families. Even outsiders tended to be grand, such as Nigel Lawson, the former chancellor, or Sir Peter Middleton, the permanent secretary to the Treasury. Marketing men tried to update the bank's image by sponsoring the Premier football league.
The chairman who had backed the idea, Sir John Quinton, was the first not to be a member of one of the founding families. Barclays considered him an experiment that did not work, and Quinton was replaced by Andrew Buxton. He came from one of the old county banking families, and considered himself competent enough to act as chief executive as well as chairman, until the shareholders declared that enough was enough. Buxton has now moved on after last month's AGM to a consultant's role, and the families' hold on the levers of power has finally been broken. Barclays was then left in a state of confusion after Mike O'Neill, who was recruited from Bank of America to be chief executive, declared himself unfit for duty.
Big Bang deregulation in the City of London in 1985 accelerated the trend towards what bankers call disintermediation, meaning the breakdown of the traditional relationship between bankers and large corporate customer like Shell or ICI. Instead of borrowing from the bank where he paid his bills, the customer instead became a client of flashy New York investment bankers like Goldman Sachs or JP Morgan and borrowed money in capital markets rather than in the high street.
Given Barclays' high opinion of itself, it was inevitable that it should combat disintermediation by being able to offer banking services in all areas of the industry, including investment banking, so corporate clients would not jump ship. Being Barclays, it did this expensively, buying established equities and gilts brokers and forming BZW as the investment banking arm of a universal bank. A different culture at NatWest took a different route to arrive at the same place. Derek Wanless, now the chief executive, recalls that the management team in 1985 was composed of people who had left school at 18 and grown up together. 'Because of the success they continued to have in the UK, they believed they could do well almost anywhere. But they were cautious lenders, somewhat secretive by nature, and the lack of diversity meant that it was a team with very little challenge in it,' Wanless says. There was a lack of leadership, too. The chairman was Lord Boardman, who had been a political hack and a routine businessman before moving from brewing to banking.
Decisions were not preceded by a thorough analysis of the new marketplace. 'The feeling was that banking is a people business, and you didn't want to pay too much for good will,' says Wanless. So NatWest acquired smaller companies that were relatively cheap. County Bank was formed to be the NatWest investment bank and it was expected to grow organically.
This was a tactic, not a well-considered strategy. 'The way they thought about the world, it would have been much more difficult to say no to starting investment banking,' Wanless said. 'Why would they? The bank had a lot of income to protect.'
The Midland was already a special case in 1985. Mention it in the City and it is remarkable how many people comment that it was once the biggest bank in the world. That was in the 1920s.
What is just as remarkable is that the Midland is now a key component in the bank which is, when measured in terms of Tier One capital, the biggest bank in the world - the Hongkong and Shanghai Bank (HSBC). But to recover some of its old glory, the Midland had first to fail.
At the time of Big Bang, the Midland was teetering on the edge of bankruptcy, having made the purchase (disastrous) and the sale (worse) of Crocker National Bank in California at a time when the two managing directors were not on speaking terms.
The Midland had bought a merchant bank - Samuel Montagu - to create an investment bank called Midland Montagu, but a new chairman, Sir Kit McMahon, who had been imported from the Bank of England in 1986, quickly shut down its loss-making gilts operation. McMahon discovered a flaw in investment banking when conducted by a retail bank like the Midland: if the traders make money, profits disappear in bonuses; if they lose money, the losses rise further - to meet the cost of bonuses.
Midland had successes in the McMahon period, such as the establishment of the innovative First Direct Bank, but he concentrated on a salvage operation - saving the Midland by preparing it for a full-scale bid from HSBC.
In 1985, Pitman was digging Lloyds out of a nasty hole. If Barclays was patrician, NatWest the bank manager's bank, and the Midland recovering from a nervous breakdown, Lloyds was a Latin American bank. Because its powerful overseas connections made it fashionable and fun, Lloyds Bank International attracted the young things from Eton and schools like it who, for generations, had become 'something in the City'. One thing they had in common was a contempt for clearing banking, which was dead from the neck up, and not at all smart - it was for grammar school boys, in fact, boys like Pitman.
Gordon Pell, an obliging fellow, a graduate banker who runs the retail banking division, guided me through the recent history of Lloyds. 'It's studded with a string of spectacularly wrong decisions,' he says with the modesty of a successful banker, although he doesn't dwell on them, except on the Latin American disaster.
