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

Annex 2: The International Division


1. The International Division was formed in 2004, comprising the Group's activities outside the UK, with the objective of accelerating their growth and increasing the proportion of group profit derived from non-UK businesses. After the formation of the International Division, the bank expanded its activities relatively rapidly. Colin Matthew, CEO of the International Division, said that although the Division existed to expand in markets outside the UK, the strategy was to grow "products and sectors where we had real expertise in the UK". The Division contained three principal units: activities in Australia and Ireland, the two largest businesses in terms of loans, and Europe and North America (ENA), containing its other non-UK businesses.[286] The expansion strategy was particularly concentrated in Ireland and Australia, where BoS already had presences and where the intention was to grow both the corporate and retail activities.[287] This annex therefore particularly analyses the Division's growth strategy in these two countries.

HBOS's activities in Australia

2. Colin Matthew presented his strategy for Australia to the Board in June 2004. His plan was for HBOS Australia to double its national market share.[288] Four local banks dominated the Australian market, but due to "significant customer dissatisfaction" and "relatively low levels of customer commitment",[289] there was "the opportunity for HBOS Australia to pursue a differentiated 'customer champion' proposition."[290] The strategy planned growth in Corporate and Business Banking, Retail Banking and bancassurance, including in the East coast markets, where the Group's shares were smaller. He presented the growth strategy in Australia as "credible, manageable and low risk."[291] By June 2006 Colin Matthew told the Board that the longer term aim for the Australian business "was to become a major Australian Financial services company with market shares in the 15-20 per cent range in chosen segments."[292]

HBOS's activities in Ireland

3. In Ireland HBOS inherited ICC Bank, a small corporate banking business. The Group also grew a retail presence, including acquiring some branches from the Electricity Supply Board, planning to convert them into banking outlets. The local management in Ireland claimed that "the business was on target to become Ireland's second largest business bank during 2004, with the clear aim of becoming the No 1 business bank during 2005."[293] A retail products initiative was aimed to "secure 15 per cent market share in residential mortgages; 5 per cent of the credit card market; 5 per cent of household savings."[294]

4. In 2006, HBOS's Irish business made EUR 213m profit before tax[295] and had EUR 27 billion of assets.[296] In May 2007 the Irish management was targeting "in excess of EUR 500m, with over EUR 50 billion of assets"[297] within five years. Furthermore, this rapid growth was described as "only the start of a journey towards the overall strategic goal of becoming the fourth largest full service Irish bank by 2009."[298] In retail markets in Ireland BoS,

    had already captured an 8 per cent share of outstanding mortgage debt from a standing start and would aim to grow share by 1 per cent per annum in future. The target was to grow Retail share to 13 per cent by 2011.

HBOS also aimed to develop an enhanced Corporate proposition in Ireland, where the Division saw significant potential for growth.

HBOS's activities in ENA

5. In 2005, HBOS's ENA businesses made £283m profit before tax. In July 2006 their aim was to "build a business capable of delivering sustainable profit growth and £1 billion in earnings by 2011,"[299] to be achieved by growth in all the principal businesses.

The Division's growth

6. The Division grew rapidly from its formation 2004 to 2008. The following table summarises the growth of the International businesses in aggregate, and broken down between the individual units, from 2004 and 2008.


The table illustrates the rapid pace of business growth generated by the Division during the period. Customer loans grew at an underlying compound rate of 31 per cent over the four years.[301] There was an increasing concentration in property and construction, which was 48 per cent of International corporate loans in 2008, compared with 34 per cent in 2004.

7. The International Division's growth was heavily lending led. Underlying compound deposit growth was 25 per cent a year over the period. Although this growth rate is high in absolute terms, it was slower than the Division's loan growth. Furthermore, as the starting figure for customer deposits was relatively small, at £10 billion, the absolute growth in deposit volumes was smaller than the growth rate might imply. Andy Hornby explained that it proved easier to expand quickly in both economies in corporate banking than in retail banking, which is natural as retail franchises take longer to build.[302] Colin Matthew said that lending growth in both Ireland and Australia particularly specialised in "asset specific transactions", which led to above average concentration in CRE and related sectors in the Corporate loan books.

