4The FSA’s approach to supervision
97.In 2004, the FSA sent an interim ‘ARROW’ assessment to HBOS which highlighted a number of weaknesses within the firm.141 In particular, the FSA emphasised the need for HBOS to embed an appropriate risk management and control environment, given the ambitious level of growth being pursued by the firm. The ARROW assessment also cited the risks posed by the Corporate division’s exposure to commercial property and the need for HBOS to have a contingency plan in the event that it faced funding difficulties.142 As the PRA/FCA report notes:
These priorities were set out in the January 2004 interim ARROW letter and were a reasonable and early articulation of the risks that would eventually crystallise and cause HBOS to fail.143
98.The fact that these risks were allowed to eventually crystallise and contribute to HBOS’s failure four years later suggests that there were deficiencies in the FSA’s supervision of the bank.
99.One theme identified by the PRA/FCA report was the willingness of the FSA to rely on HBOS’s senior management and controls to resolve prudential issues as they arose. In practice, this meant that the FSA would assign actions to the firm and then:
request confirmation that the actions had been undertaken but the level of supervisory follow up would be based on judgements about the amount of reliance that could be placed on the firm and the perceived importance of an issue.144
100.Over time, the FSA’s willingness to rely on HBOS’s senior management appears to have increased. In particular, this supervisory approach was codified as part of the FSA’s ‘regulatory dividend’ policy.145 This meant that firms that co-operated with the FSA and were thought to have effective control frameworks would benefit from less intensive supervision.
101.In the case of HBOS, the application of this policy meant that in 2006 the FSA reduced the number of items outstanding on the firm’s Risk Mitigation Programme (RMP), a running list of the main concerns the FSA wanted HBOS to address, and transferred some to the less intensive Close and Continuous supervision process (C&C).146 As the report notes:
The initiative did result in key issues being removed from supervision’s only formal tracking framework as the discipline of setting milestones for review or deadlines for action to be taken did not apply to the C&C programme. As a consequence, the pace of remediation of issues appears to have slowed. For example, some issues included in the April 2008 RMP … were broadly similar to issues identified in the December 2004 ARROW and subsequently transferred to C&C supervision in June 2006.147
102.The report adds that the decision to reduce the number of items on HBOS’s RMP led to an “even greater reliance being placed on HBOS senior management and Group control functions to confirm that issues had been addressed”.148 The FSA, meanwhile, only conducted limited amounts of testing to check whether problems had been fully resolved.149
103.The FSA also appeared willing to accept the assurances and judgement of HBOS’s senior managers in other significant areas. An example of this was HBOS’s decision to appoint a non-specialist to the role of Group Risk Director, a post with important responsibilities in terms of risk management and dealing with the FSA’s Supervision team. Although the FSA queried the appointment, it did not prevent it from taking place.150 In evidence to the Committee, Andrew Bailey said that this was not a reasonable decision. Comparing this to the current regime, he added:
If somebody had no background in risk, they would have to have some very special talent that had not been previously revealed to be acceptable for the role.151
104.The FSA’s reliance on HBOS to resolve prudential and conduct issues proved damaging because HBOS’s control framework was ultimately shown to be deficient. The PRA/FCA report highlights that, while in many areas HBOS’s approach was coherent on paper, it was often implemented poorly, such as the three lines of defence model discussed earlier in this report (see Chapter 1). The reliance on HBOS’s controls was also misguided because of the poor state of the management information collected by the firm. The PRA/FCA report notes that this was especially the case in the Corporate division. For instance, a 2008 internal HBOS document recorded concerns that, among other things, collateral values were not being accurately recorded.152 The PRA/FCA report adds that the poor state of corporate management information became more important during the crisis as it “disguised the extent to which lending was continuing to grow despite the decision to slow it down and provided misleading information on exposures.”153
105.The problems of poor management information also extended to the ‘Blue Book’ provided to HBOS’s Board, which the PRA/FCA report found often included “an imbalance in coverage given to ‘good’ news relative to ‘bad’ news”.154 In theory, HBOS’s Board should have been the ultimate check on the risks taken by the firm. The PRA/FCA report suggests, however, that HBOS’s earlier success meant key Board members displayed a degree of complacency about the risks facing the bank.155
