How Britain’s banks profit from distress

By James Nicholls (Guest Post on Ian Fraser’s Blog)

Bank-logosBanks are in the business of making money – just like every other business – and they do this by providing bank accounts and lending money at a profit. So far so ordinary. They lend to individuals and businesses and most of the time this all goes well, in that they charge fees and interest and everyone pays them back on time. This is literally called “Good Bank”.

There is another part of each bank called “Bad Bank” which is the part of the bank where problem accounts and loans are transferred. Each major bank has a different name for this part of their business and each uses a different euphemism. Years ago at Royal Bank of Scotland this department was called “Specialised Lending Services” which is about as euphemistic as you can get. It sounds like lending to, say, exotic pet shops or fracking businesses and it is laughable when you realise that “Specialised Lending” means “Asking for money back”! Here is a list of some of the larger banks and the names they currently give their “bad bank” departments:

Good Bank is the part of the bank that involves relationship managers and salespeople and its primary focus is on trying to sell each customer more services and facilities, sometimes known as cross-selling. All businesses want to sell more of their products and services rather than less. Again, so far, so ordinary. But when things go wrong and a business or individual is struggling to repay a loan two things happen.

First, the “file” or account is transferred from Good Bank to Bad Bank and the person who is dealing with it changes from the smiling, young relationship manager in a branch to a faceless manager in the recoveries department. At the same time, and at the very outset, the Bad Bank person makes a “provision” against the account – which may sound innocuous enough. A provision is an accounting term which means the new manager assesses the account and takes a guess at how much money the bank can realistically expect to retrieve from the customer in default. Obviously, for some accounts, this is quite a simple process, but for others it is very involved and can include getting up-to-date valuations of property assets and accountants to crawl all over the business. The provision is the loss that the bank thinks it will make on that particular loan. Again this all sounds perfectly reasonable  – except that this process and its consequences give rise to all sorts of conflicts of interest and unhealthy incentives.

The idea that any of the banks’ recovery departments are there to help businesses is laughable and actually quite insulting to people’s intelligence. GRG and Special Situations etc, are there to help the bank first, second to make money, and if they happen to help a customer along the way, then that’s all well and good. Of course, the banks will tend to lose more money if they push a viable business to collapse but what if, during the process, they realise not only that the business is viable, but also one that they can make more money out of?

This is where the transfer of the account from Good Bank to Bad Bank comes in. The provision or “write-down” of the loan, i.e. the loss, is put through the profit and loss account of the bank and is blamed on the relationship manager in the branch – you know, the poor sod whose targets are to sell as many unwanted facilities and products to his customers as he can, like Interest Rate Hedging Products, premium accounts and insurance.

A case study might be useful here:

Hapless Pet Supplies Ltd borrows £100,000 over 10 years and has a small overdraft of £10,000 but struggles with cashflow and defaults on its loan payments. It owes the bank £110,000 when it is transferred to the bank’s recovery department called Special Care, Attention and Mentoring Section (“SCAMS”).

The manager in SCAMS makes a 50% provision against the total debt and so writes-off £55,000. In fact, he privately believes that he can get all the bank’s money back, but sees no reason to make life difficult for himself. He can blame the 50% loss on the relationship manager and anything he manages to wring out of the situation he will be able to take credit for. And, in this world of incentive-driven capitalism, “credit” means “bonus”. So you can see how there is a massive incentive for everyone in the recoveries department to over-egg their provisions or write-downs, and this includes all the chartered surveyors, valuers, investigating accountants and other supposedly independent professionals employed to advise. Everyone knows, and is “in” on the SCAM of maximising the write-downs so the future write-backs can be maximised. No one needs any explicit instructions to do any of this, it’s just taken as read. Of course, newbies and secondees who arrive in the recovery departments take time to become accustomed to the system, because when they first arrive in the department they probably imagine they have arrived in the caring part of the bank, a bit like an A&E department or the emergency surgery department in a hospital.

So the customer is in the hands of the manager at “Bad Bank” and, because the customer has defaulted on his loans, every default provision in every contract, loan, guarantee and mortgage is triggered. The first thing that happen are that the interest rate  on the debts  will soar, and then lots of additional charges will be piled onto that customer, including valuation fees and investigating accountants’ fees. Default interest and extra charges adding up to tens of thousands of pounds will be added onto Hapless Pet Supplies’ original loan and overdraft of £110,000. So, after about six months of being transferred to the “Bad Bank”, Hapless Pet Supplies will owe £160,000 instead of £110,000. Remember the provision or write-down is not debt forgiveness or any waiver – it is just an accounting treatment in the annual accounts of the bank.

So what happens next? In a good outcome, the business will somehow manage to sort itself out. It might be that the business owner finds some new money (“refinance”), mortgages their home or moves  to another bank. Being in “Bad Bank” is such a distressing experience, some owner/managers will make every effort to sort out their business problems themselves. Whatever happens, however, the bank still  wants its £160,000. If it gets the money in full, it is seen as a positive outcome for the bank. The manager had told his superiors he thought he’d only get £55,000 back, but gains kudos and backslaps from his superiors for successfully clawing back the other £55,000 AND making another £50,000 on top. Inured to the pain the process might cause their customers, the bank’s senior management will see the recoveries manager’s activities as a cause for celebration and reward him with bonuses. It is a money-making, let’s milk our customers for fees, process that’s being repeated over tens of thousands of businesses that have the misfortune to cross over from Good Bank to Bad Bank. It is the inevitable consequence of running restructuring and recovery units as profit centres. And, of course, the picture is further muddied where banks have private equity or commercial property arms which have a habit of constantly scouring the Bad Bank, and sometimes even the Good Bank, for assets they can pick up on the cheap.

You may think the banks need to make a handsome profit from good outcomes, like Hapless Pet Supplies Ltd, in order to counterbalance situations in which they cannot retrieve their principal. Well, yes, there are occasions when banks get it completely wrong but these are actually very much in the minority. Remember: the bank lent Hapless Pet Supplies £100,000 and provided an overdraft of £10,000? Well you can be sure that the bank would not have lent anything like that unless it had security over at least £200,000 worth of assets. It would have had a mortgage on the company’s property as well as fixed and floating charges over everything else, and possibly personal guarantees from the owner/managers as well. The truth is, the bank never really had much chance of losing any money at all. Even if the company was put into administration the bank would probably get its money back first and, remember, it would not be looking for £55,000 – it would be looking for £160,000 and it could most probably recoup  this by asset stripping the company, leaving just enough funds to pay off the administrators and liquidators. And banks can do all this in a perfectly legal way. If a business customer detects wrongdoing in any aspect of the process and wishes to take action against the bank, one thing is certain. They will struggle to persuade a decent lawyer to take on their case. Almost every one of the top 200 law firms in the UK, both in London and the regions, is a members of the banks’ “panels”, or else would like to be on the panels or get tossed scraps of work “off-panel”. If approached, they will tell you they’re conflicted and unable to represent you.

If you want to read about the horrors that go on in the related factoring or asset-based lending industry, which is like an extreme version of what happens in the banks’ restructuring departments, I would recommend taking a look at the which gives a fairly good picture of how struggling businesses are actively targeted, milked for fees and asset-stripped by this industry.

The corporate recovery departments are essentially designed to take advantage of their customers when they are at their most vulnerable. The British Bankers’ Association ought to be leading the drive for better ethical practices, but they abandoned any such role decades ago.

James Nicholls is a lawyer, and an expert in insolvency law, who runs his own Birmingham-based practice, Nicholls & Co.

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