8. Loan growth in Ireland and Australia continued after the onset of the financial crisis. In 2008, organic, constant currency loan growth was 3 per cent in Australia and 8 per cent in Ireland. Colin Matthew considered that this growth reflected increased draw downs of existing facilities, the inability to sell down and the residential mortgage pipeline.[303]

9. The expansion of HBOS's international businesses was asset led, with growth in new lending exceeding growth in retail customer deposits throughout the 2004-08 period. Andy Hornby and Colin Matthew both explained that it proved relatively more difficult to grow local customer deposits than loans. Colin Matthew indicated that the plan was for the growth of the International Division initially to be funded by the Group, and, as they became more established, the international businesses were expected to grow customer deposits. However, achieving this ambition proved to be "slower than planned."[304] The International Division's loans/deposits ratio remained relatively stable on an underlying basis, but the quantum of the customer funding gap grew materially in absolute terms. As a result of business growth over the period, the customer funding gap increased from £22.4 billion in 2004 to £55.5 billion at the end of 2008. This funding gap was not directly responsible for the Division's losses, but it was a significant factor in the overall group funding gap and materially increased the Group's wholesale funding requirement. Furthermore, the International Division was a significant factor in the Group's use of wholesale funding to support relatively illiquid customer loans. Lindsay Mackay agreed that this was a policy that would no longer be adopted.[305]

10. The strategy and performance of the International businesses were regularly reviewed by the relevant group functions, including the Group's Board, ExCo and other group committees and supervisory and control functions, as for all the main divisions. HBOS recruited local management to run its businesses in Australia and Ireland and had local boards, which had independent chairmen and both local and UK representatives. The Division's internal risk management function had both local and UK elements.

11. The Group's reporting, management and control procedures imply that International's strategy was communicated internally. No witness has indicated insufficient information was available. Andy Hornby said that he considered International risks particularly carefully, because that was the area where the bank was "growing most strongly."[306] However, Sir Charles Dunstone commented that less time was spent on International than Corporate or Retail.[307] Nor has any witness indicated that there were fundamental objections at any of the various levels to the International Division's strategy or exposures, though several referred to appropriate levels of consideration and debate. However, the procedures failed to prevent and indeed sanctioned, the growth of the Division. Colin Matthew suggested that "the issue of distance was a consideration."[308]

The Division's impairments

12. Significant impairments were charged in Ireland and Australia by HBOS in 2008 and LBG in 2009-11, as illustrated in the following table:

LBG charged a further £897m of impairments against Ireland and £203m against Australia in the first half of 2012.[309]

Impairments against HBOS's business in Ireland

13. The estimated impairments against Ireland totalled £10.9 billion between 2008 and 2011, which is equivalent to 36 per cent of the Division's loan book at the end of 2008. The sterling figures actually benefit from the deprecation in the EURO over the period and would be some 5 per cent worse in local currency terms. CRE was the principal factor in the impairments; 60 per cent of impaired loans in Ireland at the end of 2011 related to CRE exposures.[310]

14. All leading Irish banks incurred significant impairments, as a result of the Irish recession. However, the losses at HBOS were relatively greater than those of the other major Irish banking groups, as the following table shows:

15. HBOS's impairments as a proportion of loans were the second highest of the major banking groups in Ireland. There is also a very significant gap between the HBOS proportion and the next highest figure.

Impairments against HBOS's business in Australia

16. The estimated impairments against Australia totalled £3.6 billion in the 2008-11 period, equivalent to 28 per cent of the Division's loan book at the end of 2008. The figures are increased by the appreciation of the Australian dollar against sterling during the period, which we estimate added some 20 per cent to the sterling figure for impairments. However, even allowing for this, impairments would still have totalled over 20 per cent of the loan book in local currency terms. The Australian economy has been one of the most resilient in the world, and impairments there for the leading banks have been amongst the lowest as a proportion of the loan book of any major banking system.

17. The International Division's Australian impairments would have been material to the HBOS Group as a whole in absolute terms. They were also high relative to the Australian corporate loan book - indeed, as a proportion of the loan book, they were higher than those of the Corporate Division.

