1Introduction
Why HBOS failed
1.In 2007 there was a sharp deterioration in credit conditions and an increasing number of UK financial institutions began to run into difficulty. Initially HBOS, as one of the UK’s larger banks, was viewed by some as a safe harbour in challenging times.1 However, beginning in the spring of 2008, investors and depositors began to question its ability to weather the storm facing the UK and global economies.2
These concerns were validated later in the year when HBOS was forced, along with RBS, to seek emergency liquidity assistance (ELA) from the Bank of England.3
2.In 2012, the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA) began work on a review intended to examine the causes behind the collapse of HBOS. This review culminated in a report - ‘The failure of HBOS plc (HBOS)’ - published in November 2015, which identified a number of reasons why HBOS failed.4
3.The cost of both HBOS’s and the regulator’s failings was high. Although HBOS was acquired by Lloyds TSB in 2009, a number of government-led financial interventions were needed to stabilise its balance sheet, eventually totalling over £20 billion.5
The role of HBOS’s Board
4.While the PRA/FCA report into the failure of HBOS makes clear that broader macroeconomic conditions both before and during the crisis had a role to play, there were also a number of factors specific to HBOS that made the firm particularly vulnerable to a change in external conditions.6 Charts 1 and 2 illustrate the extent to which HBOS’s share price and CDS spread underperformed relative to other banks during the crisis.7
5.First, the PRA/FCA report attributes ultimate responsibility for HBOS’s failure to its Board. In particular, the report argues that the Board failed to instil an appropriate culture at HBOS or to set out a clearly defined risk appetite for the firm, both of which had significant consequences for HBOS’s business strategy.8 The report also finds that the Board did not provide effective challenge to the HBOS executive during the review period. For instance, there was little evidence of the Board debating the firm’s reliance on wholesale funding or the risks associated with high levels of asset growth. The outcome of this was that the risks facing HBOS at a Group level were never fully articulated or addressed.9
| Chart 1: HBOS and other large UK banks’ share prices | Chart 2: Large UK banks’ three-year CDS spreads on subordinated debt |
 |
 |
Source: PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, Bloomberg
6.In attempting to explain the failure of the Board to address the risks facing the firm, the PRA/FCA report suggests that “as a group, the non-executive directors (NEDs) on the Board lacked sufficient experience and knowledge of banking.”10 For example, only one of the twelve NEDs on the Board during the review period held direct banking experience.11 The report argues that this lack of expertise hindered the ability of the NEDs to hold executive management to account. The Board was also responsible for the bank’s business strategy, but only played a small role in its formulation.12
Business strategy
7.HBOS’s business strategy was also identified by the PRA/FCA report as a key factor in explaining the failure of the bank, in particular HBOS’s focus on a series of ambitious growth and market share targets. The report notes:
The Group put itself under pressure to maintain an increasing level of income. As margins declined on all forms of lending, a search for yield pushed it towards more risky propositions. Each of the lending divisions experienced an increase in its risk profile as it sought to grow income levels.13
8.One consequence of this strategy was that as returns declined in some areas of the business, pressure increased for other parts of HBOS to compensate for this by growing faster. This was the case in 2007 when growth targets for the Corporate division were revised up to offset falling returns in the Retail division.14 This posed risks as it was undertaken at a time when the Corporate division already had significant exposures on its balance sheet to the highly cyclical commercial real estate and construction sectors. For example, the PRA/FCA report notes that by the end of 2007 almost half the Corporate division’s lending (£68bn) was directly to, or dependent upon, the property sector. This was up from just over a third of lending in 2001.15 The Corporate division also took equity stakes in businesses, adding to its risk profile.16
9.In theory, HBOS’s International division, another area earmarked for higher growth, could have been a source of diversification for the Group. The PRA/FCA report notes, however, that the International division’s lending was often concentrated in similar sectors to the Corporate division, meaning it was also exposed to a cyclical downturn in commercial property markets.17 The outcome was that the decision to respond to lower growth in retail by pushing for higher growth in other areas of the Group increased HBOS’s overall risk profile. It also led to a significant expansion in its asset base, particularly in the International and Corporate divisions, as shown in table 1.18
