1. 1 Government ownership of banks: stakeholder perceptions in the UK market Sandra Einig Oxford Brookes University Project sponsored by ifs School of Finance/Henry Grunfeld Foundation

2. Agenda Overview of (part-)nationalised banks Research objectives Nationalised banks in the literature Methodology Findings and discussion Conclusion 2

3. Which banks were (part-)nationalised? Northern Rock (100%) Bradford&Bingley (100%) Halifax/Lloyds (41%) Royal Bank of Scotland (83%) 3

4. Northern Rock First bank to face serious liquidity problems during the crisis Bank runs, nationalised in February 2008 No compensation for existing shareholders In 2010 business split into two separate companies: banking (savings and new mortgages) and asset management (existing mortgages and unsecured loans) to make privatisation easier Plans to sell Northern Rock soon but first offers fell £400m short of government investment in bank (£1.4bn) 4

5. Bradford & Bingley Nationalised in September 2008 Savings business and branches sold to Santander Mortgage business closed to new customers, will be wound down over time No compensation for existing shareholders 5

6. HBOS/Lloyds HBOS acquired by Lloyds after financial difficulties creating a ‘superbank’ owning about 30% of the market for current accounts and domestic mortgages Lloyds had to apply for government funding after takeover Group had to agree to a restructuring plan with the EU commission (sell a standalone retail banking business with at least 600 branches, a 4.6% share of the personal current accounts market in the UK and up to approximately 19% of the Group’s mortgage assets) Total initial government investment: £20bn (average share price of investment: 74p, now: 36p) 6

7. Royal Bank of Scotland The 5 th largest bank globally before the crisis Had to apply for government funding at the end of 2008 In return, they had to agree to restructuring plan (sell more than 300 branches; sell insurance business) Total initial government investment: £45bn (average share price of investment: 50p, now: 25p) Recovery of share price not expected before 2015 7

8. How are the stakes managed? Government set up UK Financial Investment Ltd (UKFI) UKFI’s role:  to manage the Government’s investments in the banks;  to dispose of them in full over time;  and to protect and create value by fulfilling its role in the meantime in an arms-length, commercial manner Government influence on banks:  Board representation  Curbs to executive pay  Restriction to dividend payments  Increased lending  Restriction on balance sheet growth (e.g. Northern Rock 1.5% cap on new deposits) 8

9. Research objectives Research aim: investigate stakeholder perceptions of government ownership of UK banks More specifically: Is nationalisation the right solution What risks are associated with government involvement in the banking sector How can the stakes be managed effectively What should happen to the (part-)nationalised banks in the future How can future banking crises be avoided 9

10. 10 Prior research on state-owned banks Two different views of state-owned banks have emerged:  Developmental view (Gerschenkron, 1962) o State-owned banks are needed to encourage growth in undeveloped regions and deprived economic areas o This also includes investments that are socially desirable but financially not profitable  Political view (La Porta et al., 2002) o state-owned banks are used by politicians to maximise their own political objectives, i.e. banks become a political instrument o this may or may not enhance social welfare Empirical evidence: some support for developmental view, but predominantly for political view

11. 11 Prior research continued Profitability of state-owned banks:  In developing countries state-owned banks tend to be less efficient than private banks (e.g. Cornett et al., 2008)  no evidence of lower efficiency found in developed countries (e.g. Micco et al., 2007) State-ownership and competition:  State-ownership can lead to unfair competitive advantage, e.g. higher credit ratings, due to explicit or implicit state guarantees (von Heusinger, 2005)

12. 12 Prior research continued State-ownership and macro-economic stability:  Some evidence that state-owned banks can take on smoothing role in recessions by increasing lending (e.g. Micco and Panizza, 2006)  Other research indicates that they might play a destabilising role in financial crises as state guarantee increases moral hazard problem (Kaufman,1999) and they are subject to less oversight (Reuter, 2008)  Moral hazard problem confirmed by German situation where state-owned banks required considerably more support than private banks (e.g. Reuter, 2008) State-ownership of banks associated with a number of problems

13. 13 Methodology Exploratory study, so qualitative methods considered most appropriate 24 semi-structured interviews: 10 members of banking community, 4 members of regulatory bodies, 10 other interested parties (professional bodies, consultants, academics, journalists) 30-60 minutes each, transcribed and analysed in NVivo Topics discussed:  Was nationalisation the right decision  What risks are perceived with government involvement  How much involvement should government have in managing banks  Future of nationalised banks  How can future banking crisis be prevented

14. 14 Was nationalisation the right decision? At that time most participants (88%) considered it to be the only solution “The bank markets, the credit markets, the money markets, had to be reassured that these banks were sound. And since the bank managements didn’t themselves know whether they were sound or not, capital had to be supplied somehow.” (OIP) Superior to providing guarantees as it would allow the government to take control of the failing banks and there is the potential to participate in future profits

15. 15 Was nationalisation the right decision? But: Concern that this sets a precedent that increases moral hazard “I think Mervyn King called it the implicit guarantee… if everything goes wrong we’ll just take it over anyway and guarantee it. So there is an implicit kind of ‘If you don’t get it right, we’ll bail you out.’ (OIP) Might prove more expensive for society in the long term Banks should be allowed to fail “what should happen is that a business that fails, should fail, and effectively, the market should therefore distribute the customers and the opportunities amongst those who haven’t failed.” (banker) Nearly 40% of those in support of nationalisation felt the government should have handled their intervention differently: quicker action and a clear process required

