The Inside Story of Lloyds and the Banking Crisis – book excerpt

Writer Ivan Fallon relates how Lloyds, which had spent years searching for a foreign merger partner in order to kickstart growth, cautiously moved forward as a chance arose to snatch up its domestic rival Northern Rock on the cheap in 2007.

Northern Rock customers queue outside the branch in Surrey in 2007. Chris Ratcliffe / Bloomberg News
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The past decade has been turbulent for Lloyds - but not so choppy as for some other banks in Britain. In this exclusive excerpt from Black Horse Ride: The Inside Story of Lloyds and the Banking Crisis, the writer Ivan Fallon relates how Lloyds, which had spent years searching for a foreign merger partner in order to kickstart growth, cautiously moved forward as a chance arose to snatch up its domestic rival Northern Rock on the cheap in the autumn of 2007 as the latter's housing loans began to turn rotten.


The board of Northern Rock was now meeting in more or less continuous session, nervously debating what they should do in a situation which was spiralling out of control. It was clear they needed help, either from another bank or from the government, and the Financial Services Authority (FSA) – and maybe the Stock Exchange – had to be alerted as soon as possible. The advice from the banking sector’s leading financier, Matthew Greenburgh of Merrill Lynch, was crystal clear: ‘You need a liquidity line – and you need a partner. Fast.’ The first would probably have to come from the Bank of England and the other he would get to work on at once. He immediately began to pull together a basic information pack, which would be needed for the meetings with the FSA and the Bank of England, and also with interested banks.

Once the FSA chief executive Hector Sants was brought into the picture, Greenburgh drew up a list of potential bidders, which he and the FSA, whose approval would be required, then cut back to five names, the maximum that could be approached simultaneously under the Takeover Panel rules. Lloyds was at the top, followed by the usual suspects, RBS, Barclays and HSBC.

Northern Rock, Greenburgh told the Lloyds CEO Eric Daniels, had ‘liquidity problems’, was in discussions with the Bank of England and the FSA about support but had concluded that its best plan was to merge with a stronger bank. At this stage, he said, he was basically assessing the level of interest among possible buyers and he was not yet in a position to talk about price. ‘Obviously, it’s not going to be at market,’ he emphasised, ‘the current price (over 600p a share) is irrelevant. Certainty rather than price is the main consideration.’

But it would have to be done at great speed. Northern Rock, Greenburgh went on, was due to provide the markets with a trading update in early October and that would now have to be brought forward and its liquidity problems disclosed. Daniels could guess the rest of that scenario – additional pressure on funding, mass withdrawal of deposits and, unless it was bailed out, a death spiral in the business, possibly even a run, although he didn’t let his imagination go that far.

Daniels’s instinct was to say ‘no’ to Greenburgh. He didn’t like Northern Rock’s aggressive selling tactics and was even less keen on its funding model, and he could sense all sorts of complications, including competition problems (although the FSA offered to help on that front) if he mounted a rescue operation.

‘There’s significant value here at the right price – and we’re talking a fraction of market,’ Greenburgh urged. ‘Northern Rock is a really strong player in the mortgage market and, combined with Lloyds, you’d have the biggest distribution reach in the industry.’

Northern Rock didn’t fit into the cross-border merger strategy which Daniels had been telling the City and press about for two years, but then that wasn’t working anyway and he was becoming thoroughly disillusioned with traipsing around Europe pandering to egotistic bankers who had no intention of surrendering their sovereignty in the first place. What if he reversed the strategy, seized the opportunity to get through the competition rules and grabbed Northern Rock when it was being offered to him on an exclusive basis at a knock-down price? He would never get the chance again. It might be difficult to explain to the City and might threaten Lloyds’s reputation as a low-risk bank. But, on the other hand, it could be presented as a return to the long-time Lloyd’s chairman Sir Brian Pitman’s strategy, still much admired in the City, of expanding UK market share through acquisitions, stripping out large chunks of costs along the way, and injecting growth back into the retail side of the business. It might kill any chance of going for HBOS, the really big prize, but he didn’t think that would ever be available anyway. The more he thought about it, the more interesting it became.

