Parliamentary Commission on Banking Standards - Minutes of EvidenceHL Paper 144/HC 705

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Oral Evidence

Taken before the Parliamentary Committee on Banking Standards
Sub-Committee B-Panel on HBOS

on Friday 30 November 2012

Members present:

Lord Turnbull KCB CVO (Chair)

Counsel: David Quest

________________

Examination of Witness

Witness: FSA Official, Financial Services Authority, gave evidence.

BQ1374 Chair: Welcome ***. This is a meeting of Sub-Committee B, the panel on HBOS. As you know, the Commission as a whole is looking for wider lessons from the banking crisis, which is allied to its other work on pre-legislative scrutiny of the Banking Reform Bill. We are looking at what went wrong, how it was allowed to go wrong, what warning signs were given, what warning signs could have been given but were not, and what warning signs were overridden.

We are looking particularly at HBOS, because the FSA has done 500 pages on RBS, and I understand is about to start work on its magnum opus on HBOS. We cannot wait for that, so we want to extract the main messages of the dramatic story of two well-known brands coming together with £31 billion market capitalisation in 2001, but which by 2008 were worth effectively nothing.

The process is that we are working as a panel, but go into full Commission on Monday and Tuesday when we will take evidence from Crosby, Hornby and Stevenson, as a full committee. What we are looking for today-we have looked at different aspects of the story from different people, and we have taken evidence from Clive Briault and David Strachan-is for someone with *** *** to try to piece together the twists and turns in the relationship with the FSA, which seems to us to have been hot, cold, hotted up a bit, gone cold, and then become ferocious at the end, by the time of the two decision notices. We are looking for help from you to piece together the twists and turns in that story.

On the process, an innovation is that a parliamentary Commission is employing counsel to help with questioning, not because these are court or tribunal proceedings, but because they are better at questioning than parliamentarians. It also allows me to listen to the answer, rather than think of the next question.

The understanding I have reached with the senior management of the FSA is that this is not a public hearing-these are two of your colleagues, I understand-nor is it being broadcast. We will make a transcript, but we will not put it on our website. However, we reserve the right to draw on it. I think that if we did draw on it, we would do so without attributing it to you. It would be a case of, "The FSA told us that…" Parliament basically can do what it wants, but that is basically the process. We are looking to you for help in sorting out, as I said, the twists and turns in the relationship between the company and the regulator. With that, I shall ask David Quest to take us through the questions.

BQ1375 David Quest: Good morning. Just to put you in context, you *** in April ***.

FSA official: That is right.

BQ1376 David Quest: Who were you reporting to at that time?

FSA official: At the time, I was reporting to A, who was ***.

BQ1377 David Quest: He would have been reporting to B. Is that right?

FSA official: He would have been, yes.

BQ1378 David Quest: I think that shortly afterwards B moved on and C took over.

FSA official: That is right.

BQ1379 David Quest: So you were effectively *** levels below the ***.

FSA official: That is right.

BQ1380 David Quest: That was above you. Underneath you, there were various *** for different institutions.

FSA official: There were; that is right.

BQ1381 David Quest: You mentioned, I think, that about *** teams were reporting to you.

FSA official: *** groups, which is firms, so *** firms and, throughout the period, *** to *** teams.

BQ1382 David Quest: Right. Does that mean that about *** institutions and organisations fell under your supervision?

FSA official: That is right, and it varied over the period, but the average would be about *** groups.

BQ1383 Chair: Could you place D in this?

FSA official: Yes. D succeeded A and he was *** major retail groups as well.

BQ1384 David Quest: So he was *** above you in the hierarchy.

FSA official: He was.

BQ1385 David Quest: Of the *** organisations under supervision-underneath ***-were there *** in that group?

FSA official: There were large banks, ***, and again the portfolio changed slightly over time, so that is a statement across the period.

BQ1386 David Quest: In terms of HBOS, how much of *** time was devoted to HBOS-related matters?

FSA official: It would be generally a proportionate amount, so relatively little time. Early on, when I moved in, ***, I had a series of meetings with HBOS divisions and HBOS personnel to familiarise myself with the firm. Then it would have been on an ad hoc basis, so I attended the *** board meetings, where *** presented the ARROW risk findings. Then, from the summer of ’07 onwards, I became a lot more involved with HBOS.

BQ1387 David Quest: But would it be fair to say that, prior to the particular problems that were encountered in 2007, your time was divided roughly equally between the various institutions?

FSA official: It would be roughly equally. I would tend to focus my time on the firms that would have issues at that time, so throughout the period, across the portfolio that I had, there was ***, which was focused on, and ***. Towards the end, there was the merger of ***. There was a range of things that would take my attention.

BQ1388 David Quest: Do you think, looking back on it, that *** had enough resource to supervise all these institutions?

FSA official: No. We can look at the lessons learned from RBS and where we are at the moment. The HBOS supervision team, which was looking at the HBOS group as a whole, would have about five to six people. They would also be looking across insurance, corporate banking, retail banking and the asset management elements of that firm and following through on issues from a reactive basis and also, when coming up to the risk assessments, on a proactive basis, so it was a very thin layer of resource applied to a major group.

BQ1389 David Quest: Are you able to tell us how much more resource is devoted to these kinds of issues now?

FSA official: It is hard to draw direct comparables, because HBOS does not exist any more-

BQ1390 David Quest: I mean a similar organisation.

FSA official: The RBS report picked out five people supervising it at a comparable time; there are now 23 people supervising it. I think that with the split of supervision into conduct and prudential supervision, that number has probably grown more now for a comparable type of group and firm.

BQ1391 David Quest: In terms of level of seniority? I have the impression from your evidence that your personal contact with HBOS management was relatively sporadic, in the sense that *** would present the ARROW report, but outside the ARROW reports it would be relatively infrequently that ***.

FSA official: It would be relatively infrequent. I would have attended the strategy meetings, which would have been with the FD and the CEO, along with the ***, and I would have gone to occasional close and continuous meetings, but probably no more than one or two a year.

BQ1392 David Quest: Who would have the primary day-to-day contact with HBOS?

FSA official: That would be ***.

BQ1393 David Quest: So that would be the person *** level below you in the hierarchy?

FSA official: Yes.

BQ1394 David Quest: Who would they have been liaising with at HBOS?

FSA official: For HBOS, they would have been engaging with the CEO, FD, heads of risk-that is heads across the division as well as the group-and divisional heads across the group as well.

BQ1395 David Quest: It seems that you have a situation where the liaison is between a very senior member of the management at HBOS and a relatively junior person at the FSA.

FSA official: Yes, it was focused on ***, and that was common across all the supervision teams.

BQ1396 David Quest: Again, looking at it now, is there a lesson to be learned there about the level of seniority of the contact at the FSA?

