Saving Britain's broken bank

The once proud and mighty Royal Bank of Scotland has been nationalized. Could it happen in America?

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By Peter Gumbel, Europe editor

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(Fortune Magazine) -- Royal Bank of Scotland prepared for the worst when it held its annual shareholders' meeting in an Edinburgh conference hall in early April. Beefy men in ill-fitting suits were brought in to handle security, metal detectors were set up at the entrance, and the board braced for a rough ride.

There was every reason to be cautious: Royal Bank of Scotland (RBS), Britain's second-largest bank after the international colossus HSBC, is the nation's AIG, the recipient of a massive government bailout that has enraged pundits and politicians alike and led to violent public protests. Two days before the gathering, protesters smashed up the bank's main branch in the City of London using pieces of metal scaffolding. And a couple of weeks earlier the Edinburgh home and black Mercedes of the former CEO, Sir Fred Goodwin - or "Fred the Shred," as he's commonly referred to - had been vandalized.

In the end, security at the annual meeting proved unnecessary. Yes, flashes of anger erupted - former directors "should be in jail," harrumphed one elderly shareholder, to loud applause. But on the whole, the atmosphere was morbidly subdued, part funeral wake for a troubled institution and part self-help group for those in pain because they used to believe in it. One shareholder read a poem that mourned how the "good ship RBS has run aground on the Goodwin Sands." Another lamented, "In the eyes of the public, we [shareholders] are figures of derision and ridicule." Summing up the mood, Philip Hampton, a veteran British executive who took over as RBS chairman in January, made an impassioned plea. Given the hard work that now needs to be done, Hampton said, it's time to "bring an end to the public flogging."

But one more flogging was still to come, and it was delivered by Her Majesty's government. Its representative, a former banking analyst turned civil servant named Tim Sykes, sat unobtrusively in the audience throughout the meeting. Nobody introduced him. He didn't speak. Few even recognized him. But when it came to the resolutions, Sykes used his clout. The government supported the board on every point except the one signing off on executive compensation, which was voted down by more than a 90% margin.

The government was signaling its disapproval of a $1-million-a-year pension plan for Goodwin that the board had approved in October. The act was largely symbolic: Under pressure, all but two of the directors had already been replaced, and the bank's entire compensation policy has been rewritten with the active involvement of civil servants from Britain's Treasury. Still, it was a show of force that left no doubt about who really calls the shots at RBS these days.

Royal Bank of Scotland may well be a harbinger of what's to come for some of the most troubled U.S. banks. The $35 billion loss that RBS (RBS) reported in February, which included $24 billion in write-offs, was the largest in British corporate history. The government has nationalized it - reluctantly - and is likely to end up with a stake of about 70% once a new capital structure has been finalized. Prime Minister Gordon Brown has already pumped in two rounds of fresh capital, and in February he agreed to insure a massive $480 billion of RBS assets against further deterioration. Shareholders haven't been wiped out entirely, but the stock is down 96% from its peak 20 months ago.

It all amounts to a brutal comedown for an institution that, under Goodwin's nine-year leadership, had transformed itself from a regional Scottish bank into a worldwide powerhouse, the fifth-biggest bank in the world as measured by market capitalization. Now chairman Hampton and Stephen Hester, a balding former banker and real estate developer who was brought in as CEO to replace Goodwin last October, are in grim salvage mode. Hester has already identified $350 billion in assets, about a quarter of the total, as "noncore."

Among operations headed for the chopping block are many of those in Asia, the U.S., and Europe, especially in investment banking, which Goodwin had painstakingly built up over the years. Buyers are few and far between. Job cuts are big: About 15,000 have been announced so far, out of a workforce of about 170,000. Hampton and Hester say they expect it will take from three to five years to get the bank back on its feet as a standalone operation, but they don't rule out that it could take a lot longer. "We're not talking about strategy here; it's all about the tactics of survival," says one banker close to RBS.

And the government is never very far away. Both sides insist that the relationship is at "arm's length" and that the state has no intention of meddling in the bank's day-to-day affairs. But three separate government agencies are pulling and poking at RBS, second-guessing the board on compensation, carefully vetting the toxic assets that taxpayers are insuring, and making certain that the bank hasn't stopped making loans to British customers. Hester tells Fortune that he spends between 10% and 20% of his time dealing with government officials. That's not a complaint; it's the price of survival.

RBS has company: One of the other top four British banks, Lloyds-HBOS (LYG), is also in government hands, as is Northern Rock, a mortgage lender. Prime Minister Brown was initially as reluctant as the Obama administration to nationalize faltering banks, but in the end he had little choice. Now he argues that state control, combined with Britain's new toxic asset scheme, is the best hope for a speedy return to normalcy.

Before that happens, RBS executives must deal with some heavy collateral damage. The aggressive use of leverage by Goodwin and others, and the "light touch" regulatory system that Britain once touted to attract business from around the world, are both history. In March the nation's new chief financial regulator, Adair Turner, issued a detailed report that outlined what needed to change. The short answer: everything.

The crisis "raises important questions about the intellectual assumptions on which previous regulatory approaches have largely been built," Turner wrote. The new philosophy as defined by his report: "more intrusive and more systemic."

It's not yet clear what that will mean in practice. At the very least, say several top British bankers, it'll spell a lull or even the end of the international ambitions of the nationalized institutions, and a severe brake on the investment-banking and proprietary-trading operations of all banks, British or foreign-owned. One of Turner's major suggestions is that banks be required to reduce their overall leverage and set aside significantly more capital to cover their trading activities, including in risky derivatives contracts. It's an idea that has been widely endorsed in Britain and is already influencing a bigger European debate about the future of banking.

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