Session 2012-13
Publications on the internet
Parliamentary Commission on Banking Standards - Minutes of EvidenceHL Paper 144/HC 705
Oral Evidence
Taken before the Parliamentary Commission on Banking Standards
Sub-Committee B-Panel on HBOS
on Friday 16 November 2012
Members present:
Lord Turnbull KCB CVO (Chair)
Counsel: David Quest
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Examination of Witness
Witness: Lindsay Mackay, CEO Treasury, HBOS, 2006-2008, examined.
Chair: Welcome to this HBOS panel, Mr. Mackay. Let me give a brief introduction to the Commission, the panel and the process. The Commission is looking into what went wrong in the financial crisis, particularly in terms of standards, conduct and behaviour. A lot of the structural stuff has been dealt with by Vickers-the Independent Commission on Banking. In order to draw lessons as to how things might be done better in the future, we want to know not just what happened, but why it happened, and, in particular, what warnings were given, what warnings were not given and what warnings were given but then not acted upon.
Why examine HBOS in particular? Well, it was a major event. You start with a bank that at its merger had a market capitalisation of £30 billion. By 2007, it was valued at £40 billion, and then, a year later, it was worth next to nothing. The RBS story has been written up in a lot more detail by the FSA, which looked in particular at corporate-the decision notices in relation to Bank of Scotland and Mr. Cummings. We thought that we would look at the particular case of HBOS, because it is a source of interesting insights that have not been investigated to their conclusion.
In terms of process, we have made an innovation because the Parliamentary Commission is employing counsel. May I reassure you that we are not trying to turn this into a court, a tribunal or, still less, a disciplinary hearing? It is simply that counsel are trained questioners, and the procedure also enables the Chair to listen to the answer rather than to think about what the next question is. We are working with Mr David Quest, who will ask you a series of questions because we are trying to build up the narrative and get the evidence.
The conclusions that will be drawn from this panel will be the work of the Commission as a whole; we will report to them what we have found, but they will be the ones who decide what conclusions to draw, and they will then be incorporated in the major project. Over an extended period, Mr Mackay, you have acquired an important place in this story, hence our invitation to you to come and give us evidence. With that introduction, I will ask David Quest to take up the questioning.
David Quest: Good afternoon, Mr Mackay.
Lindsay Mackay: Good afternoon.
BQ517 David Quest: You came to HBOS from Bank of Scotland, and you became a divisional chief executive of treasury in 2004. Is that right?
Lindsay Mackay: That is correct, yes.
BQ518 David Quest: For about 10 or so years before then, you had a role in funding and treasury.
Lindsay Mackay: Probably longer than that. When I joined the Bank of Scotland in the early ’80s, I went straight into the trading room, so I was always involved in funding, foreign exchange and interest rate management.
BQ519 David Quest: And I think you explain in your written submission that when you became chief executive of treasury, you were reporting to Mr Mitchell, I think, on the main board.
Lindsay Mackay: Correct.
BQ520 David Quest: The chief executive of the treasury division was not a main board position.
Lindsay Mackay: Correct.
BQ521 David Quest: I think that may have made it unique among the divisional roles. Do you know why that was?
Lindsay Mackay: I think the situation at the merger was one where the chairman and chief executive wanted to bring together suitable representation from both Bank of Scotland and the Halifax, so Gordon McQueen, who I reported to, was chief executive, treasury, before me, and was a main board director. I think time had then elapsed, and when Gordon McQueen decided to retire and I was appointed in his place, the decision was taken that it was not appropriate for me to go on to the board at that point. Perhaps that is not a question for me, but for James Crosby.
BQ522 David Quest: I understand. You reported first to the group finance director, and then, subsequently, to Mr Matthew as head of-
Lindsay Mackay: That is correct. I reported to George Mitchell. When he retired, my reporting line moved to Phil Hodkinson, as finance director. Phil indicated that he would retire at the end of 2007, and round about May 2007, Andy Hornby explained that there was going to be a change in the management structure, and my reporting line would then change to Colin Matthew.
BQ523 Chair: If you were drawing the ideal corporate structure, leaving aside the question whether the treasurer should be on the board, what would you say is the natural position? Is it reporting to the finance director?
Lindsay Mackay: I think it might be worth explaining what my role was and was not, because the treasurer is a term that can mean different things to different people. I was chief executive of treasury, which effectively meant that I was responsible for our face to the financial market activity, and treasury’s additional core responsibility was on the funding side-planning the funding and executing it. The piece I did not have responsibility for was capital management, which sat within group finance, which was based up in Edinburgh. In terms of issuing capital instruments into the market, we would take our direction from the group capital committee, and execute on that basis, but we had no responsibility on the equity side, or for dealing with equity investors and so on. It was a slightly different structure from what perhaps would be more common today.
BQ524 Chair: But you did have responsibility for the steps that were taken to lengthen the maturity profile.
Lindsay Mackay: Yes, very much so.
BQ525 Chair: That is why it looked to me as though the Hodkinson phase was the natural one, and the other two were a bit aberrant really.
Lindsay Mackay: Looking back on it, at the time the most natural fit for the treasury is within the finance side, but if you think about a business plan, there are three components to it-the business that is written, the funding that supports it and the capital that supports the business. If you move one, the other two must, by definition, move. I had responsibility for the funding plan. The capital plan was a responsibility up in Edinburgh under group finance, and of course divisions had the responsibility for the assets.
BQ526 David Quest: From the outset of the establishment of HBOS, it is right-isn’t it?-that it was recognised that HBOS had a rather greater reliance on wholesale funding than its peers.
Lindsay Mackay: That is right.
BQ527 David Quest: You should have a large file in front of you. I will show you some documents to comment on. First, if you turn to tab E10, you should see a copy of the group business plan for 2002-06. Do you have that?
Lindsay Mackay: Yes, I do.
BQ528 David Quest: It will have been the first business plan for the new merged bank. Presumably in relation to treasury, you would have had an input to this?
Lindsay Mackay: Yes. At that point, the chief executive of treasury was Gordon McQueen. I was head of funding and liquidity, so I would have prepared the funding plan that supported this business plan.
BQ529 David Quest: If you turn, for example, to page 19 of the plan, section 5.2, under the heading, "Balance sheet, funding and capital", you will see it says there in bold, "Balance sheet growth outstrips that of customer deposits to a very significant extent much more so than forecast originally, and requires extensive use of wholesale funds and securitisation… Of course, asset growth will depend to a large extent on credit demand and our continued willingness to meet it." So it was the case-wasn’t it?-that wholesale funding was always a particular issue for HBOS.
Lindsay Mackay: Yes. Let me explain the thinking here. First, it might be worth just talking about retail deposits as opposed to wholesale deposits, because there are different qualities of retail deposit that, as a liability manager, you can get hold of. I would give this example: if, on a particular day, we decided we wanted to raise an additional £5 billion of retail deposits, we could have gone out with a product and posted a rate that would have attracted in an additional £5 billion of deposits. The reason we did not take that approach is you have to look very carefully of the quality of the retail deposits you are attracting in. If on one day we post this rate and get additional retail deposits in, then equally one of our competitors the following week could post another higher rate and that money would flow out. That is an extreme example, but we did not want to attract in hot, volatile retail funds that could not be used for funding the balance sheet over the longer term. That is quite an important point.
On the way we grew our retail deposits, Bank of Scotland, Birmingham Midshires, Halifax were all brands we used to raise deposits, but we were highly aware of this quality issue. I can give an example going back, I think, to 2005, or 2006 perhaps, where, in discussion with corporate, and also our group risk colleagues, we actively managed away about £3 billion or £4 billion of retail deposits because, although they were on a managed rate and qualified in the retail bucket, they were actually more actively managed by fund managers and they did not suit the quality of deposit that we were looking to take into our retail structure.
It might also be worth me talking a little bit about the maturity profile of the wholesale funds. When this plan was written-I have not looked at the exact numbers-we had roughly, say, £100 billion of wholesale funding at that point. Of that £100 billion, about £85 billion was shorter term, with residual maturity below one year. The other £15 billion would have had a residual maturity beyond one year. When we put this plan together, we did not want to increase dramatically the amount of funding that we were taking at short end of the market, under one year. If you go forward to July 2007, our wholesale funding had gone up to about £240 billion, but the breakdown was that the shorter-term funding under one year had gone up from £85 billion to about £125 billion, and the long-term funding had gone up from £15 billion to £115 billion. The vast majority of that increase was taken in the longer-term part of the market.
Also bear in mind that we had to manage the roll-down. When we issue a five-year bond, it starts coming back as it gets closer to maturity. Of that £125 billion that we had in maturities below one year, a chunk was securities that had originally been issued for terms beyond one year. That is important to understand in terms of the distribution of our funding; the different investors that were involved in buying the paper that we were issuing in the market. We had a very well developed investor relations team, which spoke to our investors to understand their capacity and appetite for banks in general, but HBOS specifically. We managed that very carefully, and that is why we made so much use of securitisation as an instrument to fund asset growth.
As a liability manager, one of the big advantages of securitisation is that from the bank’s perspective, depending on the structure of the deal, funding is being created with a maturity profile that largely matches the maturity profile of the asset. We securitised assets from the Bank of Scotland mortgage book, the Halifax mortgage book, Birmingham Midshires and the Dutch mortgage book that we had. We also opened the covered bond market, again because it took us into an investor base that was separate from those investors that were buying securitised paper. We were actively issuing in medium-term notes, senior debt in maturities, three, five, seven years-again a different investor base in a range of currencies. We were not attacking one little pool of funding; we had a very well spread and well balanced wholesale funding. That is not to downplay the importance of retail deposits. We were trying to increase our take of retail deposits, but, for the quality reasons that I went through, at a measured pace.
BQ530 David Quest: That was a very long answer. May I pick up a couple of points from that, and, in particular, ask whether you agree with two short points? We can come back to the question of deposits. First, it is right-is it not?-that from the beginning HBOS had a greater reliance on the use of wholesale funding than its competitors.
Lindsay Mackay: Yes, I think that is correct; using wholesale funds to support retail and commercial assets. If you look at the total wholesale funding of our main competitors and their use of wholesale funding to support their securities portfolio, and so on, the numbers would be significantly higher.
BQ531 David Quest: The absolute numbers will be higher, but as a percentage of your balance sheet, HBOS had a significantly greater reliance on wholesale funding than its competitors.
Lindsay Mackay: Excluding the securities financing other banks may have, that would be correct.
BQ532 David Quest: Do you agree that more or less from the beginning, and certainly as time went on, that reliance on wholesale funding became a matter of increasing concern within the bank?
Lindsay Mackay: We planned our funding in the same way as the group planned its business plan. We looked out to five years, and as a liability manager, the particular part of that five years that is of great interest is the point between two years and five years. What does a balance sheet look like between two and five years? When we talked in our funding plans of 2006-10 and 2007-11 about our market capacity, it was all around how much market capacity do we have? Are we comfortable that our funding plan supports the growth of the group? We were always comfortable that that was the case.
BQ533 David Quest: But were you personally always comfortable that that was the case?
Lindsay Mackay: Yes. Looking back at those numbers, we were quite accurate in terms of our assumptions about market capacity. If you go right to the point where Lehmans collapsed and the markets shut down, the problem was not the wholesale funding that we had at that point but the very substantial outflows from our retail book. We lost about £30 billion to £35 billion of retail deposits from the retail bank and corporate international books. The pace of that outflow was such that we could not match it with additional requirement on the wholesale funding.
BQ534 David Quest: To look at another document at about this time dealing with this, if you go back to D15 in the same file, you will see the five-year funding plan, which I think you mentioned, for 2003, which you prepared. If you turn to page 6, you will see under the heading "Funding Requirement" that the group assets were projected to grow from £318 billion in June 2002 to double that figure, £614 billion, by 2007, with a consequent more or less doubling in the wholesale funding requirement. Do you see that?
Lindsay Mackay: Yes.
BQ535 David Quest: On the next page, at the top of page 7, you will see that you say: "The Treasury wholesale funding requirement will rise from £99 billion … to £211 billion by December 2007. It will not be possible to meet this growth in funding purely from existing sources. Significant work is being done to expand our market capacity".
Lindsay Mackay: Correct.
