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

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

7 Downfall

The need for and provision of funding

96. From its formation HBOS had a large wholesale funding requirement, as both Halifax and BoS had been already significant users of wholesale funding even prior to the merger. At the Group's formation in 2001, the Group had a loans/deposits ratio of 143 per cent and a customer funding gap of £61 billion. The Retail Division, which had been substantially derived from Halifax, had customer loans of £137 billion and deposits of £97 billion—a customer funding gap of £40 billion.[152] The rest of the HBOS Group, substantially derived from BoS, had a customer funding gap of £21 billion.[153]

97. HBOS's growth strategy meant that the funding gap increased. Customer deposits grew at a slower rate than assets. Deposits rose at 8 per cent a year between 2001 and 2008, compared with asset growth of around 13 per cent.[154] By the end of 2008, the loans/deposits ratio had risen to 196 per cent and the customer funding gap had increased to £212.9 billion. The Retail Division's customer funding gap had risen to £112 billion, the Corporate Division had a gap of £78 billion, and the International Division a gap of £54 billion. All three of the Group's principal banking divisions contributed to the increase in the Group's overall customer funding gap and the greater need for wholesale funding over the period from 2001 to 2008.

98. The Treasury Division's first priority was sourcing the funding to support the Group's asset led strategy.[155] Management papers throughout the period show that the planned asset growth posed challenges for the Treasury Division in raising the funding to support it, even before the onset of the financial crisis. The 2003-07 Business Plan (drawn up in 2002) cited funding and liquidity as possibly the bank's "greatest single challenge".[156] The Finance Director explained to the Group Board in November 2002 that their five-year business plan would make HBOS "the largest wholesale funded clearing bank in the UK", and Sir James Crosby acknowledged that funding was a "significant risk".[157] On 1 March 2005, the Board was told:

158

Lindsay Mackay, Head of the Treasury Division, told the Executive Committee in 2006 that the bank's existing wholesale funding capacity would be reached in 2009 under their current Plan. HBOS had "the highest wholesale funding need of any of the UK banks (and was close to the other Big Four banks combined)". He informed the Executive Committee that, in the longer term, the position was "untenable and unsustainable".[159]

99. HBOS took steps to mitigate its reliance on wholesale funding, including: increasing the efforts to source customer deposits; diversifying wholesale funding sources by nature, currency and type of investor;[160] holding a significant pool of liquid assets; and undertaking stress tests and scenario analyses.[161] The Group also made efforts to diversify its sources of wholesale funding, through the issuance in different currencies of covered bonds, asset-backed securities and senior debt. It also sought to lengthen the maturity of its wholesale funding. The proportion of wholesale funding with a maturity of under one year was reduced from 86 per cent in 2001 to 50 per cent by 2008. However, the bank used the benefits of its measures to raise longer term wholesale funding to support asset growth, rather than to reduce short-term wholesale funding in absolute terms. At the end of 2008 HBOS had £238 billion of wholesale funding outstanding, of which £119 billion had a maturity of less than a year, compared with £90 billion in 2001.[162]

100. The onset of the financial crisis in the second half of 2007 led to a shortening of the wholesale funding profile, as maturing longer term funding could only be replaced by shorter duration maturities.[163] In consequence, the proportion of HBOS's wholesale funding with a duration longer than one year fell from 47 per cent in mid-2007 to just over 40 per cent a year later.

101. Once the financial crisis began, HBOS did attempt to moderate its overall asset growth plans. However, several executives indicated in evidence that the reliance on the markets for wholesale funding made the Group cautious about the signals it was sending: being too aggressive in scaling back growth risked worrying the market that the bank might be in difficulty.[164] In September 2007, Philip Hodkinson, Group Finance Director, outlined to the Executive Committee steps to reduce asset growth and increase liabilities, although full-year asset growth would still be above plan. However, he also indicated, lending "could not simply be 'turned off'."[165] Growth targets for 2008 were reduced by £10 billion, largely in the International Division, and the Group targeted increased liability growth.[166] However, as we noted earlier, asset growth in the Corporate Division was accelerating soon after these measures were agreed.