10.The PRA/FCA report also identifies problems within HBOS’s Treasury division. The report notes that, from 2004 onwards, HBOS’s Board took the decision to allocate more of the Treasury portfolio away from gilts towards AAA rated securities.19 Although this was not uncommon by the standards of the time, it would add to HBOS’s difficulties during the financial crisis. For instance, the report cites the disclosure by the firm in its 2007 trading statement, showing it held significant amounts of Asset-Backed Securities (ABS) and Alt-A mortgages in its debt securities portfolio, as a factor that led to a deterioration in investor sentiment regarding the firm.20 The deficiencies in credit ratings generally, as well as the decline in market liquidity, also meant that many assets within the secondary liquidity portfolio, such as ABS, would have been poor substitutes for gilts during the crisis.21
11.Although other UK banks also had ambitious growth targets during this period, the PRA/FCA report asserts that a combination of factors within HBOS’s business plan generated unique balance sheet vulnerabilities.22 One area of weakness was HBOS’s funding profile. Customer loan growth exceeded customer deposit growth by five percentage points over the review period, meaning HBOS became increasingly reliant on wholesale funding. For example, from 2004 to the end of 2007, HBOS’s wholesale funding needs increased £95bn; its loan to deposit ratio also increased sharply.23
12.The PRA/FCA report notes that HBOS’s Board was aware of the firm’s reliance on wholesale funding. The Board’s concerns, however, mainly related to the risks this posed to future growth, rather than to the soundness of the bank. Thus, although some mitigating action was taken by the Board, HBOS’s overall funding requirements remained large on an absolute basis and would leave the firm vulnerable to the deterioration in credit conditions and the securitisation market in 2007–08.24 HBOS’s funding position was also complicated by its commitments to its Asset Backed Commercial Paper (ABCP) conduits such as Grampian.25 The result was that as the crisis worsened, HBOS initially had to increase its reliance on central bank funding schemes, as well as reducing the average term of its borrowing, before eventually even exhausting these options.26
Table 1: HBOS total assets and growth by division 2004–08 (as at 31 December)
|
£ billion |
2004 |
2005 |
2006 |
2007 |
2008 |
Compound annual growth |
|
Retail |
209 |
225 |
243 |
260 |
266 |
6% |
|
Corporate |
82 |
87 |
97 |
122 |
128 |
12% |
|
International |
37 |
50 |
61 |
76 |
68 |
16% |
|
Banking divisions |
328 |
362 |
401 |
458 |
462 |
9% |
|
Treasury and Asset Management |
85 |
107 |
107 |
120 |
147 |
15% |
|
Total banking activities |
413 |
469 |
508 |
578 |
609 |
10% |
|
Insurance and other group items |
64 |
72 |
83 |
89 |
81 |
6% |
|
Total group assets |
477 |
541 |
591 |
667 |
690 |
10% |
Source: PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, HBOS Annual Reports and Accounts, Review calculations
Weak controls and risk management
13.The problems posed by HBOS’s business strategy were exacerbated by the bank’s deficient control and risk management framework. HBOS, in common with several other financial firms, operated a three lines of defence risk management model. The first line consisted of the divisional-level risk management framework, followed by the second line of Group risk functions, and finally the third line of the various Group audit and internal audit bodies.27
14.The PRA/FCA report found problems with all three components of this framework. The report states that divisional-level controls were often “ineffective” and “did not keep pace with the rapid growth that these divisions experienced”.28 This was then compounded by weaknesses within other parts of the Group’s control framework. The Group risk function, the second line, suffered from high levels of staff turnover and a lack of expertise.29 The report also found little evidence of challenge from the third line, the Group Audit Committee. 30 Alongside the Board’s failure to establish a risk appetite for the firm, this meant HBOS lacked the means effectively to measure and control the risks resulting from its business strategy.
15.The dangers posed by HBOS’s business strategy and weak controls became apparent during the financial crisis. Despite the sharp deterioration in macroeconomic conditions, the Corporate division continued to grow its balance sheet up until the summer of 2008. Besides weaknesses in HBOS’s risk management framework, this also reflected a number of other problems within the firm.31 First, the report notes that the bank adopted a culture of lending “through the cycle”.32 This meant that it continued to extend loans to certain clients in spite of the worsening economy. Secondly, even when the decision was taken to halt asset growth, HBOS struggled to do so. This was partly a result of HBOS’s weak loan distribution function, as the Corporate division would often grant loans it intended to distribute without first lining up a set of buyers.33Once the syndication market turned, this meant Corporate had to keep a series of loans on its balance sheet that it had intended to sell down.
