Annex 1: The Corporate Division
Introduction
1. HBOS initially maintained separate
divisions for Business Banking, which served small and medium-sized
enterprise (SME) customers, and Corporate Banking, which serviced
the larger corporate sector. In 2004 the bank merged these two
divisions to form an enlarged Corporate Division. Our analysis
of Corporate activities refers to the combination of Business
Banking and Corporate Banking, as if the two divisions had been
one throughout the period. The bulk of the foreign businesses
were separated into a newly formed International Division in 2004.
Our analysis of losses in this annex essentially refers to the
domestic activities; we review the International businesses in
the next annex.
Overview of the Corporate Division's
business
2. The Corporate Division sustained
strong loan growth from 2001 to 2008:
Loan growth averaged 14 per cent a year
on an underlying basis, adjusted for intra-group transfers, which
represents relatively strong real growth. Loan growth was stronger
in the initial period following the merger, at 26 per cent in
2002 and 17 per cent in 2003, and slowed to 9 per cent in 2004
and 8 per cent in 2005 and again in 2006. Loan growth then accelerated
to 22 per cent in 2007 and 12 per cent in 2008, at the top of
the economic cycle. This growth, and the consequent increased
pressure it put on the bank's funding position, was based on substantial
risks. In the words of the FSA's final notice, the Corporate Division
was "the highest risk part of HBOS's business".[222]
3. Asset growth was significantly ahead
of customer deposits, which averaged 11 per cent on an underlying
basis over the period. Consequently, the gap between customer
loans and deposits increased from £33 billion at the end
of 2001 to £84.5 billion by 2008. The Division's asset growth
was therefore responsible for approximately £50 billion of
the £150 billion net increase in the customer funding gap
at the group level between 2001 and 2008.
Exposure to property and construction
4. The HBOS Corporate loan book contained
a high and growing concentration in property. As can be seen from
the above table, lending for property and construction represented
a significant proportion - 36 per cent - of the Division's customer
loans at the end of 2008. Lending for hotels, restaurants and
wholesale and retail trade, which would also be significantly
property based, represented a further 10 per cent. Lending to
these two categories grew significantly faster than for the Division
as a whole and represented 59 per cent of the net increase in
the Corporate Division's loan outstandings over the 2001-08 period.
The following chart shows a breakdown of the Division's loan portfolio
at the end of 2008.
The FSA highlighted this "high
degree of exposure to property", totalling £68 billion
or 56 per cent of the loan book at the end of 2008, in its final
notice.[223] The Division
believed it had competitive advantage in commercial real estate
(CRE). In a strategic review of the Division in 2007, Peter Cummings,
CEO of the Division from 2005 to 2008, said that one of his five
aspirations for the next five years was for HBOS to "be the
best real estate bank in the UK."[224]
Exposure to equity and exposure to
leveraged finance
5. The Corporate Division formerly at
BoS and then subsequently within HBOS had a very distinctive approach.
The first HBOS Annual Report in 2001 proclaimed that the Division
was "involved in a wide range of specialist activities."[225]
In addition to the focus on property, the Division also engaged
in equity finance and joint venture participations with customers.
At the peak in 2008, HBOS had a portfolio of equity investments
of at least £4.9 billion.[226]
There was a considerable degree of overlap in these activities,
including loans to joint venture partners, an activity that was
predominantly property based and a leveraged buy-out portfolio.
The bank claimed in its 2001 Annual Report that it had been the
"UK market leader" in management buyouts "by number
of deals for the last 10 years" and was "also the market
leader in Continental Europe." Its activities in management
buyouts were complemented by "close links with the venture
capital industry with investment in 81 funds". Integrated
finance offered customers "a complete funding package"
which includes "mezzanine debt and equity" in additional
to "more traditional" lending. [227]
Some 10 per cent of the portfolio was in leveraged loans.[228]
6. The FSA final notice highlighted
this "substantial exposure to equity and subordinated tranches
of debt below mezzanine", and the Division's "substantial
exposure to large highly leveraged transactions and the leveraged
finance market".[229]
Large individual credit exposures
7. The Division's high risk profile
included significant single name concentration, with the top 30
exposures in aggregate totalling £34.1 billion, 23 per cent
of the portfolio and representing individual average exposure
of £1.1 billion.[230]
The Division's exposure to large single name borrowers increased
over time as it took on increasingly large individual credit exposures.