102. Successive Executive Committee and Board papers during the financial crisis indicate management took the funding position seriously. The day after the announcement that Northern Rock had been granted emergency Bank of England assistance, HBOS set up a Contingency Planning Group, and Andy Hornby indicated that planned business growth was no longer prudent.[167] On 18 September 2007, Lindsay Mackay discussed with the Executive Committee contingency planning designed to avoid HBOS becoming "the next Northern Rock".[168] Initially at least, the management believed the external perception to be of a bank that had "managed its position through the liquidity crunch extremely well".[169] It felt regarded as one of the larger Clearing Banks, distinct from the monoline or smaller mortgage banks.[170] Philip Hodkinson said that the responses to stressed conditions, which the Group had prepared and which took effect in late 2007, together with other measures, were working and the Group felt "in good shape".[171]

103. On 13 November 2007, Lord Stevenson wrote to the Chairman of the FSA about how it was coping with the pressures of the financial crisis. He said:

[...] You asked how HBOS felt on the 'ladder of vulnerability'. Answer: without wishing to be complacent or hubristic, management has done a superb job-a job that started five years ago and not in August; most recently Andy Hornby has led his top managers into making some very tough decisions to ration assets growth next year. Good always comes out of difficult times [...]

172

104. As the crisis progressed, the HBOS credit default swap levels widened, both in absolute and relative terms.[173] The Group suffered an attack from short sellers in March 2008, which led to the withdrawal of some deposits that stabilised after an FSA statement. The market was also concerned with the structure of the HBOS balance sheet, notably its loans/deposits ratio and the absolute size of its wholesale funding.[174]

105. On 17 March 2008, the day of the announcement of the acquisition of Bear Sterns by JP Morgan in a rescue involving the Federal Reserve, the Chairman of the FSA called Lord Stevenson to ask how he was feeling. Lord Stevenson's response the next day was bullish:

I and we are feeling about as robust as it is possible to feel in a worrying environment which we would rather did not exist!

boringly boring

We have had no problems in financing ourselves over the past six months even on the hairiest of days and weeks [...]

HBOS in an admittedly uncertain and worrying world is in as secure a position as it could be

we are dealing with lenders looking to lend money to a highly conservative institution

175

By September 2008, it became clear that, far from being "a highly conservative institution" in a safe harbour, HBOS was in a storm-tossed sea.

106. It was also holed below the water line. HBOS's £60 billion liquid assets pool proved ineffective, because the bank was unable to sell or raise funds against it in the crisis, due to the nature of its investments and the seizure of wholesale markets.[176]Indeed, the market's concerns about potential losses in HBOS's investment and liquidity portfolios actually contributed to the market's increasing concerns about the bank.[177]HBOS was forced to supply liquidity to the Grampian conduit, which was unable to finance itself on the wholesale markets at attractive rates.[178] The decision by Lehman Brothers to file for bankruptcy on 14 September 2008 also proved fatal to HBOS. HBOS suffered from a two-fold crisis. First, there was an outflow of around £30 to £35 billion of customer deposits.[179]The majority of this outflow was by non-bank financial and large corporate, rather than retail, customers.[180]Second, as some of the shorter term borrowing taken out the previous Autumn fell due, HBOS found itself faced with the closure of wholesale markets, except the overnight market. In this situation, HBOS was unable to raise sufficient wholesale market financing to meet its outflows.[181]

The endgame and its consequences

107. Faced with this situation, the Board soon concluded that it needed to "secure a more stable long-term solution" in the form of takeover by Lloyds TSB.[182] The terms for the recommended acquisition were announced by Lloyds TSB on 18 September 2008. Pending completion of the takeover, which took place on 16 January 2009, HBOS was forced to accept Emergency Liquidity Assistance from the Bank of England on 1 October 2008.

108. Former HBOS shareholders have seen 96 per cent of its peak value disappear, and what remains is the result of support from the UK taxpayer and the acquisition by Lloyds TSB. The Treasury provided £20.5 billion to HBOS, Lloyds TSB and Lloyds Banking Group (LBG).[183] These injections by the Treasury were followed by subsequent injections by LBG into HBOS. Combined, the Treasury and LBG injected a total of £28 billion of equity into HBOS.[184] The market value of the Treasury holding in LBG is still £5 billion below the £20.5 billion invested.[185] In 2009 Eric Daniels maintained that LBG would not have needed state aid if it had not acquired HBOS.[186]

109. There has also been an adverse effect on the operation of the banking market. HBOS was weakened in its ability to continue its retail lending and its support for SMEs. The banking market has become less diverse and less competitive in consequence of the merger. UK competition law was altered in October 2008 to include a new public interest consideration of "maintaining the stability of the UK financial system". This consideration was used to support a decision not to refer the Lloyds HBOS merger to the Competition Commission.[187] Consumers and the wider economy, as well as shareholders and taxpayers, have paid a heavy price for the blunders of the HBOS Board.