BQ536 David Quest: So it is right-isn’t it?-that there was a strategy, really, of quite aggressively increasing the reliance on wholesale funding.
Lindsay Mackay: Let me just talk about that a little bit. First of all, I think it is important to understand that this plan was the one that supported our 2003-2007 funding plan. It was, essentially, the first plan that the bank did. We did not just do the plan, and then put it to one side; it was then updated every quarter. If we were not achieving the diversification and development of our funding that we had anticipated, then there would have to be a rebase to the plan. That could mean cutting assets, of course, cutting asset growth, or looking at other additional sources. The big step was in 2002, or very early in 2003, when I took a proposal to develop our capital markets activity to James Crosby’s executive committee, which he supported, but I then took it to the main board of the bank. When I talk about securitisation and securitising assets, I felt at that time that it was extremely important that we had the in-house capability to be able to do that. I got the support that I wanted from the main board; I got the financial resources required, and I built up and hired a team in to allow us to build our securitisation capability and our ability to structure assets internally, so that we could have a seamless route to the market in order to achieve the plans that we had set out. That was extremely effective.
BQ537 David Quest: You have just explained how you were going to implement the plans, but what I am suggesting that this document shows is that there was a strategy more or less from the beginning of quite aggressively increasing reliance on wholesale funding-
Lindsay Mackay: Yes, that is correct.
David Quest: in order to support a corresponding increase in asset growth.
Lindsay Mackay: Yes, that is correct.
BQ538 Chair: It is telling that in your own evidence you say that the role of treasury is to support the strategy. It is almost as though other colleagues determine the strategy and then they turn to you and say, "Please will you now fund this?" There is not a lot of sign of use of an iterative process, where you are saying, "I am bit concerned about this. Should we be slowing the asset growth so that we bring these two things into balance in a better way?"
Lindsay Mackay: There was an iterative process. As we put this plan together, reviewing on a quarterly basis, we discussed the funding and our success at increasing the wholesale funding; the diversity of that funding, the maturity profile and so on were discussed on an ongoing basis.
BQ539 Chair: But the fact that the wholesale funding went on increasing at 45% of the 2007 figure-that was the longer-term funding-means that you are making no progress. This deficit is growing as fast as you are succeeding in increasing the longer-term funding, so it looks to me as though you never really get on top of the short-term funding issue; it is always there because you increase the longer-term funding, but the deficit increases.
Lindsay Mackay: When liquidity problems hit in July 2007, and the longer-term markets-and the short-term markets for that matter-closed, you are faced with a roll-down of the maturity profile. At that point, the percentage of wholesale funding we had with a residual maturity beyond one year was about 47%; by the time we got to the following half-year, in 2008, it had reduced to just over 40%. So you are faced with this roll-down of maturities, but we did not, with the numbers I was giving earlier, seek to drive our short-term funding substantially higher; it was all pushed to the longer term.
BQ540 David Quest: I think the Chairman’s point on the figures you gave us before was that, although the percentage of short-term funding was pushed down over time, the actual amount increased.
Lindsay Mackay: The amount increased when the liquidity problems hit and you suffered the roll-down of longer-term maturities coming back towards you.
BQ541 David Quest: The amount increased, didn’t it? When I say "increased", I mean that it increased over the level you had in 2000-01.
Lindsay Mackay: In the second half of 2008, the amount increased-that is correct. The amount increased, in particular, because of the substantial outflows we faced post the Lehmans collapse.
BQ542 David Quest: I am asking you a different question: I am asking you to compare how the short-term funding stood at 2001, and how it stood before the liquidity crisis in 2007. As I understand your evidence, you pushed down the percentage of short-term funding, but the absolute amount, which I think you said was about £85 billion in 2001, went up to-
Lindsay Mackay: To about £125 billion.
BQ543 David Quest: So it had actually gone up, even before the 1iquidity crisis.
Lindsay Mackay: It had gone up, annualised, by about 7% per year.
BQ544 David Quest: But you still, as it were, had that rump of short-term funding.
Lindsay Mackay: Yes, but we also held a significant portfolio of liquidity securities. From a regulatory perspective, we had to cover the first eight days out of outflow; our internal prudential requirement was to cover the first 30 days of outflow. The liquidity portfolio of about £60 billion was more than enough to cover the outflow we would have faced in the first month, if we had no access to markets whatever. We held quite a significant portfolio of liquidity assets.
BQ545 Chair: Do you sometimes wish that people had listened to you a bit more and given greater priority to a stronger funding position, as opposed to the preference to expand lending?
Lindsay Mackay: When we put the funding plans together-there were many discussions before they were finalised and locked into supporting the group funding plan and the capital plan, for that matter-we were always comfortable with the capacity that we had in the wholesale markets, given the assumptions we made in the plan to meet the requirements on us. We had taken steps to build up the capital markets capability for structuring securities off our own balance sheet and facilitating the sale into the market. We were also taking certain other steps to improve liquidity in the balance sheet. I made reference in my submission to loans distribution, where we had agreed with corporate banking that loans distribution would move from corporate to treasury. Unfortunately, the discussions for that took place in the first half of 2007. The agreement, finally, was after the markets had closed, so we were not able to be effective in that, but that was done with a view to ensuring that if we had agreed, for example-Peter Cummings was very clear on this point-to underwrite, let us say, a £100 million transaction, and our comfortable level of long-term hold, let us say, was £40 million, then we had line of sight to how that £60 million would be sold into the market. Now, we did not get there, because market events overtook us and the transfer, as I say, of the team did take place. The structure was lined up to be aligned with our existing capital markets. We put the whole thing into one piece, but unfortunately that was not able to be effected because of the markets.
BQ546 Chair: Do you think that the fact that you were for only part of the time having the CFO of the company as, in a sense, your spokesperson on the board was a disadvantage to you in that the rest of the time the person speaking for you was one of the two lending managers?
Lindsay Mackay: I think there is no doubt I would have preferred to have been there, but, having said that, I had the opportunity to talk to the board about the funding plan. It was a standard procedure for me to go to the board to talk to the funding plan so I could be cross-examined on it. I was on the group capital committee, so I had the opportunity there to raise any concerns or discuss any points or talk about the risks to the plan in more detail. If the question is, had I been on the board and had a louder voice, would HBOS still be around, that is not the case.
BQ547 David Quest: I think the point may be a slightly different one, if I may, which is that, for most of the time, the director you were reporting to was a consumer of wholesale funding. It was only for a relatively short time that you were reporting to the financial director. Really, the point is, would it have been better, as it were-obviously, it would have been better if you had been on the board yourself, but leaving that aside-if the spokesperson on the board was someone who was not themselves a consumer of wholesale funding, which might be said to give rise to a conflict?
Lindsay Mackay: Remember also on the group risk function. We had a group risk oversight of the whole of treasury, but the funding plan in particular and our capacity in the markets in particular. When I was invited to go to the board to talk to the funding plan, for example, the group risk representative would be there as well. At the group capital committee, group risk were on that committee, and they reported up through the finance director, so there was the mechanism for any concerns or what have you to be elevated up to the senior level. I take your point that when I reported to George Mitchell, yes, he was running corporate, but you’ve got to understand the approach that George Mitchell-I know you are speaking to him shortly-took. It was not one of pressing to do additional funding or what have you; it was much more conservative than that.
BQ548 David Quest: But overall, was the structure-as you saw it, as HBOS saw it-that the strategy was driven by whatever decisions were taken about growing the business, and the funding was obtained in order to meet those requirements, rather than the other way round-in other words, rather than fashioning the business growth according to what funding was available?
Lindsay Mackay: It was always the case that the business would want to put down the asset growth that they are looking for, and then we would have to balance and come to an agreement on what capacity we had, whether it was in retail markets or wholesale markets, in order to meet that. There are always adjustments. The plan went through many iterations each year to arrive at it. The plan was controlled by group finance on behalf of the chief executive. There were always many iterations coming to the final mix-the final balance-of the plan.
David Quest: But overall-
Lindsay Mackay: So it was not a case of being told, "Well, look, that’s the funding. Write a plan that meets this number."
BQ549 David Quest: No, I am sure it wasn’t. I am sure there was an iteration process, but, overall, the general process was that the business was driving the funding, rather than the other way round?
Lindsay Mackay: The businesses were the consumers of the funding.
BQ550 David Quest: The businesses were driving the funding, rather than the funding driving the businesses?
Lindsay Mackay: If we felt-if a treasurer felt-that we could not meet the funding, we would not support a plan that we did not think was achievable.
BQ551 David Quest: Can we look at the document E2, which is still on the same topic? It is an executive committee awayday. You were not actually on the executive committee, were you? You attended this meeting for one of the items.
Lindsay Mackay: Yes.
BQ552 David Quest: If we turn to item 12 on funding. If you see there, it is obviously an item that you presented. It says: "Lindsay Mackay explained that the Funding position during 2006 had been subject to significant change. Customer Deposits were increasing in absolute terms over the Plan period but, as a percentage of the Group’s actual requirements would fall-and would end the Plan paid at about 43% of requirements (down from c. 50% at the time of the merger. Pre-merger, Halifax had been around 70% self funded). Divisional funding gaps (excluding securitisations) would nearly double over the Plan period (although the "quality" of that funding had probably improved)". You are explaining to the executive committee that the funding gap, or the requirement for wholesale funding, is widening as time goes on.
Lindsay Mackay: That is right.
BQ553 David Quest: And had widened significantly from pre-merger to the merged bank, and had widened further from the date of the merger to 2006?
Lindsay Mackay: It had widened from the day of the merger to 2006; that is right.
BQ554 David Quest: And then in the next paragraph, you say, "Significant progress had been made in recent years to expand the sources of funding available to the Group. There was confidence that this Plan could be funded"-"could" is emphasised-"albeit with only limited room for slippage in case of above Plan asset growth."
In the next paragraph, you say, "There was no shortage of short-term wholesale money. There had been strong growth in recent years in the Group’s deposit raising abilities. But profit pressures in Retail in particular had argued against establishing an "unprofitable" permanent attack that would simply seek to "hoover up" deposits. Internally transfer pricing these deposits to Divisions whose Assets were growing most strongly could help address that issue." Is what you are reporting here that retail did not want to increase its deposits because that was not seen to be sufficiently profitable?
Lindsay Mackay: I think you have to remember that we are looking at the plan period over five years. This is looking forward to the two to five years in the plan, and what the make-up looks like then. Also bear in mind the point that I have made on the quality of retail deposits. We are acutely aware of not wanting to reduce the quality of our retail book and that we would prefer to raise term wholesale funds than compromise the quality of the retail deposit base.
BQ555 David Quest: Sorry to interrupt you on that point, but I am asking you about this paragraph. The point that is being made is about not the quality of deposits but the profitability of the deposits. Isn’t that right?
Lindsay Mackay: I do not recall-you have to look at the equation between the cost of term funding versus retail deposits, and if you are looking simply at the cost, retail deposits would have been cheaper. I would not read too much into that sentence.
BQ556 David Quest: What does unprofitable mean if it does not mean that?
Lindsay Mackay: I think what we are driving at here is, would it be sensible for, let us say, retail to raise additional deposits to fund growth in international?
BQ557 David Quest: Just on that point, in terms of who were the main consumers of wholesale funding, was that mostly corporate international?
Lindsay Mackay: Yes. Well, retail were as well, but of course we have to look at the assets that they were carrying. The nature of the assets in corporate and in international were genuinely illiquid. In other words, from a funding point of view, there was not a lot of alternatives in terms of using the assets to create funding, whereas in retail, the quality of the mortgage portfolios, the credit cards, auto receivables and so on readily lent themselves to securitisation.
BQ558 David Quest: And international was a very fast-growing area, was it not?
Lindsay Mackay: From a low base, international was growing quickly, but also had access to different deposit markets as well, so that is something that, over the course of time, we were looking at in order to continue to develop it.
BQ559 David Quest: You did have access to deposit markets, but in fact what happened is that it had to be funded by wholesale funding, because it was not able to raise sufficient deposits.