In September 2002, the largest single name approval was for £963,000.
In September 2005, the largest single name approval was for £2.2
billion, and there were six names over £1 billion. In September
2008, the largest single name approval was £2.9 billion and
there were nine names in excess of £1 billion.[231]
The Corporate Division's approach
to credit assessment
8. BoS Corporate Banking had a tradition
of lending into a downturn, or lending through the cycle. Indeed,
the Division prided itself on this strategy and considered that
it had served it well in "numerous cycles".[232]
The bank described itself as "never a fair-weather friend"
and was proud that it supported customers "in bad times as
well as good."[233]
George Mitchell, CEO of HBOS Corporate Banking from 2001 to 2005,
claimed the bank did not do such lending "blindly" but
rather "on a case-by-case basis", but he was also clear
that this strategy something other banks were not doing and so
was a source of competitive advantage to HBOS.
9. The Corporate Division had a strong
sense of its ability to originate superior quality lending based
on its track record, and this perception was shared by others
across the Group. For instance, Peter Hickman, HBOS Group Risk
Director 2007-08, highlighted the experience in the Corporate
Division and their ability to do adopt a particular lending strategy
"based on that experience".[234]
The credit focus of the Division emphasized single name risk and
much less portfolio construction, which was seen as the responsibility
of group functions. Under HBOS's system of credit approval, the
so-called 'first line of defence' rested with the originating
division. George Mitchell suggested that the first line of defence
should be the "most robust" and that the "single
credit protection was very much within the first line of defence,"
even though this would have included "independent credit
challenge to credits happening within the Division."[235]
He considered the first line of defence within the Corporate Division
to have been "extremely robust".[236]
By contrast, he regarded group functions as having responsibility
for "macro issues like sector limits."
10. However, the FSA Final Notice found
that the Corporate Division had a culture of optimism, incentivised
revenue focus rather than risk and viewed risk management as a
constraint on the business rather than essential to it. [237]
Sir James Crosby accepted that too much confidence was placed
in the Corporate Division's management, given it was an "experienced
team with a terrific track record."[238]
He added that subsequent events showed the "risks that the
corporate bank was taking were not as well understood as everybody
thought" - a euphemism for poor lending.[239]
He accepted that incompetent lending in the Corporate Division
ultimately brought the bank down.[240]
11. There were strong similarities between
the approach followed by the HBOS Corporate Division and the strategy
it had pursued previously within BoS. As we noted above, the 2001
HBOS Report & Accounts refer to several areas of existing
strength in the Division, which remained distinctive features
of the business within HBOS. Property and Construction already
represented 24 per cent of the Division's customer loans in 2001,
with a further 10 per cent in Hotels, Restaurants and Wholesale
and Retail Trade. George Mitchell confirmed that the type of lending
HBOS's Corporate Division engaged in was "no different"
from the type of business the Division carried out when it was
in Bank of Scotland.[241]
He added that the kind of lending described in the FSA Final Notice
was "absolutely"[242]
the kind of lending that BoS had been doing. Peter Cummings expressed
a similar view:
The two main focuses, I suppose,
are private equity and real estate. The Bank of Scotland were
a buy-out bank, and had been a buy-out bank since the 1980s when
management buy-outs started to be developed as a discipline, and
we were always a real estate bank.[243]
After the 2001 merger
12. The principal difference in the
Corporate activity after the creation of HBOS was one of scale,
as described in the 2001 HBOS Annual Report:
the bigger and stronger balance
sheet that the merger has created will undoubtedly allow us to
lead and arrange more transactions and underwrite and hold larger
positions than either Bank of Scotland or Halifax could have done
on their own. We have already seen clear evidence of this in the
months since the merger and we remain confident that we can continue
the strong growth we have experienced in recent years as well
as delivering significant revenue synergies.[244]
13. After the merger, the Corporate
Division's loan book grew by 26 per cent in 2002, 17 per cent
in 2003, 9 per cent in 2004 and 8 per cent in 2005, illustrating
the increased loan volumes the Division was able to originate
and retain following the merger. George Mitchell described the
shift as follows:
The big difference was after the
merger. We had the size so that we could go into the underwriting
market rather than just being a participant bank.[245]
14. HBOS also attempted to use the BoS
product and the Halifax branch network to increase market share
in SMEs, particularly in England. The 2001 Annual Report &
Accounts set out an ambition to "break the mould" and
mount a "strong challenge to the four clearing banks."[246]
The corporate bank planned to recruit 1,500 new staff over three
years. Their strategy was to move from a transactional model (often
property related), towards a relationship one, with distribution
through 500 locations in England and Wales. The bank planned to
make "significant inroads into the market"[247]
although the "Big Four had entrenched, valuable, positions."[248]
Peter Cummings admitted to the Commission that this was "a
strategy that failed."[249]
Why did the Corporate Division increase
its rate of lending from 2007?