16. 16 What risks are perceived with government involvement? Distortion of competition (88%) “If you artificially allow an organisation to exist that otherwise shouldn’t exist, you end up with some of the issues you’ve currently got where you’ve got HSBC turning round and saying, only a week or so ago, ‘I’m competing with Citibank and RBS, both of whom shouldn’t exist’. And they do this with proxy government capital. They are distorting the marketplace because they can.” (Banker) Conflicting interests of commercially run bank and political targets (67%) “We see them (state-controlled bank) as very active still in that market but at times, we feel some of their decision-making is influenced not always by commercial decisions, it’s influenced by other pressures that they’re under from government to meet targets for lending or other things. And you could query, is that driving the right behaviour, is that going to help the sustained recovery and the building of a healthy banking system again.” (Banker)

17. 17 What risks are perceived with government involvement? Less efficient/bureaucratic (42%) Additional losses to government (33%) “I think governments are waiting till the times get better, all these kinds of things, but generally, what they miss is that their risk of downside is just as much as it is with upside. So the government in any nationalised bank is really a shareholder and can lose more money.” (OIP) Damage to government reputation (13%) “Not only does the government have normal banking risks of credit extension and profitability of the bank and things like that, but it’s also got all those kinds of intangible risks like reputation risk. If a nationalised bank goes out and repossesses somebody’s home, that now is directly tied to the government, especially if that bank makes a mistake.” (regulator) Difficult for state-controlled banks to attract good employees (13%)

18. 18 The perceived impact on competition Nationalised banks at an advantage:  Seen as safer and thus access to cheaper funding (46%);  Yes, but restrictions placed on nationalised banks effective (30%)  different objectives/less profit driven (30%)  huge market share of Lloyds (13%);  favoured by government (8%); Independent banks at an advantage  Restrictions and government targets set for nationalised banks stop them from competing effectively (21%)

19. 19 hands-off (92%) vs. imposing targets (8%) “If you really want to make sure that you can sell them off you need a hands-off approach because otherwise you cannot actually sell them off. Because once you’ve made them into a quasi national savings and investments you’re not going to sell them off again.” (regulator) “And therefore, you maybe need to start taking some tough decisions around, if you’re going to be owner of this organisation for five or ten years, what do you want it to do? … with taxpayer’s money, it should contribute to society, so arguably you would take a view that investment banking doesn’t contribute to society, and if you take the Lord Turner view that most investment banking activity is socially useless, then actually, why would you have an investment bank that is effectively owned by the government? Well, you wouldn’t.” (Banker) How should the stakes be managed?

20. 20 Return to private ownership (92%) “Well one would hope that they get sold off. The longer, despite what I said earlier, the longer they stay in government hands, the higher the chance that actually it does have... the government does influence more and does change competition etc.” (regulator)  wait until profit can be achieved (50%)  quick sale more important (21%)  timing of sale most important (13%) Maintaining current institutions (33%) vs. breaking them up (46%) Retain stakes and run as utility-like institutions (8%) “… (RBS) lost its licence to operate commercially; the fact that it went bust, by definition, means that the market doesn’t need it, and what will happen is, its client based will naturally redistribute itself. So ultimately, you would end up with a much smaller, if you like … I don’t like to use the phrase ‘Big Society bank’ but, you know, a proxy national infrastructure-type bank, which wouldn’t be a bad thing.” (banker) How do you see the future of nationalised banks?

21. 21 Basel III  step in the right direction but too complex and bureaucratic (42%)  step in the right direction but not tough enough to prevent next crisis (25%);  not useful as it will restrict lending and economic growth (21%);  does not address the real problem (4%);  good solution (4%) “Basel III I think is an attempt to address the issues. It looks still at the problem from the perspective that it has looked at it before. It has added capital, it remains complex. It has a long transitional period and I would say it remains to be seen if it is adopted and if we get into Basel IV before we ever implement Basel III“ (OIP) How can a similar banking crisis be prevented in future?

22. 22 Narrow banking  Suitable model for nationalised banks (8%)  no support for strict separation/break-up (63%); instead:  Reduce size (42%)  higher capital requirements for banks with investment banking (21%);  firewalls between divisions (17%) “Separating retail and investment banking, I don’t think it’s the issue here. I think it’s about management and the quality of management. And a narrow bank can as easily screw up as an investment bank, and in fact is more likely to. The biggest problem I think in the UK anyway wasn’t so much the CDOs, it was effectively the demutualised building societies that became banks, and under short term shareholder pressure did a lot of perhaps arguably very insensible lending. “ (OIP) How can a similar banking crisis be prevented in future?

23. 23 Resolution regimes needs to be implemented that allows banks to fail  International rules  regulates cross-border issues “What we cannot have is a system that privatises the gains and socialises the losses” (OIP) Living wills  good way forward (33%);  good idea in theory but not sure how it will work in practice (13%);  concerns about higher costs for banks (13%);  concerns whether banks have incentive to prepare proper plan (4%) “We need to take measures so that big banks can without difficulties be taken over and wound up in exactly the same way as small banks. So we need what the Governor calls ‘living wills’ – see if that works.“ (OIP) How can a similar banking crisis be prevented in future?

24. 24 Conclusion Government involvement in the banking sector problematic Government needs to communicate clearly the plans for nationalised banks Regulation needs to be implemented that will allow banks to fail to reduce moral hazard Nationalisation should be a temporary measure that facilitates an orderly wind-up or private sale; it should not be a longer-term solution Shareholders and bondholders need to take more responsibility, i.e. absorb losses