5 A failure of regulation
The FSA's initial identification
66. As well as analysing evidence on
the internal running of HBOS, we have gathered and assessed evidence
on the role of the FSA in the history of HBOS and the relationship
between the two.
67. There was an initial phase in the
FSA's regulation of HBOS, lasting until the early months of 2004,
when the FSA successfully pinpointed some of the key weaknesses
in the HBOS strategy and business design. Late in 2002, an FSA
review identified serious concerns about the Group's control functions,
including the possibility that controls were not keeping pace
with growth, that the group risk function was insufficiently embedded
in the business and that the bank was over-reliant on wholesale
funding. The HBOS Board was told by the FSA of its need for a
"robust plan" to ensure adequate access to wholesale
funding while the growth in the Retail and Corporate Divisions'
assets outstripped growth in deposits.
68. Towards the end of 2003 the FSA
expressed concern about the failure by HBOS properly to address
the findings of the 2002 review. The failings included a failure
of the control framework to keep pace with asset growth, a lack
of articulated risk appetite and insufficient embedding of the
group risk function. The FSA's concerns were such that it increased
the capital requirement on the bank by 0.5 per cent to 9.5 per
69. The FSA also identified a number
of specific concerns about the control environment in the Corporate
Division, based on a review by the FSA's credit risk specialists.
These concerns included:
A lack of clarity about the point
at which management would cease to feel comfortable about increasing
the exposure to commercial property;
Deficiencies in the credit sanctioning
The lack of a reliable risk grading
Weaknesses in the procedures for
selling down exposures (the loan distribution process), creating
a risk of exposure in the event of a failure to sell down if and
when conditions deteriorated.
The issues identified by the FSA late
in 2003 led directly to the discussion at the Board on 22 January
2004 to which we referred at the start of this Report, when the
FSA was reported as viewing HBOS as an "accident waiting
The reduction of regulatory pressure
70. A number of reviews were commissioned
in response to the FSA's concerns. HBOS Group Financial Risk and
KPMG reviewed the credit processes for the Corporate Division.
The FSA commissioned PwC to undertake a so-called 'skilled persons
review' under section 166 of the Financial Services and Markets
Act 2000 on the Group's control framework and risk management
processes. The reports made a number of recommendations for change,
but the second report concluded that the risk management processes
within HBOS in general, appeared "to work well".
Within HBOS, George Mitchell also interpreted the skilled persons
report as an indication that "the risk management control
framework was effective and satisfactory" and said that he
was "comfortable with the control environment".
71. From this point onwards, the regulatory
pressure for improvement appears to have diminished.
The FSA took considerable comfort from the reviews and reversed
the increase in the capital requirement in December 2004, which
sent a strong positive message to HBOS that they were moving in
the right direction.
An ARROW review in late 2004 noted that HBOS's risk profile had
improved and that it had made good progress in addressing the
risks highlighted previously, but the group risk functions still
needed to enhance their ability to influence the business.
Clive Briault, the FSA's Managing Director, Retail Markets 2004-08,
The supervisory judgement at the
end of 2004, as was communicated to the firm, was that sufficient
comfort was taken by the supervisors from the conclusions of the
skilled persons report, which I believe was sent to the FSA in
the summer of 2004, and by the progress evidenced through their
contact with HBOS during the year on a range of other issues and
also, perhaps I should just add in the context of the skilled
persons report, the acceptance by HBOS that it would carry forward
the recommendations contained in the skilled persons report.
The change in regulatory focus
72. From the evidence we have gathered
on the subsequent phase of FSA regulation, it is all too apparent
that the FSA switched its focus from late 2004 away from the prudential
risks inherent in the Group's business model to two other regulatory
preoccupationsimplementation of Basel II and the FSA's
Treating Customers Fairly (TCF) initiative. By 25 July 2006, Dan
Watkins was able to tell the Board that the latest review from
the FSA was "a generally positive assessment" and that:
The FSA was comfortable to place
increasing emphasis on senior management to ensure that business
and control risks were properly identified and mitigated.
In October 2007, an evaluation by the
FSA of points raised in its previous ARROW reviews concluded that
many of the issues had been addressed and could be closed. The
evaluation stated, for example, that "HBOS has prudent corporate
credit provisions in place. Issue closed."
However, the FSA Final Notice on BoS on 9 March 2012 provides
evidence that issues were in fact unresolved.
