Take Care of Some Corporate Government Risks.

Take care of some corporate government risks.

Based-on RBS “the banks that run out of money”

To: future bankers

From: Anne van den Brom (investment banker)

Date: 19 October 2014

Word count: 1994

Summary

There is considering during investing in banks. Among these considerations, there are various corporate government risks that these organizations face. In this memo, these risks are based on the case of RBS. Weak decision-making of the board and its management, a dominant leader, and non-focus on the core business of banks were the main corporate government weaknesses of RBS. The main recommendation for investing in banks is to stay focus on the core of baking and not lose your mind in focusing on grow of banks.

Different things should be considered when investing in banks. The various corporate government risks that these organizations face are among those. These risks will be illustrated by the story of the Royal Bank of Scotland (RBS), “the bank that ran out of money”.

RBS was founded in 1727 in Edinburg. Until the 1990s, it was a small bank that only focused on the Scottish economy. In the 1980s an act came into effect that allowed banks to merge with investment banks (BBC, 2011). In the hands of Goodwin as deputy CEO of RBS, NatWest was acquired in 1999 when it was three times RBS’s size. (Martin & Gollan, 2012; BBC, 2011). In 2000, after the takeover, Fred Goodwin became CEO of RBS.

Because of the takeover Goodwin was very popular. At this time, RBS focused on good corporate governance: on HRM, leader centricity and development and engagement with shareholders. The success of RBS led to confidence in the leadership and quick decision-making skills of Goodwin (Martin & Gollan, 2012). Later, as RBS was growing, this kind of decision-making turned out to be less appropriate. In 2004, the Financial Services Authority (FSA) was assessing the risk of Goodwin’s dominant leadership. The FSA considered taking action, but did not do so after some RBS directors declared they could challenge the CEO sufficiently (FSA, 2011).

Regulators like the FSA are not the only stakeholders of a bank. There are many other stakeholders that RBS and other banks are dealing with. First of all, there are its employees, who want to keep their job and be compensated; they share their economic well being with the bank. Other stakeholders are depositors, who do not want to lose the money they deposited; creditors, who want to be able to continue to receive credits that they (or their company) require; society, because when something goes wrong with a bank, society as a whole is affected by the consequences. This leads to the societal function of banks, because they hold the majority of assets of the people of society they cannot go bankrupt (Adviescommissie Toekomst Banken, 2009). Because the money of that many people is at stake, the government is forced to support banks (with tax-money) in case of impending bankruptcy. Government, because of the reasons mentioned before, and to regulate the banks. The last stakeholder of banks are its shareholders, they provide the bank with its equity as an investment on which they require a return and above all do not want to lose (Behery & Eldomiaty, 2010). Banks have a central role in the economy; the special economic function banks have are to provide clients with credit and equity and a transaction system so clients can collect and make payments (Allen & Carletti, 2005).

At the time of Goodwin’s leadership, shareholders of RBS believed in the story of the bank. Profits of RBS grew rapidly and they wanted to expand in the USA. The US arm of RBS, Citizens Bank, had become one of the biggest banks of the USA because of investment banking. Goodwin was focusing on increasing revenue, profit, assets and leverage instead of the core of banking like: capital, liquidity and asset quality (FSA, 2011).

Prior to the burst of the housing bubble the profits of RBS grew really fast and its senior management team was praised by the global financial community. However, some questions about the sustainability and motives of their acquisition strategy and the lack of short-term return were made by both the financial press and the institutional shareholders of RBS. The RBS board, which was a one-tier board, was pushing the acquisition of ABM AMRO regardless of the risks and quality issues of the bank. Goodwin had adopted a “macho-management style” and employees became scared of him (The Scotsman, 2012). Because of poor decision-making of both Board and management and the acquisition of ABN AMRO, RBS would fail (BBC, 2011).

After the acquisition of ABN AMRO and the burst of the housing bubble, the stock price of RBS dropped rapidly. Its USA arm revealed it had suffered huge losses on subprime investments; over 1.5 billion pounds. At one point, RBS began to run out of money while other banks refused them further credit. RBS came within two hours of being unable to meet their short-term liabilities. Because their bankruptcy risked bringing down the entire British financial system, the government bailed RBS out with taxpayer’s money (BBC, 2011).

There are typical liquidity risks that banks could face because of a potential mismatch of its long-term assets and short-term liabilities. Banks require sufficient liquid (short-term assets) to meet their short-term liabilities. Because of the nature of banks, most of its assets are long-term (investments and loans), whereas the size of its short-term liabilities depends mostly on the withdraws and transfers of their clients who have the right to withdraw their money at all times; unannounced and immediately. The majority of the money of clients is invested or lend out as credit; it is not liquid. When all clients, even those of a healthy bank, would withdraw or transfer their money, a bank would not have enough liquid assets to do so. This would cause them to be unable to fulfill their short-term financial obligations, which would bring down the bank.