Lindsay Mackay: Yes. If you look at the strategy, in Ireland, it was to build out a retail branch network; in Australia, it was continue to build out the branch network-having the Bank of Western Australia based in Perth on the west side, the strategy was to expand into the east side of Australia and build out the retail branch network. Coming back to the quality of deposit question, you cannot do that and then, overnight, raise a lot of the types of retail deposit you want, so there was going to be a lead time over which those were going to come online and allow us to develop them.
BQ560 David Quest: Yes, but in fact, over the period we are talking about, international was not able to raise significant deposits.
Lindsay Mackay: You would have look at the numbers again, but they were not a significant element of our retail funding base.
BQ561 David Quest: Do you think it made sense to use wholesale funding to fund illiquid international loans?
Lindsay Mackay: How we looked at it at the time was the overall balance of the liability base to support the asset base of the bank. In hindsight, and looking at what happened when the markets dislocated, it is clear now that that is not a policy that would be pursued-indeed, a lot of activity that took place in banking markets will not longer take place in banking markets; they will move into other providers.
BQ562 David Quest: Still on this document, in the next paragraph, it says: "There had been a steady increase in the Group’s wholesale funding needs over recent years. But according to this Plan, the Group would reach its current wholesale funding capacity by 2009 in the absence of other actions. There were additional risks that emerged from the quantity of the Group’s capital forecasts and volatility in capital requirements." At the end of the paragraph, in bold, you say: "HBOS had the highest wholesale funding need of any of the UK banks (and was close to the other Big Four banks combined)." Here, aren’t you telling the executive committee that not only are the requirements very large compared with other banks, but you are really near to approaching capacity?
Lindsay Mackay: "In the absence of other actions"-that is correct, and "capacity" means looking at the back end of the plan.
BQ563 David Quest: Was no one expressing any doubt about the strategy? It does seem to be much more aggressive than, as you say here, the other big four banks were taking. Did no one question it?
Lindsay Mackay: There was a lot of discussion and challenge of our capacity in the markets and our ability to meet the growth that we had planned for. As I say, the balance for that was that, on a quarterly basis, we would revisit the assumption we made in the plan versus our actual activity in the market to ensure both were still in line, and if they were not additional action would have to be taken, which ultimately would mean cutting back-reducing-asset growth, pulling out of certain lines of business, or finding other sources of funding.
BQ564 David Quest: More fundamentally, wasn’t anyone questioning whether you should be continuing to increase your reliance on wholesale funding-not just how you would do it, but whether you should be doing it at all?
Lindsay Mackay: I think there was a lot of focus on the quality of the wholesale funding base we had, and the diversification not just in terms of maturity, which we discussed, but geography and investor bases, which gave us a lot of comfort.
BQ565 Chair: As I said in my introduction, one of the things we are interested in is examples of where warnings were given and not heeded. All the way through this, I get the impression that warnings are coming from you and that, if anything, they are getting stronger and stronger as the period goes on, so that by the end we have language such as "snowball effect". That sounds like someone who is getting really worried about this, but who is not able to prevail and get someone to say, "Let’s stop and think whether this course we’re on will really work."
Lindsay Mackay: There is no doubt we made very clear in this funding plan and the following year our capacity and ability to operate comfortably within the capacity we had, and as I say, there was a lot of discussion, challenge and debate about our capacity in the markets and the quality of our wholesale funding base. Colin Matthew, in his role of strategy, was of course looking at other opportunities-inorganic opportunities-to perhaps address this, as part of our natural course of business, but it was not a case where we felt there was significant danger ahead in terms of wholesale funding.
BQ566 David Quest: Did you and the committee think that the continued growth was sustainable?
Lindsay Mackay: No. We had very strong growth up to about 2004, then the growth came down significantly, slowing to below 10% per year. When I was looking at the plans in 2007, we talked about moving the loan distribution from corporate to treasury-that would have covered international business as well-and we talked about the capital markets. Our distribution capability was always looking at a point where we were getting to a maximum size of balance sheet and we would then operate within that. That is my clear recollection of the situation at that time, but we had not got to a point where the balance sheet was flattening down and we were operating on a steady-
BQ567 David Quest: So at this point, 2006, it all still seemed to be sustainable?
Lindsay Mackay: In 2006, we were comfortable with the funding plans that were put forward for 2007-2011; that’s right.
BQ568 David Quest: Starting at the bottom of that page is a list of key challenges in relation to funding-capacity, planning and optimisation. The next paragraph states: "Timing issues were important: to open up new markets, develop new Instruments". Then, "HBOSTS"-HBOS treasury services-"would give further consideration to the options available to the Group to make material improvements to
the position", but "In the longer term, the position was untenable and unsustainable: the Group had benefited in this respect in recent years by decisions made (for other reasons) to reduce the rate of asset growth."
Lindsay Mackay: That is what I was getting at in my previous comments-so that we got to a point where the balance sheet is flattened.
BQ569 David Quest: So, as from 2006, you would have to start looking at tailing off.
Lindsay Mackay: As we were looking at the back end of the five-year plan in 2006, we needed to take certain steps in order to make that happen. The capital markets development was one; the loan distribution and so on-all would help us to get to that point.
BQ570 Chair: The calamity arose before you completed that. You had this vulnerability identified almost in 2001 and did not make a lot of progress in correcting it, although you had plans to do so, so you were left particularly vulnerable when the funding markets dried up. That affected everyone, but not everyone failed. You had more vulnerability than they did, which seems to indicate that perhaps they should have listened to you more.
Lindsay Mackay: Our failure post-Lehmans was, as I said, was the significant outflows of retail deposits, which, with no markets available, we could not match in terms of wholesale funding. We had gone way above what our anticipated capacity was in the wholesale markets at that point, so yes, that’s exactly what happened.
BQ571 David Quest: Why was that something that particularly affected HBOS?
Lindsay Mackay: In terms of how HBOS was affected, perhaps you need to go back to the original dislocation in the markets in July-August 2007. Of course, the first main event was Northern Rock, and there is no doubt that that had an impact on international investors as well as domestically, which I think is well understood. After that point, investors were, first, quite surprised that it had happened, and the feedback from our investor relations team, who talked to investors directly, was that they were surprised that UK banks did not have the same access as European banks to the ECB in order to generate liquidity. That was well understood within the UK, but not so well externally.
We also had a series of issues with regard to the share price. There was an incident towards the end of 2007 and a more significant one in 2008, where the FSA were involved. It was not just the share price but also the credit default swap market, with an instrument whereby you can buy protection for a term-generally five years-against an entity. There was huge volatility and activity in that market, which was acting negatively against HBOS in particular, and markets in general. There was also the fact that we announced a rights issue in March/April 2008, with a very long lead time before it was settled. Although it was fully underwritten we had, I think, a four-month period between announcing the issue and getting it settled-again, creating uncertainty around the HBOS share price and the credit default swap market.
We then had the whole question of wholesale, which we have discussed-wholesale markets drying up, very large use of wholesale markets by HBOS, the roll-up effect and so on. When you take liquidity out of the market, asset prices will be affected. HBOS was a very big property bank, of course, in the retail sector, but also in commercial real estate and the corporate and international book.
BQ572 Chair: So you are saying there that the perceived quality of your assets-your loan book-was one of the reasons why the market in a sense picked on you early on in this process and lost faith in HBOS before Barclays or whatever.
Lindsay Mackay: If we look back at, say, April 2008, it seemed that markets were getting a little bit better. We issued a securitisation off the permanent programme. It was not a large deal-it was about £600 million-but it was a public deal, well received, good press. Around the same time, we did a term senior deal and a term capital deal. Others of course were issuing as well, and it seemed that there was a bit more activity coming into the market, and things looked slightly better.
Post the summer, there was always a concern, as markets tend to shut down and investors stop around July and maybe come back in September/October, and there was a big focus on the refinancing that the market in general would have to complete before year end. We then had the Lehmans collapse and a catastrophic closure of all markets. This was not just HBOS. It is no exaggeration to say, and I think Sir Mervyn King said towards the back of 2008, though I cannot remember his precise words, that financial markets came very close to collapsing altogether.
The liquidity that was sucked out of HBOS and the consequent problems also had an impact on the asset values held by banks, and in particular HBOS, with its exposure to various categories of product.
BQ573 Chair: Maybe the moral of that is one needs to look at the quality of your loan book, because it not only has to be funded but can affect the ability to fund through wholesale markets.
Lindsay Mackay: Yes. In hindsight, this also comes to your earlier point, that in terms of business being carried on a bank balance sheet those illiquid type of loans to that extent do not make sense.
BQ574 David Quest: Perception of loan quality and perception of exposure to wholesale funding must have been particular difficulties in relation to HBOS’s position.
Lindsay Mackay: Absolutely.
BQ575 David Quest: On page 4 of your statement, you refer to being aware that, prior to market dislocation in July 2007, there was some concern at senior management level over the long-term strategy of the group and your ability to manage within your resources of capital and liquidity.
Lindsay Mackay: This ties into what we were talking about earlier. We were looking over the planned period at balance sheet growth at the point we get into a smooth position.
BQ576 David Quest: Are you saying that particular people were concerned, or just that there was a general-
Lindsay Mackay: There was a general discussion at the group capital committee with aggregate risk colleagues within treasury about what the longer-term strategy was in the back years of the plan, having brought it into overall balance. That helped us to develop our capital markets and to move the loan distribution to treasury. I refer to a paper I took to the group executive in the first quarter of 2007, which again really looked at this whole question of planning and bringing responsibility for capital funding together in a joined-up way to give us a better line of sight on the way things were developing over time. I stress that this was trying to improve things at the margin; it was not a sea change in the way the approach was taken.
BQ577 David Quest: When you talk about before the market dislocation, when are you talking about?
Lindsay Mackay: I refer to the market dislocation as being July and August 2007.
BQ578 David Quest: And when were the concerns expressed?
Lindsay Mackay: Prior to that.
BQ579 David Quest: Just to get an idea of what kind of time period we are talking about.
Lindsay Mackay: You can see in the 2006 to 2010 funding plan that 2007 to 2011 is discussed at that point.
BQ580 David Quest: On a different topic-treasury operations-in the 2008 financial statements, treasury and asset management reported a very large loss of something over £3 billion, which presumably would have been the first loss that the division had ever made.
Lindsay Mackay: Okay. Let me talk a little about that. We carried about £80 billion of assets within treasury. Just under £20 billion was an investment portfolio; the other £60 billion was our liquidity portfolio. Of that £60 billion, we had £20 billion in structured credit and £40 billion in Government and bank assets. If you take our structured credit exposure of about £40 billion, in February 2009, looking at the performance of the portfolio at that point, we had taken losses of £200 million and made provision for a further £200 million against potential future losses on that portfolio. On our bank assets, we had taken losses of £600 million, chiefly to two US banks that had collapsed, giving total losses and provisions of about £1 billion against a portfolio of £80 billion. In addition to that, we took negative fair value adjustments of about £2.5 billion. These were securities held on trading books, so if we were forced to sell them at that point, we determined that we would have had a loss of about £2.5 billion, but had we held them to maturity, we would have been repaid in full.
We also decided at the time-it was a group finance decision-not to take the positive fair value adjustments on the debts we had issued. I cannot remember the numbers, but they would have significantly outweighed the negative fair value adjustments that we had taken on the trading portfolios. I think that I am right in saying that, through the merger accounting, Lloyds took the uplift of the positive fair value adjustments at that point.
BQ581 David Quest: The structured credits on which you took the mark to market loss, which represented the largest part of the book loss-
Lindsay Mackay: That would have been across the structured credit and, from memory, the banking assets as well.
BQ582 David Quest: You said that if you had held them to maturity you would have been repaid in full-only, presumably, if they had paid out on maturity.
Lindsay Mackay: That is quite an important point, because if we, and for that matter our external accountants, felt they were not going to be paid out in full, we would have had to provide for them.
BQ583 David Quest: In the end, you did have to mark them to market with a significant loss.
Lindsay Mackay: That is a negative fair value adjustment, yes, which is different from a loss.
BQ584 David Quest: Well, it was reported in your accounts as a loss.
Lindsay Mackay: Yes, but the point I am making is that if they had been held to maturity, we would have expected to be paid in full.
BQ585 David Quest: But there have not been any recoveries by lawyers on those assets, have there?
Lindsay Mackay: I am not sure.
