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

Conclusions and recommendations

The 'new force in banking'

1.  The strategy set by the Board from the creation of the new Group sowed the seeds of its destruction. HBOS set a strategy for aggressive, asset-led growth across divisions over a sustained period. This involved accepting more risk across all divisions of the Group. Although many of the strengths of the two brands within HBOS largely persisted at branch level, the strategy created a new culture in the higher echelons of the bank. This culture was brash, underpinned by a belief that the growing market share was due to a special set of skills which HBOS possessed and which its competitors lacked. The effects of the culture were all the more corrosive when coupled with a lack of corporate self-knowledge at the top of the organisation, enabling the bank's leaders to persist in the belief, in some cases to this day, that HBOS was a conservative institution when in fact it was the very opposite. We consider the effects of these cultural weaknesses in the chapters that follow. (Paragraph 19)

The avenues to impairment

2.  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. (Paragraph 28)

3.  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. (Paragraph 30)

4.  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'. (Paragraph 31)

5.  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. (Paragraph 32)

6.  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. (Paragraph 39)

7.  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. (Paragraph 42)

8.  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. (Paragraph 43)

9.  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. (Paragraph 46)

10.  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. (Paragraph 47)

A failure of internal control

11.  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. (Paragraph 53)

12.  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. (Paragraph 63)

13.  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. (Paragraph 64)

14.  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. (Paragraph 65)

A failure of regulation

15.  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. (Paragraph 83)

16.  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. (Paragraph 84)

17.  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. (Paragraph 85)

18.  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. (Paragraph 86)

'The best board I ever sat on'

19.  The corporate governance of HBOS at board level serves as a model for the future, but not in the way in which Lord Stevenson and other former Board members appear to see it. It represents a model of self-delusion, of the triumph of process over purpose. (Paragraph 91)

20.  The Board, in its own words, had abrogated and remitted to the executive management the formulation of strategy, a matter for which the Board should properly have been responsible. (Paragraph 92)

21.  There was insufficient banking expertise among HBOS's top management. In consequence, they were incapable of even understanding the risks that some elements of the business were running, let alone managing them. (Paragraph 93)

22.  The non-executives on the Board lacked the experience or expertise to identify many of the core risks that the bank was running. In Sir James Crosby's revealing phrase, it was not composed in a manner that would be appropriate for "a business concentrating entirely on banking". The board was composed in a manner which appeared suitable for a retail-oriented financial services company, but that board lacked the necessary banking experience among its non-executives, particularly in relation to higher risk activities, for a bank whose strategy and business model was posited on asset-led growth led by non-retail divisions of the bank. (Paragraph 94)

23.  Judging by the comments of some former Board members, membership of the Board of HBOS appears to have been a positive experience for many participants. We are shocked and surprised that, even after the ship has run aground, so many of those who were on the bridge still seem so keen to congratulate themselves on their collective navigational skills. (Paragraph 95)


24.  Consumers and the wider economy, as well as shareholders and taxpayers, have paid a heavy price for the blunders of the HBOS Board. (Paragraph 109)

25.  As a home-grown banking failure in traditional banking, HBOS stands alone. (Paragraph 114)

26.  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. (Paragraph 115)

27.  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. (Paragraph 116)

28.  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. (Paragraph 117)

29.  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. (Paragraph 119)

30.  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. (Paragraph 120)

31.  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. (Paragraph 122)

32.  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. (Paragraph 123)

33.  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. (Paragraph 124)

34.  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. (Paragraph 125)

35.  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. (Paragraph 126)

36.  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. (Paragraph 134)

37.  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. (Paragraph 135)

38.  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. (Paragraph 136)

Conclusion: a manual for bad banking

39.  HBOS had no culture of investment banking; if anything, its dominant culture was that of retail banking and retail financial services more widely, areas from which its senior management were largely drawn. Whatever may explain the problems of other banks, the downfall of HBOS was not the result of cultural contamination by investment banking. This was a traditional bank failure pure and simple. It was a case of a bank pursuing traditional banking activities and pursuing them badly. Structural reform of the banking industry does not diminish the need for appropriate management and supervision of traditional banking activities. (Paragraph 138)

40.  Another lesson is that prudential supervisors cannot rely on financial markets to do their work for them. In the case of HBOS, neither shareholders nor ratings agencies exerted the effective pressure that might have acted as a constraint upon the flawed strategy of the bank. By the time financial markets were sufficiently concerned to act as a discipline, financial stability was already threatened. (Paragraph 139)

41.  Through our work, we have identified some of the themes on which we expect the FSA to expand. In particular, we require the FSA study to shed further light on the following issues:

a)  The extent of losses in each division, which we have had to estimate;

b)  The decision-making processes within the FSA which led to the effective retreat from a position of warranted close supervision up to the start of 2004;

c)  The reasons for the reliance placed on reports commissioned from third parties as to the adequacy of controls within HBOS;

d)  The reasons why the FSA closed the issue of the prudence of HBOS's corporate credit provisions;

e)  The reasons why the FSA did not undertake serious analysis of the quality of the HBOS loan book in the period from 2005 to 2007;

f)    The extent to which regulatory decision-making at all levels was influenced by the protests of HBOS senior management, including claims about disadvantage to its competitive position;

g)  The nature and extent of FSA senior management involvement with HBOS;

h)  Whether, rather than having their Approved Persons status simply lapse, Lord Stevenson, Sir James Crosby and Andy Hornby (and anyone else presiding over a similar failure in the future) should be prohibited from holding a position at any regulated entity in the financial sector;

i)    The extent to which the judgements in the FSA Enforcement Final Notices in respect of HBOS reflect judgements that either were, or should have been, reached by the FSA during the course of their supervision of HBOS.

We expect the Treasury Committee to monitor how far and how effectively the FSA pursues these issues. (Paragraph 141)

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Prepared 5 April 2013