Conclusions and recommendations
Introduction
1.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. (Paragraph 22)
Setting up the HBOS review
2.The Financial Services Authority failed to instigate a full review into the collapse of HBOS and RBS. This is extraordinary in itself. They resisted doing it even after strong prompting from Parliament. The unacceptability - not just to specialists following this issue, but also to a wider public - of their original decision not to undertake a full review eluded them for too long. (Paragraph 34)
3.It is regrettable that the FSA (and subsequently PRA & FCA) agreed to undertake these reviews only following sustained pressure from the Treasury Committee over a number of years. In the case of the HBOS reports, the Treasury Committee insisted on the innovative arrangements originally used for the RBS review, with Committee-appointed independent reviewers given the task of overseeing the regulators’ drafting of the reports. (Paragraph 35)
4.The decision to appoint Stuart Bernau and Iain Cornish as independent reviewers proved to be of great value. The independent reviewers revealed that the first drafts of the HBOS reports had been superficial. In the case of the enforcement section, they had such grave concerns that they argued this particular section should be written independently of the regulators. An impartial assessment of the FSA’s actions with respect to enforcement has been essential. Without it, the regulators would have been marking their own homework. (Paragraph 43)
5.The independent reviewers also made numerous requests for further analysis and detail. They carried out quality assurance on both the regulators’ report and the Maxwellisation process. Consequently, their input was crucial, both in raising the standard of the HBOS reports and in providing assurance that the reports’ findings are a fair and balanced reflection of the available evidence. Parliament and the public can now have more confidence that these final reports give a full summary of the causes of the failure of HBOS. (Paragraph 44)
6.The Committee would like to reiterate its thanks to the independent reviewers and Andrew Green for the considerable time and effort that they devoted to the HBOS review. (Paragraph 45)
7.Concerns have been raised about the length of time it took to reach publication of the HBOS reports. Beyond the FSA’s initial reluctance to conduct a review at all, the primary cause of this delay was the decision by the FSA not to start the HBOS review until it had concluded enforcement action in 2012. The regulators have indicated that this was a result of legal advice. (Paragraph 49)
8.It is likely that a future bank failure would result in subsequent enforcement action, which may be a lengthy and complex process. It is unacceptable, however, that the public should have to wait so long for an explanation of what went wrong in cases of major bank failure. In the light of legislative changes since HBOS’s collapse, the Treasury and the regulators need to explain to the Treasury Committee what steps they can take to ensure that reviews of this type - which in future will be led by independent persons - can be run, at least in part, alongside enforcement investigations. An arrangement where the public must wait several years for a review even to start would be wholly unsatisfactory. (Paragraph 50)
9.The Maxwellisation process has attracted considerable controversy. It is clear that a balance needs to be struck between the rights of those criticised and the need for the timely publication of important reviews. This is vital to ensure that the public receives the explanation they deserve in cases of major financial failure. (Paragraph 55)
10.Recognising this, in March 2016 the Treasury Committee commissioned a review into Maxwellisation. This is being conducted by Andrew Green QC, focusing on inquiries and investigations of a financial nature. The aim of the review is to set out what the law requires and the typical problems caused by Maxwellisation. It may also attempt to establish a set of principles, or make recommendations, to help guide future financial inquiries and investigations in their use of Maxwellisation, to ensure that the process is fair and proportionate. (Paragraph 56)
11.Both the regulators and the independent reviewers supported the view that future inquiries into major bank failures should best be conducted wholly independently of the regulators. The Committee agrees. The Government has already partially addressed this in the provisions contained in the Financial Services Act 2012. In theory, the Act goes some way towards providing what is needed. In practice, the legislation remains defective. It is far from satisfactory that the Treasury retains the authority to prevent an inquiry under the Act, even when both the regulators and the Committee may have concluded that one is necessary. There may be a case for a Treasury override in the national interest in exceptional circumstances, accompanied by an obligation to report to the House. However, the current legislation has gone too far. The Treasury has arrogated to itself full control over the scope and continuation of any inquiry. The case for an amendment to the Act, overriding this blocking power, is therefore strong. (Paragraph 62)