FSA official: There is, and I think we have said that certainly within the new organisational structure, the level of senior management-I mean at director and MD level-is closer to the senior management of the large organisations. It was happening at the end of 2007, going into 2008, where senior management had fairly interactive relationships with HBOS, but actually it is now a current approach for supervision.

BQ1397 David Quest: With the best will in the world, one can see the difficulties of a relatively junior person at the FSA trying to deliver a difficult message to the CEO of HBOS.

FSA official: Yes. I think that, with the benefit of hindsight, I would agree with that.

BQ1398 David Quest: You have explained your own personal involvement with HBOS. Moving up the FSA hierarchy, as it were, when, if at all, did the people you reported to have direct contact with HBOS?

FSA official: The *** would have periodic meetings, again primarily with the FD and the CEO of group. The periodicity of it changed over time. Towards the end of the period, they would have met them several times in the year; towards the beginning of that, it would probably be on an annual basis, if that.

BQ1399 David Quest: To what extent were issues and concerns about HBOS being generated by the people you reported to, or were they tending to be generated by the people who were involved directly in the supervision?

FSA official: Primarily, it would be generated by two sources. First, it would come from the supervision team. The supervision team would be identifying issues and risks. That would be reported upwards, through what was our firms and markets committee, so there would be an upward-reporting mechanism. But there were also horizontal functions, so risk would be looking across the piece on risk aggregation and risk issues, and they would be reporting to the director and challenging the director, and that challenge would come down. Towards the end of the period, we had specific banking risk teams, and the banking risk team again provided a risk map and then challenge to the director in a risk committee, and that would have come back down as well.

BQ1400 David Quest: Right. But can you recall any occasions-this is before the end of 2007, going back to the earlier stages-where issues were raised by more senior representatives of the FSA and passed down, rather than being passed up?

FSA official: I think the areas where they would have been passed down would have been at the ARROW risk review panels, when we were looking at the risk portfolio for the firm. That would have happened when thematic work was occurring; one example was around stress testing, where the challenges would be passed down, and through the Basel work, where things were looked at on an aggregate portfolio basis, and issues were passed down.

BQ1401 David Quest: What I would like to do, to see how matters developed, is to go through the various ARROW documents that were produced. I appreciate some of these were produced before you became involved, but, presumably, when you did take over responsibility ***, you looked back to see what had happened up until then.

Perhaps we could start with what I think was the first ARROW review of HBOS, which was in 2002. If you have the file in front of you, you will find at C04 the letter to Mr Crosby, as chief executive, following the first risk assessment. Various points are raised, but the one I wanted to ask you about-I am afraid the pages are not numbered-is on the last page of the letter, just before you get to the appendix. The heading is "Wholesale Funding". The letter says, "The group has recognised that its growing demand for wholesale funding is a risk" and "We will need to understand your plans to meet this requirement". One thing that seems to have set HBOS apart from its competitors, as far as we can see, and as far as people have told us, is that it had a much greater reliance on wholesale funding than other banks. That was presumably recognised by the FSA, was it?

FSA official: Yes.

BQ1402 David Quest: What did the FSA do to address that issue?

FSA official: If I can put it into context, the reliance on wholesale funding for HBOS probably more reflects the Halifax bit of the business. It was not uncommon for a converted building society to have a higher degree of reliance on wholesale markets than even a mutual or more diversified bank. HBOS was not unusual in the context of Northern Rock, Alliance and Leicester, and Bradford and Bingley. It had a greater reliance on wholesale funding than RBS, Lloyds and its other large commercial peers. That is just to put it in the context of where it sat within the spectrum of wholesale funding, although its wholesale funding was not that different from RBS’s.

The concern that we had, I think-reflecting back to 2002-was that, as a newly merged organisation, HBOS had ambitious plans for driving out the synergies from the merger, on the corporate side and on the retail side. Its funding structure had been outstripped by growth up until the time of the ARROW, and there were concerns that if that were to continue, the funding would run behind, or significantly behind, business and asset growth.

The focus was on making sure that there was diversity of funding and maturity of funding. The liquidity approach that we had at the time and virtually all the way through the period was very rudimentary, and it was really just looking at sterling stock and at trying to manage an outflow of 5% deposits over a five-day period. It was not predicated on "Wholesale: good or bad?" or "Retail: good or bad?" It was really just on the aggregate.

So what I read into this, when I have looked back at it, is concern around funding and funding sources and the aggregate level of funding. The action that was taken as a result of this was that the firm significantly termed out its funding requirements, and also diversified its funding sources, and diversified on a geographic basis and also on a basic source basis.

BQ1403 David Quest: Just before I come back to that and to make sure that I have understood it, as you saw it the wholesale funding issue in 2002 had largely been inherited from the Halifax side of the business.

FSA official: I think that a large part of it is from the Halifax. Bank of Scotland would be largely wholesale-funded as well, but I think as a merged building society, it would not be unusual from its peers to have a higher proportion of its funding from wholesale markets than from retail deposits.

BQ1404 David Quest: Right. Then what actually happened as time went on is that because of the growth of the business the requirement for wholesale funding continued to increase?

FSA official: It did. The percentage or its reliance on wholesale funding, from recollection, did not vary dramatically over the period, so as a percentage of overall funding, but certainly the quantum of funding that it had to provide through both retail and wholesale group.

BQ1405 David Quest: You referred to the attempts that were made to reduce the maturity of the wholesale funding. I think we have heard that they were successful to some extent in that the overall percentage of short-term or short-maturity funding decreased, but I think from the figures we have also seen, because the total amount was increasing, there remained more or less the same amount of short-maturity funding through the life of HBOS.

FSA official: I have not seen the figures to support that, but I think that is right.

BQ1406 David Quest: It wouldn’t be surprising?

FSA official: No, it wouldn’t be. As the balance sheet grew, the overall funding requirement grew. So while they had termed out elements of the book there would still be quite a lot of the short term.

BQ1407 David Quest: Did anyone ever float the possibility that another way of dealing with it would be to reduce the reliance on wholesale funding?

FSA official: From mid to late ’07 onwards, yes. Before that, not in a way that would have driven us to direct the firm or require the firm to change its funding mix.

BQ1408 David Quest: So up until really the financial crisis was upon us, the issue, as the FSA saw it, about wholesale funding was in managing how you got it and the maturities rather than controlling the total amount of it?

FSA official: It was to make sure that there was a diverse set of funds available-yes, absolutely-rather than being prescriptive about the levels or amounts.

BQ1409 David Quest: We will see as we go through. There is a reference to the wholesale funding issue here. I don’t think it was subsequently raised in any of the ARROW assessments pre-2007.

FSA official: Yes.

BQ1410 David Quest: So pre the financial crisis, having been raised in 2002, it does not then form part of the subsequent ARROW letters?