73. A huge amount of regulatory time
and attention, in relation to HBOS as with other banks, was devoted
to the Basel II model approval process, whereby banks could apply
for a waiver to be permitted to use their own internal models
to calculate capital adequacy requirements. HBOS attached importance
to obtaining the so-called 'advanced status', because it would
potentially enable them to hold a lower level of regulatory capital.
The minutes of the HBOS Board meeting on 24 June 2003 state that:
"Advanced" status was
the only credible status for HBOS. It was an essential defence
against competitive erosion and a key weapon in driving competitive
advantage. "Advanced" banks would have the capacity
to undercut competition on chosen tranches of business, with cost
of capital being a key strategic weapon.
74. Jo Dawson told the Board in March
2005, "the Group was likely to be a relative 'winner' compared
with the peer group".
She subsequently reported to the HBOS Executive Committee in May
2005 that: "The advanced approaches to credit and operational
risk would bring financial benefits (potentially major in terms
of capital requirements, although this was yet to be proven)".
75. In June 2007, the month in which
Northern Rock was granted a Basel II waiver,
the HBOS application was not granted by the FSA. The HBOS application
was then granted in September 2007, subject to conditions that
needed to be satisfied by 1 January 2008. Michael Foot (the FSA
Managing Director for Deposit Takers and Markets 1998-2004) described
Basel II as "immensely complex and immensely resource demanding"
and "a complete waste of time".
At the time, Lord Stevenson said that HBOS staff had devoted "tens
of thousands of hours" to try and secure its Basel II waiver,
and Andy Hornby conceded that the process was a "huge distraction".
76. Although the FSA had initially identified
HBOS's reliance on wholesale funding as a concern, the regulator's
attention to liquidity weakened dramatically between 2004 and
2007. Ironically, HBOS itself seemed more aware of the deficiencies
than the regulator. On 1 March 2005, the Board was told:
Liquidity [...] remained a significant
management challenge. HBOS was structurally illiquid: this needed
to be overcome through ensuring sources of funds were appropriately
diversified, with identified additional capacity in case of need.
There were no global regulatory standards in relation to the holding
of liquidity. The FSA's current regime was weak: There were intentions
to improve these requirements, to look at the issue in an international
context, but these were unlikely to be effective until 2008.
77. Clive Briault accepted that too
much prudential supervision between 2004 and 2006 was devoted
to capital rather than liquidity.
He also drew attention to the fact that, following push back from
the industry, the FSA Board had chosen not to pursue quantitative
liquidity requirements at a national level until the outcome of
international work on liquidity was clearer.
The FSA only focused again on the threat to HBOS from lack of
liquidity late in 2007, writing to HBOS on 21 December 2007:
We expect HBOS to stress test the
ability to access wholesale funding markets and for this exercise
to be complete by January 2008. Due to the recent market conditions
and your reliance on wholesale funding, we have increased our
liquidity monitoring which will continue for the foreseeable future.
We also expect HBOS to carry out analyses of funding maturities
and funding diversification - wholesale and deposits, to ascertain
78. In June 2008, the FSA looked again
at the credit risk management issues in the Corporate Division
that it had identified in 2003. In October 2008, the FSA wrote
to Peter Cummings to inform him that the review had identified:
Shortcomings in the sphere of credit
risk management and processes. For example; challenge in credit
decisions is not always evident; management information, while
developing, has a considerable way to go before it can be relied
on for managing the book; the quality and timeliness of data use
for risk management needs improving; portfolio management is in
its infancy; procedures and processes for syndications/sell downs
79. Although the FSA had shown an intermittent
interest in credit controls, it paid far less attention to analysis
of asset quality itself. According to one of the FSA staff responsible
for regulating HBOS:
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 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 book.
Clive Briault confirmed that the FSA
was more concerned at that time with systems and controls than
with the "quality of individual loans on the loan book".
The scale and level of FSA engagement
80. The team responsible for the supervision
of HBOS was located within the Major Retail Groups Division at
the FSA. The team reported to a Head of Department who had responsibility
for the supervision of around 15 groups, spanning large banks,
insurance firms and asset managers. The team comprised a manager
and five staff (although it increased in size from late 2007 in
response to the financial crisis). As well as supervising HBOS,
the team supervised one or two other smaller retail groups, but
the majority of their time was spent on HBOS. The team was responsible
for the oversight of both prudential and conduct issues and was
able to call on risk specialists within the FSA in areas such
as credit, market, operational and insurance risk, conduct risk
and financial crime. Day-to-day contact with HBOS was primarily
undertaken by the manager of the team, including communications
with the Board following the FSA's formal risk assessment reviews.