15. The Corporate Division loan growth
accelerated once the financial crisis began. Customer loan growth
of 8 per cent a year in both 2005 and 2006 increased to 22 per
cent in 2007 and 12 per cent in 2008, before impairments. The
Commission received somewhat conflicting explanations for this
acceleration. George Mitchell said that he was surprised by the
pace of loan growth after he left the bank.
I was slowing growth every year.
The year I left-2005-it had been 8 per cent. The plan was that
it would be even lower the following year. That was because at
the time I left there were clear signs that the credit markets
were overheating and it was becoming increasingly difficult to
source transactions with the right risk/reward characteristics.[250]
He suggested that HBOS's growth in 2007
and 2008 was not involuntary:
What surprised me, and is the one
thing that has surprised me since I left HBOS, was when I read
the annual report for '07 about the speed at which the bank
not just corporatewas growing, at a stage in the cycle
when other banks were slowing or pulling back. That is a significant
difference, because if I had still been in corporate, I find it
difficult to believe that I would have been growing the business
at that speed.[251]
16. The HBOS report and accounts attributed
Corporate loan growth to "strong originations and lower levels
of refinancing and sell-down activity"[252]
in the second half of 2007 and in 2008 "due to a pipeline
of business."[253]
Peter Cummings said that the acceleration in loan growth after
August 2007 reflected increased "utilisation of facilities",[254]
and "carrying on while nothing is getting sold,"[255]
also effectively attributing the rise in lending to the seizure
of markets and the consequent inability to reduce exposures. These
explanations suggest that some involuntary increase in lending
is inevitable whenever secondary liquidity reduces. Peter Hickman,
HBOS Group Risk Director from September 2007, agreed that during
the crisis it was easier to slow lending in Retail than in Corporate.[256]
He agreed that slowing Corporate was like turning an oil tanker.[257]
However, Peter Hickman, also said that the bank made judgements
"about maintaining a franchise and about the risk of being
seen to be pulling back too hard."[258]
He explained that HBOS was "more nervous" about the
signals that it sent out than "a stronger bank" would
have been.[259] However,
Peter Hickman also indicated slowing Corporate loan growth took
some three months longer than other divisions, due to the greater
difficulties in doing so and a greater reluctance on the part
of the Division.[260]
Andy Hornby accepted that HBOS "should have slowed corporate
quicker."[261]
17. Early in the financial crisis, Peter
Cummings continued to make relatively confident comments. For
example, in October 2007, he said: "Some people look as if
they are losing their nerve, beginning to panic even in today's
testing property environment; not us." [262]
The Corporate section expected "only a modest increase in
impairment losses in 2008"[263]
and claimed that the HBOS commercial property portfolio was "expected
to continue to perform relatively well."[264]
Peter Cummings claimed that whilst his public stance was to maintain
confidence in the business, his actions were more cautious: "saying
things and doing things are quite different."[265]
He denied that the accelerated loan growth was a reflection of
the policy BoS had successfully pursued previously of lending
through downturns. He also denied that there was a culture of
optimism at HBOS, or that he saw the onset of the financial crisis
as an opportunity to gain share, without the need to change course.[266]
Instead, the Group was subject to "world events" that
it "could not control."[267]
However, he accepted that the Division was still writing new business
in the 2007-08 period, "but only for existing customers"[268]
and "not very much",[269]
although he was unable to say how much.[270]
18. The Group as a whole did take action
to rein in growth, although Peter Hickman suggested that the Corporate
Division showed a greater reluctance to slow loan growth than
the other divisions and took some three months longer to do so.[271]
The Executive Committee decided in October 2007 to "deliver
a reduction in asset growth of £10 billion across the Group
[in 2008]." However, it gave responsibility for delivering
this reduction to the International businesses, rather than the
Corporate Division.[272]
19. Several factors are likely to have
been involved in the increase in the HBOS Corporate loan book
in the early stages of the financial crisis. The seizure of wholesale
markets and increased utilisation of facilities by customers are
both likely to have been important factors. Furthermore, HBOS's
management did not react quickly enough to the crisis in its Corporate
Division. The Division's history and culture of lending through
the cycle may also have played a role. However, it is not possible
to quantify how much of the accelerated loan growth in 2007 and
2008 was involuntary and how much could have been avoided. Loans
that were granted in 2007 and 2008 are likely to have been higher
risk and disproportionately responsible for the level of subsequent
impairments. Nevertheless, it is unlikely that more aggressive
management action once the crisis began would have been enough
to alter the fate of the Group. By that stage it was already too
late.