FSA official: Not from recollection.

BQ1411 David Quest: Perhaps we will see as we go through. So that was the position in 2002. Then if we move on to 2004 *** if you recall there was an interim ARROW review. Do you recall that? Do we have that here? In particular you probably remember that at the end of 2003 there were some fairly significant concerns raised in relation to the corporate division.

FSA official: Yes.

BQ1412 David Quest: Which resulted in a 0.5% increase in the individual capital requirement.

FSA official: Yes. It was not just in respect of corporate.

BQ1413 David Quest: It was not just in respect of corporate, but perhaps if we just have a look at the letter to corporate because the most serious concerns were raised there. If you turn to tab C01, you will see the letter to Mr Mitchell, chief executive, corporate. Do you have that? Let me just point out some of the things that were said. At the top of the second page, it said, "We are concerned that despite these shortcomings in controls, the group is pushing ahead with this rapid expansion of the commercial property book. In addition to implementing solutions to these specific control weaknesses, we consider it is the group’s senior management’s responsibility to ensure the overall control environment in this area is appropriate." If you look to the next page, you will see, under the heading "Specific findings and recommendations", that there are some pretty serious points made about risk appetite management information, and then over the page, stress testing and credit approval. Presumably-I say presumably because it resulted in an increase in the individual capital requirement, which is a significant step to take-those were regarded as really quite serious concerns at the time.

FSA official: Yes, they would have been.

BQ1414 David Quest: While we are looking at this, this particular letter triggered a fairly robust response from George Mitchell at C02. You will see at the top of the second paragraph, he says, "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." So he was rejecting it pretty firmly. Was that a typical attitude to see from those who were being supervised?

FSA official: It is not untypical. It depends firm by firm, but I have certainly seen quite a lot of letters or verbal responses like this to issues that have been raised, and again throughout the period, so it is not unusual.

BQ1415 David Quest: One of the consequences of this interim ARROW review is that a section 166 skilled persons review was directed. Did that take place after you had taken on your role, or had that already happened?

FSA official: That would have taken place just after I joined, or certainly would have been delivered after I joined.

BQ1416 Chair: Isn’t there a letter in the dossier somewhere? After this robust exchange, the FSA write and confirm the 0.5% increase and, I think, at that stage demand the section 166.

BQ1417 David Quest: There is. That is the letter that we are just fetching. It should be in the file, but it isn’t. It is the timing of it. If you turn to C07 you will see that on 13 January there is the letter to the chief executive, notifying him of the increase in ICR, and what went with that, unfortunately, was the group interim ARROW letter, which, as the Chairman said, also indicated that there would be a section 166 review. That 166 review took place and, as I think that you say in your statement, the result of that was the conclusion by PwC who did the review. Essentially, the risk controls, which have been the subject of the initial concerns were "fit for purpose".

FSA official: Yes, if I may, I think that there are three things that might be worthwhile discussing within this. From what I understand, the concerns that we had with risk-the words "atypical approach" have been used throughout this-is that the risk approach in the Bank of Scotland was very unsophisticated. It was on a case-by-case approval basis and it was approved by single individuals, so our concerns were around ensuring that there was greater rigour and independence around those credit decisions, and the decision making within that. We had concerns around retail and concerns about the risk that the culture within retail was geared towards selling, to the exclusion of all else. We had concerns that, within a relatively new group structure that was federal in nature, the risk oversight, governance and management were not effective. So the section 166 picked up on the federal structure and risk management piece.

There was a piece of work undertaken by, I think, group regulatory risk to look at the sales culture. That was reported back to us. A piece of work was undertaken by group risk alongside, I think, KPMG, which looked at the credit control environment within corporate. They were the three things we were looking at in the context.

BQ1418 Chair: What you are saying is very interesting. Section 166 was only one item on this agenda.

FSA official: Yes. From my recollections, it was only one of the issues that drove the half per cent increase.

BQ1419 Chair: So the subsequent appointment of a group risk director-it might have been Jo Dawson-was part of the accolade of "fit for purpose"?

FSA official: I can’t say for sure from memory whether the two were directly linked together. I think there is reference in the section 166 report to the changes that they were planning to make in terms of bolstering the group risk function.

BQ1420 Chair: But the interesting thing is that the section 166 didn’t look at what looks now, with hindsight, to have been the most dangerous issue in the company, which was the quality and management of the corporate loan book.

FSA official: It wouldn’t have looked at the quality of management or the quality of the book. It would have looked at the quality of the risk management framework-divisional and group-overseeing that.

Chair: That is an important distinction.

FSA official: Yes it is. There was a separate piece of work that was undertaken by the firm with, I think, KPMG that looked at corporate and the more granular corporate decisioning work.

BQ1421 David Quest: I just want to pick up on that point. Regarding the point about the quality of the assets and the book, as I understand it, that was not really looked at at all, at least not until late in 2007 or 2008. Is that because no one thought that there was an issue with it, or because it was seen to be outside the scope of the FSA’s supervision obligations?

FSA official: At the time, a lot of the work that was done in terms of reviewing credit quality did not involve a hands-on, detailed assessment of the books or the individual credits themselves, so it wasn’t deep dives. A lot would have been done in terms of reviewing the regulatory returns or the published financial returns and some degree or measure of stress-testing or peer comparability across firms. But in hindsight, that was nowhere near sufficient to be able to get to grips with the actual quality of the underlying assets within the books.

BQ1422 David Quest: Right, but even leaving aside the deep dives, one of the things that seems to have distinguished the HBOS loan book from its peers is its particular focus on commercial property, relatively high-value individual credits, equity participations and things of that nature. It was a rather different shape of loan book from those operated by other banks. Did anyone think about it or think that it was their responsibility to consider whether it was a good idea to have a loan book that looked like that?

FSA official: There was work and analysis done, looking at it from a comparability point of view. From that point of view, it was not necessarily atypical from a number of peers. But did that work lead to further analysis or further testing of the assets? No, it didn’t.

BQ1423 David Quest: One of the points that was made in the FSA’s final notice is to emphasise the peculiarly high-risk profile of the loan book, drawing attention to some of the factors that I have just mentioned. But it does not seem as though anyone at the time thought that that was something that needed to be considered.

FSA official: The loan book changed over time, particularly with the move into taking equity participation, so that became a feature of the book towards the end of the period, but broadly, I agree with you that-

BQ1424 David Quest: Sorry to interrupt you, but is that really right? If you look back through the annual reports, right back to 2001, you see that, as early as 2001, they are saying-trumpeting, really-that one of the things they pride themselves on doing is taking equity participation.

FSA official: I think it became more of a feature towards the end of the period. So out of the £117 billion book, about £10 billion was equity participations, and that was towards the end of the period ’08-I think, from recollection.

