If claims in a UK government report published last week have any basis, then the latest scandal surrounding the Royal Bank of Scotland makes LIBOR manipulation look like just a rainy start to the cricket season. The Tomlinson report, established by UK Business Secretary Vince Cable, found evidence that RBS intentionally forced small and medium entreprise customers into default so that it could take over their assets and resell them at a gain.
When a small business secures a loan from a bank, the banking relationship takes place at the bank’s local branch. The business customer has a relationship manager at the bank, whose role is to regularly monitor the financial performance of the business and be its advocate internally at the bank. A responsible company will communicate frequently with their bank’s relationship manager, because when the bank reviews its loan portfolios, this person will often emerge as the company’s best champion internally.
Now when a business customer encounters financial difficulties, banks become nervous, as they want to ensure the borrower can repay its loan. This is why typical loan agreements contain all kinds of protective clauses for the banks: first dibs on the company’s assets, covenants on liquidity and profitability ratios, and often even aggressive tools like acceleration clauses. Depending on the severity of the difficulties, the relationship manager will usually first try to work with the company to help get things back on track. For example, a tripped Ebitda covenant alone is not necessarily a serious offense; being late on a scheduled loan repayment is more serious. The relationship manager may have a variety of carrots and sticks at his disposal to find a solution, such as extending the loan repayment period in exchange for a higher interest rate margin.
However, if the bank judges the problems severe, it may shift the client file to its dedicated recovery group. While the relationship banker’s goal could generally be characterized as helping the business customer get back on track with its loan payments. The bank’s recovery group is generally more of the mindset of “let’s cut our losses.” Cutting their losses may involve taking over the assets of the business and liquidating to repay its debt. A typical loan agreement provides for this if the customer defaults on its loan. However, historically a balance of power existed, as the bank was likely to take a loss on this approach so only exercised such extreme measures when there was no longer much hope of the business returning to sufficient profitability.
A one-way ticket to banking hell
Here’s where the supposed practices at RBS really stink. Allegedly, RBS would intentionally push some of their customers into default, because the bank actually made more money by forcing struggling but still viable business customers into their recovery group. As per the report, “Once in this part of the bank, the business is trapped with no ability to move or opportunity to trade out of the position – they are forced to stand by and watch an otherwise successful business be sunk by the decisions of the bank. The bank extracts maximum revenue from the business, beyond what can be considered reasonable and to such an extent that it is the key contributing factor to the business’ financial deterioration.”
By moving the business out of the local branch and into their recovery group, RBS generated more revenue through excess fees. The report cites one example of a small business whose time in the recovery group had cost them £256,000 in fees alone, not to mention the detrimental impact it had on their ability to operate the business or find other financing. Even worse, evidence arose where RBS would push their customers into insolvency, then turn around and sell the company assets for a gain, in some cases via another division or a private equity fund associated with the bank. The balance of power had completely broken down.
Yes, Virginia, there are some good bankers out there
At least some spirit-raising news also came last week. I learned that the commercial banker of one of my portfolio companies accepted a promotion opportunity inside his bank. This news was slightly bittersweet for us: the individual in question proved to be a true business partner in every sense of the word. He genuinely listened, sought to understand my portfolio firm’s business, reflected constructively on solutions adapted to my investment while navigating the constraints of his bank. Like in every tech startup, there were speed bumps and setbacks. It’s during the tough times that you glimpse a person’s true character, and this banker showed great integrity. ABN AMRO undoubtedly recognized this individual’s talents and offered him a new challenge. Good for him; he deserves it.
I’m not suggesting that RBS is full of unscrupulous schemers and ABN only of saints. I have no direct business experience with RBS but could imagine that there are many solid individuals there too. There can be many good apples in rotten organizations. Eventually, the good people try to leave, and in an efficient market this can happen quickly. But rotten organizations usually don’t rot over night. And it usually takes people a while, even the perceptive ones, to wake up and smell the rot. The labor market is less efficient in many European geographies, so the re-balancing occurs more slowly, but it eventually occurs.
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