Those at the most senior levels within the FSA, such as the Managing
Director and Director with responsibility for the supervision
of HBOS, had very little direct contact with the firm.
The attitude of HBOS management
to the regulator
81. In the early phase of the short
corporate life of HBOS when the FSA identified key weaknesses
in the control environment, it met with complaints from the bank.
When the FSA spelled out its concerns about the Corporate Division
late in 2003, George Mitchell replied that he was "extremely
disappointed by the overall tone of your letter and indeed find
many of the comments and findings to be unfair".
The Audit Committee rejected the FSA's findings that growth had
outpaced the control framework and encouraged a response that
should be "measured and robust".
82. When HBOS was informed that its
Basel II waiver would not be granted in June 2007, Lord Stevenson
wrote to the Chairman of the FSA in intemperate terms, questioning
whether there might be "any legitimate grounds for concerns
about the consistency, the proportionality or the fairness of
As late as 1 August 2008, Andy Hornby wrote to the FSA, from what
he saw as a position of capital strength, to warn against "excessive
conservatism" on the part of supervisors.
Despite such communications, in the words of David Strachan, FSA
Director of Major Retail Groups 2006-08:
the FSA judged HBOS plc to have
an open and constructive relationship with it [...] This resulted
in the FSA placing reliance on HBOS plc's senior management to
deliver some actions within the Group's risk mitigation programme.
83. The picture that emerges is that
the FSA's regulation of HBOS was thoroughly inadequate. In the
three years following the merger the FSA identified some of the
issues that would eventually contribute to the Group's downfall,
notably the risk that controls would fail to keep pace with aggressive
growth and the Group's reliance on wholesale funding. The FSA
failed to follow through on these concerns and was too easily
satisfied that they had been resolved. The FSA took too much comfort
from reports prepared by third parties whose interests were not
aligned with those of the FSA.
84. From 2004 until the latter part
of 2007 the FSA was not so much the dog that did not bark as a
dog barking up the wrong tree. The requirements of the Basel II
framework not only weakened controls on capital adequacy by allowing
banks to calculate their own risk-weightings, but they also distracted
supervisors from concerns about liquidity and credit; they may
also have contributed to the appalling supervisory neglect of
asset quality. The FSA's attempts to raise concerns on these other
fronts from late 2007 onwards proved to be a case of too little,
85. In our First Report, drawing upon
evidence from Sir Mervyn King, we emphasised the need for regulators
to be able to exercise judgements in their supervision of banks
without feeling that they were engaged in a process of negotiation.
The experience of the regulation of HBOS demonstrates the fundamental
weakness in the regulatory approach prior to the financial crisis
and as that crisis unfolded. Too much supervision was undertaken
at too low a level - without sufficient engagement of the senior
leadership within the FSA. The regulatory approach encouraged
a focus on box-ticking which detracted from consideration of the
fundamental issues with the potential to bring the bank down.
The FSA's approach also encouraged the Board of HBOS to believe
that they could treat the regulator as a source of interference
to be pushed back, rather than an independent source of guidance
and, latterly, a necessary constraint upon the company's mistaken
courses of action.
86. Regulatory failings meant that
a number of opportunities were missed to prevent HBOS from pursuing
the path that led to its own downfall. The priorities of the supervisor
also reinforced the senior management of HBOS in their own misplaced
priorities. Ultimate responsibility for the bank's chosen path
lies, however, not with the regulator but with the Board of HBOS
102 B Ev w 450 Back
B Ev w 476 Back
PwC, HBOS plc: Skilled persons Report under Section 166 of
the Financial Services and Markets Act ('FSMA') (2000), July
BQ 728 Back
B Ev w 392 Back
B Ev w 492 Back
BQ 1087 Back
B Ev w 413 Back
B Ev w 527 Back
Bank of Scotland, FSA Final Notice, 9 March 2012, paras 2.7 -
B Ev w 355 Back
B Ev w 405 Back
B Ev w 288 Back
Treasury Committee, Fifth Report of Session 2007-08, The Run
on the Rock, HC 56, para 43 Back
BQ 1074 Back
B Ev w 525 Back
Q 1484 Back
B Ev w 402 Back
B Ev w 177 Back
B Ev w 179 -180 Back
B Ev w 531 Back
B Ev w 558 Back
BQ 1421 Back
BQ 1102 Back
B Ev w 268 Back
B Ev w 174 Back
B Ev w 471 Back
B Ev w 283 Back
B Ev w 525 Back
B Ev w 557 Back
B Ev w 266 Back
First Report, paras 132-133 Back