BQ1425 David Quest: It is a loan book that may have become more concentrated, but there was not a sea change between 2001 and 2008.

FSA official: No. It was a firm that was highly concentrated on UK property-retail and commercial.

BQ1426 David Quest: I think you mentioned before that there was a horizontal process within the FSA, where there were specialist teams that looked at, for example, risk. Were those teams deployed before mid-2007 on HBOS?

FSA official: The teams would have been deployed pre-2007 primarily on Basel-related activity. The risk review team, which was the specialist team that provided the majority of technical support for supervision, would focus on credits, market, and operational risk-related activities. Around the time, there were probably about 50-ish individuals in that team that would cover the whole portfolio of banks. A lot of their time was dedicated to focusing on Basel II preparations. Towards the end, certainly in ’07, there was more of a details focus on HBOS and HBOS policy, but not before that.

BQ1427 David Quest: Before then, if anything, it was focused on capital.

FSA official: Yes.

BQ1428 David Quest: As a result of the various reviews that were done in 2004, if you then turn to C11, you will see the final ARROW risk assessment for 2004. ***

FSA official: Yes.

BQ1429 David Quest: And that coincided, more or less, with the reduction of the ICR back to 9%.

FSA official: Yes.

BQ1430 David Quest: We can look at the detail of this letter, but the impression that it gives-it seems to us, anyway-is that the FSA is saying, "We did have significant concerns last year. You will remain under close and continuous supervision, but essentially, the concerns we raised have been, or are being, addressed."

FSA official: I think that is broadly right. The concerns we had in those three areas for the ICR increase had been broadly addressed and the decision was that for the capital-related issues, they would be taken forward under the auspices of Basel II and the review process around it.

BQ1431 Chair: I have interpreted this using the terminology of education: that it was no longer in special measures. With all firms, there are always issues on the boil at any one time, but from this point onwards, you were dealing with the normal run of issues that you would expect for a company of this kind.

FSA official: I think that is broadly right. There is quite a detailed risk mitigation programme for the firm that would not have been replicated across all of the firms. So there is a more detailed risk mitigation programme, but we had certainly moved away from our concerns around integration.

BQ1432 Chair: It is about this time that Basel II and the pursuit of the waiver starts to come to the fore. Is that right?

FSA official: Yes.

BQ1433 David Quest: Just one small point on this letter, if you go to page 3 of it, there is a main heading that says "Key Findings." In the third paragraph-"We observe that |Corporate Division has made a good start"-in the penultimate sentence, there is a reference to "the challenge that the Division faces in terms of delivering the cultural change necessary if it is to maximise the benefits it reaps from these initiatives." What was meant by the cultural change there?

FSA official: The cultural change there was one of moving away from where they were in 2002-which was around individual, independent, expert bankers making decisions individually on their own-into an environment where there needed to be greater control over credit risk management, greater transparency around the portfolio and the MI from the book as a whole. It was really maturing the business and bringing it into a more sophisticated environment.

BQ1434 Chair: Looking at where HBOS ended up, do you think that cultural change ever happened?

FSA official: With the benefit of hindsight, I would have to say no. As I was reading through and refreshing myself ahead of this, going through the ARROWs and the Basel responses, common issues keep cropping up. So they progress in terms of delivery but they still fall short of expectations of the standard of delivery that they need to provide. I think there was still very much a focus on growth within corporate ahead of ensuring that there were controls in place to be able to manage the growth.

BQ1435 David Quest: If we take the chronology on to 2006 and you turn to C12. This is the interim risk assessment of 29 June 2006. By this time, if you see how corporate is being dealt with, in the letter itself it is dealt with relatively briefly, at page 4 under the heading "Corporate Issues".

FSA official: I think it is also dealt with under page 3 within the Basel context. That is again very focused on the models and the Basel approach rather than the wider context and concerns.

BQ1436 David Quest: In terms of credit control, which was the big issue that had been raised in 2003, you see on page 4, "Corporate has made good progress in developing credit grading systems and, as such, we no longer consider specific actions on these points is required." Again, the message seems to be that they either have addressed or are addressing the points that you raised previously to the FSA’s satisfaction.

FSA official: The points that were raised in 2002 before, yes I agree. The Basel requirements then went way beyond that in terms of expectations for-it mentions modelling in this-not just modelling but the oversight and management of the portfolios as well. I think a lot of the focus then shifted from specific points and then wrapped it up into the Basel overall implementation programme.

BQ1437 David Quest: What is raised in this letter in a slightly alarming way is international. If you look on page 2 and the second full paragraph, it refers to the "aggressive overseas growth strategies posing risks to the whole group". That is put rather dramatically. What did you perceive at the time as being the risks associated with international?

FSA official: Again, my recollection is that the international, which I think for this was Ireland and Australia-and this was probably more focused on Australia at the time-was around growth of the acquisition of Bankwest and the plan to migrate Bankwest, which was a regional bank in west coast Perth, across Australia as a whole, both from a retail and corporate point of view. One of the actions that came from that is that we did a visit to Bankwest and met the Australian regulator. A number of issues came out of that that we fed back to HBOS. From memory, they were more around the operational risks arising out of the number of initiatives that they were looking to try to launch in Australia, requiring them to scale back on planned activity.

BQ1438 David Quest: What about Ireland? They also had pretty aggressive plans for Ireland.

FSA official: They did. I cannot remember if it was from this piece of work, but there was also a review team visit to Ireland to look at the strategy in Ireland, the controls and the management within that, and where that fitted within the overall group.

BQ1439 David Quest: The concerns that have been raised here mirror the concerns that had been raised in relation to corporate a couple of years earlier.

FSA official: Yes.

BQ1440 David Quest: In other words, growth without sufficient control.

FSA official: Yes.

BQ1441 David Quest: That is 2006. We can then go forward to late 2007, and if you turn to C16, you will see a document headed, "Evaluation of progress against issues in the ARROW letter" and the 2006 ARROW letter. I say 2007, because at the very bottom of the page, the file name has "20071026", so it looks like it is October 2007.

FSA official: I think that’s right.

BQ1442 David Quest: This is presumably when the financial crisis was really beginning to get under way. In relation to the two points about which we have just been talking, if you turn to page 2, you will see what is said about corporate. There are four headings, "Stress Testing", "Credit Decisioning", "Risk Grading" and "Provisioning". Those four areas came eventually under particularly the criticism in the FSA final notice, but the way they are presented in here, you will see that for each one of them, it essentially said that the conclusion is that the issue has been plugged.

FSA official: Yes.

BQ1443 David Quest: That is stress testing. We should close credit decisioning, we should close risk grading, we should close provisioning-we should close. As late as October 2007, it looks as though the FSA do not consider that there is any particular problem in any of these issues in relation to the corporate division.

