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

4  A failure of internal control

The weaknesses of the federal model

48. HBOS operated a federal model. With the exception of the Treasury Division from 2004, each of the divisions whose operations we referred to in the previous chapter and the Insurance & Investment Division operated with their own Chief Executive and their own divisional management and risk and control structures. Day-to-day management of the Group was delegated to the Group Management Board, subsequently renamed the Executive Committee (ExCo). ExCo comprised the Group Chief Executive and the Finance Director, along with the divisional chief executives and other, selected senior executives.

49. Each division was formed by combining activities of the two constituent banks. The lead role was assumed by the stronger partner in the relevant area. Former Halifax management led the Retail and Insurance & Investment Divisions, while former BoS executives led the Corporate and Treasury Divisions, as well as the International Division from 2004. The Group's two Chief Executives both came from the retail side, Sir James Crosby from the previous Halifax leadership and Andy Hornby recruited to head the Retail Division in the first instance. Large exposures required an additional executive director to sign them off, but because Colin Matthew (International) and Peter Cummings (Corporate) were recognised as having the most corporate expertise, they were largely responsible for signing off each other's exposures.[67]

50. Jo Dawson felt that the level of internal challenge to the divisions was "quite low".[68] She said that she understood ExCo to be an "advisory committee whose role was to support" the Group Chief Executive; the authority to challenge executive directors rested with the Group Chief Executive, supported by the Finance Director.[69] Peter Hickman shared this view.[70] With regard to the Corporate Division, Mike Ellis admitted that the challenge process at Group level did not necessarily involve people with direct corporate banking experience.[71] Peter Hickman said that the senior management of HBOS clearly had a lot less understanding of corporate banking than the divisional managers and that there was "huge degree of trust" in Peter Cummings's judgement.[72] Andy Hornby admitted that most of his focus was on other areas because "there were other parts of the business that were causing us more concern in terms of the risk profile than corporate lending".[73]

51. Risk Assurance was provided by internal control functions, including the Audit Committee and Internal Audit. Divisional Risk Control Committees (RCCs), distinct from the divisional risk committees, reported to the Audit Committee and comprised two non-executive directors, an executive director from another division, and a member otherwise external to the HBOS Group. The RCCs were the result of an initiative from the Chairman, who believed they examined all the risks present in their area.[74] Anthony Hobson, Chairman of the Group Audit Committee from 2001 to 2008, considered that the RCCs had the duel advantage of giving non-executive directors direct exposure to risks in individual divisions and executive directors knowledge of risks in other parts of the Group.[75] Andy Hornby indicated that he "relied very much" on the RCCs and their composition.[76]

52. However, Anthony Hobson regarded the function of the Audit Committee as more backward than forward looking, which was in his view more the responsibility of the executive risk committees. He regarded the RCCs as effectively performing the role of divisional audit committees in their role, compared with the executive divisional risk committees.[77]

53. The HBOS Group operated a federal model, with considerable independence given to the divisions. Central challenge to the divisions from senior executive management appears to have been inadequate in the case of the three divisions that ultimately caused the most significant losses (Corporate, International and Treasury). HBOS senior management derived from Halifax and the Retail Division. Accordingly, their understanding of retail banking was stronger, and their relative weakness in other areas meant that their reliance on divisional management in the corporate banking areas was greater. The key role of assessing exposure to future credit risks was dominated by the executives of the individual divisions. These weaknesses in senior management were instrumental in the pursuit by these three divisions of the policies and practices that led to devastating losses.

The group risk function

54. The weaknesses of executive control could perhaps have been mitigated by an effective risk function at Group level, but the Group Chief Executives did not develop a strong Group-level risk function. Paul Moore took up a post as Head of Group Regulatory Risk in late 2003, but said that he met resistance to his proposed approach to the management of risk. The main reporting line of the divisional risk functions was to the divisional management rather than to the group risk function. Paul Moore said that this

    created a kind of 'us and them' culture between the group risk functions and the divisional risk functions, which was dysfunctional.[78]

He also detected what he termed a "cultural indisposition to challenge".[79]

55. In early 2003, Sir James Crosby wrote to the FSA accepting "the need to make more progress in some areas, notably the relationship between group risk and divisional risk functions".[80] In evidence to us, Sir James rejected Paul Moore's characterisation of the relationship as "dysfunctional",[81] and his chosen solution at the time involved creating a new role of Group Risk Director, going through "a good succession planning process" and concluding that "somebody else other than Paul Moore was better qualified to head that function" in consequence of which Mr Moore was made redundant.[82]

56. The new post of Group Risk Director was held by Jo Dawson for 14 months before she was promoted to Head of the Insurance & Investment Division. Her successor, Dan Watkins, was Group Risk Director for less than a year before also being promoted to Head of Retail Products and being appointed to the Board. He in turn was succeeded by Peter Hickman. Jo Dawson had held senior positions in the Retail Division before taking up her post, but had no market or large corporate experience;[83] Dan Watkins had worked in the Morgan Grenfell treasury and become Managing Director of Birmingham Midshires, which undertook higher risk mortgage lending for HBOS. Peter Hickman was previously director of group finance.