BQ586 David Quest: Do you know whether lawyers have made any recoveries on the assets?
Lindsay Mackay: I am talking about the point in time of February 2009-it was quite an important point-where we made that assessment after everything that happened in the markets. It was a negative fair value adjustment. In the same way, we could have taken a positive fair value on the debt we had issues: quite an important point.
BQ587 David Quest: The negative fair value adjustment was taken because the perception at that time was that those securities have reduced substantially in value.
Lindsay Mackay: Correct. If we had had to sell the securities immediately, we would have suffered a loss. We had some US student loans, for example, 98% of which were guaranteed by the US Government. We still took negative fair value adjustments on those, and you would fully expect those to be repaid in full. So, sell immediately, you would have taken a loss; hold to maturity, you would expect to be repaid.
BQ588 David Quest: A significant proportion of the structured credits were Alt-A securities, weren’t they?
Lindsay Mackay: Yes.
BQ589 David Quest: Which are one step above sub-prime.
Lindsay Mackay: They sit between prime and sub-prime, yes.
BQ590 David Quest: So they are at the lower end of the loan quality spectrum in terms of the assets that make up the security.
Lindsay Mackay: You have to look very carefully at each of the securities to understand the underlying quality. We did not buy any assets unless we were comfortable internally, although the disclosure we always gave was in terms of the external ratings, because that is what everybody understood. But we made no credit decisions based on external ratings; they were always made on internal. We insisted on a 30% level of subordination on the Alt-A securities before we bought them. That meant that to lose money in those securities would require about 60% of the mortgagees to go into default, and then a loss given default of over 50%. The £200 million provision that I mentioned on our structured credit portfolio was against the Alt-A securities. There were various different types of Alt-A; it is not a generic set cost.
BQ591 David Quest: I think you said that the structure portfolio was about £40 billion-
Lindsay Mackay: Just under £40 billion.
BQ592 David Quest: And that had increased from about £18 billion in 2000.
Lindsay Mackay: That is correct.
BQ593 David Quest: How was the decision made to increase the size of that portfolio?
Lindsay Mackay: The £18 billion of structured credit assets-this goes back to the Halifax time; I was not at Halifax-as I understand it, none of that was held for liquidity purposes, so in effect we basically kept that number stable as an investment portfolio and invested in additional structured credit assets for liquidity purposes.
BQ594 David Quest: Whose decision was that?
Lindsay Mackay: That was a proposal from treasury that the structure within which we could buy securities-the types and so on, the range of currencies-went through the group credit committee, and the individual credit authority was sanctioned down through the group wholesale credit committee.
BQ595 David Quest: But the proposal as to the type of securities and the increase in the size of the portfolio was a proposal that came from treasury.
Lindsay Mackay: Correct.
BQ596 David Quest: And to what extent do you think that the board members understood the nature of the securities that were being acquired? A moment ago, you said that what was disclosed was by reference to the credit rating of the securities. When you say "disclosed", is that what the board was told as well, or do they have more information?
Lindsay Mackay: I was not on the board. The board got, I think, very full information. When I say "disclosed", I mean disclosed to the market. At the end of 2007, we made a disclosure on all our structured credit-not just the external ratings, but, as I recall, the asset classes we invested in. That was then updated in a slightly changed format, but so that you could compare things like for like. There was a slightly different format when we did the rights issue. We updated the market again at the half-year and the full year.
BQ597 David Quest: Within HBOS, it is obviously a very specialised area. Realistically, outside treasury, was there anyone else in senior management who was really capable of forming a view?
Lindsay Mackay: You mentioned the Halifax number. At merger, we looked at that business; we looked in from the Bank of Scotland side at the Halifax side before we got together. We thought, "Is that a business we should be in or not?" When we merged, my responsibility was funding liquidity, so that was not my area, but it did get, I think I am right in saying, a lot of scrutiny at the board level, so that the Bank of Scotland directors could have explained to them what this business was and how it operated, which the Halifax directors were familiar with.
BQ598 David Quest: You think the Halifax directors were familiar with what was in that portfolio?
Lindsay Mackay: The nature of the portfolio at the time of the merger? I do not know it for a fact, but I am pretty sure that would be the case.
BQ599 Chair: I have one very general question. I was under the impression when we started this project that, at the merger, you had the Bank of Scotland, which was expanding its lending very rapidly and which had a wholesale funding deficit, appearing to merge with an ex-building society with lots of deposits. What I think I get from this-I wonder whether you can confirm this-is that the H bit of HBOS also came into the merged group with a substantial wholesale deficit.
Lindsay Mackay: I think the position on Halifax solo had just switched from being a net long of retail funds, if I can put it that way, to a short position. I cannot remember the exact numbers, but they were a net taker of wholesale funds at the point of the merger, yes.
BQ600 Chair: But it looks to me as though when this merger took place, the BOS bit thought that it was going to be greatly aided to expand much more rapidly, because it was merging with an organisation that had very large deposits. The quantum was very large, but it turns out that this organisation was, as you say, not long on deposits-it had a deficit as well.
Lindsay Mackay: That is right, but I think it was relatively small. Of course, you put the two together, and there is a much bigger balance sheet.
BQ601 David Quest: Perhaps I can just help you with a number on that. We looked at the document from 2006, when you were the executive committee minuter, and you said in that that pre-merger Halifax had been around 70% self-funded. Is that the right figure?
Lindsay Mackay: That sounds correct.
David Quest: So 30% wholesale funding and 70% deposit funding.
BQ602 Chair: It is quite an interesting insight that there was not a pool of surplus funds, so to speak, that BOS could draw on. You both had a wholesale deficit, so that explains why concerns were being expressed right from the start, even before you came into your role, about wholesale deficits being a crucial strategic weakness.
Lindsay Mackay: Yes, and we had to ensure we had the right maturity profile spread and so on.
BQ603 Chair: And the story seems to be that despite work on treasury’s behalf to try to make that more manageable, right at the point where the collapse came, that strategic weakness was still there-if anything, it had grown.
Lindsay Mackay: That is correct; there is no doubt about it. When the collapse came, with the dislocation from ’07 through to ’08, post-Lehmans, wholesale funding was just non-existent.
BQ604 Chair: There was a kind of Augustinian policy: it will make me virtuous in terms of my funding balance, but not yet. I think you said you had plans and that, by 2010, you were hopeful this was going to get into balance.
Lindsay Mackay: We were on a glide path to bring that into balance. Unfortunately, despite the very robust nature of our wholesale funding-and it was robust-we just did not have that additional capacity to meet the retail outflows that we suffered.
Chair: Okay. I think I understand it better now. Thank you very much for your evidence. It is all part of a jigsaw that we are assembling.
Examination of Witness
Witness: George Mitchell, CEO Corporate and Treasury, HBOS, 2001–2005, examined.
Chair: Thank you for coming on a gloomy Friday to this spookily empty building.
George Mitchell: There are lots of tourists!
Chair: Yes. Let me give you a bit of context. The commission as a whole is looking at conduct and standards in banking. In some senses, this is a continuation of the more structural work that the Independent Commission on Banking has done. We are looking at what went wrong, why it went wrong, how it was allowed to go wrong and where warning signs were not given or where they were given but not acted on-it is as much the dogs that didn’t bark as the dogs that did. Why is this panel, which I have been asked to lead, doing a case study on HBOS? For one thing, it is a pretty dramatic story by any account. The bank has a market capitalisation at the merger of £30 billion. That appears to go up to about £40 billion by 2007 and then appears to disappear almost completely. Also, it has been less thoroughly dealt with in the public arena. The FSA has basically done the RBS story for us. No one really looked at HBOS while the enforcement proceedings were going on. It was only when they finished that it became possible to open this story up.
On process, an innovation is being developed. Parliamentary Committees, or Commissions, have acquired counsel to help us with the inquiry. Can I assure you that this is not turning this into a court, tribunal, disciplinary hearing or anything of that kind? These guys-David Quest here-are better at questioning than we are, and it allows a Chairman to listen to the answer rather than thinking of what the next question is. I recognise that we are an evidence-collecting process. The judgments about how to interpret this and what you think the story is will be made by the full Commission when we have reported all the bits and pieces of the jigsaw back to them. This is just a preliminary hearing. Thank you for your witness note, which was very helpful. With that I will hand over to David Quest.
BQ605 David Quest: Good afternoon, Mr Mitchell. You retired from HBOS at the end of 2005. You were governor of the Bank of Scotland, and you were also chief executive of the corporate division.
George Mitchell: That is correct.
BQ606 David Quest: At the time you retired, the bank-the corporate division in particular-were looking in very good shape. They were profitable and the share price was good. HBOS either had done or was contemplating a share buy-back programme, as things seemed to be going so well. Three years later, in December 2008, the corporate division reported a loss of about £10 billion, which was a remarkable turnaround in those few years.
George Mitchell: Yes, indeed.
BQ607 David Quest: You were not there in those three years, but I wonder if you can help us by giving us your thoughts on why you think the HBOS corporate division and its corporate loan portfolio did so badly in that period. What was it about the loan book that caused it to suffer such catastrophic losses?
George Mitchell: Clearly, I was not there, so it is very difficult for me to answer. I will try throughout my evidence not to keep saying that, but it is difficult for me to comment on why we moved from ’05 to ’08, or why the corporate book sustained these losses. I have a view on why HBOS collapsed in 2008, but I do not really have a view on how corporate went from a to b, because I wasn’t there.
BQ608 David Quest: You have no idea at all.
George Mitchell: No, I have no idea. How could I have an idea when I was not there? The corporate loan book that was in place when I left in 2005 was in very good shape. Even two years after I left, the impairments in corporate were very low. In addition, as the final notice says, the corporate book was turning over at 30% per annum. I left in ’05-with that book turning over at 30% per annum-and two years later the impairments were still very modest. How we went from that position to where we ended up, I obviously don’t know. I think you would have to have been there to know.
BQ609 David Quest: We will come back to this point, but, so far as you are concerned, there was nothing in the make-up of the corporate loan book when you left in 2005, which, looking at it now, you think might have contributed to the problems that were suffered later?
George Mitchell: No, nothing. Don’t get me wrong: I am not saying that in a deep recession impairments would not have risen and perhaps risen significantly; I think I am suggesting that these provisions would have been at a very manageable level.
BQ610 Chair: May I just clarify? You became the head of corporate when it was simply BOS. There was a period of between one and two years when you were doing the job that you did, but it was part of BOS, and you carried on doing that when it was in HBOS. Did that change make any difference or did the modus operandi of corporate basically date from the pre-merger experience?
George Mitchell: The types of lending that corporate was engaged in in HBOS was no different from the type of business we were engaged in when we were Bank of Scotland, so we had a lot of experience in these markets. They did not just start when HBOS was created. The big difference was after the merger. We had the size so that we could actually go into the underwriting market rather than just being a participant bank, but the type of lending from a credit perspective was actually no different.
BQ611 David Quest: It was perceived that one of the benefits of the merger was that a larger balance sheet would enable an expansion of the BOS corporate lending.
George Mitchell: It did indeed, because it allowed us access to markets that had previously been closed to us, by which I really mean the underwriting market. In the first year of HBOS’s existence, corporate grew quite rapidly, albeit from a pretty low base, and that is because we had access to markets that were previously closed to us. However, every year thereafter, when I was in corporate, the rate of growth slowed.
BQ612 David Quest: Perhaps we could make that point good by looking at a couple of documents. In the file before you, if you turn to the tab marked E10, you will see a copy of the 2002-06 group business plan. That would have been the first business plan post-merger. If you turn to page 39, under the heading "8.2 Corporate Banking", it says, "The markets in which Corporate Banking operates are large and have the potential to deliver strong sustainable growth. Notwithstanding the current uncertain economic outlook, the successful establishment of HBOS plc gives Corporate the balance sheet firepower to fully exploit such opportunities". That is the point that you were just making, is it?
George Mitchell: Yes.
BQ613 David Quest: In that same document, if you turn back to page 18-
BQ614 Chair: Before we leave that page, the next bullet point states, " We are looking to become more self-funding", but by the time you left, is it true that you had not made a lot of progress on that front?
George Mitchell: On self-funding?
Chair: Yes.