12.In the meantime, steps must be taken to ensure that the independence of such inquiries is safeguarded in future. At a minimum, the Treasury should be required to gain agreement to the terms of reference from the person appointed to chair the inquiry and from the Treasury Committee. Such permission should also be sought if the Treasury seeks to discontinue an inquiry under the Act. (Paragraph 63)
Monitoring the regulators
13.The PRA/FCA HBOS report contains findings similar to those of the original regulatory report into the collapse of RBS. Both illustrate the extent to which the FSA paid insufficient attention to prudential matters in the lead up to the financial crisis. In its own report into the failure of RBS, the Treasury Committee in the last Parliament concluded that this was a serious indictment of the FSA’s senior management and leadership, in particular the Chairman and Chief Executive in place at the time. The evidence seen by the current Committee regarding HBOS strongly supports this original assessment. (Paragraph 72)
14.The FSA’s senior leadership, in particular Sir Hector Sants, claimed to want to pursue an ambitious enforcement strategy in response to the financial crisis. Andrew Green’s report demonstrates that such a strategy was not implemented successfully. This is deeply concerning. It is also of considerable concern that, at the time when the FSA’s Enforcement division was first considering enforcement action, it failed to consider the full range of relevant individuals (formerly employed by HBOS), that is those for whom the statutory threshold test for conducting an investigation had been satisfied. The only person that it considered for investigation was Peter Cummings. Responsibility for these omissions and failures, and for the procedural failures summarised in paragraphs 150 and 151, rests with Sir Hector Sants, as CEO of the FSA. (Paragraph 80)
15.Both the independent reviewers and Andrew Green concluded that the HBOS reports should have named some employees below the level of Director. The Treasury Committee agrees with them. The evidence in the reports shows that less senior employees can have a significant impact on regulatory strategy and outcomes. (Paragraph 85)
16.The policy of naming individuals should be flexible. In most cases it may be appropriate to offer anonymity to employees below the level of Director. There should, however, be scope for exceptions. In future, those leading a review should have the freedom to determine if the public interest would best be served by naming particular employees. (Paragraph 86)
17.It is right that the regulators should review their conflict of interest policies for appointments to their Boards. The Treasury Committee has repeatedly identified this as a crucial issue for regulatory governance. Conflict of interest policies must not be allowed to exclude access by regulators to much needed industry expertise. But regulators also need to have, and to be seen to have, a set of robust procedures for dealing with a conflict of interest when it does arise. (Paragraph 95)
18.These objectives are not irreconcilable. Best practice in the private sector can provide a guide. Regulators need at all times to maintain the highest standards with respect to conflict of interest. The Committee will seek assurances from the relevant regulatory Boards that such procedures are in place. (Paragraph 96)
The FSA’s approach to supervision
19.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. (Paragraph 109)
20.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. (Paragraph 113)
21.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. (Paragraph 114)
22.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. (Paragraph 115)
23.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. (Paragraph 120)
24.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. (Paragraph 122)
25.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. (Paragraph 123)
26.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. (Paragraph 130)
Enforcement - The way ahead
27.Andrew Green’s assessment that the regulatory regime in place at the time of HBOS’s collapse did not encourage ambitious enforcement action is concerning. The Committee agrees. In order to be a credible last line of defence, there must be a perception that regulators are able to undertake even the most challenging and complex of cases. It is to be hoped that the Senior Managers and Certification Regimes will enhance the credibility and fairness of enforcement in future, given that they should lead to much clearer lines of individual responsibility. If the regulators find in future that these changes are not enough to establish a credible enforcement regime, they should say so. (Paragraph 136)