The Division's losses
20. The 2008 results revealed total
impairments of £7.4 billion in the Corporate Division. HBOS
ceased disclosing divisional breakdowns of its results after 2008,
so the exact level of impairments incurred by the Corporate Division
is not available. However, it is possible to estimate them by
using the Group impairment figures and estimates for the charges
at other divisions. We estimate that aggregate 2008-11 customer
loan impairments on Corporate Division loans have 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.
21. The Corporate Division had a lower
quality loan book. As the FSA pointed out, "the credit quality
of the portfolio was low", with "around 75 per cent"
sub investment grade and a proportion "not rated at all".
[273] George
Mitchell attributed this low credit quality to the nature of the
Division's business, saying that "by definition" it
was "sub-investment grade".[274]
However, as the FSA pointed out in their final notice, the Corporate
Division had "a specific focus" on sub-investment grade
lending, and HBOS's corporate "book had a higher risk profile
than the equivalent books at the other major UK banking groups."[275]
The FSA concluded that the combination of factors to which we
have drawn attention meant that the Division's "portfolio
was highly vulnerable to a downturn in the economic cycle".[276]
22. Senior HBOS executives attempted
to argue that the level of impairments reflected the impact of
the financial crisis on the assets to which HBOS was exposed,
rather than to inherently poor lending. They accepted that the
level of impairments was "horrendous",[277]
"horrible"[278]and
"appalling".[279]
However, they attributed the impairments to the impact of the
changed conditions after the financial crisis on the loan book,
rather than on the nature of the loan book itself, although Peter
Cummings acknowledged the role played by the concentration "in
real estate" and the existence of "a private equity
group".[280]
23. George Mitchell argued that when
he left in 2005 the corporate loan book was in "very good
shape":
I am not saying that in a deep recession
impairments would not have risen and perhaps risen significantly;
I think I am suggesting that these provisions would have been
at a very manageable level.[281]
He claimed that he would be "absolutely
amazed if any major or significant losses came out of the book"
he had left at the end of 2005.[282]
He cited the FSA final notice as indicating that the "corporate
book was turning over at 30 per cent per annum,"[283]
therefore implying that the individual customer identities would
have substantially changed by 2008, when impairments deteriorated.
24. The Corporate Division's growth
was not the result of superior performance, but a consequence
of its strategy. When the Division later incurred large losses,
these too were due to the particular nature of its business and
resulted directly from its strategy. Its losses were significantly
higher than those incurred by any other major UK bank because
of its distinctive loan book, which included high CRE and leveraged
loan concentration, high exposure to single names, a high proportion
of non-investment grade or unrated credit and holdings of equity
and junior debt instruments. The nature of the loan book resulted
in the Division being significantly more exposed to the domestic
downturn than other large UK corporate banking businesses.
25. Former HBOS executives claimed that
the bank's high impairments were due to the effects of financial
markets on the Group's loan book and were not indicative of bad
lending. We estimate that the HBOS Corporate loan book has continued
to incur significant impairments in every year since 2008, implying
that the losses are not related to temporary liquidity events
in wholesale markets. HBOS's Corporate Division was significantly
more vulnerable to the downturn in the economy due to the nature
of its loan book.
26. The Corporate Division would have
incurred substantial problems whenever the recession occurred.