Process over substance
106.Besides the decision to rely on HBOS’s senior management, the FSA’s approach to supervision was also undermined by the emphasis placed on a number of process, rather than judgement, intensive tasks. The most notable example of this was the implementation of Basel II standards. This absorbed significant supervisory resource and became the major theme of the supervisory relationship with HBOS. As the PRA/FCA report notes:
In the long run, some benefits might have resulted from this new bank capital adequacy regime, which required more detailed assessment of asset-specific risks. However, considerable work was still required by HBOS in 2008 and many planned model changes were not approved prior to its failure. As a result, the devotion of significant FSA resources to Basel II implementation did not make a significant contribution to making HBOS, or any other major bank, more robust in the face of the financial crisis.156
107.There is also the risk, identified by the PCBS, that the use of the Basel framework ultimately distracted the FSA from focusing on the key prudential risks within HBOS’s balance sheet.157 The PCBS noted regulators needed:
to avoid placing too much reliance on complex models rather than examining actual risk exposures. Regulators were complicit in banks outsourcing responsibility for compliance to them by accepting narrow conformity to rules as evidence of prudent conduct. Such an approach is easily gamed by banks, and is no substitute for judgement by regulators.158
108.The PRA/FCA report also cites the decision by the FSA to develop a new ARROW II framework as an example of an initiative that resulted “in too much focus on process rather than substance”.159
109.The consequence of both the reliance on HBOS’s senior management and the heavy burden of process-led work meant that the FSA’s supervisory regime paid inadequate attention to the important issues of asset quality and liquidity.
110.Stuart Bernau supported this assessment, suggesting that the time spent on conduct and other matters meant the regulators “had not really focused on the capital implications of a downturn in the economy or the liquidity position”.160 In evidence to the HBOS review, some FSA staff at the time appeared to justify the less intensive and ultimately reactive regime, as well as their unwillingness to criticise banks’ business models, on the need to avoid becoming shadow directors. The report notes that:
FSA executive management did not define it as part of supervision’s role to criticise a firm’s business model and FSA staff were told that they should not get into the position of being shadow directors. As a result, supervisors did not always reach their own judgements on the key business challenges and strategic risks in firms’ business models, based on in-depth, rigorous review. Without in-depth analysis of a firm’s strategy, the supervision team’s ability to assess the adequacy of the underlying control framework was undermined. FSA staff could have done this without acting as shadow directors.161
111.Andrew Bailey agreed with this, noting that he did not feel that becoming a shadow director was actually an “issue”.162
112.These supervisory failings were discussed extensively by the PCBS which summarised its concerns by stating:
From 2004 until the latter part of 2007 the FSA was not so much the dog that did not bark as a dog barking up the wrong tree. The requirements of the Basel II framework not only weakened controls on capital adequacy by allowing banks to calculate their own risk-weightings, but they also distracted supervisors from concerns about liquidity and credit; they may also have contributed to the appalling supervisory neglect of asset quality.163
113.The FSA initially demonstrated a good grasp of the problems that would cause HBOS to fail, yet over time the quality of supervision deteriorated markedly. The focus of the FSA’s work shifted to process or box-ticking exercises, at the expense of prudential oversight of the firm. The consequence was a supervisory approach that failed to engage with the prudential risks accumulating on HBOS’s balance sheet. The Committee agrees with the PCBS’s assessment that this was thoroughly inadequate.
114.The decision to assign a lower priority to prudential supervision did not occur by accident, but by design. The FSA Board and senior FSA executives chose to focus the organisation’s attention on conduct issues and the implementation of Basel II. They also supported a supervisory approach that placed a growing reliance on HBOS’s senior management to rectify prudential concerns. The FSA rightly held the Board of HBOS responsible for the firm. But it did too little as a regulator to ensure that HBOS was taking the necessary remedial action on areas of prudential concern. In particular, the FSA had an inadequate understanding of the asset quality and liquidity risks within the firm.