57. During her brief time in the role of Group Risk Director, Jo Dawson concluded that she had influence rather than authority. Her ability to effect change was dependent on her relationship with the divisions.[84] This arrangement essentially reflected the very weakness that the creation of the post was, according to Sir James Crosby at the time, designed to address. When Jo Dawson raised concerns from competitors that the Corporate Division was too aggressive from a risk perspective, her recollection was that the Chairman and Chief Executive said that they were comfortable with the position and that competitors were "mudslinging".[85] Peter Hickman saw his role as more than advisory, but acknowledged that the seniority of his post relative to that of the divisional heads was an issue.[86]

58. When we asked Eric Daniels, Chief Executive of Lloyds TSB at the time of the takeover of HBOS, for his reflections on the difference in the culture of the two organisations, he highlighted the difference in approach to Group risk functions:

    My observation would be that HBOS had a desire to grow rapidly and they were seemingly able to pull off growth within acceptable risk parameters—seemingly [...] I think it was a question of having an ambitious set of growth goals without having some of the experience and moderating influences in many of the cases [...] In HBOS [the group risk role] was viewed more as a rotational set of assignments to round out people. So rather than getting experts, they would bring in people as development experiences.[87]

He accepted the possible benefit of senior managers aspiring to run a bank serving in risk positions at an earlier stage in their career, but not at the most senior level of risk:

    I do not believe that you can put talented amateurs in some of these positions, no matter how smart the individuals are. You really need deep professionalism, especially in today's environment: the sophistication of financial products and the ways in which things can go wrong are that much greater than in the good old days.[88]

59. Sir James Crosby told us that his aim in creating the position of Group Risk Director was to enhance its profile and "enhance the position in the context of the Group".[89] He nevertheless conceded that it was "unusual" that two successive holders of the new post had no specific experience in risk functions.[90] Indeed, he conceded that it could be characterised as "bizarre".[91] Lord Stevenson agreed that the rapidity with which Jo Dawson moved on from the risk function was "less than desirable",[92] but said that it reflected "the philosophy of trying to give our outstanding executives experience of the risk function".[93]

60. Seeking to draw lessons from his experience in HBOS, Andy Hornby told us:

    In big, diverse banks, to have a technically strong and personally adept group risk director is totally crucial because to be able to see through the various trends to what the really big things are that need to be challenged is utterly crucial. Secondly, I believe that it is easier if the divisional risk teams have a straight-line reporting relationship to the group risk director, as that takes away an element of potential tension. Ultimately, though, however good your credit risk assessors, divisional risk teams and group risk teams may be, you need to ensure that there is a proper culture of welcoming challenge from the risk teams. That is [the] responsibility of the entire board, and that has to be constantly emphasised.[94]

61. Sir James Crosby and Jo Dawson indicated that the prime responsibility and expertise for risk management and credit assessment rested with the individual divisions, while group risk functions set overall policy and standards, provided functional leadership and oversight and undertook reviews of certain issues.[95] In particular, the divisions had sole responsibility for individual credit sanctioning, with no involvement at Group level. The Corporate Division in particular had a strong sense of its ability to source good quality assets. Jo Dawson indicated that Corporate was less open to challenge and that it did not believe Group functions had the expertise to advise it.[96] George Mitchell regarded the function of Group Risk as concerning "macro issues" such as sector limits, approval processes, policies and the bank's readiness for Basel II.[97] However, the view of the Corporate Division was that individual counterparty assessment was the most important judgement in credit risk.[98] It therefore requested headroom in sector limits, so as to have the flexibility to lend on the basis of its assessment of individual counterparty risk, rather than being constrained.[99] This effectively rendered sector limits meaningless.

62. Both Peter Hickman and Jo Dawson said that the Corporate Division had great confidence in its credit expertise, partly because it had not only weathered previous downturns but had also benefited from them. Peter Hickman acknowledged that he had had "quite full debates" with Dan Watkins, then in charge of Retail on specialised mortgage lending risks, "probably helped by the fact that he had been a group risk director".[100] In contrast, Corporate Division was more confident in its own credit assessments.[101]

63. Group senior management and central risk functions had greater understanding of the Retail business and several of them had direct expertise of working on the Retail side. There was therefore greater involvement by senior management and central functions in Retail and greater willingness to accept that on the part of the Division. By contrast, there was much more limited challenge and ability to challenge Corporate, International and Treasury activities and also, on the part of Corporate at least, willingness to accept it.

64. The risk function in HBOS was a cardinal area of weakness in the bank. The status of the Group risk functions was low relative to the operating divisions. Successive Group Risk Directors were fatally weakened in carrying out their duties by their lack of expertise and experience in carrying out a risk function, by the fact that the centre of gravity lay with the divisions themselves rather than the group risk function, and by the knowledge that their hopes for career progression lay elsewhere in the bank. The degradation of the risk function was an important factor in explaining why the high-risk activities of the Corporate, International and Treasury Divisions were not properly analysed or checked at the highest levels within the bank.

65. The weaknesses of group risk in HBOS were a matter of design, not accident. Responsibility for this lies with Sir James Crosby, who as Chief Executive until 2005 was responsible for that design, with Andy Hornby, who failed to address the matter, and particularly with Lord Stevenson as Chairman throughout the period in question.

67   BQ 1278 and B Ev w 248 Back

68   BQ 259 Back

69   B Ev w 195; BQ 238 Back

70   BQ 505 Back

71   BQ 315 Back

72   BQ 506 Back

73   Q 1446 Back

74   Q 1629 Back

75   BQ 937 Back

76   Q 1468 Back

77   BQ 939 Back

78   BQ 7 Back

79   BQ 40 Back

80   B Ev w 469 Back

81   Q 1386 Back

82   Q 1388 Back

83   BQ 216 Back

84   BQq 217, 233 , 234; B Ev w 194 Back

85   BQ 253 Back

86   BQq 489 - 92, 507 Back

87   Q 4293 Back

88   Q 4294 Back

89   Q 1425 Back

90   Q 1422 Back

91   Q 1423 Back

92   Q 1742 Back

93   Q 1756 Back

94   Q 1513 Back

95   BQq 204, 206, Q 1392 Back

96   BQq 222 , 227 Back

97   BQ 675 Back

98   BQ 507 Back

99   BQ 507 Back

100   BQ 493  Back

101   BQ 489 Back

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© Parliamentary copyright 2013
Prepared 5 April 2013