FSA official: Yes, I think-again, from memory-that this was part of the discovery pack, so it was work done before on-site assessment was done through the ARROW. I think you should read the ARROW letter as being the conclusion-the decision point-rather than these points feeding into it.

BQ1444 David Quest: We will look at the ARROW letter in a moment. I think that it was said by one of the other witnesses that this was a desk-top type process, rather than a detailed investigation.

BQ1445 Chair: This represented, in a sense, the FSA’s state of mind going into the ARROW process, not what you concluded at the end of it.

FSA official: I would need to look at the packs to remind myself, but I think this was a reconciliation of issues that had been raised in the context of past actions. In that narrow sense, they would have been closed down, but that would not mean that we had moved away from stress testing or from credit decisioning. It would mean that when we went in to do the assessment, we would not necessarily be looking back at these. We would be looking at the state at that time and then focusing forward.

BQ1446 David Quest: But at least up to this date-and we will look at the letter in a moment-the impression seems to be that some quite serious concerns raised in 2002-03 were over time gradually being closed by HBOS. That is how it was seen.

FSA official: Yes. Again, to put that in context, the risk mitigation programmes that you see attached to the ARROW letters are relatively live documents that change over time, so there isn’t a true picture of progression through the RMPs between the ARROWs, and new things can appear over time as they come in as well. Looking at this, this would be, as you say, a desk-top review of the issues that were raised and the mitigation that had been put in place. It does not necessarily mean that new issues then were not opened-

BQ1447 David Quest: No, but certainly HBOS is not being told here, as it was being told in 2003, that there was a serious problem in corporate.

FSA official: No, but this did not go to HBOS; this was an internal document.

BQ1448 David Quest: No, but there was close and continuous supervision at this time.

FSA official: Yes.

BQ1449 David Quest: And presumably this reflects what HBOS was being told as part of that process.

FSA official: I imagine part of this would reflect that, but, again, given that the issues change throughout the course of the period there would be new issues coming on over the period of time as well.

BQ1450 David Quest: While we are on this document, it also covers international, as you will see at the bottom of page 3. Again, it refers to concerns being raised about "oversight and control…at a time of ambitious retail expansion in Australia and Ireland"; but, again, the outcome-underneath, in italics-is "improved oversight and controls for the overseas business. Following our review of the Australian operations we have put in place further RMP actions for HBOS to increase their systems and controls". So, again, they have got some work to do, you are telling them, but they are no longer being told this is something which is threatening the whole group, which is what they have been told earlier.

FSA official: Yes. I have not got reference to what the RMP actions are, but that is a good example of where the risk mitigation programme would have changed inter-ARROW period; so the actions from the Australia visit fed into new actions for them to take forward.

BQ1451 David Quest: Okay; so that is 2007, and then you mentioned the 2008 ARROW letter. We find that at C15. It is the culmination of this process-22 April. Just before we look at this, there is an earlier draft of this letter, which I think we find at C17. I just mention it because in that letter it refers to a regulatory dividend-the maintenance of a regulatory dividend that had been granted to HBOS. This is a draft letter. You see at the bottom of page 2 of the draft? That did not appear in the final letter, and we just wanted to clarify it. As far as you are aware, was any regulatory dividend granted to HBOS?

FSA official: No. If I look back at other firms at the time, where regulatory dividend was provided, that resulted in far fewer issues being reported on the risk mitigation programme, and issues just being reported within the letter, and the letter then requesting management to address those. So I think within the context of HBOS, whilst we took reliance on senior management for taking forward a number of issues, there was prescriptive RMP that was on the back of it.

BQ1452 David Quest: Right. So that is just a mistake-the reference to the dividend.

FSA official: I do not know where that one has come from, to be honest.

David Quest: It did not appear in the final letter.

BQ1453 Chair: It looks as though someone more senior edited it out.

FSA official: You are quite right; there is a filtering process that would ultimately end within a panel discussion around the firm, the issues, and then the sign-off of the final letter. So the sign-off of the final letter would have been at this panel.

BQ1454 David Quest: The final letter, as I say, is at C15-this is after the ARROW review has been done; and if we look at what is said about credit risk: "We did not explicitly review credit risk management during the ARROW process (except for retail unsecured credit provisioning), but relied on our recent IRB waiver review work. Although you have not to date had any major credit losses…in the context of the UK banking sector the Group is one of the most exposed to the risks of a UK downturn." Then it says, "Given the significant credit risk posed within the Group we will be heavily monitoring credit risk and provisioning across all of HBOS, and key areas will be looked at in depth on a thematic basis during 2008."

So the message given there is not at this stage that there is anything wrong with the processes, but that because of the financial crisis and HBOS’s particular exposure to it, you were going to look into them more carefully.

FSA official: Yes. I think there are probably two messages or two issues that interplay across all of this, that are probably quite confusing. The one is around the Basel work, which would have reviewed a significant number of these types of issues. I think this is a separate piece, although we refer to the IRB as well, around explicit concerns. It is couched specifically in terms of the retail book, but around potential pockets of loss that might be hidden within the overall portfolio. If you look at the overall portfolio, you could potentially take false comfort from the fact the LTVs are not significant.

David Quest: Right.

FSA official: I think specifically that one that was focused on retail.

BQ1455 David Quest: But up to April 2008, the work that had been done for the ARROW to produce this letter and the work that had been done for the IRB waiver had not so far resulted in any specific concerns by the FSA about controls-about risk controls.

FSA official: The Basel work had identified significant issues, particularly on the corporate side, in terms of the preparations and the extent to which models and controls around the models were advanced, to the extent you would expect them to. It did not pick up on any specific issues around the deep dives of either the books or the asset quality of the books. So this was more, from a retail perspective, a view that there may be significant risk hidden within the book and we wanted to go and look at it. I think that is separate from some of the credit risk decisioning pieces, which we would have picked up within Basel.

BQ1456 David Quest: Right. But there is no suggestion here that you had already picked up any serious problems. What you are saying, as I read it, is that you are going to look at it carefully because of your particular exposures.

Chair: David, that is referring to residential rather than corporate.

BQ1457 David Quest: So this is just residential.

FSA official: Yes.

Chair: All these figures are loan to values, yes.

FSA official: Yes.

BQ1458 Chair: As I understand it, your attention to corporate gets swept up in the Basel II. You are carrying it forward in that dimension, rather than the kind of things you were looking at earlier, about atypical credit procedures, asset concentration, and so on. Basel II then became the forum for those discussions.

FSA official: I think that is right. The intention of the Basel II would have been to put in place structures and procedures that would have mitigated our previous concerns around the atypical stance that HBOS were taking.

BQ1459 David Quest: There is also reference to commercial property in this section-it says here-

FSA official: Yes, sorry. I was not saying that it wasn’t just commercial; I was just saying in-

BQ1460 David Quest: That was dealt with as part of Basel.