115.The case of HBOS demonstrates that detailed rules are no substitute for high-quality supervision. The challenge now for regulators is to rely less on bureaucratic processes and instead to demonstrate that they can exercise more balanced judgement across a complex financial system. This is no easy task.
External pressure
116.The PRA/FCA report argues that other factors, specifically the external environment in which the FSA operated, also influenced the approach to regulation. This included:
A sustained political emphasis on the need for the FSA to be a light-touch regulator in order to retain the international competitiveness of the UK’s financial system… [and]
A consensus among practitioners and policy-makers that financial innovation and complexity had made the financial system more stable at a time of benign economic conditions.164
117.In evidence to the Committee, Iain Cornish - one of the independent reviewers - agreed that there had been an agenda of light touch regulation, although he added that the FSA Board had been very comfortable to “buy into” that particular approach.165
118.In evidence, Andrew Bailey also picked up on this theme, noting that prior to the crisis the FSA’s job was made harder as many external observers viewed HBOS as a success story, and the financial industry in general as the “goose that was laying the golden egg”, and cautioned against tougher supervision.166 In contrast, Andrew Bailey added that in future the regulator needed to ensure it did not “bend either way” in response to external pressure, and instead applied a consistent standard of regulation.167
119.This aspiration is reflected in one of the PRA/FCA report’s recommendations around the “will to act”, which states:
Where intervention is warranted, the regulators must be willing and able to do so free from undue influence, in particular when markets are benign and in the face of changing public policy priorities.168
120.The regulators have repeatedly asserted that they operated in an environment which encouraged ‘light touch’ regulation. This point may have merit but it does little to justify the severe flaws in the supervision of HBOS. In its report on RBS, the Treasury Committee in the last Parliament correctly identified that the FSA was given statutory independence to enable it to resist political pressure. The FSA’s past recourse to political encouragement to promote ‘light touch’ regulation does not inspire confidence in the new regulators’ capacity to demonstrate the independence required by their statutory mandates. In future, if the regulators do feel under such pressure, it is their duty to inform Parliament. The Treasury Committee will expect them to do so.
Regulatory reform
121.Since the financial crisis there have been a number of changes intended to establish a more appropriate regulatory regime. Many of these have followed from the recommendations of the Parliamentary Commission on Banking Standards and Independent Commission on Banking. Following significant pressure from the Treasury Committee and PCBS, the Financial Policy Committee has been granted powers over the leverage ratio, and there is now a provision to electrify the ring-fence, the mechanism that gives the regulator the power potentially to restructure banking groups.169 On conduct, March 2016 has seen the introduction of a new Senior Managers and Certification Regime, to replace the Approved Persons Regime. In addition, the development of the ‘twin peaks’ system, whereby the old FSA was split into separate prudential and conduct regulators, has sought to address the problems identified in the HBOS report of seeking to balance these two policy areas.
122.The financial crisis exposed major shortcomings in the existing approach to financial regulation. While there was a consensus that reform was needed, it nevertheless took significant pressure from the Treasury Committee and the PCBS to ensure that the Government followed through with a number of much needed changes. This included securing powers over the leverage ratio for the Bank of England and the provision to electrify the ring-fence. As a result, the regulators now have a better set of tools at their disposal. The Treasury Committee expects the regulators to demonstrate independence in their use.
123.Both the new powers gained by regulators and their poor performance prior to the crisis increases the need to ensure that regulators are challenged and required to explain their actions and decisions. This is primarily a duty for Parliament in general, and the Treasury Committee in particular. The new accountability arrangements - including new powers for the Treasury Committee over the appointment of the Chief Executive of the FCA - are an improvement. But it is not yet clear that the current framework is satisfactory. The Treasury Committee will need to consider this issue further in the light of the changes made by the Bank of England and Financial Services Act 2016.
