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

5  A failure of regulation

The FSA's initial identification of weaknesses

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.[102]

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 cent.[103]

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 process;

  The lack of a reliable risk grading system;

  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 to happen".

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".[104] 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".[105]

71. From this point onwards, the regulatory pressure for improvement appears to have diminished.[106] 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.[107] 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.[108] Clive Briault, the FSA's Managing Director, Retail Markets 2004-08, said:

    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.[109]

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 preoccupations—implementation 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.[110]

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."[111] However, the FSA Final Notice on BoS on 9 March 2012 provides evidence that issues were in fact unresolved.[112]

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.[113]

74. Jo Dawson told the Board in March 2005, "the Group was likely to be a relative 'winner' compared with the peer group".[114] 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)".[115]

75. In June 2007, the month in which Northern Rock was granted a Basel II waiver,[116] 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".[117] At the time, Lord Stevenson said that HBOS staff had devoted "tens of thousands of hours" to try and secure its Basel II waiver,[118] and Andy Hornby conceded that the process was a "huge distraction".[119]

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.[120]

77. Clive Briault accepted that too much prudential supervision between 2004 and 2006 was devoted to capital rather than liquidity.[121] 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.[122] 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 key dependencies.[123]

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 need strengthening.[124]

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.[125]

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".[126]

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.[127] 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.[128]

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".[129] 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".[130]

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 the process".[131] 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.[132] 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.[133]


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, too late.

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.[134] 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 itself.

102   B Ev w 450 Back

103   B Ev w 476 Back

104   PwC, HBOS plc: Skilled persons Report under Section 166 of the Financial Services and Markets Act ('FSMA') (2000), July 2004 Back

105   BQ 728 Back

106   B Ev w 392 Back

107   B Ev w 492 Back

108   Ibid. Back

109   BQ 1087 Back

110   B Ev w 413 Back

111   B Ev w 527 Back

112   Bank of Scotland, FSA Final Notice, 9 March 2012, paras 2.7 - 2.19 Back

113   B Ev w 355 Back

114   B Ev w 405 Back

115   B Ev w 288 Back

116   Treasury Committee, Fifth Report of Session 2007-08, The Run on the Rock, HC 56, para 43 Back

117   BQ 1074 Back

118   B Ev w 525 Back

119   Q 1484 Back

120   B Ev w 402 Back

121   B Ev w 177 Back

122   B Ev w 179 -180 Back

123   B Ev w 531 Back

124   B Ev w 558 Back

125   BQ 1421 Back

126   BQ 1102 Back

127   B Ev w 268 Back

128   B Ev w 174 Back

129   B Ev w 471 Back

130   B Ev w 283 Back

131   B Ev w 525 Back

132   B Ev w 557 Back

133   B Ev w 266 Back

134   First Report, paras 132-133 Back

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Prepared 5 April 2013