In 1983 Latin America had undergone a dreadful debt crisis, and Lloyds, which had lent a lot of money there, was engaged in a serious survival struggle. 'It was very dramatic and deeply traumatic, but it coincided with Brian getting the top job,' he recalls
Pitman had little in common with the Old Etonians, but he already had sufficient authority to manage them, and had done so as executive director of Lloyds Bank International, between 1976 and 1978, during his canter to the executive winning post. Once he had made it to the top, Pitman formed a fruitful partnership with Sir Jeremy Morse, a Wyckehamist, one of the few intellectuals working in the City, who became an executive director of the Bank of England at 36. Morse was a restraining influence on Pitman while Pitman forced Morse to be more radical. They were known as 'the odd couple'.
Born in Cheltenham, where he took his 'O' levels at the local grammar school, Pitman had joined the bank from Cheltenham and Gloucester Building Society, aged 20, in 1952, working his way through the branch structure, and doing the things that young bank employees did - playing cricket and golf.
One of his fellow bank chairmen in the City remarks: 'He pretends not to be as clever as he is.'
But Pitman's bosses considered him clever enough, when he was in his thirties, to be sent on secondment to the Mellon Bank. That was where he learned to love American capitalism. He devoured balance sheets and studied the tricks he would apply when he became boss of Lloyds. The US confirmed his belief in the ruthless approach to managing a business. He liked to say: 'If it can't make money by Tuesday, close it down.'
When the Latin American debt crisis struck, Pitman was deputy group chief executive, in charge of Lloyds' strategy; and the impact of it can be judged from his 1984 Strategy Review, one of the most significant documents in the recent history of English banking. To begin with, it recalled the most recent policy: 'In the 1982 Strategy Review, the objective was to retain our position as one of the strongest of the world's international banking groups.' Two years later the tune had changed completely. The world role was a thing of the past. Now: 'The Group's objective is to obtain a superior and sustained return on equity, which shall be its primary driving force.' Pitman had proclaimed the American concept of shareholder value; it was to transform Lloyds into a very successful business. His competitors, who took 10 years to catch on, have still to catch up.
At the time of Big Bang, Pitman didn't buy any flashy brokers; Lloyds couldn't afford a modest broker, never mind a flashy one. It cobbled together a small merchant bank from within the bank, but Pitman closed it a year later. It was under-capitalised, but the real reason for closing it was that the trading culture of a merchant bank perturbs clearing bankers like Pitman: 'Clearing bankers can't cope with volatility,' says Pell.
Since Lloyds had learned from bitter experience that it was not easy to make money abroad, Pitman decided to concentrate instead on the domestic market - or the narrow stream, as it became known. But Pitman shocked the clearing bankers to the core by bringing in the public schoolboys responsible for the Latin American debacle to manage the retail banking business. Strict targets were set. Shareholder value was to double every three years, boosted by profits of 15% a year and continuous cost-cutting. Unlike the other Big Four clearing bankers, Pitman did not believe it necessary to offer customers a full range of banking services. He was not afraid of disintermediation, or of losing corporate clients in tight competition. Banks fought to retain these big corporate customer, not because they made much money but because they lent prestige.
Pitman was not interested in prestige. His view was: 'If a corporate account is only earning half a per cent, who needs it?' Pell says: 'We disaggregated our thinking quite early. Any business that couldn't make 15% was starved of capital, starved to death.'
Acquisitions were made, but they were made at home, not abroad. Lloyds went into insurance with the Abbey Life purchase in 1989. It had been the first of the Big Four to sell mortgages in 1979. It consolidated its position in 1994 with the sentimental purchase for Pitman of the Cheltenham and Gloucester Building Society. Biggest of all was the takeover of TSB in 1996. The idea was to put together a financial conglomerate designed to see the organisation - and shareholders - through the entire economic cycle of boom and bust.
Pitman introduced to Lloyds an American concept known as economic profits. This meant that each division of Lloyds was judged not by the amount of money it made, but by how much more profit it had made than if its capital had been put on deposit at the building society. Pitman introduced share options, and, as Lloyds' share price went on rising, these were attractive. Generous bonus schemes were related to the quality of service in Lloyds' branches - measured by regular customer surveys. Generations of managers came and went, but Pitman stayed on past 65, retiring as chief executive in 1997 after 14 years, when he became chairman. Judged by the share price, his performance was awesome. Lloyds' market capitalisation at the beginning of March 1999 was nudging £50 billion - twice as much as NatWest and more than half as much again as Barclays. The 1998 results showed why: profits from UK retail banking ( £774 million) up 25%; profits from mortgages ( £729 million) up 14%, and from insurance and investments ( £982 million) up 18%. UK financial services contributed 75% of pre-tax profits of £3.29 billion. Shareholders' equity was up 20%.