Not enough capital
124.The supervision of HBOS took place in the context of internationally agreed regulatory standards of the time. For much of the review period HBOS was judged against the capital standards set out under Basel I, although the firm transitioned to the newer Basel II framework towards the end of the period.170 Under the Basel frameworks, banks were required to hold certain amounts of capital in relation to their risk weighted assets. The type of capital was not uniform and included Tier 1 and 2 instruments alongside common equity. The FSA also set out its own standards for UK banks, which were higher than the minimum standards agreed under the Basel framework.171 For most of the period in question, the HBOS Board maintained a capital target well above the minimum ratios.172 HBOS was also in line with its peers in terms of capital strength.173
125.The onset of the financial crisis and the significant losses suffered by HBOS on its lending revealed that HBOS had insufficient loss absorbing capital to cope with its estimated £26bn of losses.174 Notably, this meant that without significant capital injections from the UK taxpayer and Lloyds, HBOS would have become insolvent; the extent of HBOS’s losses relative to capital are shown in table 3.175 As the PRA/FCA report states, these events indicated that the prevailing approach to capital among banks was “inadequate”.176
126.The fact that HBOS lacked sufficient capital to survive its losses highlights a number of failings in the previous Basel capital regime. One significant issue was that the Basel framework in place at the time did not require banks to hold enough common equity as a proportion of their total capital. As the PRA/FCA report states:
HBOS did not have enough high-quality capital to absorb the losses it incurred between 2008 and 2011. The Basel I and Basel II regimes were built on the misunderstanding that the lower tiers of capital instruments could absorb losses in a going concern state short of resolution. This was wrong.177
Table 3: Movement in total equity between 2007 and 2011
|
£ |
|
|
Total equity as 31 December 2007 |
22.2 |
|
Net losses (January to August 2008) |
(0.3) |
|
HBOS April 2008 share issue |
4.0 |
|
Dividends(b) |
(1.3) |
|
Shareholders’ funds as at August 2008 (c) |
24.6 |
|
September results (d) |
(3.1) |
|
Shareholders’ funds as at September 2008 (e) |
21.5 |
|
Cumulative loss October 2008 to 2011 (after inclusion of a subvention payment of £3 billion from LBG and gains of £2.9 billion on LBG’s capital management exercises in 2009 and 2010) |
(21.3) |
|
UK Government capital injection 2009 (£8.5 billion ordinary shares and £2.8 billion preference shares) (f) |
11.3 |
|
LBG capital injections 2009 (g) |
14.0 |
|
LBG capital management exercise 2009 and 2010 (h) |
2.6 |
|
Redemption of UK Government and other preference shares 2009 |
(4.3) |
|
Other reserve movements |
0.4 |
|
Total equity at 31 December 2011 |
24.2 |
Source: PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, HBOS Annual Reports and Accounts, HBOS Board management information, Review calculations
127.A second related issue was the limited risk sensitivity of the Basel I system. The PRA/FCA report highlights how HBOS’s Corporate division’s average risk weight was little changed between 2004 and 2007, even though the Corporate division was increasingly taking more risk.178 The fact that this was not identified by the risk weight system, however, gave undue comfort to HBOS and the regulators that the bank was in a strong position. As the PRA/FCA report notes, poor risk measurement meant HBOS “overstated the return for the risk taken”.179
128.Following a request from the independent reviewers, the PRA and FCA included an assessment in their report of how HBOS would have fared under a Basel III framework.180 The results indicate that as of end December 2007, HBOS would already have been in breach of the minimum standards set by Basel III.181 This would have had important consequences for HBOS, as it would have been denied permission to pay dividends until this standard was met.182
Table 4: Summary of the estimated impact of Basel III capital calculations as at 31 December 2007
|
£ billion |
|
|
Additional capital to meet the Basel III: |
|
|
Minimum standard (4.5%) |
1.4 |
|
Capital conservation buffer (2.5%) |
7.7 |
|
Systemically significant buffer (3%) |
9.4 |
|
Sub-total |
18.5 |
|
Pillar 2 capital requirement and other tools (2.5%–3%) |
8.9 |
|
Total additional capital requirement |
27.4 |
|
Less additional capital to meet the minimum standard. This is on the assumption that the firm must still meet this requirement while covering its losses |
