The Dunfermline - What happened?

We are becoming numb to financial scandals. We have seen far too many. So when a mid-sized regional bank fails, it barely registers.

However, the failure of the Dunfermline building society is scandalous. Yet again, the FSA failed to properly supervise an institution that was taking unacceptably dangerous risks. It was also an institution that had a highly paid but basically incompetent management team. The FSA missed it all. Yet again, the taxpayer has been lumbered with a huge bill to clean up yet another FSA supervisory disaster.

The FSA had a opportunity to step in when the Dunfermline building society prepared their Basel II Pillar 3 Disclosures 2007 document. This submission is supposed to outline the institution's exposure to various kinds of risk. This is what the Dunfermline management said about their commercial property risk profile.

Our commercial risk appetite is confined to loans secured on property where the Society is able to achieve an adequate return for that risk, where the commercial investment is in lower risk areas, and where the Society is able to take advantage of risk mitigation such as guarantees to limit its risk.

The Society seeks to limit its risk to any one area of commercial lending by imposing sector limits.

This wasn't a terribly accurate representation of the magnitude of their commercial property exposure. The Chancellor - Alistair Darling - picked up on this point on Monday when he was forced to explain why the Dunfermline failed.

"This is a building society that, unfortunately, took out over £650million in loans in commercial property. In the last couple of years, it bought some mortgages from an American company that had gone bad. It's had to write off some of its IT systems because of difficulties it's had and it needed between £60 million and £100 million to keep it going. When you bear in mind that the society has never made more than about £5 million or £6 million a year in the recent past, it couldn't even service that sort of loan, let alone repay it.”

Presumably, someone at the FSA took a look at the Basel II document and concluded that everything was fine. Yet if someone had bothered to look at the loan portfolio, they would have quickly realized that the Dunfermline was far too exposed to a commercial property downturn.

After all, as the 2007 annual report pointed out, the institution had assets amounting to ₤3.3 billion. It had ₤117 million in capital, giving it a leverage ratio of 28. Holding a £650million exposure to commercial property was a very precarious position for a bank like the Dunfermline. The FSA should have picked this up.

The Dunfermline debacle sadly reveals that the FSA continues to incompetently supervise the financial sector. In fact, it is worse than that. The institution is dangerous. With each bank failure, it pushes huge clean up costs onto the taxpayer. In summary, it has wrecked the financial viability of UK public finances. It has to be stopped before it does any more damage.