The full picture

110. All HBOS witnesses accepted that management did not expect, still less make contingency planning for, the severity of the financial crisis, including the near closure of term wholesale money markets to banks for over a year.[188] All senior management accepted that their failure to plan for such a severe funding and liquidity crisis as occurred was an error and many of them apologised for it. However, in evidence to the Treasury Committee in 2009 and in evidence to this Commission, senior figures within HBOS have portrayed themselves as victims of forces beyond their control. According to Sir Ron Garrick:

189

111. Sir James Crosby denied that the growth in his time as Chief Executive made what subsequently happened "inevitable".[190] He said that wholesale funding was seen as a risk to the strategy, but not a risk to the bank.[191] The events that subsequently unfolded were "not a foreseeable scenario".[192] Andy Hornby suggested that the scale of losses on the corporate loan book went back to "the unforeseen and unprecedented total closure of wholesale markets".[193]

112. Lord Stevenson argued that there was a single cause of the failure of the HBOS:

194

At the end of 2011, the HBOS Group tangible ordinary shareholders' funds were £23 billion. However, this was only after injections first from the Treasury and subsequently from LBG, totalling £28 billion in 2009 and 2010. It is therefore clear that without these injections, HBOS would have had, and still would currently have, significant negative net worth, let alone insufficient equity capital with which to continue to operate. When this was put to Lord Stevenson, he rejected outright the suggestion that the capital provisions resulted from anything other than the liquidity problems in the particular circumstances of the closure of wholesale markets.[195] He went on to say:

196

113. If HBOS's difficulties were solely the result of funding and liquidity problems, their lasting effects would have been much more limited, including for the taxpayer. The impairments on its bad lending continued well after then. The market's justified fears over the quality of HBOS's lending were as much a cause of the Group's liquidity problems as the subsequent impairments were the result of an evaporation of liquidity. Michael Foot pointed out that banks which caused the markets the biggest concerns about asset quality tended to have the greatest problems refinancing wholesale funding.[197] This point was also acknowledged by George Mitchell, who said:

198

114. The other major bank failure which took place in the UK in 2008, that of RBS, was in considerable measure precipitated by a decision taken by the RBS Board after the onset of the financial crisis, namely the disastrous decision to acquire ABN AMRO. This acquisition was part of the story of how RBS weakened its mainstream bank through the growth of its investment banking business. As a home-grown banking failure in traditional banking, HBOS stands alone.

115. The problems of liquidity were the occasion for the failure of HBOS, not the cause. If HBOS's difficulties were solely the result of funding and liquidity problems, their lasting effects would have been much more limited, including for the taxpayer. LBG has now repaid all the Government backed funding raised during the financial crisis. Without solvency pressures, HBOS would not have needed equity support from the taxpayer.

116. The HBOS failure was fundamentally one of solvency. Subsequent results have shown that HBOS would have become insolvent without capital injections from the taxpayer and LBG. At the end of 2011, the HBOS Group tangible ordinary shareholders' funds were £23 billion. However, this was only after injections, first from the Treasury and subsequently from LBG, totalling £28 billion in 2009 and 2010. It is clear that without these injections, HBOS would have become insolvent.

117. The bank's solvency pressures reflect substantial operating losses. HBOS reported pre-tax losses each year in the period 2008-11; the aggregate pre-tax losses for this period totalled £30 billion. These losses were the result of very large asset impairments. Aggregate impairments for the same period were £50 billion, concentrated in customer loan impairments, which totalled £46 billion. Losses on this scale necessitated the recapitalisations.

118. Table 3 compares the HBOS impairments with those of the other large UK based commercial banks.

Table 3

119. The total 2008-11 HBOS loan impairments were equivalent to 10.5 per cent of the end 2008 customer loan book. This percentage was more than twice as high as the next largest proportion of loans incurred by a leading UK domestic commercial banking group, RBS, which also required Government equity injections. The disproportionate scale of impairments at HBOS compared to the UK banking industry, even to RBS, indicates the appalling condition of HBOS's asset base.

120. The poor quality of HBOS's assets becomes even more stark when account is taken of the fact that more than half of the bank's loan portfolio was in residential mortgages, where impairments were proportionately substantially lower than for other types of lending. The group figures therefore contain much higher impairments as a proportion of loans in the corporate lending portfolios, both in the UK and abroad.