Praise for Pitman's role comes from competitors as well as colleagues. A fellow chief executive says he learned from Pitman that: 'great results are achieved by concentration'. Barclays' head of retail banking, John Varley, says: 'He's systematically delivered on his promises, and created tremendous returns for the shareholders. The market has fallen in love with Brian Pitman.' The Pitman regime has its weaknesses, as all regimes do. His may become evident during the next decade. He may eventually be accused of having focused too narrowly on the UK, especially if NatWest and Barclays get their acts together and compete more effectively in their own backyard.
Their acts fell apart in the decade after Big Bang, when Barclays and NatWest discovered that playing the Premier Banking League against the Americans and Japanese was a horribly expensive business. It was prone to sudden shocks like Blue Arrow (County Bank told untruths to smooth a share issue), and the rogue trader who cost NatWest nearly £100 million.
Blue Arrow was especially damaging because it undermined NatWest's street credibility as well as creating tension between the retail and the corporate business. But Wanless refuses to blame NatWest's problems on Blue Arrow; he says raising fresh capital for a corporate customer like that was the kind of deal that the investment bank was set up to do.
For Wanless, the defining moment came when NatWest's managers realised they had been misled by their own culture. They discovered that there were, after all, financial businesses they were not experienced enough to manage or big enough to afford. 'We realised there were going to be a limited number of leading players, and that the chance of our being one of them was receding, despite all the money that was being put into the business. The concept simply couldn't be justified,' says Wanless.
No more enthusiastic amateurism for him. Outsiders were hired (for the first time in the history of NatWest, the finance director is now an accountant); assets were scrutinised coldly, and NatWest decided that the place to go was back to the beginning. 'The fact that we could make higher returns in the retail business persuaded us internally that this was the way to develop. We're now much more focused on the things we can do well,' says Wanless.
All the banks had continued to make substantial profits at home, and all had survived the short but deep recession from 1990 to 1992, although that had been an unsettling experience for them. For example, Lloyds lost more money in a single English town (Lloyds refuses to identify which town) than it had lost in Latin America in 1983.
Barclays had raised a billion pounds through a rights issue in the late 1980s without having thought what they might do with it. The money burned a hole in Barclays' pocket, and it was dissipated in an orgy of property speculation, financing country-house hotels and golf courses with an enthusiasm which showed that reckless abandon was not confined to the trading floor.
Despite occasional misgivings, high-street customers are not merely loyal, they are extremely profitable. At NatWest, customer turnover in the current-account business is an astonishingly low 4% a year. NatWest's profit before tax from the UK in 1998 was £1.71 billion, 80% of the group record profit of £2.15 billion.
The English customers lack the glamour of international finance, but they have consistently bailed out NatWest, despite having been taken for granted for 15 years. Wanless promises that they are now to be taken more seriously than international capital markets. Not before time.
Barclays has dealt with similar problems in a similar way, although the language the bank uses for its new targets in the domestic market is unique. Varley describes the objectives as BHAGs, which stands for Big Hairy Audacious Goals which are based on customer primacy (sounds pretty hairy).
This is the gee-whiz marketing language of English banking on the cutting edge. Although some of Varley's predecessors would have deplored the language, they would surely have liked the profits. In 1998 results, Barclays' retail financial services made pre-tax profit of more than £1.5 million, of which £338 million comes from Barclaycard.
But Barclays exemplifies a grave problem, which is that bankers are still not quite sure what they are there for. 'Banking is a mixture between a utility, a business and profession, and they're never quite sure on which level they ought to be operating,' says an investment banker - who is in it for the money, of course. At Barclays this toxic mixture was made stronger by the addition of patriotism. One reason why it set up BZW with such a flourish was that the directors believed it was undesirable to leave investment banking to the Americans and the Japanese. They believed they were something special, and if joining that exclusive party meant paying a premium price, they did not choke on that.
But in 1993, Barclays felt sufficiently uncertain about its judgment, at home and abroad, and the City was sufficiently sceptical about Andrew Buxton. Since there was no obvious successor as chief executive in the Barclays hierarchy, the board looked to industry. Martin Taylor had worked for the Financial Times and at Courtaulds Textiles, and he saw the 'premium price' of investment banking as intolerable. Like Pitman, Taylor believed in growth through keeping the business simple, and he decided that BZW was too complicated. He began to dismantle the structure that had been expensively built to support the bank's global ambition. The corporate finance and equities businesses were sold at a poor price in a buyers' market. For Taylor that was only the beginning of the drive to simplify.
