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

3  The avenues to impairment


20. Although the Group's strategy was based on aggressive expansion across all divisions, as time went on asset growth was concentrated particularly in areas of higher risk. A bank's lending appears on its balance sheet as an asset. If there is evidence of permanent loss of value, the loan is written down in a process known as impairment. In this chapter, we examine the asset growth in three divisions of HBOS where the assets have subsequently been subject to impairment on a massive scale—the Corporate, International and Treasury Divisions. Further detail about each division is provided in Annexes 1 to 3. We also consider some characteristics of the Retail Division, which is examined further in Annex 4.


21. The growth of HBOS's domestic corporate loan book averaged 15 per cent on an underlying basis, adjusted for intra-group transfers, in the period from 2001 to 2008. After an initial period of very rapid expansion—26 per cent in 2002 and 17 per cent in 2003—the growth rate slowed to single figures, but then accelerated sharply to 22 per cent in 2007 and fell back, but still in double figures, to 12 per cent, in 2008. Asset growth ran well ahead of corporate customer deposits, so that the Division's contribution to the funding gap increased from £33 billion at the end of 2001 to £84.5 billion by 2008.

22. HBOS planned to use the BoS corporate expertise and the Halifax branch network to expand its market share among SMEs, particularly in England. The stated ambition in 2001 was to "break the mould" and mount "a strong challenge to the four clearing banks".[23] In 2004 the Board referred to its plan to make "significant inroads into the market", although the "Big Four had entrenched, valuable positions".[24]

23. The quest for expansion in the face of entrenched positions was even more apparent in relation to larger businesses. In particular, in 2006, Peter Cummings, Chief Executive of the Corporate Division from 2005 to 2008, set the aspiration to "be the best real estate bank in the UK",[25] underpinning an expansion that was focused on property and construction. This sector represented over a third of the Division's customer loans at the end of 2008. Lending for hotels, restaurants and wholesale and retail trade, which would also be significantly property-based, represented a further 10 per cent. Lending to these two categories of business grew significantly faster than the Division as a whole and represented 59 per cent of the net expansion in outstanding loans between 2001 and 2008.

24. In addition to the dominance of property-based investment, there were other characteristics of HBOS corporate lending which contributed to its subsequent demise:

  A close relationship between its conventional business loans, particularly in the property sector, and its provision of equity and leveraged loans, so that customers were offered "a complete funding package" including "mezzanine debt and equity" in addition to "more traditional" lending;[26]

  Large individual credit exposures, expanding rapidly in the later years, so that in September 2002 the largest single name loan approval was £963,000, but by September 2008 the largest single name approval was £2.9 billion and there were nine names in excess of £1 billion;[27]

  An emphasis on offering loans to be syndicated to others, a strategy which depended upon the continuance of an active market in the syndication of loans; and

  Lowly rated debt, equity and joint venture participations.

25. George Mitchell pinpointed that the corporate market had some characteristics of saturation by the time he left in 2005: "there were clear signs the markets were overheating and it was becoming increasingly difficult to source transactions with the right risk/reward characteristics".[28] In pursuit of expansion, HBOS sought out and found "sub-investment grade" business.[29] The FSA pointed out that the Corporate Division had "a specific focus" on sub-investment grade lending and that its "book had a higher risk profile than the equivalent books at the other major UK banking groups".[30]

26. One of the most striking features of the Corporate Division's business was the expansion in its rate of growth in 2007 and 2008 compared with the immediately preceding years. Part of the reason for this was rooted in the culture of HBOS, largely inherited from BoS, which prided itself in "leaning against the wind"—lending through the cycle—maintaining its commitment to customers even in tough times. In October 2007, for example, Peter Cummings said:

    Some people look as if they are losing their nerve, beginning to panic even in today's testing property environment; not us.[31]

Early in 2008, HBOS reported that its commercial property portfolio was "expected to to continue to perform relatively well".[32] Peter Hickman, Group Risk Director from September 2007, recollected that the bank made judgements "about maintaining a franchise and about the risk of being seen to be pulling back lending too hard";[33] he thought that HBOS was "more nervous" about the signals it was sending than "a stronger bank" would have been".[34] Peter Cummings stressed that his actions at the time were more cautious than his words,[35] and there were other factors in the accelerating growth in 2007 and 2008.