FSA official: Yes.

BQ1461 David Quest: Right. Then, as I understand it, there was a review of internal controls, which resulted, as I think you say in your statement, in a letter that was written to Mr Cummings in October 2008.

FSA official: Yes.

BQ1462 David Quest: And we see that letter at tab B2. It begins by referring back to the ARROW letter and your indication that you would be carrying out an in-depth monitoring. And this letter obviously raises some significant concerns about corporate. The date of this letter is 17 October 2008, so that is essentially after HBOS had already got into such difficulties that it had to be taken over by Lloyds.

FSA official: Yes.

BQ1463 David Quest: It refers in the letter to the fact that the merger has already been announced. So in that sense it is pretty late in the day, isn’t it, to be raising these points.

FSA official: Yes.

BQ1464 David Quest: And in terms of the points that are being raised, if you look at B3, there is a risk mitigation programme, which I assume was produced at about the same time-was it? Was it attached to the letter?

FSA official: Yes, it was. I think this is the one that was attached to the letter.

BQ1465 David Quest: Right. And just to pick up a couple of points from that, about which concerns have been raised, if you turn to numbered page 4, there is a section headed, "Portfolio Risk". The issue being raised is, "High levels of concentration in the book could leave the firm over exposed to market fluctuations" and "Corporate Division have both single name as well as sector concentrations". This was not a new point, though, was it?

FSA official: No.

BQ1466 David Quest: The high level of concentration in commercial property and the single name and sector concentrations must have been apparent more or less since the original merger, yet it was only raised as an issue in October 2008.

FSA official: Yes, but the issue that is being raised here is around the controls over that risk, so I think you are right. The risk has always been there; it has been inherent in the business model. It is the actions of the piece that we were focusing on, and the controls around that where the in-depth review showed that they had inadequate controls over the business, and that the controls they had stated were not being applied.

BQ1467 David Quest: It was not only a risk that had always been known about; it was a risk that the FSA had already raised as a concern back in 2003, and had already required there to be a review of the risk controls by the skilled person, and had already satisfied itself that those issues were being addressed. It seems surprising that it was raised again in October 2008.

FSA official: Yes. The issues that were raised back in 2002 were specific to that time around the nature and style of the credit decisioning and the credit processing. As we moved on into 2005-06, the expectations increased around the quality of the management and the quality of the MI around credit decisioning through Basel. The implementation programme was then put in place by the firm. This was then us going into test in full the implementation, and finding that the implementation had not been done. The issues have a consistent and common thread, but the issues that have been identified are slightly different from piece to piece.

BQ1468 David Quest: I am not quite sure why they are different. One of the actions, the third one, is, "HBOS Corporate to investigate and implement interim measures to manage and control the concentrations in the portfolio". Isn’t that the sort of control that must have been looked at in 2004?

FSA official: Not necessarily. The 2002 issues that came across into 2003 and 2004 were purely around the credit decisioning-the credit risk management. This is around portfolio management and oversight of the portfolio, which has a feed in to credit decisioning and credit oversight, but I do not think is directly the same as the 2002 and 2003 issue.

BQ1469 David Quest: Is that because in 2003 and 2004 no one was really thinking about portfolio concentration issues, and they were looking at more technical control issues?

FSA official: In 2002, it was far more basic in terms of just making sure there was independent challenge and oversight of the credit decisions that were being made. As we progress into this one, a number of the issues in this RMP were raised in the April RMP as well. This is specifically around the more sophisticated portfolio management of the business.

BQ1470 David Quest: That seems to be because it was only once the financial crisis had eventuated that it actually focused the FSA’s collective mind on the issues associated with portfolio concentrations.

FSA official: In the absence of the financial crisis, those issues would have been identified, and remedied through Basel implementation. We made a decision internally that we would not test the implementation of Basel until the end of 2008. This is slightly different; because of the concerns we had with the portfolio, we went in and tested HBOS’s review during 2008.

Chair: Are you near the end of the chronology?

BQ1471 David Quest: Yes. I have just one more I want to raise on that October letter.

In B03 page 1, you will see that the first item on page 1 is credit risk management, and one of the things that needs to be assessed-I think it is raised in the letter as being an issue-is whether there are appropriate levels of challenge at all stages of the credit approval process. What was perceived to be the problem with challenge at that stage?

FSA official: To be honest, I can’t recall the detail around that. I’m sorry.

BQ1472 David Quest: It seems to have been quite an important issue, because it is No. 1 on the list.

FSA official: Credit risk management-this would have been put in risk order-would be the most important.

BQ1473 David Quest: You can’t recall what the difficulty with challenge was?

FSA official: Not offhand, I am afraid, no.

BQ1474 Chair: We have the chronology, very helpfully, from ’02 to ’08, but I have a couple of questions about prior to that. When you came into this post, had you come in via the bank or from the private sector?

FSA official: I had come by ***. I was in ***. I worked in ***, and I worked in ***. Then, partly as a result of the Barings crisis, ***, so I joined ***. That was probably just a few months before the announcement of ***. Then I moved ***, and spent some time there as ***.

BQ1475 Chair: You came across with E and B.

FSA official: Yes.

BQ1476 Chair: In terms of general lessons, one is that, for most of this period, HBOS was not a priority case: you were not looking at this as your most difficult case; it was something you were dealing with under the normal processes. It was only when you get to *** that it requires disproportionate attention from you.

FSA official: Yes. To be fair, it would be true of virtually all banking firms within the FSA that the tension turned up significantly in ***.

BQ1477 Chair: The other general point is, do you think you should be kicking yourselves in the sense that you spotted very early on two things that subsequently turned out to be absolutely crucial-the wholesale funding question and the quality of the corporate loan book? You come back to these right at the end, when it is almost too late. In the meantime, you let your focus move to other things. In a sense, you got it right, right at the start, and then, instead of following through on that, you followed through on other things. Do you wish you had followed through on the agenda as it was when you first came in?

FSA official: Personally, I do kick myself, and on a number of issues. Generically, across banks as a whole-I will maybe come back to HBOS afterwards-the FSA did not focus on liquidity to the degree it should have done, and that is in common with most regulators globally. But liquidity is the issue that kills a firm first, and there was insufficient focus on liquidity.

BQ1478 Chair: You phrase it in a rather interesting way: "kills a firm first" implies that HBOS was going to die anyway. Do you believe that, given the extent of its losses, and even if it had been provided with enough liquidity, it would have survived? Did it really have a solvency problem, given the size of the losses it was making?

FSA official: When I said killed quickly, I meant that liquidity rapidly escalates to create a crisis with the firm, whereas asset quality issues take time to transpire and then to kill a firm. From an HBOS perspective, and from a personal perspective, I was trying to think when would be the point that you could have intervened and made a difference to whether it would have survived.