George Mitchell: No, quite the reverse. If we are talking about corporate, as opposed to HBOS, the corporate self-funding ratio at the time of the merger was 33%, and by the time I left at the end of ’05, it was 53%. I think we had made considerable efforts in improving the self-funding. I think the wholesale funding gap in monetary terms still grew, but we did improve the self-funding ratio from 33% to 53%.
Chair: You are talking about the self-funding ratio of corporate as opposed to the self-funding ratio of the group.
George Mitchell: That is correct, yes.
BQ615 Chair: The group gets worse, whereas your bit of it is improving. Is that what you are saying?
George Mitchell: Yes.
BQ616 David Quest: Which bits of the group were getting worse in that respect?
George Mitchell: I don’t have the numbers in front of me, and I am not sure what the self-funding ratios were in ’01 and ’05 for the other divisions, but I know that the funding gap between ’01 and ’05 for the group as a whole did increase. Although corporate’s did increase in monetary terms, notwithstanding deposits were growing faster, the increase in the corporate funding requirement was quite modest.
Chair: I think have understood this now: the ratio improved but the absolute amount widened because the nominator-you were growing at 30% and you may be improving the ratio, but the absolute amount of wholesale funding that you are requiring is still growing.
George Mitchell: That is correct.
Chair: Got it. Okay.
BQ617 David Quest: I didn’t quite catch the figures you gave, but if the ratio increased-I think you said it increased to 33%.
George Mitchell: No, it increased from 33% in ’01 to 53% in ’05.
BQ618 David Quest: Quite, but the size of corporate banking increased by a greater ratio than that, didn’t it?
George Mitchell: Yes.
BQ619 David Quest: In the same document, if you turn back to page 18, you will see that there is a paragraph that begins, "Corporate Banking PBTE grows by around 22% per annum with overall interest margins remaining fairly constant … Strong asset growth in all business areas (averaging 24% per annum)is the main driver of income growth". At this time, the bank was projecting fairly rapid growth in corporate, and indeed in all divisions in the bank.
George Mitchell: Yes. As I say, in the first year of HBOS the corporate book grew at roughly that rate, but every year thereafter it slowed. In my final year, 2005, the rate of growth had fallen to 8% with the expectation that it would be even lower the following year. It is a case of growing at the right time and pulling back at the right time-that is the secret of corporate banking.
BQ620 David Quest: The overall growth between 2000 and 2005 would have resulted roughly in a more than doubling of the corporate loan book. Does that sound about right to you?
George Mitchell: No, it doesn’t sound right.
BQ621 David Quest: Well, we can look at some of the figures.
George Mitchell: Perhaps the misunderstanding is because half way through that period business banking and corporate banking came together, so you had two divisions’ assets at the end date, and only one division at the beginning.
BQ622 David Quest: I thought I had taken that into account, but we can look at the numbers if necessary.
George Mitchell: My understanding is 25% in year one, 11% in year two, then 9%, then 8%, then 8%. If you add those together, there was a constant slowing of the growth rate.
BQ623 David Quest: In terms of the corporate bank’s offering to its customers, how did you see what the corporate division was offering as being different from what other banks were doing? What were the features of it that you thought made it stand out?
George Mitchell: I have seen comments about this. I think that a lot of the business we were doing was not different from what other banks were doing. One of the proofs of that is that we had absolutely no difficulty in selling down the loans that we underwrote, which means that other banks were taking on exactly the same business as we did. We were one of the few players in the integrated finance market, where we were a one-stop shop providing the debt, the mezzanine and the equity, but there were many, many, many banks participating in the leverage buyout market.
BQ624 David Quest: Can we just see whether we can identify what was particular about the corporate division at the time of the merger, so thinking back to 2000-01. Just to help with that, we have in the file at tab D22 an extract from the annual report of 2001. I want to highlight a couple of things to see whether this is right. Do you have that?
George Mitchell: Yes. Which page?
BQ625 David Quest: The first page, which should be headed, "The new force in corporate banking continued". Do you have that?
George Mitchell: Is this D22?
David Quest: It is D22, and it should be first page in the file. It is D21.
Chair: Have you got a little box in the left hand corner?
BQ626 David Quest: Does it look like this? Why don’t I just hand you this copy?
George Mitchell: I do not have that one.
BQ627 David Quest: It is a general description of what corporate banking was doing. You will see that the second full paragraph on the page refers to integrated finance offerings, which provide a complete funding package for customers, including mezzanine debt-you mentioned that was a particular feature of your offering. This is obviously the HBOS accounts, but it is something that had been done at BOS as well. It was not new to HBOS.
George Mitchell: Yes.
BQ628 David Quest: So it was a continuation of the BOS strategy. Also on this page, you will see-I’m afraid it is a little faint-a heading, about two thirds of the way down, that says, "Never a fair-weather friend." The point that is made under that section is that HBOS was not a fair-weather friend to its customers, and it would support them in bad economic times as well as good economic times.
George Mitchell: That is correct.
BQ629 David Quest: That is what is sometimes referred to as lending through the cycle.
George Mitchell: Yes.
BQ630 David Quest: Again, that was something that had been done successfully at Bank of Scotland in the previous financial crisis-in the 1990 financial crisis.
George Mitchell: Yes, in numerous cycles.
BQ631 David Quest: And that was something that BOS-is this fair?-had prided itself on, on having lent through the cycle and done so successfully.
George Mitchell: Yes.
BQ632 David Quest: Again, it was a particular selling feature, as it were, to its customers.
George Mitchell: Obviously, it was not done blindly.
David Quest: No, I am not suggesting it was.
George Mitchell: It was done on a case-by-case basis. If you felt that there was a good chance of turning bad money into good, then that is what you would be trying to do.
BQ633 David Quest: But it was something you felt that you were doing that other banks were not doing, and you thought that that was an advantage.
George Mitchell: Yes, it was.
BQ634 David Quest: Then, under the next heading down, "Scale matters", it is stated: "But in Corporate Banking size is still important, and the bigger and stronger balance sheet that the merger has created will undoubtedly allow us to lead and arrange more transactions and underwrite and hold larger positions". Again, we have mentioned that already, and the advantage that you saw here-which was a new advantage from the merger-is that you could lend larger amounts as main underwriter, rather than taking positions in syndication.
George Mitchell: That is correct. Always with a view to selling them down to our comfort hold level.
BQ635 David Quest: Yes, but you would be the bank initially taking on the exposure.
George Mitchell: That is correct.
BQ636 David Quest: And as time went on, you did increase the number of larger loans to individual customers.
George Mitchell: Yes.
BQ637 David Quest: If we leave that for a moment and turn forward to D23 in the same file, it is a list dated 2002 of corporate banking advances over £20 million-we have blanked out the names for confidentiality reasons-but you will see, in the third column, new facilities being granted and the top four are £900 million, £900 million, £800 million and £500 million. That is 2002. If you compare that with the document in the next tab, which is the position three years later, you will see that the largest exposures are very much larger now, so you have got £2.1 billion, £1.9 billion and £1.5 billion. I suggest that that reflects a development of the business since 2001 that resulted in increasingly larger loans being made to individual customers. With a view, as you said, to selling them down.
George Mitchell: With a view to selling them down, yes, that would be in the strategy being put in place.
BQ638 David Quest: With a significant increase in the amount of the individual loans being made, as those documents show.
If I can go back to the document that we were looking at before, which was the 2001 accounts, I have a couple of other points from here. You will see in the second column, the first heading after the first paragraph, "Our performance"-
George Mitchell: Where are you now?
BQ639 David Quest: The accounts document, the annual report document-the one I handed to you. In the second column, under "Our performance", you will see the reference in the second paragraph to: "the lending commitments growing by 32% in the year"-again, at the outset at least, very significant levels of growth.
George Mitchell: Yes.
BQ640 David Quest: If you turn over the page, you should see a balance sheet-do you have that? At the bottom of the left-hand column, you will see the heading "Classification of advances", which divides it into different categories. Under the heading "Construction and property", you can see that you have roughly about 29% of the book at that stage in construction and property exposure.
George Mitchell: Yes.
BQ641 David Quest: And at the time, this did not include business banking, which was a separate division, so that is to be added to that. Another feature of Bank of Scotland and HBOS’s book was that by comparison with other banks it had a relatively high exposure to commercial property.
George Mitchell: I am not sure if that is necessarily the case, but we had about a third of our book in commercial property. I have not studied the balance sheets of other banks to know whether that was particularly an outlier.
BQ642 Chair: Mr Quest has just said that in 2001 roughly 28%, that is all these different aspects of property plus hotels, is in property. If you move on to D22, the same table is reproduced for 2005, two or three pages on. By that time loans and advances have increased to £79 billion. You pointed out that by that time you had picked up the other division and you have got the SME lending in there.
If you look at those numbers, and you look at property investment-20 in property going down to 11 in hotels-of that very substantially expanded loan book, the share of property has gone up from just under 30% to just under 50%. You are expanding very fast but you are also expanding the share that is property or property-related businesses.
George Mitchell: It has gone from 36% to 47%. That is if you include hotels and restaurants and regard that as property lending, but we would have regarded that largely as business lending as well, with property there as a secondary.
BQ643 Chair: One of the reasons you are lending to them is probably that you can get access to secure-
George Mitchell: You can but you are also lending to them as a business.
BQ644 Chair: These definitions are not absolutely precise. What it illustrates is that this is a bank that is expanding rapidly but also the share of its book is getting more property rich.
George Mitchell: The figures clearly show that, yes.
BQ645 David Quest: If I can expand on that point, it was property rich to start with. I know you said you weren’t aware of the other figures: I am told, for example, that Barclays had a 14% exposure to property and construction. HBOS had about a third exposure to property, even from 2000, and it got slightly richer in property as time went on. Is that a fair summary?
George Mitchell: Yes.
BQ646 David Quest: In the same file, if you go to a different document, D10, this is a board meeting on 28 October 2003, which you attended. I ask you to look at section 4, "Corporate banking-review of property lending", you will see that it says there, as you have told us, that "Property was the largest sector in the Corporate book…about one third of the Division’s total lending."
At the end of that paragraph, it says, "A number of other competitors claimed to have withdrawn from or to be minimising exposure to the commercial property market-although this was clearly not true in a number of instances."
I suggest that what was happening here is that at HBOS, which had a relatively large exposure to property, the perception of the board was that other banks were being too cautious in terms of their investment in property; and that while others appeared to be or said they were withdrawing from the property market, HBOS was very much staying in it. Is that a fair summary?
George Mitchell: I think it would be fair to say that my reading of that comment is more that some banks were saying that they were not involved in property when they were.
BQ647 David Quest: Yes, that as well. But it also seems, certainly at this stage at least, that HBOS feels very comfortable about the size of its exposure to property.
George Mitchell: Yes indeed, because to me this is about quality first and foremost-the assessment of individual credits, the canons of sound lending applying. There may have been a concentration risk in property in the corporate book, but, at the end of the day, it is a series of individual credits of high quality, the right locations, the right loan to values and the right covenant strength. I think that having that percentage of the book in property was not a danger to the bank.
BQ648 David Quest: To be fair to you, if you turn over the page you will see, at the end of the section, just above section 5, that it concludes with the statement: "Given lessons learned during the last property recession, together with strong deal structuring skills, a diversified portfolio, and a strong focus on risk management and mitigation, this was firmly believed to be a safe and well rewarded asset class for the Group." That is obviously how it was seen at the time.
George Mitchell: Yes, and I think that that was accurate at the time.
BQ649 David Quest: We looked at particular elements of the corporate division book in the 2001 accounts, for example the level of property exposure, the interest in integrrated lending and the other points we mentioned. Did that strategy more or less continue unchanged throughout the period when you were heading the corporate division?
George Mitchell: Yes.
BQ650 David Quest: In terms of the make-up and strategy of the business?
George Mitchell: Yes, the type of lending we were doing never really changed.
BQ651 David Quest: May I move on to another topic and ask you about what involvement HBOS management outside the corporate division had in the formulation of the corporate division strategy? In the written statement you gave to us, you explained the process by which the growth and profit targets would be submitted to a challenge process, initially by the finance director and chief executive. Is that right?
George Mitchell: That is correct.