27. One factor was the weakness of the syndication market. HBOS acknowledged that it had continued with "strong originations" despite "lower levels of refinancing and sell-down activity".[36] As Peter Cummings put it, the Division was "carrying on while nothing [was] getting sold",[37] leading to what Sir Ron Garrick, the Senior Independent Director at the time, admitted was a "very sharp increase in the loan book in the second half of 2007".[38] Another element was that committed loan facilities extended by HBOS to customers in earlier years were drawn down as borrowers found that other sources of funding, such as the commercial paper market, were no longer accessible to them.[39]

28. The consequences of the specific characteristics of the HBOS corporate loan book, and the Division's apparent inability to prevent acceleration in its rate of growth in the second half of 2007 and in 2008, have become evident subsequently. Although separate reporting for the former divisions of HBOS has ceased since it became part of Lloyds Banking Group, we estimate that aggregate customer loan impairments on Corporate Division loans in the period 2008 to 2011 totalled some £25 billion, equivalent to 20 per cent of the end 2008 loan book, not counting further impairments and write-downs on equity and joint venture investments.

29. We put to Lord Stevenson the picture that had emerged from our work, including the facilities available and taken up by individuals in the corporate sector by September 2008. He responded:

    You cannot look at those provisions and not be horrified and appalled. However, in terms of trying to understand what the truth of the matter is, I think the question I am proposing as to the extent to which they were affected by the closure of wholesale markets and the extent to which there was incompetence is a very real question, which I do not have the ability to measure. But please, please, please, I am not trying to avoid the finger saying that we over-lent in corporate, because we did.[40]

Sir James Crosby told us:

    We always believed and my colleagues in the corporate bank always believed that they had a good understanding of the risks they were taking and we in aggregate as a bank had no evidence to the contrary.[41]

Having defined competent lending as striking the right balance between risk and reward, Sir James acknowledged, in hindsight, that the bank's lending had been incompetent.[42]

30. The growth of HBOS's Corporate Division was not the result of superior performance but of its high-risk strategy. The nature of its activities did not alter after the creation of HBOS, although the pace of growth accelerated and the scale significantly increased. When the Division later incurred huge losses, these too were due to the particular nature of its business and resulted directly from its high-risk strategy. Its losses were on a larger proportionate scale than those incurred by any other major UK bank. This was caused specifically by its distinctive loan book, including concentration in commercial real estate and leveraged loans, high exposure to single names, a high proportion of non-investment grade or unrated credit and holdings of equity and junior debt instruments. The loan book was therefore significantly more exposed to the domestic downturn than that of any other large UK corporate banking businesses.

31. The acceleration in loan growth, in part caused by the Division's neglect of the storm signals of 2007 and 2008, is likely to have exacerbated the scale of the subsequent losses. However, even without this acceleration, the Division would still have incurred disastrous losses. The roots of all these mistakes can be traced to a culture of perilously high risk lending. The picture that emerges is of a corporate bank that found it hard to say 'no'.

32. In view of the reckless lending policies pursued by HBOS Corporate Division, we are extremely disappointed by the attempts of the most senior leaders of HBOS at the time to attribute the scale of the consequent losses principally, or in significant measure, to the temporary closure of wholesale markets. The lending approach of the Corporate Division would have been bad lending in any market. The crisis in financial markets was merely the catalyst to expose it. Losses in the Corporate Division did not prove temporary. Indeed, we estimate that the HBOS Corporate loan book has continued to incur significant impairments in every year since 2008, demonstrating that the losses were the result of incompetent lending and not caused solely by the events of 2008. Furthermore, HBOS's Corporate Division was significantly more exposed than other banks to the downturn in the economy due to the nature of its loan book.


33. HBOS was, at the time of its creation and in its early years, a largely domestic bank. This was regarded within HBOS as a source of weakness,[43] and, particularly from 2004 onwards, HBOS sought to grow aggressively abroad, building on what it believed to be its areas of expertise in UK markets, and concentrating particularly in Ireland and Australia.[44] The Board set ambitious targets for market share gains from strong local incumbents.[45]

34. The fastest growth took place in Ireland, where HBOS aspired to become "the No. 1 business bank during 2005",[46] with the overall strategic goal of becoming "the fourth largest full service Irish bank by 2009".[47] In particular, HBOS sought to grow its corporate business in Ireland. Many of the characteristics that facilitated rapid growth were shared with the UK corporate book: an increasing concentration on property and construction; and the use of "asset specific transactions", again concentrated in the commercial real estate and related sectors.[48] As in the UK, loan growth continued in 2008, in Ireland at a rate of 8 per cent in constant exchange rate terms, growth which Colin Matthew attributed to the draw downs of existing facilities, the inability to sell down and the residential property pipeline.[49]

35. Similarly, in Australia, HBOS sought to double its national market share and to be a new rival to the four local banks that dominated the market.[50] By June 2006, Colin Matthew was telling the top management that the longer term aim for the Australian business "was to become a major Australian financial services company with market shares in the 15-20 per cent range in chosen segments".[51]

