British regulators have finally published their report into HBOS, the bank formed from the merger of Halifax with Bank of Scotland, more than seven years after its collapse. The 600-odd pages contain much detail on events and personalities. But there are general lessons for all businesses. Avoid the diversifier’s fallacy. Beware the winner’s curse. Fear adverse selection.
The diversifier’s fallacy is a generalisation of the Peter Principle: individuals rise within an organisation until they are given a job they are not competent to do. Companies diversify until they are engaged in businesses in which they have a competitive disadvantage relative to incumbents. This seems particularly common among financial companies. Most of the institutions hit in the crisis — most strikingly troubled insurer AIG — were crippled by losses in areas far from their principal business.
HBOS enjoyed market leading positions in UK mortgage lending and retail banking within Scotland. But these markets did not offer sufficient growth to meet the aspirations of HBOS executives. Since these expectations could not be met by things the bank knew how to do well, they were fulfilled by increasing market share in areas it did not know well: corporate banking in the UK and retail banking in Ireland and Australia.
While mortgage losses increased after the 2008 crisis, the core lending activity of Halifax remained not only viable but profitable. While the problems that became a crisis in October 2008 manifested themselves as a crisis of liquidity born of over dependence on wholesale funding, the underlying issue was one of solvency. Losses from diversification into corporate banking and international operations proved more than sufficient to wipe out shareholders equity.
When similar individuals or businesses are contenders for an object whose true value is uncertain, the winner will usually be the bidder who offers to pay too much. First observed in auctions of offshore oil blocks, the winner’s curse explains why mobile phone licence auctions raised so much more than governments expected.
HBOS’s rival, Royal Bank of Scotland, experienced the curse when it outbid Barclays for ABN Amro, a contest whose outcome was likely to bankrupt whichever bank “won”. What the corporate banking division of HBOS described as “innovative lending” was lending on more aggressive terms than any other bank. The same principle underpinned expansion in Western Australia, a far away country of which Edinburgh knew nothing, and in Ireland, a market already crowded with foolish lenders.
In Ireland, the winner’s curse was aggravated by adverse selection: when HBOS rolled out a new branch network after 2005, the borrowers who came through its doors inevitably included many whom better established banks had turned away. In credit markets, you can earn profits by doing better credit assessment than your rivals, or gain sales by doing worse credit assessment than your rivals. HBOS chose the latter.
Much is made, and rightly, of the failures of risk control in HBOS. The underlying issue is more fundamental. The sustainable rate of profitable growth in any business is determined by the strength of its competitive advantage and the scope of the application of that advantage. It is always a mistake to set growth targets to meet the expectations of ambitious executives or analysts rather than to derive them from a realistic assessment of the competitive position of the business. The result is to drive the organisation towards the diversifier’s fallacy, the winner’s curse and adverse selection. For HBOS, that meant strategy and risk control would inevitably come into conflict, and strategy would win. Until everyone, and everything, lost.
This article was first published in the Financial Times on November 25th, 2015.