To the extent that the business model was such-even in 2002, and at merger-that it was highly concentrated on UK property and had a wholesale funding requirement, I think the actions that the firm took in respect of funding actually did give it some benefit and did bear fruit to a degree during the financial crisis, because it allowed it to survive for a reasonable period of time, until markets completely turned against it. But given the business model and given the concentration, the financial crisis as it transpired could not have been more perfectly attuned to tackling UK corporate and UK residential property concentrated firms.

Certainly as we got to the financial crisis-again, this is my personal reflection-it was too late for us to change the outcome. Significant amount of effort went into it. The firm were responsive to a degree, and the lending curtailed significantly. However, by then, they had significant undrawn commitments on the book and pipeline commitments on the book that kept feeding assets through, so it was too difficult.

BQ1479 Chair: We have noticed that you get a re-acceleration of lending rates, but I think, and the decision notice does not really capture this, that that was not because they were going out and lending to more people-in other words, the gross of lending was not increasing-for two reasons. One is that people, being short of liquidity elsewhere, were drawing on their facilities more actively, and secondly, sell-downs slowed down. With both of those, even if it had stopped lending completely, the actual lending left on its books could rise.

FSA official: Yes. It was left with a number of stick positions that it could not syndicate down. You are right in terms of draw-downs as well. Having said that, they were still optimistic that they could ride out the storm, and they prided themselves in corporate that they had done that a decade before and been successful.

Chair: We have noted that, and that is a bit like driving using the rear mirror.

FSA official: Yes.

BQ1480 Chair: The other thing that has come out from your evidence is this: you said it was quite normal for a mortgage bank to have a sizeable portion of wholesale funding, but of course they then cease to be exclusively mortgage banks, so it looks to me as though they are using the mortgage model to fund a bank that is actually expanding its other lending as well.

FSA official: Yes. It was not atypical; the funding model was not vastly different from where RBS was at the time.

Chair: No, but it was destroyed as well.

FSA official: Absolutely.

BQ1481 Chair: Can I come to Basel II? There is a view that was expressed to a different part of this Commission by a different panel under the name of the elephant in the room. One of the effects of devoting a lot of attention to a big model is that you stop looking at other risks or you stop looking at them in a particular way. It seems as though, from 2006 onwards, most of the dialogue-again, this has been borne out by evidence we have had from Peter Cummings-was about getting ready to be Basel II compliant and get the waiver. From your side, was that work being done by the resources you had, or did you bring in super-specialists to work on that?

FSA official: It was a mixture of both. The supervision team would take the role of programme managers, so they would oversee the overall programme that HBOS, or a firm, was looking to implement. They would then call on specialist resource to come in and to review the quality of that implementation in a narrower sense-

BQ1482 Chair: What sort of people were this specialist resource? Were they PhDs in maths and actuaries?

FSA official: They were a mixture of people. All, largely, market practitioners, so people in from the market with firm-specific either credit-operational or market expertise. Some of them had PhDs and were quants; some of them were more practical and aligned to the overall portfolio management.

BQ1483 Chair: But what seems to have got lost was good, old-fashioned things which even I could do, such as how fast is its lending growing and what percentage is in commercial property? Looking at the schedule of the major credits, look who they were: largely entrepreneurs dealing in property or property-dominant businesses; a lot of fancy finance. You could get to the answer that corporate was going to be a problem without all this work on probabilities and stress tests and so on. Do you think, looking back on it, that the emphasis on Basel II diverted you and made it more difficult for you to find where the real problem was?

FSA official: With the benefit of hindsight, and my personal view, Basel II had very laudable aims to improve the quality of risk management, to improve the engagement of senior management in credit decisioning and the overall management of the book. It was a significant piece of work to be delivered. It took considerable resources from firms and from support for firms alongside significant effort and investment from our perspective. It undoubtedly diverted resources away from other activities.

BQ1484 Chair: So this all comes to a head in Andy Haldane’s Jackson Hole lecture, "The dog and the frisbee", the way he is strongly critical of this high quant world of internal models, which he sees as being at the expense of much simpler things like leverage ratios or looking at asset concentration using fairly simply metrics?

FSA official: I can see his line of argument and I have some sympathies with his line of argument. It was undoubtedly a diversion. I do think, however, that implemented properly, used properly, Basel is the significant step-change in the management of risk.

BQ1485 Chair: Even though it has been abandoned and people are moving on to the next thing?

FSA official: Basel III, which is the next level. I don’t think it has been abandoned. I think it is being taken forward.

BQ1486 Chair: I think people are seeing all sorts of other defects in it as well. I think people now believe it actually contributed to instability. It wasn’t a system that-I don’t think anyone is now thinking that Basel II was a great success.

FSA official: No. Again, with the benefit of hindsight, it was a diversion.

BQ1487 Chair: Let me come to enforcement. What David Quest has established is that there appears to be some justice in the companies, particularly Peter Cummings’ complaint that, "You didn’t tell me this at the time." The way that- paragraphs 4.30, around about there-the defects to the risk management system are written up, and the ferocity with which they are written up: "You weren’t really telling me this at the time." One of the senior independent directors, Sir Ron Garrick says, "Had I known that that’s how badly you thought about the risk system of HBOS, we the board would have responded to it." The relevant period for both decisions, the corporate and the individual one, starts in ’06, but well into ’06 and ’07 there are things like "issue closed", "reasonable progress", etcetera, etcetera. The warning signs that the FSA thought so badly of the risk management system do not seem to be there. So, you can understand why the company and the CEO of corporate feel aggrieved by this.

FSA official: I cannot talk for the company, but my personal perspective is that the board were fully aware of our concerns in respect of Basel and in respect of the extent of progress within Basel on the corporate side. Dennis Stevenson wrote to the chairman of the FSA complaining that we were not progressing the authorisation of the model for corporate.

BQ1488 Chair: So he was blaming the FSA for slowing things down?

FSA official: Yes, for misunderstanding the extent of progress that they had made and the quality of the work that they had.

BQ1489 Chair: But that still looks like business as normal. A lot of work is going on in the company, but you are still not satisfied, so they put in their application. You say-you being the organisation-that you want more. They come back and iterate, and further work gets done and the waiver is eventually granted.

FSA official: Eventually with conditions, which was highly unusual. The stance that we were taking with the firm was very robust on the corporate approach overall. We were telling them that they were not compliant with our rules and regulations, the BIPRU rules and regulations.

BQ1490 Chair: I saw the phrase BIPRU. Can you tell me what it is?