For some of the non-executive directors, however, it was already a step too far.
Last summer provided the pretext for an attack on Taylor: Barclays lost more than £200 million in Russia and on its loan of £250 million to Long Term Credit Management, the American hedge fund that narrowly escaped collapse in September. The received wisdom in banking circles was that Taylor was too nice, and that he should have hired a couple of bastards from outside the bank to enforce his views on unsympathetic colleagues.
Taylor was vulnerable, and in November 1998, when he understood that he had lost the support of the non-executive directors, he resigned. Once again, there was no obvious successor.
Sir Peter Middleton, the deputy chairman who was approaching his 65th birthday, had to forget about retirement. He became acting chief executive, until Mike O'Neill was recruited from Bank of America, at which point Middleton became acting chairman - Buxton having signalled his intention to leave. Even before O'Neill quit, before having begun work, the fiasco caused caustic commentators like Christopher Fildes to ask what the directors had been doing for their fees, for they certainly weren't presiding over an orderly succession.
Since O'Neill's agenda had sounded similar to Taylor's, the initial City reaction to the arrhythmic heartbeat that caused him to step back was that this cardiac condition was more threatening to Barclays than to O'Neill. But the suggestion Taylor had been sacrificed unnecessarily leaves the modern banker unmoved. 'Look at the share price since the news of O'Neill's appointment,' says Varley. Spoken like Pitman. The Midland, because it dumped its institutional history when it was taken over by HSBC in 1992, has become a fierce competitor in the retail banking market.
Since its headquarters are now formally located in Hong Kong, and HSBC has branches in 80 countries, the Midland no longer has to worry about its standing abroad ... a few disgruntled refugees turned up at other banks, saying that they did not want their money in the hands of the Chinese, but, mostly, the customers remained remarkably loyal. The international character of the bank meant that the appointment of a Canadian called Bill Dalton to run the Midland created less stir than did O'Neill's appointment at Barclays. (Mind you, Dalton's salary is less hairy.)
HSBC has been run by hard-headed and ruthless Scotsmen, but their successors now appear anxious to create a solid revenue base in the UK to balance the volatile earnings in Asia. That means generous investment in new capital. A competitor says: 'The Midland will be overinvested and allowed to underdeliver on profits. It can manage itself for growth.' He is envious, and not a little anxious.
One banker I spoke to compared the Big Four to a bumble bee: 'Under any conventional theory, clearing bankers shouldn't be able to make the sort of money they do today. They shouldn't be able to fly at all.' After a troubled time, all four are flying, some higher than others. But if the profits are so good, the Government will want to know why, and others will want a share - either by starting up in the business themselves (telephones and computers make that easier than ever), or by buying into retail banking.
A Royal Bank of Scotland bid for Barclays, especially after O'Neill's departure? A merger between Barclays and NatWest? A takeover of Lloyds by Citibank? All seem conceivable. When the Big Four dominated English banking a decade ago, the Bank of England may have blocked any mergers.
Now that the Bank has lost control over bank supervision, its clout has withered - 'to zero', according to one insider. Retail bankers concede that they have considered mergers and bids involving close rivals, but all four reach a similar conclusion. Mergers between the Big Four would be unacceptable to the politicians because a merged bank would control too big a share of the market for small-business loans, and would be too enthusiastic about closing branches. A bid from a Scots bank might create no difficulty in London, but what would the new Scottish parliament say?
Other potential bidders are to be found in New York and in Frankfurt. Since banks still reflect their cultural environment, a link with New York is more credible than one between, say, Lloyds and Deutsche Bank. The idea of Lloyds as the UK retail arm of Citibank's international retail division does not appear to cause a nervous breakdown in head office in Lombard Street.
Rumours of bids and mergers have everything to do with the new profitability of the old Big Four. These profits are based on exacting standards for bank lending designed to reduce bad debts. (If your postcode registers too many bad debtors, you will have to pay more to borrow.) The Treasury inquiry headed by Cruickshank is intended to investigate any evidence of social exclusion, and it is likely he will recommend alterations to the competitive structure of the business. There is a real danger the rich cushion provided by the inflated profits from the domestic business will be pricked.
Whatever happens after Cruickshank, the experiences of the past 15 years have forced English banks to learn a new language. The most vivid example I came across was at Barclays, where Paul Barber, a bright, bushy-tailed director of communications told me: 'In the past 300 years we've managed this business to suit ourselves. Now we are managing the business to suit our customers.'
That remark is revolutionary.