(1.4) |
|
Additional capital required by Basel III available to cover losses |
26.0 |
|
Cumulative net loss 2008 to 2011 |
26.0 |
Source: PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, firm regulatory reporting to the FSA, Annual Report and Accounts, Review Calculations
129.Therefore, overall the findings suggest that HBOS would have needed to hold significantly more capital than it did prior to the crisis in order to meet Basel III minimums. However, whether this would be have been enough to cover all its losses depends on uncertain assumptions regarding the size of its Pillar II and cyclicality buffers, as illustrated in table 4.183The PRA/FCA report concludes that even given the difficulties in accurately estimating HBOS’s Basel III position, the overall higher levels of equity required by Basel III meant:
It seems likely that HBOS would have responded to a Basel III regime by significantly amending its business model. For example, the Group may not have pursued the significant asset growth that it achieved [ … ]184
130.The pre-crisis standards governing bank capital requirements were not fit for purpose. Inaccurate risk weights, and a lack of emphasis on the holding of core equity, allowed banks such as HBOS to create the illusion of prudence, when risks were in fact increasing. Basel III has rightly put much more emphasis on the need for banks to hold more equity capital. Nevertheless, residual uncertainties about the risk weighting system, the scope for some banks to measure risk using their own internal models, and the subjective nature of some asset valuations, mean that the capital ratios cannot provide complete reassurance. The onus is now on the Bank of England, given its significant new powers, to exercise judgement about whether the banking system is appropriately capitalised. The Treasury Committee will be investigating these issues in more detail during the course of its forthcoming inquiry into bank capital.
141 The ARROW risk assessments were one of the FSA’s supervisory tools. It allowed FSA staff to investigate various business and control risks within a firm.
142 PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, p 267
143 Ibid
144 Ibid, p 253
145 Ibid, p 277
146 Ibid, pp 277-8
147 Ibid, pp 278-9
148 Ibid, p 279
149 Ibid
150 Ibid, p 321
151 Q 155
152 PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, p 212
153 Ibid
154 Ibid, pp 210-11
155 Ibid, p 207
156 Ibid, p 256
157 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, Paras 83-85, p 28
158 Parliamentary Commission on Banking Standards final report, Changing banking for good, 12 June 2013, HL Paper 27-I/HC 175-I, Vol II, Para 158, p 148
159 PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, p 253
160 Q 54
161 PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, pp 253-4
162 Q 162
163 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 84, p 28
164 PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, p 251
165 Q 54
166 Qq 162-3
167 Q 170
168 PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, p 39
169 Parliamentary Commission on Banking Standards, Statement by the former members of the Parliamentary Commission on Banking Standards, 4 November 2014
170 PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, p 28
171 Ibid, pp 140-41
172 Ibid, p 140
173 Ibid, p 28
174 Ibid, p 139 [£13.5bn of capital on a Basel III standard]
175 Table 3: Ibid, p 148, [Table 2.24]. Notes: (b) The final 2007 ordinary share dividend (£1.2 billion) and preference share dividends. (c) The last reported position in the management accounts prior to 1 October 2008, the point of failure. (d) Due to Corporate impairment losses, the effects of market dislocation in September on security values and write-down on BankWest. (e) Shareholders’ funds reported in the management accounts as at the approximate point of failure, but prepared after that date. (f) The measures announced by the UK Government 8 October 2008. The £2.8 billion preference shares are net of expenses (£0.2 billion). (g) These injections were also used to redeem HBOS preference shares (including those issued to the UK Government). (h) The various capital management exercises raised £5.5 billion in 2009 and 2010, of which £2.6 billion was recognised as share premium on the conversion of debt into shares and £2.9 billion was recognised directly in the income statement, as the debt was bought back at below its carrying value.
176 Ibid, p 139
177 Ibid, p 146
178 Ibid, p 147
179 Ibid
180 Ibid, pp 149-51
181 Ibid, p 149
182 Ibid, p 150
183 Table 4: Ibid, p 150, [Table 2.25]
184 Ibid, p 150
© Parliamentary copyright 2015
22 July 2016