Start and stop

By the beginning of September Greenburgh was down to just one potential buyer: Lloyds. He and Sants had talked to the chief executives of all the other potential bidders, but only RBS, probably out of respect for Greenburgh, expressed more than a desultory interest.

Daniels called Greenburgh to say he was willing to enter into discussions with Northern Rock but only on the condition that Lloyds could get a two-year funding package from the Bank of England. They could discuss price later, but he would be looking at a ‘fraction’ of the existing price, something nominal. Daniels knew that Northern Rock was already talking to the Bank about emergency funding, and he now proposed that Lloyds, with Northern Rock’s permission, should approach the Bank with its own proposal. He would be seeking a £30 billion facility, a sum which even the Bank of England could not take on its own balance sheet without a guarantee from the Treasury. This would not have been a cash injection or recapitalisation, which is what occurred more than a year later – simply a guaranteed line of liquidity which could be used to repay the Northern Rock loans as and when they fell due. The Bank would lend money at normal commercial rates and take securitised mortgages on its books as collateral, fully covering itself in the event Lloyds defaulted. There would be no risk and the facility would not rank as government debt – it would sit on the Bank’s balance sheet, matched by at least an equal amount of securities.

If the markets re-opened, the strength of the Lloyds reputation and balance sheet might mean not all – or even none – of it would be needed, but Daniels was not going to take any chances on that. ‘Eric was demanding certainty,’ says a Lloyds director, ‘and he was right.’

Later there would be questions asked as to what exactly Lloyds’s intentions were towards Northern Rock and just how serious it was about taking it over. ‘I felt they were merely sniffing around for a bargain,’ the chancellor of the exchequer Alistair Darling said dismissively. The Bank of England governor Mervyn King was equally scathing, remarking later that at no stage did Lloyds table a firm offer, and the prime minister Gordon Brown repeated that message in the House of Commons.

In fact Daniels and the Lloyds chairman Sir Victor Blank were serious enough to call a board meeting for Monday 10 September to approve a deal they expected to be agreed by the weekend and announced the following Tuesday. ‘They were pretty keen to go ahead and they knew it had to be done quickly,’ says one of the advisers. ‘And if they’d got their line of credit from the Bank of England, they would have bought it.’

Decision time

Daniels had driven his team hard in the last three weeks, hammering out the bones of a structure in which Northern Rock would be merged with Cheltenham & Gloucester - a former building society taken over by Lloyds several years earlier - with the Lloyds mortgage business moved on to its more sophisticated systems with considerable benefit in both cost savings and cross-selling. One of the critical components of the model was the forecast for house prices over the next few years, and the Lloyds economics team was remarkably sanguine (and wrong) about that, estimating they would remain level during 2008 and experience ‘a mild pick-up’ after that. On that basis the model threw up some juicy figures.

Even if house prices remained flat for the next three years – the most pessimistic assumption – the team concluded that the business value of Northern Rock to Lloyds would be £2.5–3 billion. At the right price, it could be one of the great bargains of its day and would sort out Lloyds’s growth issues for the next few years at least.

Daniels, after subjecting the figures to a further series of stress tests, took Blank through the funding issues, setting out clearly the degree of Bank of England support he was asking for. The Lloyds team, working with Merrill’s, had meticulously valued the Northern Rock securities and loans which fell due over the next two years, working on the most pessimistic assumption that none of them would be rolled over and nothing new could be raised from the markets. On that basis, Northern Rock needed £10 billion of funding in the first three months alone, £20 billion within six months and £30 billion in the first year. The comparative tables prepared by his team starkly highlighted the vulnerability of the Northern Rock funding model: deposits from savers accounted for only 24 per cent of total funds compared to a healthier 56 per cent for Lloyds and 71 per cent for Nationwide which had remained as a building society and was the most conservatively funded of all the UK banks. Even HBOS, for all its wholesale dependency, still raised 44 per cent of its funding requirements from its depositors, a legacy of its building society days.