BQ652 David Quest: And it was also reviewed by the corporate board before it was submitted to the main group functions?
George Mitchell: That is correct.
BQ653 David Quest: When you said the corporate board, that is a board within the corporate division?
George Mitchell: Yes, it was.
BQ654 David Quest: And who was on that board?
George Mitchell: It was all the senior executives in corporate. I chaired it. It would be the managing directors of each business unit within corporate, plus support functions such as HR and so on.
BQ655 David Quest: In the process of challenge between you and the non-corporate division people, that is, between you and the finance director and chief executive- just to understand the nature of what the challenge was. During the period you were there, was anyone pressing you to reduce growth rates?
George Mitchell: No one was pressurising me to reduce growth rates or increase rates; that was my decision, and I did reduce growth rates. The fact that I was reducing the growth rates anyway would almost negate the need for someone to pressure me to reduce them.
BQ656 David Quest: Right, but the general process was that you were responsible for setting the growth rates, and then there was a process of approval by the finance director and chief executive?
George Mitchell: That is correct.
BQ657 David Quest: And those rates were not altered as a result of that process?
George Mitchell: No, they were not.
BQ658 David Quest: In terms of the business strategy, we have talked about the focus in the different areas, the focus on property and so on. During that process, was there any pressure or request to change the lending strategy of the corporate division?
George Mitchell: No, there wasn’t. It was a very successful lending strategy. Everyone in HBOS was aware of what the corporate strategy was; it was very open and very transparent, and it was very successful.
BQ659 David Quest: And for those elements that we have discussed, there was never any suggestion by anyone on the board or in the group functions that there was anything wrong with it or that it needed to be revisited?
George Mitchell: No. There was often challenge about the area that you touched on-commercial property-are we certain that that is a high quality book? But other than that, everyone was very content.
BQ660 David Quest: The message you were giving them, presumably, was that, yes, it was a high-quality book.
George Mitchell: Yes, because it was a very high-quality book. As I answered earlier, I would be absolutely amazed if any major or significant losses came out of the book I left at the end of ’05.
BQ661 David Quest: The finance director and chief executive at the time were Mr Crosby and Mr Ellis. Neither of them had a corporate banking background, did they?
George Mitchell: They did not.
BQ662 David Quest: Who in senior management, outside the corporate division, did have a corporate background? It was Mr Matthew, I know.
George Mitchell: In the early days, Peter Burt, Gordon McQueen and Colin Matthew.
BQ663 David Quest: After Mr Burt and Mr McQueen left, it was really only Mr Matthew, wasn’t it?
George Mitchell: It would be Colin, yes.
BQ664 David Quest: Speaking frankly and with hindsight, do you think those on the board and those in senior management who did not have corporate banking backgrounds were really in a position to gainsay what the corporate division was doing?
George Mitchell: There was plenty of business experience around the board table. As I say, what corporate was doing was very open and transparent. I think the directors had enough experience to challenge, and I believe we received quite a bit of challenge in corporate. The skill set was there to do that.
BQ665 David Quest: It was open and transparent, but what you were doing was-certainly by the standards of the market-relatively innovative, such as the integrated lending.
George Mitchell: I do not agree. As I said earlier, the vast majority of lending that corporate did was not dissimilar from lending that other banks did. If that were not the case, we would not have been able to sell down the loans that we were underwriting. During my time, between ’01 and ’05, we had next to no difficulty in writing down to our desired hold level. That is a clear indication that other banks were taking on exactly the same risk as HBOS.
BQ666 David Quest: The ability of the board, for example, to second-guess the corporate division’s view of the strength of the commercial property book was inevitably going to be fairly limited if they didn’t have corporate backgrounds themselves, wasn’t it?
George Mitchell: Well, the board’s role is to make sure the processes are in place so that loans are approved properly, and the board then relies on group risk and others to give them the assurance. External auditors and the FSA then come in. There are plenty of people going over the book. You would not expect a board to be getting involved in assessing single credits.
BQ667 David Quest: Who at board level was involved, if anyone?
George Mitchell: Sorry?
David Quest: Was anyone at board level involved in the approval of corporate loans?
George Mitchell: Yes, there was at the outset.
BQ668 David Quest: Who was that?
George Mitchell: Loans above a certain size had to be approved outwith the division, so they had to be approved by another executive director. We also had a situation in place originally where, for larger credits, a non-executive director had to sign off on individual credits.
BQ669 David Quest: Who was the executive director who approved larger corporate loans? Do you remember?
George Mitchell: It would be Colin, Peter and Gordon, when they were there.
BQ670 David Quest: And once they left, it would have been just Colin Matthew?
George Mitchell: It would predominantly have been Colin Matthew, yes.
BQ671 David Quest: Do you know who approved larger loans from Mr Matthew’s division?
George Mitchell: I certainly would have approved some of them.
BQ672 David Quest: One of the challenges as part of the process that I think you referred to is the challenge that came from group credit risk. I want to ask you about that. From the beginning of 2005, a new position was appointed, which was the role of group risk director. That was Jo Dawson, who was appointed at the beginning of 2005, so you would have overlapped for about a year.
George Mitchell: That is correct.
BQ673 David Quest: We heard evidence from her, and she described her role as group director as essentially, as she put it, an advisory/oversight role, as opposed to one that had authority to change things. Do you accept that description? Is it a fair description of what she was doing?
George Mitchell: That is not how I saw her role, no.
BQ674 David Quest: How would you have seen it?
George Mitchell: I would have seen it as a role of authority, to challenge, and recommend things get changed, if she felt that way; and also to be able to escalate it if she was not happy.
BQ675 David Quest: The other point she made in her written evidence is this: "Given the advisory…role afforded to Group Risk, the ability to challenge individual divisions…depended on the quality of relationships between the Group Risk team and the divisional CEOs and their teams." She said that the "relationship between Group Risk and the Corporate division…was probably the most challenging of these"-referring to her relationship with you in particular. What kind of professional relationship did you have with Jo Dawson?
George Mitchell: I thought I had a very good relationship, to be honest. I am not sure where that is coming from. The corporate involvement with Group Risk would be mainly around what I would call macro issues-sector limits, approval processes, policies, and also our readiness for Basel II. Basel II was a very challenging project, not just for HBOS, but for all banks. Certainly, when I was there, we were a bit behind plan in our readiness for Basel II, so she may be referring to that; but, to be honest, no one ever came to me and said there was a problem in the relationship between corporate and group risk.
BQ676 Chair: The corporate had its own risk committee-is that right?
George Mitchell: Yes, it did.
BQ677 Chair: Chaired by a non-executive director?
George Mitchell: I chaired the senior credit committee, within the division. There is also a risk control committee, which you may be referring to, which was chaired by the deputy chairman of HBOS, Sir Ron Garrick.
BQ678 Chair: The impression we have is of a highly federal organisation where much of the risk discipline comes in each group, with corporate group risk appearing to be relatively weak compared with the individual business groups. I think that may be what Jo Dawson is referring to: as far as I could see, whereas in your corporate risk committee there was a non-executive director, this preceded the era, as recommended by David Walker, where there was a group risk committee, to whom the group risk officer could take her problems.
George Mitchell: Well, I was always under the impression that the group risk-or Jo-could go to the chairman of the audit committee any time she wished. That is the normal escalation process. As far as I was aware, she had the ability to do that.
BQ679 Chair: So the audit committee was doubling up as the risk committee.
George Mitchell: The divisional risk control committees were really reporting to the audit committee. I think this was a way of the audit committee trying to delegate some of the responsibility. So each division had such a risk control committee, chaired by a non-executive director.
BQ680 Chair: Right. Well, we are seeing Sir Ron next week, so we will fill in the picture then.
George Mitchell: But you are right, it was very much a federal model in HBOS, and the first line of defence-and I would argue the first line of defence should be probably your most robust- the first line of defence within corporate was extremely robust. There was so much internal challenge within the division, to begin with; and, as I say, when you move to the second line of defence group-I regard it more as macro-issues, as I said earlier.
BQ681 David Quest: Would it be fair to say that by the time you got out of the corporate division and got to the second line of defence-and there, of course, you are dealing, with Jo Dawson, with someone who does not have any experience in corporate banking-in so far as you are looking at, for example, the make-up of the corporate book, there was not really much she could practically have added, was there?
George Mitchell: As I say, she was more looking at macro issues like sector limits, so she could add there; approval process-she had input into what that was; lending policy-she had input into that. I think there is plenty she could influence.
BQ682 David Quest: But it was more at the macro and process level, because she was not a corporate banker.
George Mitchell: As opposed to single credit. The single credit protection was very much in the first line of defence. There was challenge from line management; there was challenge from the credit department; there was challenge from the credit committees.
I chaired the senior credit committees, so the larger credits had significant challenge from myself because I was never involved in the origination of transactions. So there was plenty of challenge before anything left the division.
BQ683 David Quest: In that respect, can I ask you about the FSA ARROW review, which, as you know, took place in 2003. You will find at E6 in that file, a copy of the FSA’s letter to you as chief executive of corporate banking. Before we look at that, you obviously did not accept those findings and we will see a bit later that you wrote back a letter contesting them. Just in terms of what it was that the FSA was saying in 2003, rightly or wrongly, the main point that they were making, and you will see that at the top of the second page of the document, was that they were concerned that despite shortcomings in controls, the corporate division was pushing ahead with a rapid expansion of the commercial property book. Then they made a series of specific points, as you will see on the next page under "Specific findings and recommendations." For example, they said there was no statement of risk appetite in respect of commercial property. Over the page again, they made criticisms of the selling down procedures. As you said, the ability to sell down loans was, as you saw it, an important part of the strategy, and the FSA were very critical of that. They were critical of the stress testing in the portfolio, which they said was not "regular or reliable". Finally, they were critical of the credit approval process, which they described as "atypical". It was atypical because it lacked the involvement of an independent credit function in the approval of every credit. We will come to your response in a moment, but so far as the FSA saw it, these were really very serious concerns they were raising. The criticisms they were making were serious.
George Mitchell: Yes, they were and they were treated seriously. As you say, I felt that they were extremely unfair.
BQ684 David Quest: We see your response in the next tab E7. Just to give a sense of the tenor of it, you say in the second paragraph, "You will be more than aware from our earlier meeting on this subject that I am extremely disappointed by the overall tone of your letter and indeed find many of the comments and findings to be very unfair." Essentially, you completely rejected them.
George Mitchell: I was not completely rejecting them. No, that would not be correct. I was challenging the assumptions. Apart from them being unfair, I believe that they were using isolated incidents to infer that there was a widespread problem. That was usually not the case.
BQ685 David Quest: You thought they were wrong to raise serious concerns?
George Mitchell: I did not think that they were wrong to raise them; that is their job to raise them and to challenge us. Equally, if you feel that you know what you are doing, you have a right to stand up to that challenge and question it. That is what I did.
BQ686 David Quest: This letter from you-was anyone else involved in the drafting of this letter? Did you consult on the form of the letter?
George Mitchell: To be honest, I cannot remember. I would suspect so. I cannot believe that I would send a letter like that without consulting with James Crosby. I cannot honestly put my hand to my heart and say who I consulted. It was nine years ago. That was quite a strong response, a deliberately strong response, that I sent because we felt strongly about it. Therefore, I would clearly have consulted colleagues.
BQ687 David Quest: The strength of the response was felt by the board as a whole?
George Mitchell: Yes, it was.
BQ688 David Quest: We can see that from one of the board meetings at the time. Go back to D12. Another set of board minutes. If you turn to page 7 of the minutes, you will see the heading, "Review of credit approval process in corporate banking". This document is dated, I think, July 2004, so it is a few months later. It seems that since then, there has been an internal review carried out by group financial risk and KPMG, which was the bank’s auditors. Do you recall that happening?
George Mitchell: Yes.
BQ689 David Quest: You will see, in the first paragraph, the discussion of what they had found. The last line of the first paragraph says that "the lack, in most instances, of independent credit challenge was the key unusual feature." That is what the FSA had said. Is it right that that meant that there was no one from outside the corporate division looking at the individual lending policy or individual loans?
George Mitchell: That is correct, but there was incredible challenge in the first line of defence within the division, which I believe was sufficient.
