'An accident waiting to happen': The failure of HBOS - Parliamentary Commission on Banking Standards Contents

2  The 'new force in banking'

11. HBOS was created in 2001 from the merger of the Bank of Scotland (BoS) and Halifax. The Halifax had been the UK's largest building society and was one of the last of the major societies to demutualise and float in 1997. At flotation and for the period afterwards, Halifax was almost entirely a retail organisation, and was the leading UK mortgage and savings company, with a 22 per cent share of mortgages and 16 per cent of retail savings. The Halifax profitability and share price stagnated post flotation. It was viewed as having an excessive reliance on mortgage and savings, and the mortgage market in particular was becoming a more competitive area. For Halifax, a deal with BoS offered an almost unique opportunity to transform itself into a broad based commercial bank, particularly in the corporate area.

12. Since the 1970s, BoS had followed a very successful strategy of organic market share growth. The strategy combined maintaining its leading full service market position in Scotland, with targeted expansion in England. The expansion in England involved segments that could be penetrated with 'direct banking' techniques, supplemented by a very limited branch presence. Consequently, the bank prioritised areas such as high value mortgages and deposits and niche segments in the corporate market, including smaller value management buy outs/leveraged loans, asset finance and limited larger corporate banking sectors, notably energy. It also had a significantly higher relative exposure to Commercial Real Estate (CRE).

13. BoS continued to make gains in market share relatively successfully through the early 1990s downturn, which reinforced its confidence in its credit selection procedures. The BoS expansion in England was also primarily, though not exclusively, asset-led and therefore involved a reliance on wholesale funding to support it. By the late 1990s, there were concerns, both among investors and among the bank's management, that the strategy was beginning to stagnate. BoS considered a number of inorganic options. It made a hostile bid for National Westminster Bank, but ultimately lost this battle to its principal Scottish rival, RBS. For BoS, a merger with the Halifax offered the potential of a significantly enhanced balance sheet, from a capital and funding perspective. It was also a relatively complementary merger, with limited overlap. In particular, Halifax had little or no expertise in the corporate and treasury areas, where BoS was expected to provide the basis for the enlarged Group.

14. The creation of HBOS had the effect of turning the 'big four' banking groups into the 'big five'. At the end of 2001, HBOS had total assets of £275 billion, larger than Lloyds TSB and three-quarters of the size of Barclays and of RBS. In its first Annual Report, HBOS described itself as the "new force in banking".[16] The new Group saw an opportunity to benefit from its increased scale and from distributing its broadened product range to an enlarged customer base. It set medium-term targets to achieve product market shares near the 15 to 20 per cent that Halifax had enjoyed in its core markets.

15. The Chief Executive, James Crosby, gave a public target for the new Group to increase the return on equity (RoE) from an underlying figure of 17 per cent in 2001 to 20 per cent by 2004.[17] This increase implied a target of 80 pence of earnings per share by 2004, compared with the underlying earnings per share of 56 pence per share in 2001. The aim was to achieve this target through rapid growth across all divisions. HBOS essentially achieved this target, with underlying earnings per share of 84 pence and a return on equity of 19.8 per cent in 2004.

16. HBOS sustained significant business growth between its formation in 2001 and 2008, as illustrated by Table 1, which highlights key figures for the Group and its main divisions.

Table 1

Table 1 underlines that, in the period after its creation, HBOS pursued a strategy of asset-led growth, expanding its lending significantly faster than its deposits. Total group loans grew at a compound rate of 13 per cent over the 2001-08 period, excluding the impact of acquisitions and disposals. Customer deposits rose by only 8 per cent per annum during the same period. The growth rate of the loan book was faster up to 2004 than in the years from then until 2008. This slower growth was due to slower retail expansion; there continued to be growth of the corporate and international books, a matter we discuss further in the next chapter. The effect of growth in assets outstripping growth in customer deposits was to increase the bank's reliance on wholesale funding, the consequences of which we explore further later in this Report.

17. According to Colin Matthew, who was successively Divisional Chief Executive of Business Banking and, from 2006, Chief Executive of Strategy and International Operations:

    The Board understood the long-term growth strategy and that any strategy involving growth would entail a certain level of risk. For example, the Board recognised the level of exposure to the UK residential and commercial property market.[18]

18. Despite pursuing a strategy of high growth with commensurate risk, HBOS preserved the self-image of a conservative institution. Addressing potential funding problems in a private letter to the Chairman of the FSA in March 2008, Lord Stevenson wrote:

    The commonsense of the situation is that we are dealing with lenders looking to lend money to a highly conservative institution.[19]

This self-image was partially preserved in evidence to the Commission. George Mitchell, Head of the Corporate Division until 2005, said of that period that HBOS was

    less conservative than some, but was certainly no more aggressive than many against whom it invariably competed for business.[20]

Sir James Crosby said of the same period:

    The fact of the matter was that we did expand very fast, but the performance of the business in terms of its impairments and risk factors was satisfactory [...] I am not sure I would accept that in the period up to 2005 we had expanded too fast.[21]

Lord Stevenson told us:

    This was not an organisation that was obsessed by growth or had a culture of optimism. You can go through the history of any organisation and find decisions that look over-ambitious. If you go through HBOS, you will find quite a lot of decisions that were quite conservative.[22]

19. The strategy set by the Board from the creation of the new Group sowed the seeds of its destruction. HBOS set a strategy for aggressive, asset-led growth across divisions over a sustained period. This involved accepting more risk across all divisions of the Group. Although many of the strengths of the two brands within HBOS largely persisted at branch level, the strategy created a new culture in the higher echelons of the bank. This culture was brash, underpinned by a belief that the growing market share was due to a special set of skills which HBOS possessed and which its competitors lacked. The effects of the culture were all the more corrosive when coupled with a lack of corporate self-knowledge at the top of the organisation, enabling the bank's leaders to persist in the belief, in some cases to this day, that HBOS was a conservative institution when in fact it was the very opposite. We consider the effects of these cultural weaknesses in the chapters that follow.

16   HBOS, 2001 Annual Report and Accounts: The New Force  Back

17   HBOS, 2002 Annual Report and Accounts: 'Even in tough markets, this is the strategy that delivers' Back

18   B Ev w 246 Back

19   B Ev w 534 Back

20   B Ev w 251 Back

21   Q 1275 Back

22   Q 1651 Back

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Prepared 5 April 2013