28.The scope of the FSA’s original HBOS enforcement investigations was not reasonable. There were also significant procedural failings. In particular, the FSA’s Enforcement division formed the view in early 2010 (having not considered the position in 2009) that the statutory threshold test for starting an investigation had been met in the case of Andy Hornby (CEO of HBOS 2006–09), but it decided not to investigate him. However, because of a failure in communication, the Enforcement division never informed Sir Hector Sants of its view that the statutory threshold test for investigating Andy Hornby had been met. (Paragraph 150)
29.The Committee finds this wholly unacceptable. Knowledge of which individuals had met the statutory test for investigation was crucial to allow the FSA’s leadership to judge whether the scope of the HBOS enforcement investigations was appropriate. Furthermore, it is clearly unacceptable that important meetings and decisions among Enforcement staff, where major decisions were made concerning the scope of the HBOS enforcement investigations, went unrecorded. These oversights add to the already extensive evidence that the FSA was not up to the job. It was clearly a highly dysfunctional institution and its legacy continues to pose a major challenge for its successor bodies, particularly the FCA. (Paragraph 151)
30.Improvements in the approach taken to enforcement at the regulator are just as important as the new rules embodied in the Senior Managers Regime. Andrew Green makes several recommendations to deal with the severe procedural failings identified in his report. These include steps to require the regulators in future to retain a far clearer record of which persons have met the statutory threshold test for starting an investigation. It is welcome that the PRA and FCA have already incorporated Andrew Green’s recommendations in their recent consultation document. The establishment and performance of a new enforcement decisions committee at the PRA will also be carefully examined by the Treasury Committee in due course. (Paragraph 152)
31.In its final report, the Parliamentary Commission on Banking Standards identified some of the problems that arose as a result of keeping both the enforcement and supervision functions within a single regulator. The PCBS noted that both functions had different objectives which, at times, could be a source of tension, especially if the Enforcement division had to reach judgements about matters in which supervisors were involved at the time. There was also the danger that insufficient priority would be placed on enforcement within a larger organisation, reducing its effect as a credible deterrent. One solution discussed by the PCBS was to place the enforcement function into a separate statutory body. This option was subsequently rejected by a Treasury-led review. (Paragraph 158)
32.Nonetheless, the findings of the Green report reveal that the relationship between enforcement and supervision within the FSA was indeed highly problematic. Keeping both functions within the same organisation did not result in a high degree of co-operation, undermining the argument that the two functions should remain under the same roof. In the light of this, the Committee believes the merits of structural separation bear re-examination. (Paragraph 159)
33.First, the Committee notes that the collapse of HBOS, along with other UK financial institutions during the crisis, was the result of prudential failings. It is far from satisfactory that the bulk of enforcement staff and expertise still lies within the FCA, which has no role in prudential supervision of banks. An independent enforcement function could and should sit equidistant between the PRA and FCA. (Paragraph 160)
34.Secondly, a separate statutory body would bolster the perception of the enforcement function’s independence. The current system, whereby the same organisation both supervises, applies and prosecutes the law is outdated and can be construed as unfair. By moving enforcement away from supervision, it can focus independently on undertaking its key functions: interrogating evidence and assessing whether a regulatory breach has been committed. This could increase confidence in the impartiality of regulatory enforcement decisions, and facilitate objective scrutiny of supervisors’ actions by enforcement staff. (Paragraph 161)
35.Thirdly, separation would allow all three regulators - the FCA, PRA and an enforcement body - to enjoy much greater clarity over their objectives. There is a danger, especially with the FCA, that its multitude of objectives and initiatives are leading to regulatory overload. An FCA with fewer objectives, and a single separate body responsible for enforcement, would probably result in better accountability and better outcomes. (Paragraph 162)
36.The Committee concludes that the case for structural separation has merit. The Treasury Committee expects the Treasury to appoint an independent reviewer to re-examine the case for a separate enforcement body. (Paragraph 163)
The auditing of HBOS
37.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. (Paragraph 182)
38.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. (Paragraph 183)
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22 July 2016