BQ690 David Quest: Let us look at what the next paragraph says: "It was proposed"-this would be the board proposing-"that additional ‘objectivity’ or ‘independence’ should be added to the process from within Corporate Banking (which was the Group’s sole reservoir of expertise in relation to corporate lending and corporate credit assessment)-not from outside the Division." Is it right that although the FSA had thought that there was a need for, or raised an issue about, independent credit challenge, the way the board saw it was that since all the expertise about corporate lending resided within the corporate division, the appropriate place for any challenge was from within the division, not from outside? Is that how it was seen?
George Mitchell: It was seen that the main challenge for individual credits would come from the first line of defence within the division, yes.
BQ691 David Quest: So the requirement for a so-called independent credit challenge was proposed to be dealt with by still having someone from inside the corporate division take on that role.
George Mitchell: Yes, but it is still independent, because it is from people within the division who are not involved in loan origination.
BQ692 David Quest: As it goes on to say: "It was proposed that the objective assessment would be provided by experienced credit professionals independent of the lending team." These were going to be people who were independent of the lending team, but not from outside the corporate division.
George Mitchell: They were in the corporate division.
BQ693 David Quest: The next paragraph says: "This and other proposals, to develop and refine the process, were being considered by Corporate Banking. George Mitchell confirmed that it was highly likely that the Division would amend its processes, in an effort to make them more ‘acceptable’ to the FSA". Do you know why "acceptable" was put into quotation marks?
George Mitchell: I have no idea.
BQ694 David Quest: The suggestion seems to be-if I can put it this way, so you can think if this is fair-that within this board meeting, you and possibly the others on the board, did not really think that the FSA’s concerns were justified in the first place, and what you were looking to do was to find something you could do that could be explained as "acceptable" to the FSA. But this was really a cosmetic exercise.
George Mitchell: No, not at all. I think it would be quite insulting to the FSA to infer that. When the FSA has done an in-depth ARROW review, as they did here, and they come up with observations or concerns, and they produce a risk mitigation programme, you have to enter into dialogue with them to do one of two things: you either change your processes to their satisfaction, or you manage to convince them that their observations are not justified. My experience is that when the FSA have issued a risk mitigation programme, it does not go away until it is 100% happy that their concerns have been addressed. I do not think that paying lip service to them, which is what you seem to be inferring, would work in any shape or form, nor would we try to do that.
ARROW findings were treated extremely seriously. It does not mean that because the FSA challenges you on something, you should just roll over and accept it. If you feel that their challenge is unfair, you have the right to stand up to them. They would want you to do that, and that is what would happen.
BQ695 Chair: What we notice in this thing is that the FSA come in pretty hard with some quite strong statements. You push back pretty strongly too. That is resolved by appointing a section 166 skilled persons review by PWC-
George Mitchell: Yes.
BQ696 Chair: And they help to broker a solution. There is a resolution. When this process was completed are you saying that by then the FSA had reached an accommodation with you on an agreed position?
George Mitchell: I don’t think it is so much an accommodation. How the process worked, to the best of my recollection, is that following the ARROW review and my response, we did comprehensive analysis of the points and especially the commercial property book, which was another area of concern they had. I had more than one meeting with the FSA to debate and discuss these points. At the end of the day-as I say, I cannot remember the outcome of each point-we would either have changed our processes to their satisfaction or they would have withdrawn their comment.
BQ697 Chair: The theme we are following is that there is a strong challenge from the FSA. Then there is the PWC’s skilled persons report. Then there appears to be a kind of reconciliation between the two of you. You then have the Paul Moore episode and KPMG basically says it is alright to continue. Then somewhere in ’06-this must have been after your time-the FSA come back again. Again they are talking to HBOS as though you are not in special measures any more. Then you get to 2012 and they write this thing saying your risk systems were completely inadequate and your successor and colleague gets very severely dealt with. I am still trying to piece this story together.
George Mitchell: My reading of that final notice-I think there is a particular clause in it-was that the FSA was not suggesting that the controls in place were unreasonable. What they were saying was that the controls in place were unreasonable to cope with the level of growth that took place in 2007. So I don’t think it is quite as large a contradiction as that.
BQ698 Chair: Right. That leads on to another question. You had been in this corporate group before the merger and you took it all the way through to the end of 2005. There are certain characteristics there. It was growing fast, although not as fast at the end as at the beginning. Growing property component; willingness to increase the loan size; take on some riskier customers and some innovative techniques: all those were established. My impression is that nothing much changed at the succession. In a sense this was part of the philosophy of corporate and you don’t detect that your departure changed the way in which they did business in any major way. Would that be reasonable?
George Mitchell: No, I don’t think that would be reasonable. Corporate lending is all about knowing when to lend and at what stage in the cycle to lend. There was clearly a difference after I left in the growth strategy in HBOS. As I said earlier, I was slowing growth every year. The year I left-2005-it had been 8%. The plan was that it would be even lower the following year. That was because at the time I left there were clear signs that the credit markets were overheating and it was becoming increasingly difficult to source transactions with the right risk/reward characteristics. What surprised me, and is the one thing that has surprised me since I left HBOS, was when I read in the annual report for ’07 about the speed at which the bank-not just corporate-was growing, at a stage in the cycle when other banks were slowing down or pulling back. That is a significant difference, because if I had still been in corporate, I find it difficult to believe that I would have been growing the business at that speed.
Taking risk is a good thing, actually. We all see the problems in the current economy because banks are refusing to take risk. It’s taking risk responsibly and at the right time in the cycle-that is what corporate lending is all about.
BQ699 Chair: Your view, then, is that you had slowed it down, but then it speeded up again.
George Mitchell: It speeded up quite significantly.
BQ700 Chair: At a time when you would have said that it should have been continuing the slow-down.
George Mitchell: Absolutely.
Chair: That is very interesting.
George Mitchell: In fact I would suspect-although obviously I don’t know-that it was the fact that HBOS was growing so rapidly when others were not that probably spooked the markets, which probably led to HBOS being disproportionately impacted by the macro events of the global financial crisis and the wholesale markets.
BQ701 Chair: Leaving aside the personal position of your successors and just looking at the final decision notice against BOS-you are saying that you think that was a valid finding on the part of the FSA?
George Mitchell: Yes, I do.
BQ702 David Quest: I want to come back to that in a moment. I just have one more question on the document you were just looking at. First of all, we looked at a passage where it said you would "amend its processes, to make them more ‘acceptable’", but you emphasise that "it was essential not to compromise the Division’s speed of decision-making, which was a key competitive advantage". At the bottom of the page it says: "The Division’s processes were already subjected to continuous review and improvement; the KPMG review contained some positive suggestions that would be adopted; ‘independence’ was not the same as, or a substitute for, ‘competence’." The point that is being made there is that, the way you saw it, provided that things were being dealt with competently within the corporate division, it wasn’t particularly helpful to have someone outside the corporate division looking at it.
George Mitchell: My view is that the independence was within the first line of defence. If you wanted to structure it so there was another division doing it, I wouldn’t have had a problem, but that was not the way HBOS was structured-it was a federal model. As long as I was confident-and I was-that there was independent credit challenge to credits happening within the division, which I do believe there was, I was content.
BQ703 David Quest: What does that mean, "‘independence’ was not the same as, or a substitute for, ‘competence’"?
George Mitchell: Well, it is not. I can’t remember. I suspect I am saying that there is no point having another party doing it if they don’t have the competence to do it. You are far better having competent people doing it than someone who just sits in a different building doing it.
BQ704 David Quest: You left at the end of 2005. When you left, how did you see, or expect, the trajectory of the corporate division to move from there, in terms of growth rate?
George Mitchell: I expected it to slow quite dramatically. It was 8% in my final year. The plan, as I understand it, was 6% for ’06. My view was, "If they can do 6%, they are doing very well", because, as I said earlier, at that time there were clear signs the markets were overheating, it was difficult to source transactions that were acceptable, and, had I still been there, I would have been struggling to know where growth was going to come from. I expected it to slow quite considerably.
BQ705 David Quest: Peter Cummings, who took over from you, had himself been in corporate for many years. Presumably you worked very closely with him over the years?
George Mitchell: Yes, I did.
BQ706 David Quest: What was said in the annual report when he was appointed was that Peter Cummings "has been at the heart of Corporate’s many successes" up to 2005. Is that a view you would subscribe to?
George Mitchell: I would indeed, yes.
BQ707 David Quest: Did you and he, during the period that you were working together, have essentially a shared view as to corporate strategy, or was there a difference between you?
George Mitchell: I think we would have a shared view.
BQ708 David Quest: So there was no disagreement in principle between you and him?
George Mitchell: I do not recall any major disagreements, no. I’m sure we had arguments from time to time, but no major disagreements.
BQ709 David Quest: So, essentially, your view of how the corporate division should pursue its general strategy was the same?
George Mitchell: Yes.
BQ710 David Quest: And presumably you had sufficient confidence in him to recommend him as your successor?
George Mitchell: I did indeed, yes. I had a very high regard for Peter. I should perhaps say that Peter as described in the final notice is not a Peter I recognise.
BQ711 David Quest: Let me just turn to the final notice. You should have a copy of it in the file, at tab E13. This is the final notice against Bank of Scotland, not the final notice against Mr Cummings. There are obviously a large number of different points made by the FSA, but I just want to ask you about a couple of them, recognising of course that this is relating to a period that begins immediately after you left.
For example, if you look at paragraph 4.10 of the final notice, the FSA says, "The Corporate book had a higher risk profile than equivalent books at other major UK banking groups." The FSA identifies as reasons for that four things, which you can see in paragraph 4.11 "‘concentration risk’… ‘risk capital’… exposure to large highly leveraged transactions… and the credit quality of the portfolio was low". That description of the corporate book-let us leave aside for the moment whether you would characterise it as high-risk or not-is a description of the book as it had really always been, isn’t it? I mean, it had always had a high degree of exposure to property, it had always had exposure to "risk capital" and so on. Those are not really new features of the book, are they?
George Mitchell: No. There was risk in the corporate book-I wouldn’t for a minute begin to deny that-but equally I do believe that in corporate we had the experience and the expertise to assess and manage that risk. And as I said before, the types of lending, which are listed there, are no different from the types of lending we’d been doing in Bank of Scotland, so I think it is fair to say we did have a lot of experience in these markets.
BQ712 David Quest: But what the FSA is describing is this-it’s not a new book in 2006. This is the book and the book had had this make-up all the way since Bank of Scotland.
George Mitchell: Well, the book at 1 January 2006 was obviously the book I left.
BQ713 Chair: And in style, that goes back all the way to the time before the merger?
George Mitchell: Yes.
BQ714 David Quest: For example, in paragraph 4.12(2) you will see a reference to "significant exposure to large single name borrowers." The point is made there that there is an increase in that from 2006 to 2008-it gets significantly larger-but again the strategy of increasing, subject to sell-down, exposure to single name borrowers, as we have already seen, is something that was really planned from the merger. Again, the idea of increasing your lending to "large single name borrowers" was not a new idea?
George Mitchell: No, subject to credit quality.
BQ715 David Quest: Subject to credit quality and subject to an attempt to sell down.
Again, for example, paragraph 4.13 says, "Corporate Division’s exposure to risk capital… comprised… equity stakes and holdings of subordinated debt". Again, there is nothing new structurally about what the FSA has said?
George Mitchell: No. There may have been a difference in quantum, but not in structure.
BQ716 David Quest: Again, in relation to credit quality, by which I mean the credit rating of the borrowers, historically there had always been a relatively high proportion of lending to borrowers that were rated comparatively low?
George Mitchell: Well, that’s the middle market. We did not lend to the FTSE 250, if that is what you mean, so by definition if you are a banker to the middle market, it’s sub-investment grade.
BQ717 David Quest: That is not necessarily a bad thing.
George Mitchell: No, it is certainly not a bad thing, if you have the skills to do it.
BQ718 David Quest: But again, the kind of lending the FSA are describing in the final notice, leaving aside quantum for a moment, is the kind of lending that Bank of Scotland have been doing all along?
George Mitchell: Absolutely.
BQ719 David Quest: In terms of growth, we see that 4.56 refers to the business plan for 2006-10, setting out lending growth of 6.4% and profits growth of 9%. The plan they are referring to-the 2006-10 plan-would have been a plan you were involved in?