36. In Ireland, estimated impairments between 2008 and 2011 totalled £10.9 billion, equivalent to 36 per cent of the loan book at the end of 2008; 60 per cent of impaired loans in Ireland at the end of 2011 related to exposures to commercial real estate. All leading Irish banks incurred significant impairments, as a result of the Irish recession. However, the losses at HBOS as a proportion of loans were greater than those of all but one of the major Irish banking groups, as Table 2 shows:

Table 2

37. In Australia, the impairments over the same period totalled £3.6 billion, equivalent to 28 per cent of the value of the loan book there at the end of 2008, an even higher loss as a proportion of loans than incurred by the Corporate Division in the UK. This loss is all the more striking in view of the comparative resilience of the Australian economy in the global downturn: in this period, the Australian banking sector remained profitable and no entities received any public capital support during the crisis.[52]

38. Sir James Crosby accepted that the losses in Australia were indicative of an appalling lending record,[53] but sought to defend the Irish impairments by reference to the "extraordinarily difficult conditions" that that market experienced.[54] Andy Hornby accepted that the growth in Ireland was "mistaken", but defended at least the retail element in Australian growth, while acknowledging:

    It was difficult to grow as quickly in retail banking as in corporate banking because it takes so much longer to build franchise-built deposit bases and build scale.[55]

Lord Stevenson emphasised the excellence of the team HBOS had in Australia and the time he and the main Board had devoted to growing that business. When asked about the level of impairments that developed, he said:

    I cannot distinguish between the loss of value reflected by the knock-on effects of the closure of wholesale markets and the knock-on effect from bad lending decisions in any markets. That it is a horrible figure is beyond doubt.[56]

39. Abroad as at home, HBOS took what it saw as the relatively quick and easy path to expansion without acknowledging the risks inherent in that strategy. As in the UK, HBOS concentrated on sectors which enhanced the intensity of its subsequent exposure. In two markets alone—Australia and Ireland—it incurred impairments of £14.5 billion in the period from 2008 to 2011. These losses were the result of a wildly ambitious growth strategy, which led in turn to significantly worse asset quality than many of its competitors in the same markets. The losses incurred by HBOS in Ireland and Australia are striking, not only in absolute terms, but also in comparison with other banks. The HBOS portfolio in Ireland and in Australia suffered out of proportion to the performance of other banks. The repeated reference in evidence to us by former senior executives to the problems of the Irish economy suggests almost wilful blindness to the weaknesses of the portfolio flowing from their own strategy.


40. As we noted in our First Report, one of the characteristics of the years leading up the financial crisis was the transformation of treasury functions within UK banks from their traditional role of funding safely profit-generating activity elsewhere in the business to being profit-centres in their own right.[57] HBOS viewed its Treasury Division as relatively conservative, and it ceased its interest rate proprietary trading activities in 2005, but it was not immune from this weakness.[58] The Division consistently maintained significant liquidity, partly in recognition of the Group's substantial use of wholesale funding. Initially, this liquidity was invested in government bonds and bank certificates of deposit.[59] However, from 2004, a strategy was agreed to reduce its perceived over-reliance on these types of holdings. The Board was told in May 2004 that new products such as credit derivatives "would have superior returns and liquidity characteristics" and would "leverage expertise to create income".[60] The Division had also inherited a portfolio of structured credit assets from Halifax and these roughly doubled over the life of HBOS, as the liquidity portfolio was diversified. The Division held an increasingly significant proportion of its assets via conduits, the most significant of which (Grampian) held half of the Group's asset-backed securities investments.

41. The Executive Committee understood that there was greater risk inherent in the move to instruments with higher returns,[61] although some members of the Board may not have done so, judging by Jo Dawson's (Group Risk Director in 2004-05 and subsequently Group Board member and Head of Insurance & Investment Division and Retail Distribution) admission that she "would not have known what an Alt-A security was".[62] Immediately after the creation of HBOS, the Head of the Treasury Division was a member of the main Board, but his successors were not, reporting via heads of other divisions whose asset growth relied on the funding which the Treasury Division was charged with raising.

42. As the financial crisis hit, the HBOS Treasury Division turned from a source of profit to another source of loss. The aggregate profit and loss charges attributable to the Division in the period from 2008 to 2011 totalled £7.2 billion. Losses on this scale alone would have required recapitalisation of the Group. All relevant functions at HBOS, from the Board downwards, did not properly understand the nature of the risks embedded in the Treasury Division's structured investment portfolio, either from a credit risk or liquidity perspective.

43. Far from providing liquidity and offering some protection against the Group's use of wholesale funding, the liquidity of the portfolio evaporated when the financial crisis developed, substantial losses were incurred as a result of a sharp decline in market valuations and the size and nature of the securities portfolio served to increase market concerns towards HBOS. The bank was, of course, far from unique in incurring losses in structured investments; many other banks, both in the UK and in other countries, also incurred such losses. However, HBOS was excessively confident that its understanding of UK residential mortgages and related securitisations gave it the ability to understand and evaluate the risks in a wide range of asset-backed investments.