121. Several leading former HBOS executives suggested to the Commission, that the company's impairments were the result of the financial crisis and the seizure of wholesale funding markets, which particularly affected its customers. The Chairman and both former CEOs acknowledged that the impairments were "appalling",[199] and Sir James Crosby accepted that the HBOS impairments indicated "incompetent" lending. However, all three put the emphasis on the unprecedented closure of the wholesale markets.[200] In contrast, former FSA Managing Director, Michael Foot gave an alternative interpretation, pointing out that the banks where the market had concerns about their asset quality were the ones which tended to have the greatest problems refinancing wholesale funding.[201]

122. The explanation by senior HBOS management given to the Commission for the scale of the Group's losses is entirely unconvincing. The impairments and losses incurred were substantially worse than for the peer group. Losses have been sustained over a period of at least four years, indicative of fundamentally poor asset quality, rather than the result of temporary liquidity pressures. The losses were also incurred in three divisions, rather than concentrated in one area, indicative of more general asset quality weaknesses.

123. Poor asset quality was the direct result of the company's strategy, which pursued asset growth in higher risk areas. This asset growth was compounded by a risky funding strategy. The combination of higher risk assets and risky funding represents a fundamentally flawed business model and a colossal failure of senior management and of the Board.

124. Their misjudgements were toxic for HBOS. The problems of solvency were a direct consequence of the strategy set by the Board and the failure of controls on the practices that were fostered by its commitment to an asset-led, high-risk approach to growth.

125. The Commission was very disappointed by the attempts of those who led HBOS into the abyss to acknowledge, even now, either the nature of the problems that eventually consumed the bank or the extent to which they flowed from their own decisions rather than unforeseeable events. No bank is likely to be immune from the effects of an economic downturn, but the scale of HBOS's credit losses was markedly worse than that of any of its major peers. In these circumstances, the apologies of those at the top of HBOS for the loss imposed upon the taxpayers and others ring hollow; an apology is due for the incompetent and reckless Board strategy; merely apologising for having failed to plan for an unforeseeable event is not much of an apology.

126. Many of the principal causes of the HBOS failure and the weaknesses in its business model were known to financial markets. Public disclosures by the Group showed the pace of asset growth, key distinctive features of the Corporate Division's assets (including the exposures to commercial real estate, leveraged finance and equity and joint ventures), the pace of the International Division's growth and its concentration in commercial real estate, and the overall Group reliance on wholesale funding. Nevertheless, the financial markets as a whole, including shareholders, debt-holders, analysts and rating agencies, also failed to discipline the company's growth until it was too late. When they did, the Group had become a serious threat to financial stability.

The price of failure

127. At its creation in 2001, HBOS had an initial market capitalisation of £30 billion.[202] At its peak in 2007, the market capitalisation had grown to over £40 billion, when its tangible book value was £18 billion.[203] The HBOS annual compound total shareholder return was 6.9 per cent over the period of nearly six years from its formation to the end of June 2007, when the equity market was also near its peak. As we have already noted, 96 per cent of that value has disappeared. Those who retained their shareholdings have therefore paid a large monetary price for failure. These shareholders include Lord Stevenson, who told us that he invested a great deal of his own money in HBOS shares.[204]

128. Sir James Crosby did not fare so badly.[205] As with other directors, as part of the long term incentives element of his remuneration package, he received shares in HBOS. After leaving the bank in July 2006, Sir James chose to sell two thirds of his holdings.[206] He told us that his motive for selling his shares was "balancing my portfolio of assets".[207] Because Sir James disposed of so many of his shares before financial markets crashed, he would have fared considerably better than those who continued to hold all their shares in HBOS until the bank failed. This raised the issue of whether the period for vesting deferred shares is long enough. Sir James Crosby was knighted, was appointed to the FSA Board and then became its Deputy Chairman, before resigning in 2009.

129. One person has paid a more direct monetary price. Peter Cummings, who was Head of the Corporate Division which was the largest single source of impairments on the HBOS balance sheet in the three years from 2008, was fined £500,000 by the FSA. The FSA's Final Notice to Peter Cummings of 12 September 2012 states that the fine was imposed on the grounds that Peter Cummings failed to exercise due skill, care and diligence in managing the business of the firm for which he was responsible (a breach of FSA Principle 6) and was knowingly concerned in a contravention by the Bank of Scotland of Principle 3 (a firm must take reasonable care to organise and control its affairs responsibly and effectively; with adequate risk management systems).[208] The enforcement action against Peter Cummings cost the FSA approximately £5.4mn (just over 12 per cent of the FSA's total annual enforcement budget for 2012/13).[209] We have seen that the management of the Corporate Division contained significant weaknesses, which help to explain the scale of the losses. Peter Cummings had significant autonomy in the running of the Division, but he was not operating in complete isolation. Peter Cummings told us that he was under pressure from the top of the bank to increase profit targets year on year[210] because, as he told us, "there was a point where the retail bank was not performing and not delivering on the expectation, and I was asked to step in".[211] Whilst accepting that the targets were not imposed on him, Peter Cummings said that, "I certainly made it clear to my superiors at that point that I was not all that happy about it".[212]

130. Evidence from Peter Cummings reflected his dismay at the process to which he was subject by the FSA Enforcement Division, as well as the apparent arbitrariness of the means by which the level of his fine was eventually arrived at. On the way in which he been singled out for censure, Peter Cummings told us:

213

131. In relation to the Enforcement process, Peter Cummings found the approach to fining an individual to be oppressive, noting that he had no institutional framework to fall back on; no ability to call witnesses; and no ability to analyse documents.[214] Peter Cummings said that "anything I explained to them, or any representations I made to them, frankly they were not interested".