George Mitchell: I would have been involved in it. I would imagine Peter drove that particular plan, because of the fact that I was not going to be the one to deliver it.
BQ720 David Quest: You remained the head of corporate division when that plan was made.
George Mitchell: Yes I did, and I would have signed off on it. I think that confirms what I said earlier-that I saw growth being even slower in ’06 than it was in ’05.
BQ721 David Quest: What I understand your evidence to be is that when you read the notice you were not surprised about the kind of lending that had been done. What surprised you was the level of growth.
George Mitchell: Yes, and not so much in ’06, which 4.56 refers to; it was more in ’07 and ’08. That is when I was particularly surprised, because it should have been becoming increasingly evident that there were challenges out there by that time.
BQ722 David Quest: Before we go on to ’07, in 4.57, it says, "During the group challenge process, the Firm had directed Corporate to double the profit target contained in the plan." That group challenge process is in relation to the 2006 plan, so it would have taken place in 2005. Do you recall that happening?
George Mitchell: I have no knowledge of that. I have no knowledge of ever being directed to change profit targets or lending growth, so I may not have been involved in that discussion because, as you know, I was leaving.
BQ723 David Quest: Well, you were, but the plan must have been debated by the board prior to your leaving the bank.
George Mitchell: Yes. I don’t know what they mean by "during the group challenge process". That might have been the discussions with the FD and the chief executive. I am honestly not trying to be evasive; I have no recollection of ever being directed to do that.
BQ724 David Quest: You do not know anything about that?
George Mitchell: No. To double the profit target? I think I would remember that. I have never been party to discussions.
BQ725 David Quest: The point the FSA make is that "the Firm had directed Corporate to double the profit target".
George Mitchell: Do you think they mean from 9% to 18%, or from 4.5 to 9?
David Quest: I think from 9% to 18% because when you look at what they actually achieved, they did in fact achieve more or less double the profit.
George Mitchell: I have no knowledge of that.
BQ726 David Quest: The FSA make this point: "In the light of the unresolved wide-ranging and serious issues in the business… directing growth at these levels was imprudent." If the firm had done that, it would be imprudent, wouldn’t it?
George Mitchell: If you are talking about profit growth, doubling it from 9 to 18 would not necessarily be imprudent. If you were talking about doubling the lending growth, that would be imprudent. You could double the profit target by just cashing in on the embedded value we had in investments on the balance sheet, so it could be done that way without it being imprudent. Again, at the time I left, there was considerable value in the embedded investments.
BQ727 David Quest: The other thing I should say is that they refer to the unresolved wide-ranging and serious issues in the business, as summarised at paragraphs 4.21". If you turn back to that paragraph, there is a section headed "Significant flaws in the control framework of the Corporate Division: first line of defence"-that is within the corporate division. There is a whole series of criticisms of the control framework. Certainly as I read the report, the FSA are saying that these are criticisms of the existing control framework of the corporate division-that is, the control framework as it stood at the beginning of 2006. They are, in this report, making criticisms of the framework of the corporate division during the time that you were managing it.
George Mitchell: I do not read it that way. My reading of it-and I think I mentioned this earlier, and they specifically say this-is that the FSA is not suggesting that the control environment was unreasonable. They are saying it was unreasonable to support the scale of growth that took place in 2007. It is not a control environment I recognise anyway, and it is also very much at odds with the skilled persons review-
BQ728 David Quest: That may be thought to be a slightly generous reading of it, because there is a long section headed "Significant flaws in the control framework", and the points they make in that section are all general points about the way in which the corporate division worked.
George Mitchell: Yes, I am saying that I disagree with a lot of these comments. It is totally at odds with the skilled persons review, which opined that the risk management control framework was effective and satisfactory. I am not saying things were perfect-don’t get me wrong. You can always do things better and you can improve things, but I was comfortable with the control environment when I was there.
BQ729 David Quest: These criticisms that are made in this report-do you recall whether criticisms of this nature were made, post the 2003 or 2004 ARROW, by the FSA while you were there, in the period 2005?
George Mitchell: No, the ARROW focused on specific issues, like the atypicality of our approval process, and not many of these things.
BQ730 Chair: There is a general remark in the ARROW letter, which is the one that is the reply to your letter, which talks about the risk infrastructure not keeping pace with the growth of lending. Then, as we discussed earlier, after the skilled persons report there seems to have been a reconciliation of view between the FSA and HBOS, and what we have not yet found out is why they suddenly appear to turn on the company in describing what was then in place at the start of 2006 as being as unsatisfactory as this. You are saying that there were no warning signals in your last year, when they were saying, "Hmm, this isn’t satisfactory." If you had still been at the bank, you would have been very surprised to have received this kind of criticism, given the relationship you had had with them up to that point?
George Mitchell: Yes, I would have been extremely surprised.
BQ731 David Quest: In terms of growth, in 2007, you will see those figures at 4.65. These are proposed targets for 2007, and so those presumably would have been set towards the end of 2006. Is that the way it works?
George Mitchell: Yes.
BQ732 Chair: So you are saying in your era you had got growth down to about 6%, and it turned-out to be 8%? In the next edition of the plan, the plan is raised to 9% and you go over the page and the out-turn is 10%. So that illustrates the turning point in the trajectory of growth that you were referring to earlier.
George Mitchell: In fact, it ended up about 22%, I think, if my understanding is correct.
Chair: We have not got that far yet.
BQ733 David Quest: Are you looking at paragraph 4.68? Sorry, that is profits. One of the difficulties as we understand it with controlling lending growth as the financial crisis fell upon HBOS was that, as you said, the strategy was to lend with a view to selling down, and if you couldn’t sell down you were not able to constrain your lending growth. Does that sound right?
George Mitchell: Yes. That is why it’s the wrong time of the cycle to lend.
BQ734 David Quest: Because if you lend with a view to sell down and you cannot sell down-
George Mitchell: Not if everyone else has stopped lending.
BQ735 David Quest: You are growing without control. The figure of 10% that was planned-indeed, more was achieved-you are saying that that was too much at that time? Nevertheless, in the end it was still only 10%. The losses that were eventually suffered on the loan book were colossal. Even if they had held the growth back in 2007, there must be a serious possibility that there would still have been very large losses in the loan book?
George Mitchell: It doesn’t necessarily follow, my view being that it was the rapid rate of loan growth-not just in corporate, but in HBOS as a whole, when others had pulled back-that spooked the market and caused the collapse in the first place. These things are all inextricably linked, obviously, but if HBOS had not had liquidity difficulties it might not have failed. It was the failure of the banks that led to an exacerbation in the fall in asset values, which in turn leads to an increase in impairments, so I don’t think it is quite as simple as to say, "Even if they had held it back to 10% they would still have had problems." If they had held it back to 10%, or probably lower than 10%, to 5% or zero, we might-I emphasise might-never have had the problem in the first place.
BQ736 Chair: You have taken us on to 4.84. That’s where you have the 22% growth. In other words, in the space of two years growth has gone up from 6% to 22%.
George Mitchell: Yes.
BQ737 David Quest: Unintentionally?
George Mitchell: I don’t know.
BQ738 David Quest: Well, unintentionally in the sense that they obviously did not plan to grow at 22%. You can see their plan to grow at 7.5%.
George Mitchell: Certainly – well in the figures you have shown, the plan was 10%.
BQ739 David Quest: Just to go back to your "inextricably linked" point, it is right that when there is shortage of wholesale funding the problem is that those banks that are perceived as having more difficult asset positions find it more difficult to get wholesale funding.
George Mitchell: I would broadly agree with that. I think that what you are saying is that once you have spooked the market and once confidence in your name has gone, it doesn’t matter if you are trying to raise £50 billion or £150 billion, you are not going to get it because the markets close to you. They might be global, but they are a veritable village when it comes to gossip and rumour. If they are spooked by, for example, the speed of growth in HBOS, confidence in your name gets eroded.
BQ740 David Quest: And HBOS had the additional difficulty of having a particularly large exposure to the wholesale funding-more than other banks?
George Mitchell: It did. I don’t think the absolute amount was that much higher than others, but, as I am saying, once confidence in your name has gone the actual quantum of what you are looking for doesn’t really matter. Whether it is £50 billion or £150 billion, you won’t be able to get it.
With this whole issue of the wholesale markets, I am not saying that the amount you are taking from the wholesale markets is unimportant, but what is more important is how diverse your sources are, and how long and how staged the maturities of these wholesale deposits are. It is quite dangerous to assume that customer deposits are necessarily more reliable than wholesale deposits. In fact, my understanding is that at the height of the crisis there was a considerable outflow of customer deposits from HBOS. My own view is that it is a bit simplistic just to say that HBOS was too reliant on the wholesale markets; I think it is a far more complex subject than that. It’s about confidence, first and foremost.
BQ741 Chair: This tells you that you have to assess risk at a group level. When you have a combination of an aggressive lending policy and an ambitious wholesale funding policy, those two things don’t go naturally together, because they feed on each other. But this is what appears to have happened in this 06-07 period: a wholesale funding gap that was not getting any smaller and a perceived weak lending book. That then means that people will take money out, which, in turn, forces people to sell, which means that people take money out and then you get into a spiral.
George Mitchell: Yes, but it is the former more than the latter. It is the aggressive growth as opposed to the actual quantum you needed from the wholesale market, because, as I say, when the markets have lost confidence in you, the amount that you are wanting from the wholesale market becomes partially irrelevant.
BQ742 David Quest: From what you are saying, I understand that HBOS essentially misjudged the market. They kept growing at a time when they ought to have been slowing down or stopping and, because they kept growing, that resulted in all the consequences in 2006 and, particularly, 2007 that we have discussed.
Now, it might be said that it seems strange that the whole survival of the bank should turn on whether you make that correct judgment of calling the market at the right time. It might be said that that in itself might tell you something about the book of business that the bank had set itself up with. In other words, it had got itself into a position where, in order to avoid getting into difficulties and to avoid spooking the market, you needed to make sure that it was always making the right judgments. In other words, there was no room for any mistakes. When a mistake was made in terms of pushing the growth just too far, that had catastrophic effects.
George Mitchell: Yes, but I do not think that it had anything to do with the type of lending that the division was doing. One of the key important elements of corporate banking is always to know where you are in the cycle. That is very important. It is not a case of just getting that wrong. That is a huge thing to get wrong. It was not the type of lending that was being done; it was the quantum of growth. As I say, that was not peculiar just to the corporate bank either.
BQ743 David Quest: But it does seem as though, in the HBOS business, there was no room for any mistakes about judging the turn in the cycle. Is that fair?
George Mitchell: I think there was as much room in HBOS as there was in any bank. I think any bank that had grown at that speed in ’07, when everyone else had pulled out and stopped, would have had similar difficulties. In a normal environment, it would not have mattered so much, but with the fragility of the markets caused by the financial crisis, I would venture to say that any bank that did that would have had the same difficulty, so I do not think it was anything to do with the HBOS model.
BQ744 David Quest: There was no room for any banks that were in that kind of business to make any mistakes about the market?
George Mitchell: Not at that time, because of the financial crisis and the fragility. The markets were looking for outliers to attack. The short sellers were looking for outliers to attack. Normally, that would not be the case, but that was happening in 2008, and you saw it on both sides of the Atlantic.
BQ745 Chair: You concur with the judgment that HBOS was an outlier?
George Mitchell: It was an outlier in terms of its pace of growth in ’07.
BQ746 Chair: At various points in the story, you read minutes where the defence is put forward, "We were only growing at the same rate as other people." We have come across a case where people were reported as saying that other banks were beginning to draw back, and it was the fact that they did not draw back at this crucial moment that you think was the fatal step?
George Mitchell: I think in most years that is the case. HBOS was not growing faster than other banks. It may have appeared to be growing faster in percentage terms, because our corporate book was relatively small compared with our peer group, but in volume or monetary terms HBOS was not growing any faster than the other corporate lending banks, but clearly in ’07 it was.
Chair: Thank you very much. I think you have helped us to tease out some parts of the story, which, as well as being a tragic one, is actually a complicated one, but we are very grateful to you for coming and giving evidence.
George Mitchell: Thank you.