Review of the reports into the failure of HBOS Contents

6The auditing of HBOS

The auditing of HBOS

164.The broader failings of bank audits were covered extensively by the Parliamentary Commission on Banking Standards. In its final report, the PCBS concluded that auditors, and the accounting standards they used, had fallen down in their duty to ensure the provision of accurate information to shareholders about companies’ financial positions. This included a failure by auditors to act “decisively and fully to expose risks being added to balance sheets throughout the period of highly leveraged banking expansion.”223

165.The PRA/FCA report contains a description of some of the key features and decisions specific to HBOS’s financial statements during the period 2004–08.224As the report states, the significant rise in impairments within HBOS’s loan book in the period after it had received emergency liquidity assistance (ELA) from the Bank of England in 2008 is a notable part of the overall HBOS story. For instance, while impairments in the Corporate division were only £1.7bn at the end of Q3 2008, by the end of Q4, this had risen to £7.4bn; further detail is in table 5 below.225

Table 5: Published impairment losses HBOS Group 2008

£ billion

Impairments to end-Q2 (as per interim Results published 31 Jul 2008)

Impairments to end-Q3 (as per IMS published in Nov 2008)

Impairments to end-Nov (as per interim Trading Update published Dec 2008)

Impairments to year-end 2008 (as per Annual Report and Accounts, published Feb 2009)














Treasury and Asset Management




Other/rounding adjustment



£1.3 billion

not published

not published

£12.1 billion

Source: PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015

166.One important element of HBOS’s provisioning process was the practice in the Corporate division of putting loans into either good or bad books. The report describes how during the review period HBOS’s auditors, KPMG, directly assessed loans in the bad book, but did not conduct the same level of direct testing on those loans in the good book. It subsequently transpired that the Corporate division had not been properly re-categorising its loans into the bad book when they became distressed.226 Later in 2008, during preparations for the end-year financial statements, KPMG decided that HBOS’s processes for assessing impairments and provisions “could no longer be relied on”.227

167.During the oral evidence sessions with the Committee, there was a degree of debate about whether the pre-2008 approach was appropriate. Iain Cornish argued that:

Any key processes that the auditor is relying on to reach its conclusions, it feels to me, there is a case for saying they should have tested. In the case of HBOS, the process of allocating loans to the different buckets of performing, impaired and with or without loss was identified to be clearly deficient. You would expect the auditors to have looked at whether that process was working effectively before reaching conclusions about impairments.228

The relationship between KPMG and HBOS

168.The discussions held between KPMG and HBOS’s senior management over the level of provisioning are also covered in the PRA/FCA report. Provisioning is the process whereby a bank decides how much to set aside to cover losses on impaired assets. It is not an exact science but a judgement, however there is an acceptable range. If provisions are set too low, they leave a firm exposed to further losses, but if they are set too high, they open the firm up to an accusation of being over pessimistic and reducing profits. A bank’s auditors will review provisions as part of the process of signing off a firm’s accounts. Therefore the dialogue between the firm and the auditors on provisioning is an important element in judging the performance of the auditors.

169.The PRA/FCA report highlights several instances when KPMG felt that the provisions initially suggested by HBOS’s senior management, especially in 2007–08, were at the “lower end” of the acceptable range. Frequently this led to KPMG challenging the firm to set a higher level of provisions.229The PRA/FCA report notes:

the degree of challenge that took place between senior management and some senior members of the Risk functions reflected a tendency within senior management to look towards the lower end of any range presented by those functions; and

the firm kept its auditors under pressure in an attempt to keep the figures low and proposed and tried to defend impairment figures which, following intense discussion, were increased to levels that the auditors viewed as just within the acceptable range. 230

170.The independent reviewers concurred with this assessment. While noting that it was “one of the areas where it is hardest to tell exactly what happened”, Iain Cornish continued by saying:

The sense that we get, as some of the material from KPMG suggests, is that the management put the auditors under a huge amount of pressure. There were individuals within HBOS who felt that the behaviour of the senior management was inappropriate. There is an example of a senior individual in risk claiming that he was excluded from subsequent meetings, having identified the fact that he thought they were not provisioning adequately.231

171.The PRA/FCA report also noted that the audit process in general appeared to give some HBOS senior executives and Board members false comfort. It adds that it was “the responsibility of the firm, its Board and its senior management (rather than the auditor) to assess impairments correctly and to make appropriate provisions”.232

Improvements to audit and accounting

172.In its final report, the Parliamentary Commission on Banking Standards considered a number of improvements that could be made to bank auditing. The PCBS noted that besides some of the well-documented deficiencies in International Financial Reporting Standards (IFRS), some evidence covering the process of implementing the standards themselves also raised questions whether that this had “led to an over-emphasis on compliance and box-ticking”.233The PCBS acknowledged, however, that as accounting standards were set at an EU or international level, there was a limited amount UK authorities could do to change the IFRS standards themselves.234

173.Nevertheless, the PCBS did recommend that steps should be taken to enhance the role of audit, to help ensure that there was not a repeat of the failings seen prior to the financial crisis. This included the suggestion that a new set of accounting statements should be developed purely for use by the regulator.235 The PCBS also argued in favour of regular meetings between supervisors and the external auditors of banks.236 Andrew Bailey picked up on the latter point during the evidence sessions, noting that one of the things that “surprised and shocked” him, was the “mutual distrust” that had built up between the FSA and the auditors prior to the crisis.237 The findings from the PRA/FCA report illustrate this by showing that while some meetings between the FSA and KPMG did take place, these were infrequent and there was only a single telephone call in the whole of 2006 to discuss HBOS.238 Andrew Bailey added that this relationship was now being “rebuilt”.239

The role of the FRC

174.The PRA/FCA report does not posit an opinion as to the quality of the original auditing of HBOS. The regulators note that such an opinion would be outside their terms of reference and is the responsibility of the Financial Reporting Council (FRC).240

175.The FRC first looked at the HBOS case in 2013, choosing to examine loan loss provisions in HBOS’s Corporate division. At that time the FRC’s conduct committee found that there were no “reasonable grounds” to suspect that there may have been misconduct in the auditing of HBOS.241 The FRC committed at the time to reviewing the full HBOS report once it was published, in case there was further information that might inform an investigation.242

176.Hence, following the publication of the final PRA/FCA report in November 2015, the FRC indicated that it would check again to see if the reports contained any new evidence to warrant an investigation.243 At the same time, the Treasury Committee wrote to the FRC to urge it to reconsider the need for an investigation, given the significant public interest in HBOS.244

The FRC’s handling of the HBOS case

177.During the evidence sessions, the Committee heard evidence to suggest there was some concern over the FRC’s handling of the HBOS case. Iain Cornish noted that, based on the independent reviewers’ observations of the process, the FRC demonstrated a “lack of curiosity” with regard HBOS; adding this seemed to suggest that the FRC had not run “the most diligent of processes.”245

178.The timing of the FRC’s decision not to investigate the HBOS case in 2013 was also discussed amongst the witnesses. Stuart Bernau noted that his impression was that the FRC had made a decision not to investigate before receiving a final referral letter from the PRA and FCA.246 Iain Cornish added that this argued for much more transparency around the FRC’s decision-making process, which had not been subjected to the same level of scrutiny as the other regulators.247 The independent reviewers summed up their concerns in written evidence by recommending that the auditing of HBOS was an area in which the Treasury Committee may want “to take a continuing interest”.248

179.The concern over the FRC’s decision to announce it would not be investigating the HBOS case in 2013 was also raised by the regulators. Andrew Bailey noted in evidence his view that it was “sensible” for the FRC to reach their conclusions once the regulators had given them the “full final report and the full set of evidence”. He added that it was an open question “as to on what basis they took the interim decision.”249