Losses in HBOS's International Division

18. We estimate that the impairments taken against Ireland and Australia in the 2008-11 period total £14.5 billion.[311] Senior former HBOS executives described the losses in HBOS's International Division as "appalling",[312] "catastrophic",[313] and "horrible",[314] and gave a range of explanations as to their cause. Many referred to the seizure in financial markets generally, including that they particularly affected asset markets, which in turn, particularly affected the HBOS businesses, due to their CRE exposure. Most witnesses also referred to the problems in the Irish economy and the losses of banks in Ireland generally. Some accepted that these factors alone could not explain the scale of HBOS's international impairments, particularly relative to the losses incurred by other local banks. A few witnesses accepted that the scale of losses implied mistakes on the part of the HBOS Group. Colin Matthew said that, with the benefit of hindsight, the "principal weakness" in the approach the Division followed was that "the expansion plans were wrongly timed", but he defended other aspects of the Division's strategy.[315] Jo Dawson later assumed responsibility for the former HBOS businesses in Ireland and Australia, when at LBG. She claimed that she then became aware of significant asset quality issues and the need to strengthen risk management.[316]

19. HBOS's losses in the International Division were in large part due to the Division's strategy. The Division followed an ambitious growth strategy in Ireland and Australia, involving over-optimistic targets and assumptions for market share growth from local competitors. The Division's pursuit of rapid business growth led to a concentration in higher risk corporate areas, notably in CRE and related sectors, rather than in potentially more sustainable and less risky areas, which would have involved a slower build. The specific nature of the Division's loan portfolio resulted in higher credit losses. The nature of the losses mirrored those incurred in HBOS's UK Corporate Division. After the Corporate Division, the International Division was the next most significant source of HBOS's impairments. While the International Division's losses were smaller than in Corporate in absolute terms, they were significantly bigger as a proportion of the loan book in both Ireland and Australia. While all major banks suffered high losses in Ireland, HBOS's were by a significant margin the second worst as a proportion of the loan portfolio. The company also incurred heavy losses in Australia, where the economy and the banking industry have been relatively resilient. The evidence from those two countries clearly suggests that HBOS had significantly worse asset quality than other banks.

286   ENA comprised a collection of essentially separate businesses: European Financial Services; a primarily German life, pensions and investment business; a retail banking network in Spain; a mortgage business in the Netherlands; and corporate banking in the USA and Canada. Back

287   Qq 1462,1558, B Ev w 238 Back

288   B Ev w 391 Back

289   Ibid. Back

290   Ibid. Back

291   Ibid. Back

292   B Ev w 298 Back

293   B Ev w 390 Back

294   Ibid. Back

295   HBOS, Group Business Plan 2008 - 2012: "When The Going gets Tough...", p 78 Back

296   HBOS, Group Business Plan 2008 - 2012: "When The Going gets Tough...", p 30 Back

297   B Ev w 420 Back

298   Ibid. Back

299   B Ev w 414 Back

300   The growth rates in the table are adjusted for the disposal of BankWest and divisional restatements. Back

301   At its peak in 2007, the division represented 16 per cent of group customer loans. Back

302   B Ev w 238 and Q 1463 Back

303   BQ 151 Back

304   B Ev w 247, 238 Back

305   BQ 561 Back

306   Q 1468 Back

307   BQ 838 Back

308   B Ev w 249 Back

309   "2012 Half-Year results", Lloyds Banking Group News Release, p 123 Back

310   Lloyds Banking Group, 2011 Annual report and Accounts: Becoming the best bank for customers, p 155 Back

311   Lloyds Banking Group (LBG) does not publish divisional figures for HBOS, but it is possible to estimate the impairments subsequently required in Ireland and Australia. LBG does disclose impairments in Ireland and Australia for the enlarged group. Reconciling the HBOS 2008 press release disclosure on the International division (pp 32-41) with the combined figures for LBG in its 2009 Annual Report & Accounts (p 37), it can be shown that substantially all the LBG customer loans in Ireland and Australia were originally loans made by HBOS. This would also be logical as the former Lloyds TSB did not have the local presence in these markets that HBOS did. We therefore assume that the LBG impairments in Ireland and Australia relate to former HBOS exposures. It is not possible to estimate impairments taken against the ENA portfolio, as LBG disclosure is likely to include charges against loans originated by Lloyds TSB. Back

312   Q 1293 Back

313   Q 1463 Back

314   Q 1557 Back

315   B Ev w 248 Back

316   B Ev w 186 Back

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© Parliamentary copyright 2013
Prepared 5 April 2013