132. On the way in which the fine was imposed, Peter Cummings told us:

215

216

133. On the question of whether the FSA had considered taking enforcement action against anyone else from HBOS, they informed us that the enforcement investigation had been conducted in the context of the large impairment losses in the HBOS Corporate book and that "the evidence gathered in the investigation demonstrated clearly that the most culpable senior manager for the Corporate Division's failings was Peter Cummings". The FSA told us that it had considered the prospects of successfully establishing personal culpability against other individuals to be very low.[217]

134. The analysis that we have undertaken of the circumstances of the downfall of HBOS leave no doubt that that downfall cannot be laid solely at the feet of Peter Cummings. While his personal responsibility for some staggering losses should properly be recognised, significant and indeed disastrous losses were also incurred by other divisions, whose heads have not been held personally accountable in the same way. Losses were incurred across several divisions. The losses were caused by a flawed strategy, inappropriate culture and inadequate controls. These are matters for which successive Chief Executives and particularly the Chairman and the Board as a whole bear responsibility.

135. We asked Sir James Crosby whether he considered himself a fit and proper person to run a financial company. He replied that he had no plans to apply to be considered as such, and doubted whether he would be approved if he applied.[218] Andy Hornby appeared sufficiently chastened by his experience at HBOS as to imply that he will also not be seeking further employment in the banking sector. Lord Stevenson viewed the question as to whether he was a fit and proper person to run a financial institution as "rather academic" given his age and that he had no intention of working in financial services.[219] Notwithstanding these points, Lord Stevenson remained in a non-executive position entailing his presence on the FSA approved persons register until 2012, and in fact only formally relinquished his position a matter of days before giving evidence to the Commission.[220] In the view of this Commission, it is right and proper that the primary responsibility for the downfall of HBOS should rest with Sir James Crosby, architect of the strategy that set the course for disaster, with Andy Hornby, who proved unable or unwilling to change course, and Lord Stevenson, who presided over the bank's board from its birth to its death. Lord Stevenson, in particular, has shown himself incapable of facing the realities of what placed the bank in jeopardy from that time until now. Apart from allowing their Approved Persons status at HBOS to lapse as their posts were wound up, the FSA appears to have taken no steps to establish whether they are fit and proper persons to hold Approved Persons status elsewhere in the UK financial sector. In cases of this importance the Commission believes that simply allowing Approved Persons status to lapse is insufficient. The Commission therefore considers that the FSA should examine, as part of its forthcoming review of the failure of HBOS, whether these three individuals should be barred from undertaking any role in the financial sector.

136. The Commission considers it a matter for profound regret that the regulatory structures at the time of the last crisis and its aftermath have shown themselves incapable of producing fitting sanctions for those most responsible in a manner which might serve as a suitable deterrent for the next crisis. We will consider the changes in regulatory powers or approach that will be needed to rectify this in our final Report.

152 HBOS, 2002 Annual Report and Accounts: "Even in tough markets, this is the strategy that delivers", p 7 Back

153 Ibid., pp 70, 129 Back

154 HBOS, 2001 Annual Report and Accounts: The New Force and HBOS, 2008 Annual Report and Accounts Back

155 HBOS, 2007 Annual Report and Accounts: Delivering our Strategy ..., p 60 Back

156 HBOS Plc, Secret 20/20 Vision Group Business Plan 2003-2007, p 61 Back

157 B Ev w 348 Back

158 B Ev w 402 Back

159 B Ev w 319 Back

160 The Group's wholesale funding included covered bonds, securitisations and senior debt. It also raised funds in different currencies. However, as the table above illustrates, US dollar funding proved to be relatively volatile over the crisis and the HBOS balances from this source approximately halved in 2008, as shown in HBOS, 2008 Annual Report and Accounts, p 27. Back

161 BQq 54, 345, 437, 472, 529 Back

162 HBOS, 2008 Annual Report and Accounts, p 27 Back

163 BQq 539 - 540 Back