180.In a letter to the Treasury Committee, the FRC denied that it has reached a “premature conclusion” as to whether to mount an investigation in 2013.250 The FRC subsequently confirmed on 21 January 2016 that it had begun preliminary inquiries to consider whether there should be an investigation into the auditing of HBOS.251 These would consider the extent to which KPMG, during the course of their audit:

considered the appropriateness of management’s use of the going concern assumption in the preparation of the financial statements for the year ended 31 December 2007, and

considered whether there were material uncertainties about the entity’s ability to continue as a going concern that HBOS needed to disclose in the financial statements.252

181.In response to the announcement of these preliminary inquiries the Treasury Committee wrote to the FRC to seek answers to some of the Committee’s questions about how the FRC was planning to manage this process. This included the Committee’s concerns about the extent of independent and external oversight of the FRC’s work and the setting of the terms of reference for the inquiries.253In June 2016, the FRC subsequently announced that it had commenced an investigation into KPMG’s audit of HBOS for the year ended 31 December 2007.254

182.The Financial Reporting Council (FRC) decided not to investigate the auditing of HBOS in 2013, well before the completion of the final HBOS report. This was a serious mistake. The process by which it reached its decision suggests a lack of curiosity and diligence. These failures are all the more concerning given the scale of the problems at HBOS, and the clear public interest at stake. It is extraordinarily unhelpful that the FRC has taken so long and has belatedly reconsidered its position, only after considerable pressure from Parliament and the Treasury Committee. Following its preliminary inquiries, the FRC has now finally commenced an investigation into the auditing of HBOS.

183.The auditing of HBOS is the one major element of the HBOS affair that has yet to be subject to adequate scrutiny. The Committee will expect the FRC to undertake an extremely thorough analysis of the HBOS case. Regardless of the outcome of the FRC’s investigation process, it is likely that the Committee will want to consider its work and regulatory approach in more detail. The investigation announced on 27 June 2016 is better late than never. But the very tardy response by the FRC appears to be as inexplicable as it is unacceptable.

223 Parliamentary Commission on Banking Standards final report, Changing banking for good, 12 June 2013, HL Paper 27-I/HC 175-I, Vol II, Para 181, p 157

224 PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, Chapter 2.11

225 Table 5: Ibid, p 168, [Table 2.26]. Notes: HBOS published a 2008 half-year financial statement, a Q3 Interim Management Statement Interim Trading Update, and a 2008 Annual Report and Accounts

226 Ibid, p 169

227 Ibid, pp 184-5

228 Q 66

229 PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, pp 169-90

230 Ibid, p 188

231 Q 77

232 PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, pp 168-9

233 Parliamentary Commission on Banking Standards final report, Changing banking for good, 12 June 2013, HL Paper 27-I/HC 175-I, Vol II, Para 1028, p 458

234 Ibid, p 459

235 Ibid, p 463

236 Ibid, p 468

237 Q 184

238 PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, p 273

239 Q 184

240 PRA and FCA, The failure of HBOS plc (HBOS), 19 November 2015, p 167

241 Financial Reporting Council, FRC statement following PRA/FCA review of HBOS, 19 November 2015

242 Ibid

243 Ibid

244 Letter from Chairman of Treasury Committee to Chief Executive of the Financial Reporting Council, 10 December 2015

245 Qq 71-72

246 Qq 71-3

247 Q 73

248 HBO001

249 Q 183

250 Letter from the Chief Executive of the Financial Reporting Council to the Chairman of the Treasury Committee, 15 December 2015

251 Letter from the Chief Executive of the Financial Reporting Council to the Chairman of the Treasury Committee, 21 January 2016

252 Financial Reporting Council, KPMG Audit plc’s audit of HBOS plc, 21 January 2016

253 Letter from the Chairman of the Treasury Committee to the Chief Executive of the Financial Reporting Council, 3 February 2016

254 Financial Reporting Council press release, Investigation into KPMG Audit plc’s audit of HBOS plc, 27 June 2016

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22 July 2016