The bankers' new clothes

The banks' model had been to use towering quantities of leverage to make unimaginable amounts of cash by investing in exotic instruments with names such as CLOs (collateralised loan obligations), CDOs (collateralised debt obligations) and SIVs (structured investment vehicles). But the well-padded bankers failed to realise that much of what they were buying was in fact the skilfully repackaged and relabelled debt of US subprime borrowers - many of whom had little chance of repaying their loans. Greed and naivety came together to allow the bankers to believe they could banish all risk.

Last August, the party came to an abrupt end. The collapse of the US housing market meant millions of America's sub-prime borrowers - the people who had been propping up the whole edifice - started defaulting on their loans. Hubris turned to panic as frightened bankers stopped lending money even to each other and the price of risk started to escalate. Within a matter of weeks, sanity had started to prevail - at least among US and continental European bankers.

They responded with savage write-downs on the valuations of their investments in toxic debt instruments, they launched massive rights issues - meaning that they invited their existing shareholders to buy additional shares at a discount and some sacked their chairmen and chief executives. Others invited Gulf-based sovereign wealth funds to come to their aid through the purchase of large discounted stakes. Most of these investors have, perhaps unsurprisingly, already had their fingers burnt as bank share prices continued to plummet.

Until RBS's belated mea culpa last week, Britain's banks believed they could avoid such painful and humiliating steps. In a display of herd-like machismo, perhaps out of desire to prolong the debt-fuelled rave at which they had been DJs, they decided to reward their shareholders with increases in their dividends in February and March. Most also made massive additional payouts in bonuses and incentive payments to the very executive directors who had led them to the brink.

With hindsight, these payouts were foolhardy in the extreme. Apart from anything else they were a provocation to Bank of England governor Mervyn King, who had been listening for months to repeated pleas for bail-outs from UK banks and building societies to help ease the credit crunch.

The idea that the likes of RBS chief executive Sir Fred Goodwin should come bleating for handouts at a time when RBS shareholders were being rewarded with hefty dividend hikes and its directors with inflation-busting increases clearly rankled with the mild-mannered King, a relatively underpaid civil servant whose faith in the concept of "moral hazard" still stood. He couldn't understand why, unlike the rest of Europe and the US, British banks should count on bail-outs while insulating themselves and their shareholders from the pain.

Finally, a couple of weeks ago, something clicked at Royal Bank of Scotland. Goodwin and his board colleagues realised that if the government and Bank of England were going to do more to remove the financial blockages in the system, then the banks would have to do more to put their own houses in order.

"A Faustian bargain was struck," says Neil Dwane, chief investment officer at fund manager RCM. "No more nationalisations, and nearly all the liquidity you need, but existing shareholders must suffer through dilutive rights issues and dividend cuts."

This is what lay behind the extraordinary display of contrition from RBS last week. In December, while the Gogarburn-based bank was still in a state of denial, it claimed its write-downs from subprime slime were just £1.25 billion. Last week the bank admitted they would in fact be £5.9bn, more than four times higher.

Many observers wonder how on Earth the bank could have got its sums so wildly wrong. The bank's line is that "market conditions deteriorated significantly in March", but this does not wash with many investors. Other theories include poor reporting lines within the bank and the fact that middle-ranking executives within RBS's global banking and markets division may have been economical with the actualité to secure their 2007 bonuses.

RBS last week also announced a deeply discounted rights issue, with which it expects to raise £12bn to shore up its capital base and from which advisers UBS, Merrill Lynch and Goldman Sachs will earn £210 million. Not only is this Europe's largest ever rights issue it is also worth more than the entire amount RBS paid for its portion of the Dutch bank ABN Amro last year.

In what must have been an agonising decision for Goodwin, the bank also announced it will sell its general insurance division, which includes the prized assets Direct Line and Churchill, a sale that should raise an additional £5bn to £8bn. Direct Line, with its 20% share of the UK general insurance market, is already being eyed by private equity houses Kohlberg Kravis Roberts and Apax Partners.

These are humiliating steps back for Goodwin. The Paisley-born accountant is now facing demands from some investors to resign within a year. However, speaking after the AGM, his former chairman Sir George Mathewson said: "This is not the day for throwing out the baby with the bathwater." He said it would be "meaningless" and "fanciful" to set a timetable for replacing the chief executive while the bank has a lot of work to do to integrate ABN Amro.

Most in Scotland's financial services industry, inevitably seen as a "mafia" by the metropolitan provincials of the City, agree that Goodwin should stay - at least for a couple of years. This is largely because his integration skills are so sorely needed. Ben Thomson, chairman of investment bank Noble Group, said: "Sir Fred is the right person to get the existing management teams focused on getting the integration strategy right."