The FSA’s supervision of HBOS
16.The PRA/FCA report also concludes that there were failings in the FSA’s supervision of HBOS. According to the report’s findings, these were caused by senior FSA management devoting too little attention and resource to prudential oversight of HBOS. The resulting supervisory regime was reactive, placed too much trust in senior HBOS personnel and did not adequately monitor the credit and liquidity risks facing the bank.34 The regulatory failings identified in the PRA/FCA report are discussed more fully in Chapters 3 and 4 of this report. 35
Role of the Parliamentary Commission on Banking Standards
17.The Parliamentary Commission on Banking Standards (PCBS) published its own report into the failure of HBOS in April 2013.36
18.The PCBS’s report identified the risks posed by HBOS’s decision to adopt a strategy of “aggressive, asset-led growth across divisions”.37 It estimated that over the period 2001–08, total HBOS loan growth outpaced customer deposit growth by five percentage points, a similar figure to that established by the PRA/FCA report, increasing HBOS’s reliance on wholesale funding.38 Despite this, in evidence to the PCBS, some former HBOS executives and Board members argued that HBOS’s strategy had been relatively conservative.39 The PCBS disagreed with this view, however, noting that following the onset of the financial crisis, impairments in HBOS’s loan book were much higher than other comparable banks; the PCBS estimated that the 2008 Corporate division loan book suffered impairments of up to 20 per cent.40 To the PCBS, this suggested that HBOS’s growth was neither conservative nor the result of superior performance but stemmed from a high-risk strategy.41
19.In line with the PRA/FCA report, the PCBS found that HBOS’s Corporate division had concentrated exposures to certain sectors of the economy, including a large portfolio of loans to property-based borrowers. In some cases the Corporate division also provided a “complete funding package”, which sometimes included taking equity stakes in businesses. The PCBS noted that some elements of the Corporate division’s strategy were also replicated in the International division, especially the focus on the property sector. As a consequence, impairments in the International division were eventually even higher as a proportion of loans than in Corporate.42
20.The PCBS similarly concluded that the quality of the internal control environment within HBOS was poor. One significant problem was HBOS’s federal structure.43 In theory the bank’s various divisions could still be controlled by the Group. Yet the PCBS heard evidence that the amount of challenge of the Corporate and International divisions by Group-level executives was low, meaning there was not an effective central check on these divisions’ strategies.44 A second problem was deficiencies within the Group risk function, which the PCBS described as a “cardinal area of weakness”.45 Again, to an extent this was found to be because the “centre of gravity” lay with the divisions and was due to a lack of expertise in certain key risk roles.46 Overall these flaws contributed to a weak control environment, leading to HBOS incurring significant losses during the crisis.47
21.The time constraints imposed on the PCBS meant there were a number of points where it was unable to conduct further analysis. It therefore identified eight areas where it requested the regulators undertake additional work. These are addressed in an appendix to the PRA/FCA report.48This report seeks to focus more closely on the lessons for regulators from the HBOS reports, rather than the specific decisions and individuals responsible for HBOS’s demise, given that the PCBS - and now the regulators - have covered the latter in extensive detail.
22.The Parliamentary Commission on Banking Standards’ (PCBS) report, published in April 2013, reached similar conclusions to those of the regulators. Both emphasised the primary responsibility of the Board for determining HBOS’s business strategy, the poor state of HBOS’s internal controls and the risks posed by high rates of asset growth as key factors in explaining the demise of the firm. The PCBS report argued that many of these shortcomings were unique to HBOS. The scale of its losses could not just be blamed on the deterioration in the UK and global economies at the time of the financial crisis. This assertion was supported by evidence in the final regulators’ report, showing that impairments as a percentage of the loan book were twice as high at HBOS as at RBS.
1 PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, p 132
2 Ibid, p 21
3 Ibid, p 14
4 Ibid, p 9
5 Parliamentary Commission on Banking Standards, Fourth Report of Session 2012-13, “An accident waiting to happen” – The failure of HBOS, HL Paper 144/HC 705, 4 April 2013, Para 2, p 3
6 PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, p 14
7 Charts 1 and 2: PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, p 21 [Chart 1.1-1.2]
8 Ibid, p 14
9 Ibid, pp 29-30
10 Ibid, p 29
11 Ibid
12 Ibid, p 30
13 Ibid, p 18
14 Ibid, p 79
15 Ibid, p 62
16 Ibid, p 18
17 Ibid
18 Table 1: PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, p 24 [Table 1.1]. Notes from report: HBOS Annual Reports and Accounts and Review calculations. 2004 has been adjusted to reflect the introduction of International Financial Reporting Standards from 2005. A number of transfers of business took place between the divisions in 2007 and 2008. No adjustments have been made to restate the earlier periods for these transfers (e.g. the European corporate business of International transferred to Corporate in 2007 and is only shown as part of Corporate for 2007 and later. Prior to 2007 this business is included within International).
19 Ibid, p 120
20 Ibid, p 21
21 Ibid, p 131
22 Ibid, p 24
23 Ibid, pp 26-27
24 Ibid, p 27
25 Ibid
26 Ibid, pp 135-6
27 Ibid, p 198
28 Ibid, p 30
29 Ibid, p 225
30 Ibid, p 31
31 Ibid, pp 78-80
32 Ibid
33 Q 68
34 PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, p 15
35 The main findings of the PRA/FCA report are outlined in full in Appendix 1.
36 Parliamentary Commission on Banking Standards, Fourth Report of Session 2012–13, “An accident waiting to happen” – The failure of HBOS, HL Paper 144/HC 705, 4 April 2013
37 Ibid, para 19, p 8
38 Ibid, para 16, p 7
39 Ibid, paras 17-18, p 8
40 Ibid, para 28, p 12. An impairment charge is defined in the PRA/FCA report as the estimated loss on an impaired asset that is charged to the income statement
41 Ibid, paras 30-32, p 13
42 Ibid, pp 9-15
43 Ibid, para 53, p 19
44 Ibid
45 Ibid, para 64, p 22
46 Ibid
47 PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, pp 71-72. “Impairment losses on loans and advances experienced by RBS between 2008 and 2011 amounted to £38 billion or 4.5% of its 2008 loan book. This was less than the £44.7 billion impairment losses incurred by HBOS over the same period, at a loss rate of 10%.”
48 PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, pp 362-75 [Appendix 4]
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22 July 2016