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

Annex 1: The Corporate Division


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 corporate—was 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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Prepared 5 April 2013