44. The Retail business was the largest division in HBOS in terms of customer loans. A key element of the Division's mortgage strategy was to grow 'non-standard' mortgage lending, particularly buy-to-let and self-certified mortgages, where margins had remained higher than for standard mortgages and the overall profitability was thought to be more attractive, despite higher credit risks. By the end of 2008, £66.5 billion (28 per cent) of the banks' retail mortgage lending was classified as non-standard and 62 per cent of the Division's book had a loan-to-value ratio of over 70 per cent.[63] These proportions are significantly higher than for any other mainstream mortgage lender. Furthermore, at the end of 2008, the Retail Division had customer deposits of £144 billion and customer loans of £255 billion, a gap of £111 billion[64] which accounted for over half the Group's total funding gap of £213 billion.[65]

45. LBG does not publish divisional results for the HBOS Group and so it is not possible to know precisely the impairments the Retail Division has incurred since the financial crisis. We do, however, know that at the end of 2008, HBOS had retail impairments of £2.2 billion, of which £1.1 billion was against secured lending,[66] up from just £28m in 2007. We estimate that total Retail impairments would have been some £7 billion between 2008 and 2011.

46. The impairments incurred by the Retail Division were substantially less than those incurred by the Corporate and International Divisions and were not a material factor in the failure of HBOS. The Retail Division is likely to have remained profitable during the crisis period and subsequently, albeit at a reduced level. We note, however, that the Division incurred substantially higher mortgage-related losses than its major competitors, reflecting the bank's strategy of pursuing growth in higher risk non-standard mortgages. We also note that the Division's customer funding gap was a major factor in the Group's overall funding gap, which was a principal immediate cause in the short term of the failure of the bank. Prudent customer funding should have been a secure source of stability during market storms.

Overall conclusions

47. The massive impairments in HBOS were not confined to a single division. In the case of the Corporate Division, the impairments of £25 billion on their own would have threatened the ability of the bank to operate or require complete recapitalisation. The impairments in the International Division of £15 billion set HBOS apart among its comparators and, although smaller than in the Corporate Division in absolute terms, were larger as a proportion of the loan book. They too would have been sufficient on their own to necessitate substantial recapitalisation. The losses in the Treasury Division of £7 billion would also have been sufficient on their own to require recapitalisation. Both the relative scale of such large losses and the fact that they were incurred in three separate divisions suggests a systemic management failure across the organisation. Taken together, the losses in these three divisions would have led to insolvency.

23   HBOS, 2001 Annual Report and Accounts: The New Force, p 24 Back

24   B Ev w 379 Back

25   B Ev w 307 Back

26   HBOS, 2001 Annual Report and Accounts: The New Force, p 28 Back

27   B Ev w 437 - 441, 446 - 448 Back

28   BQ 698 Back

29   BQ 716 Back

30   Bank of Scotland, FSA Final Notice, 9 March 2012, para 4.10 Back

31   BQ 1191  Back

32   HBOS, 2007 Annual Report and Accounts: Delivering our strategy..., p 32 Back

33   BQ 495 Back

34   BQ 496 Back

35   BQ 1247 Back

36   HBOS, 2008 Annual Report and Accounts, p 7 Back

37   BQ 1206 Back

38   B Ev w 215 Back

39   BQ 1212 Back

40   Q 1729 Back

41   Q 1347 Back

42   Qq 1348-1350 Back

43   B Ev w 233; Q 1558 Back

44   B Ev w 233, 247; HBOS, 2005 Annual Report and Accounts Back

45   B Ev w 404, 415 Back

46   B Ev w 390 Back

47   B Ev w 420 Back

48   HBOS, 2007 Annual Report and Accounts: Delivering our strategy..., pp 53-54 Back

49   BQ 151 Back

50   B Ev w 391-392 Back

51   B Ev w 298 Back

52   Financial Stability Board, Peer Review of Australia: Review Report, September 2011, p 5 Back

53   Q 1293 Back

54   Q 1292 Back

55   Q 1463 Back

56   Q 1558 Back

57   Parliamentary Commission on Banking Standards, First Report, HC (2012-13) 848 and HL Paper 98 of Session 2012-13 (hereafter cited as First Report), para 39 Back

58   B Ev w 242-244 Back

59   BQ 593; B Ev w 385-386 Back

60   B Ev w 385 Back

61   B Ev w 302 Back

62   BQ 270 Back

63   HBOS, 2008 Annual Report and Accounts, p 124 Back

64   Ibid., p 47 Back

65   Ibid., p 42 Back

66   Ibid. Back

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Prepared 5 April 2013