If Lloyds absorbed Northern Rock, the total funding required over two years would be nearly £60 billion, including a ‘shock’ amount, estimated at £9 billion, which Lloyds reckoned could be withdrawn by savers once the news of Northern Rock’s problems became public knowledge. As what he called a ‘sweetener’, Daniels offered to fund half of that if the Bank of England would guarantee the other half. ‘I don’t know where the markets are going to go,’ he told Greenburgh, ‘but if everything closes I need to have cash and liquidity from somewhere. I want a line of £30 billion for the first year and £15 billion for the second, although I don’t think I’ll need it in year two. We’re not entirely happy about the book, but we can work with that – but we can’t get our heads around the funding issue.’

‘What happens if we don’t get the funding?’ asked Greenburgh.

‘Then it’s a non-starter,’ Daniels replied firmly.


King, by now under siege from all quarters, including his own Court of Directors, called an emergency meeting at the Bank on the evening of Thursday 13 September. He and the FSA chairman Callum McCarthy, he told them, had just advised Darling to authorise a liquidity facility to the stricken bank which would carry the same penalty rate he had demanded from Lloyds. There was, he agreed, ‘the potential for some commentators to suggest we are doing a U-turn’ by comparing his recent statements with what he was proposing now. The minutes of the meeting indicate he remained defiant on that front: ‘There was a clear distinction to be drawn between moral hazard of a general bailout to banks … and the type of collateralised assistance considered here.’ That distinction would be lost on the City, on Darling, on MPs and on the commentators who would roast him over the coming weeks and months for his intransigence and lack of foresight when it was needed.

Whatever the level of debate in the Court that evening, the Governor had gone through the motions, got the approval he technically needed for what he called ‘the most significant lender of last resort facility since the lifeboat episode in the seventies’, and had his Court-approved statement ready to go. His intention was that the Northern Rock facility would be announced after the weekend, but Darling, fearing the story would not keep that long, insisted it should go out the next morning, Friday 14 September. They never got that far. The meeting at the Bank broke up at seven on Thursday evening and within minutes details of the bailout were running live on prime-time television. The BBC’s economics editor,

Robert Peston, who was to have scoop after scoop during the events that followed, revealed that Northern Rock was in trouble and had been forced to seek support from the Bank of England. ‘But,’ he added disingenuously, ‘no one should panic.’

Of course that’s precisely what everyone did, including the government and officials. The national newspapers hastily remade their front pages to lead with the story which dominated the late news bulletins and the early morning news. By seven the next morning, just twelve hours after the meeting in the Bank, Darling was forced to announce that he had authorised the Bank of England to provide a liquidity support facility ‘to help Northern Rock to fund its operations during the current period of turbulence’. The FSA, he added, ‘judges that Northern Rock is solvent, exceeds its regulatory capital requirement and has a good-quality loan book’.

The statement simply fanned the flames. By eight o’clock queues began building outside Northern Rock’s branches and by nine they were stretching around the block. There were only two branches in London with two tills each to handle depositors, and dealing with each customer took time.

At first the bank staff tried to persuade customers their money was safe and they didn’t need to panic, but that caused the queues to get even longer. By mid-morning TV footage of lines of depositors, bearing flasks of tea and deckchairs, were flashing around the world, and by lunchtime it had turned into a full-scale bank run, which for any financial regulator – or government – was the stuff of nightmares. No self-respecting banker could watch the scenes on TV without a shiver of terror as the relentless 24-hour news programmes beamed it onto their office screens.

As King and Darling both later admitted, depositors were merely doing the logical thing: protecting their savings, and no one could blame them for that. It was the officials and the board of Northern Rock who had to bear the blame.