Willie Watt, chief executive of fund manager Martin Currie, said: "Fred has experience of the BCCI workout, and the integration of NatWest and RBS - there aren't that many people with that level of experience around."

In the City, however, it is becoming increasingly apparent that RBS chairman Sir Tom McKillop's coat is on a shooglie peg. As recently as February, the bank was insisting that no rights issue would be required - so even though it is welcome, last week's announcement represents a massive U-turn for the RBS board. Investors seem to be calling for his head partly because of his relative lack of banking experience, his apparent inability to rein in the headstrong Goodwin over aspects of the ABN Amro deal and the way in which he started last Tuesday morning's conference call with investors and analysts.

"Sir Tom opened that session in a very patronising way. While it would be difficult for him to go in the middle of a rights issue, I think he will have to go within a year," said one RBS investor.

There is still relief that RBS has grasped this particular thistle and been more open about the error of its ways than some of its rivals. Respect is also accorded to the drastic steps it is taking to restore its balance sheet. Others are likely to follow.

Analysts at JP Morgan estimate overall that British banks need to raise some £37bn to bring their capital bases into line with international norms. If this is to happen, all with the exception of HSBC will probably need to follow RBS's example and carry out rights issues.

Ken Murray, chief executive at Blue Planet Investment Management, said: "The outlook will continue to deteriorate over the next 12 to 24 months. In the face of rising incidence of defaults on residential mortgages, unsecured credit and car loans, there is going to be a whole spate of capital-raising by banks in Europe, including the UK, and America."

Carla Antunes da Silva, bank analyst at JP Morgan, believes that HBOS and Barclays are currently the two most exposed UK banks. "We don't think the lack of capital to be a RBS-specific issue. It is a systemic one. What RBS did last week will put pressure on the other UK banks, not only in terms of capital but also in terms of the level of write-downs. On our estimates, there is an £11bn capital shortfall at HBOS, £8bn at Barclays, and £4bn at Lloyds TSB."

In recent weeks, Bank of Scotland is understood to have taken three companies "to the wire" on planned debt-funding packages but pulled out at the last minutes to the dismay of the corporate executives concerned. If this sort of thing is to be avoided in future, shouldn't the bank follow RBS's example and make its shareholders suffer though a rights issue?

HBOS spokesman Shane O'Riordain gave a firm "no comment" when asked if HBOS is contemplating a rights issue, but the absence of a firm denial suggests the Edinburgh-based bank might indeed have something up its sleeve. However, the bank is seen as much less likely to sell off non-core assets such BankWest, Clerical Medical or its 60% stake in St James's Place.

Murray said: "HBOS is the most geared of all the British banks. They are in a more precarious position because they are more exposed to the capital markets to fund their business. They are also entering an increasingly difficult trading environment over the next few years and are heavily exposed to the property market."

Barclays was not giving much away on the subject at its AGM last Thursday. The bank claims to have an equity-tier-one ratio of 5.1% and chief executive John Varley declared he "wants to see our equity ratio at least at 5.25% in time". However, shareholders at the meeting seemed unhappy at the lack of clarity offered by Barclays's chairman, Marcus Agius. All he would say was that raising new capital was "an option" and that the bank was seeking to improve its capital position over time, but its superior performance to some rivals gave the bank a range of options.

Some analysts believe it is more likely the bank will seek alternative means of shoring up its balance sheet, such as tapping the sovereign wealth fund investors it brought in to help fund the abortive ABN Amro bid - Singapore's Temasek and China Development Bank - for some of the sums required.

Should other banks follow RBS's example, it will benefit from first-mover advantage. When it comes to persuading investors to dig deep into their pockets, banks that dither for too long will incur investor fatigue when it's their turn at the head of the queue.

One thing is certain. After the fiasco of Northern Rock and the banquet of humble pie at Gogarburn, Britain's banks are going to be much more carefully watched by regulators in the future. They are also going to be forced to behave more responsibly, and they are also never again going to dominate national stock-market indices as they did in 2003-07.

They may also find that regulators will do more to ensure that rather than "the great and the good" on their boards, they will insist banks have people with genuine banking experience as non-execs. Their entire approach to incentivising staff will have to be changed.

Others are even more critical of the bank's behaviour. Drayton Bird, a London-based marketing professional who has worked with all the UK's leading banks, said: "The banks have pulled off a tricky feat: they have alienated their customers, the politicians, their own staff, screwed up the world's economy - and lost billions in the process. And as a result they have destroyed mutual trust, which strikes at the heart of banking."

Not bad going.

The Scottish banking giants, which succeeded the Clydeside engineers as the world-bestriding pride of the Scottish economy, will this weekend have cause to consider their part in the great transformation.