FSA official: It is our rule book, or source book, so it is a banking prudential rule book. It is an abbreviation. That was a very firm message. The level of their concern then triggered their chairman to write to our chairman. I think that they understood that this was a serious and significant issue. And then as we progressed towards the end of ’07, we approved the model but purely with conditions applied to it. And the conditions again came back with a number of issues that they had to put in place.

BQ1491 Chair: But they did not relate, as I remember, to going back to the key issues of concentration on property and concentration on single credit names-you know the particular flaws in the asset types. These conditions, when I looked them up, are much more technical.

FSA official: It is, you are quite right. It is not about the quality of the underlying assets; it is really about the quality of the management framework around it. In the ARROW letter in April, we also identified actions for us. We were going to go in there and test some of the issues, because of the concerns that we had. During the summer of ’08-I take your point fully that by the time the letter was received by the board, the merger had already been agreed-we identified significant issues and concerns that we also replayed back to Sir Ron Garrick. There was a meeting with Sir Ron Garrick during the summer where a number of these issues were played back.

BQ1492 Chair: When do you think that was?

FSA official: It would be some time in the second half of ’08. It was around the time of the letter.

BQ1493 Chair: You say that you have concerns, but these decision notices are finding serious fault. Had HBOS still existed, a fine in the tens of millions would probably have been levied.

FSA official: Possibly, yes.

BQ1494 Chair: So there still seems to be a mismatch-you were dissatisfied with progress on Basel II, that is clear. Even with conditions, you did actually approve it. It wasn’t saying there was serious disregard or breaking of the BIPRU rules.

FSA official: Through the approval letter and the sort of notice beforehand, I agree. The area where we identified more serious concerns was when we went in and did our own testing and review, and we found that the progress that had been stated wasn’t actually there or being delivered.

BQ1495 Chair: I think we are getting to quite a crucial point here. In your submission to us, on page 7, we had put to you that you were saying one thing now that you weren’t saying earlier. Part of the answer, on page 7 of your own answer to our questionnaire, is that between January ’06 and December ’08-the final period notice covered ’06 to ’08-there was "a forensic review of all information available, including information that was not available to or disclosed to the supervision team at that time". That is quite an important statement. What was it that was not disclosed at the time that the forensic team by enforcement discovered?

FSA official: I did not want to imply that the firm had wilfully not disclosed information to us. The enforcement team has considerably far more resources available and the depth of its analysis covered documents that were created within the firm that the supervision team would not have seen at that time, or would not have had made available. It is not meant to be an aspersion against the firm not providing information to us. It is more the ability of enforcement to go in with hindsight but also with significant resource and to review the totality of the documentation on decision-making arrangements.

BQ1496 Chair: The decision, though, is implying that the firm was-in that phrase-"knowingly concerned". They must have been aware that they were ploughing on with a car whose brakes were defective, so to speak. They knew-or should have known-that the risk infrastructure was not good enough. That may have been the discovery and your view of it, but it still doesn’t look as though anyone at the time said that to the company.

FSA official: The issues that we put forward to them, particularly through the October reissuing of the RMP on corporate, should have sent significant messages. Because we asked for it to be reviewed by the board in terms of the quality of controls over them.

BQ1497 Chair: September?

FSA official: October.

BQ1498 Chair: This is October ’08.

FSA official: It is October ’08.

BQ1499 Chair: Whereas, the relevant period for which the company and the chief executive are being censured starts in ’06.

FSA official: It does. I think that the October ’08 piece is a reflection of issues that haven’t crystallised in October. They actually crystallised over that period. They were manifestations of lack of controls over the business throughout that period that were identified during ’08. From memory, it was during the summer of ’08 and then that was fed back to the firm. There were also other issues that were fed back to the firm.

BQ1500 Chair: We can see that by the time it got to ’08 their style of lending, allied to the business model for funding it, was a recipe for disaster. You could say that that could have been predicted back in ’04. Indeed, the phrase "an accident waiting to happen" appears in HBOS minutes. I think it is a phrase used by someone in HBOS, paraphrasing in effect what the FSA were saying. It seems to me the FSA missed this just as much as the company, but it is the company and particularly the CEO who gets the fine.

FSA official: Yes.

BQ1501 Chair: Right at the start, I referred to the fact that the FSA are undertaking a review of what they think went wrong in HBOS-not the kind of six-week job that we are doing-and the FSA’s performance in that story, which will be parallel to the magnum opus on RBS. Presumably, this whole question of whether you spotted things early on but then did not follow them up will come into that review.

FSA official: Yes, I am almost certain that it would do.

BQ1502 Chair: Has it actually started? Have they started asking you about this story or-

FSA official: They have, and one of the people sat behind me is doing that as well. The initial information gathering for the review happened a little while ago. The interviews across the piece, with all the individuals involved in it, are happening at the moment.

BQ1503 Chair: There was quite a fierce argument between the chairman of the commission and the chairman of the FSA about whether this would be shared with Parliament. I think in the end it was and I am assuming that the same will apply to this one.

FSA official: I cannot answer that.

BQ1504 Chair: No, it is just a comment. One minor piece is the Paul Moore episode. This was drawn to your attention at the time.

FSA official: Yes, it was.

BQ1505 Chair: I think KPMG looked into it.

FSA official: Yes, that is right.

BQ1506 Chair: But no one said, "You’d better pay attention to this guy because he’s absolutely right."

FSA official: There was a relationship with Paul Moore, in terms of close and continuous, before the issue arose. I am referring to his role in terms of regulatory risk within retail. At the time the allegations were made, the KPMG review was agreed. It was to undertake an investigation as to whether there was veracity around his allegations. Broadly, that came back giving us comfort that there wasn’t. But his allegations were specifically around the manner in which the new group head of regulatory risk had been appointed and also in respect of concerns that he had that reports that had gone to the board had in some way, shape or form been doctored in terms of the minutes, in terms of the outcomes. I think he subsequently raised other risks and issues in respect of HBOS and more widely, a number of which have got a lot of veracity and truth.

BQ1507 Chair: But it did not lead you to take any further action yourself. The company made its decision to part company with Mr Moore, and following the KPMG report it was left there.

FSA official: It was, but part of the issues he was raising was around the sales culture review within retail, and that is where, particularly, his concerns were at the time-around retail and retail growth. He participated in pulling together that review, which was one of the issues that led to the reduction in the ICR. So we did go back and have a look at that review again, and test some of that review, but again, we were comfortable with the extent of the coverage and the input into it.

BQ1508 Chair: I think I have come to the end of my questions. We are grateful to you for filling in the pieces and enabling us to construct an end-to-end narrative. We had one or two gaps in it, but we now understand it much better. Thank you very much.

FSA official: Thank you. It is quite a task looking through very limited pieces of information that span quite a long period of time.

Chair: Yes, the FSA is notorious for rotating people, so it’s special to find someone who spans-who has lasted for about ***.