In Downing Street, Gordon Brown watched in growing disbelief the first bank run on a British bank in 141 years (Overend, Gurney & Company collapsed in 1866). He later remarked, ‘It was like a scene in a film or a picture in a text book, but not something I had ever expected to see in my lifetime or under our watch.’ It was, he added, ‘the first sign the British people had of the global banking problems that would eventually overwhelm our largest banks’. And in a swipe at  King, he added: ‘It was a disastrous outcome after what should have been a straightforward bank rescue.’

Next door in No. 11, an equally shaken Alistair Darling determined he would no longer be pushed around by King. ‘I was damned if our reputation was going to be destroyed over the failure of a small, reckless bank,’ he said later. ‘We had to stop this run and regain control of events, no matter what it took.’

That day Brown and Darling, who were barely on speaking terms after a series of slights and policy disagreements, decided to take the momentous step of guaranteeing that every penny of savers’ money in Northern Rock was safe, a desperate measure which they hoped would stem the immediate panic. But there still remained the problem of what to do with the stricken bank. ‘I had concluded that we would have to offer a guarantee to savers in Northern Rock,’ wrote Darling, ‘but if we could link it to a purchase by Lloyds … that might do the trick. I was reluctant to provide an open-ended guarantee to depositors without being able to say that the bank had been purchased and thus ending the crisis.’ The Bank of England, rather than the FSA, was given the task of trying to re-open talks with Lloyds, the only major bank which might be remotely interested, even if the Bank of England made a credit facility generally available.

Daniels was in Paris on a shareholders’ roadshow on Monday morning when he got a call from the Bank of England’s Sir John Gieve. ‘Where do you think this is all going to go?’ asked the deputy governor.

‘Think £10 billion a day,’ replied Daniels laconically.

Gieve then indicated there had been a change of mind over the weekend and asked would Lloyds still be interested in Northern Rock if the Bank supported a rescue. ‘What would it take for you to do it?’

A week earlier, Daniels would have done the deal. But the situation had changed dramatically with the run and the Lloyds CEO reckoned Northern Rock had now gone past the point of no return. A rescue would only focus attention on Lloyds – no one knew how the Northern Rock contagion might spread and if ever there was a time to be cautious, this was it. Politely but firmly he told Gieve that, even with a guaranteed line of liquidity, it was too late. Lloyds could not enter into discussions to rescue a bank that was in the middle of a run.

When the message was passed back to the Treasury, a disconsolate Darling trooped next door to No. 10 to give the Prime Minister the news, adding that not only would there be no rescue, but they would now have to guarantee not just savers’ deposits but also funds, amounting to billions, deposited with Northern Rock by local councils and commercial bodies. The chancellor announced the blanket guarantee a few hours later at a press conference in the Treasury, standing beside Hank Paulson, the US Treasury Secretary who happened to be visiting London for routine talks. Watching the scene in bemusement, Paulson shook his head and remarked to Darling: ‘Your guy Mervyn sure does have a high pain threshold.’

For his part, Sants still burns with anger at the way things worked out:

“I believe to this day that the Bank of England’s decision was one of the biggest mistakes made in the UK in this period. If we had stopped Northern Rock failing in a disorderly fashion, we would have been seen as the leader by the rest of the world and in control of the situation. Lloyds, with a liquidity guarantee, could easily have absorbed Northern Rock whose balance sheet actually wasn’t that bad.”

The Aftermath

Northern Rock was eventually taken into full government ownership. It proved a precursor to the biggest banking crisis in British history: the collapse of the Wall Street bank Lehman Brothers in September  2008 was followed by the collapse of Royal Bank of Scotland (RBS) and Halifax Bank of Scotland (HBOS), respectively the second and fourth biggest banks in the UK. Lloyds, after the personal intervention of Gordon Brown, bailed out HBOS with the aid of a £21 billion capital injection from the government. Over the next two years it had to write off more than £45 billion of HBOS losses. The UK government has sold off most of its Lloyds shares at a profit but still owns 85 per cent of RBS.

* Extract taken from Black Horse Ride: The Inside Story of Lloyds and the Banking Crisis by Ivan Fallon. Available now from The Robson Press.

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