The nature of its lending did not alter due to the creation of
HBOS, or subsequently. The losses would have been magnified by
the Division's compound growth. However, significant losses as
a proportion of loans would still have been incurred if the recession
had struck earlier. George Mitchell's arguments to the contrary
were not credible. Indeed, his confidence in the asset quality
of the Division when he left is symptomatic of the Division's
misplaced belief in its ability to source superior quality loans
in higher risk segments. Although the book would have turned over
significantly after he left the Group, all witnesses, including
George Mitchell himself, agreed that the nature of the HBOS lending
did not alter. In terms of growth, the 2006 business plan for
the Corporate Division agreed by George Mitchell at the end of
2005 assumed 6 per cent asset growth for the Division.[284]
This compares with the 8 per cent actually generated.[285]
As losses are estimated to have ultimately reached 20 per cent
of the loan book, it is difficult to regard the 2 per cent higher
loan growth in 2006 as a material factor. The acceleration in
loan growth in 2007 and 2008 at the peak of the economy is likely
to have been a significant factor in the subsequent losses. However,
simply slowing loan growth to even a low single digit rate would
have been insufficient to avoid impairments on a scale that HBOS
would have been unable to absorb on its own.
222 Bank of Scotland, FSA Final Notice, 9 March 2012,
para 4.9 Back
223
Bank of Scotland, FSA Final Notice, 9 March 2012, para 4.11 (1)
and 4.12 (1) Back
224
B Ev w 307 Back
225
HBOS, 2001 Annual Report and Accounts: The New Force, p
28 Back
226
"HBOS plc Interim Results 2008", HBOS plc press release,
31 July 2008, p 21 Back
227
HBOS, 2001 Annual Report and Accounts: The New Force, p
28 Back
228
BQ 409 Back
229
Bank of Scotland, FSA Final Notice, 9 March 2012, para 4.11 (2)
and (3) Back
230
Bank of Scotland, FSA Final Notice, 9 March 2012, para 4.12 (2) Back
231
B Ev w 437 - 448 Back
232
BQ 630 Back
233
HBOS, 2001 Annual Report and Accounts: The New Force, p
28 Back
234
BQ 489 Back
235
BQ 702 Back
236
BQ 680 Back
237
Bank of Scotland, FSA Final Notice, 9 March 2012, para 4.21 Back
238
Q 1301 Back
239
Q 1303 Back
240
Q 1369 Back
241
BQ 610 Back
242
BQ 718 Back
243
BQ 1170 Back
244
HBOS, 2001 Annual Report and Accounts: The New Force, p
28 Back
245
BQ 610 Back
246
HBOS, 2001 Annual Report and Accounts: The New Force, p
24 Back
247
B Ev w 379 Back
248
Ibid. Back
249
BQ 1168 Back
250
BQ 698 Back
251
BQ 698 Back
252
HBOS, 2007 Annual Report and Accounts: Delivering our strategy...,
p 28 Back
253
HBOS, 2008 Annual Report and Accounts, p 8 Back
254
BQ 1212 Back
255
BQ 1206 Back
256
BQ 510 Back
257
Ibid. Back
258
BQ 495 Back
259
BQ 496 Back
260
BQ 509 Back
261
Q 1461 Back
262
BQ 1191 Back
263
HBOS, 2007 Annual Report and Accounts: Delivering our strategy...,
p 32 Back
264
Ibid. Back
265
BQ 1247 Back
266
BQ 1250 Back
267
BQ 1251 Back
268
BQ 1315 Back
269
BQ 1314 Back
270
Ibid. Back
271
BQ 509 Back
272
B Ev w 334 Back
273
Bank of Scotland, FSA Final Notice, 9 March 2012, paras 4.11 (4)
and 4.15 Back
274
BQ 716 Back
275
Bank of Scotland, FSA Final Notice, 9 March 2012, para 4.10. Elsewhere
in the Report we examine the extent to which the division's high
risk business and lending strategy was matched by a commensurately
robust level of control. Back
276
Bank of Scotland, FSA Final Notice, 9 March 2012, para 2.5 Back
277
BQ 1213 Back
278
Q 1558 Back
279
Q 1438 Back
280
BQ 1215-16 Back
281
BQq 608-09 Back
282
BQ 660 Back
283
BQ 608 Back
284
HBOS, Group Business Plan 2006 - 2010, "Targeted Growth",
p28 Back
285
HBOS, 2006 Annual Report and Accounts: Our strategy has five
key elements to create value, p 42 Back
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