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

Annex 4: The Retail Division


1. The Retail Division was the largest division in HBOS in terms of customer loans and generally of profits. The Division combined the retail banking activities of Halifax, primarily in mortgages and savings under the Halifax and other brands, with those of BoS, which comprised a branch banking business in Scotland and products delivered through direct channels throughout the UK. The enlarged HBOS Retail Division was arguably the leading UK retail financial services business. It had market leading positions both in mortgages, with a 20 per cent share of new mortgages written in 2008, and in deposits, with a 13.2 per cent share of Household Liquid Assets at the end of 2008.[333] During the period following the merger, the Retail Division broadened its activities, increasing its shares of financial service products other than mortgages and deposits. The Division achieved a 16 per cent share of new UK current accounts in 2008, when it also had a 10 per cent share of unsecured lending balances and 11 per cent of new credit card accounts. The Retail Division was also the leading UK bank distributor of insurance, both investment and general insurance products.[334]

The Division's strategy

2. From the point of the merger the Retail Division followed a strategy positioning itself as the "customer's champion," claiming that it offered "outstanding value for money" right across its product range and products and prices that were "easy to understand." [335] The Retail business was the one division in HBOS that held a leading incumbent position, in the form of its mortgages and savings business, which was a potential opportunity for competitor banks. At the time, the mortgage market saw a significant increase in competition from existing players and new entrants, particularly due to the abundance of wholesale funding at attractive rates. However, HBOS saw itself as a challenger organisation in most other retail financial service products, with the opportunity to gain share by distributing them to its existing customer base. Consequently, the Retail strategy involved managing the effects of competition on its mortgages and savings business, while increasing its share in other products.

3. A key element of the Division's mortgage strategy was to grow 'non-standard' mortgage lending, particularly buy-to-let and self-certified mortgages, where margins had remained higher than with standard mortgages and the overall profitability was thought to be more attractive, despite higher credit risks.[336] At the end of 2003, £36 billion (20 per cent) of the Division's portfolio was classified as non-standard.[337] By the end of 2008, this figure had risen to £66.5 billion of mortgage lending (28 per cent)[338]. As a result, 35 per cent of the Division's book had a loan-to-value ratio of over 70 per cent by the end of 2007, and this proportion rose to 62 per cent by the end of 2008[339], due to the fall in house prices. These proportions are significantly higher than for any other mainstream mortgage lender, which makes the Division's portfolio more vulnerable to a housing market downturn than those of other leading mortgage banks.

4. The strategy of expanding shares in products outside mortgages and savings was successful in increasing shares as outlined in paragraph 1 of this annex. The Retail Division unsecured loan book totalled £16.7 billion at the end of 2008.[340] Retail also built significant shares in new current accounts and the distribution of insurance products. At the end of 2008, the Retail Division had customer deposits of £144 billion and customer loans of £255 billion, a gap of £111 billion.[341] The Division was therefore the largest element in the overall HBOS group customer funding gap, representing over half the Group's total funding gap of £213 billion at the end of 2008.[342]

The Division's impairments

5. As LBG does not publish divisional results for the HBOS Group, it is not possible to know precisely the impairments the Retail Division has incurred since the financial crisis. We do, however, know the figures for 2008. The HBOS 2008 disclosure shows Retail impairments of £2.2 billion, of which £1.1 billion was against secured lending, up from just £28m in 2007.[343] By contrast, Lloyds TSB only incurred impairments of approximately £170m against mortgages in 2008. In order to get an idea of the size of HBOS's mortgage impairments for 2009-11, it is possible to look at the aggregate LBG Retail impairments against secured lending for the period, which were £1.5 billion.[344] Assuming the bulk of LBG impairments against mortgage lending continued to be related to HBOS loans, we estimate that HBOS mortgage impairments for the 2008-11 period would have been some £2 billion (which represents 1 per cent of the 2008 book of secured loans).

6. There was a general deterioration in UK banking industry unsecured loan arrears experience in the early part of the last decade. HBOS was no exception. As a result, the bank tightened its unsecured lending criteria in 2004.[345] Consequently, the Retail Division's unsecured lending grew relatively moderately in subsequent years, averaging annual growth of 3 per cent in between 2003 and 2008. However, the Division's impairments continued to rise, initially because the lending it wrote in 2002-03 'seasoned' and thereafter because of the economic downturn. The Division's unsecured impairments were £486m in 2003 and £1.1 billion in 2008, averaging about £1 billion a year over the 2003-08 period;[346] and we estimate that they continued at a similar level subsequently. These figures would be equivalent to annual impairment charges of 7 per cent of loans per year, which shows that HBOS's unsecured loan charges were generally significantly larger than for its mortgage portfolio, both in absolute terms and as a proportion of the book.[347]

7. Although experiencing some deterioration as a result of the crisis, particularly in respect of non-standard mortgages, HBOS's Retail impairments were substantially less than either the Corporate or International Divisions incurred and were not a material factor in the failure of HBOS. We estimate that total Retail impairments would have been some £7 billion between 2008 and 2011. The Division generated profits before impairments of £3.5 billion in 2008.[348] Even allowing for significant pressure on this figure in subsequent years and for charges against the mis-selling of payment protection insurance, the Division's pre-impairment profits would have allowed the Group to absorb the likely level of impairments and still generate profits.[349]

8. The prime reason for the resilience of the Retail Division was the resilience of its credit quality. There are likely to have been several factors for this. The Retail business was the market leader in mortgages and savings. It was not a relative new entrant, unlike the International Division and, to a lesser extent, the Corporate Division. The market position of the Retail Division was therefore stronger, and it generated higher quality business. Group senior management and central risk functions had greater understanding of the Retail business and several had direct expertise having worked 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.

9. The Retail Division participated in higher risk mortgage segments and grew the proportion of higher risk lending. However, such business remained a minority of its mortgage exposure, with mainstream mortgage loans still 72 per cent of the mortgage portfolio at the end of 2008. This focus is in contrast to HBOS's corporate lending, both domestically and internationally, where the divisions adopted a strategy of specialisation in higher risk segments, including CRE. The downturn in the residential property market was not as pronounced as in the commercial property area, which resulted in significantly less pressure on mortgage asset quality than on CRE. Should there be a downturn in the residential property market, the higher LTVs resulting from HBOS's growth in non-standard mortgages would be likely to make its portfolio more vulnerable than those of other leading mortgage banks.

10. Although the Retail Division incurred higher losses than its major competitors and still today retains higher risks in its mortgage portfolio, it was not a major contributory factor in the failure of HBOS. The Division is likely to have remained profitable during the crisis period and subsequently, albeit at a reduced level. Nonetheless, the Division's customer funding gap was a major factor in the Group's overall funding gap.

333   HBOS, 2008 Annual Report and Accounts, p 7 Back

334   HBOS, 2007 Annual Report and Accounts: Delivering our strategy..., p 16 Back

335   HBOS, 2001 Annual Report and Accounts: The New Force, pp 12-13 Back

336   HBOS, 2003 Full Year Results Presentation, lloydsbankinggroup.com, slide 27 Back

337   "HBOS plc Preliminary Results 2004: Stock Exchange Announcement", HBOS Press Release, 2 March 2005, p 13 Back

338   "HBOS plc Preliminary Results 2008: Stock Exchange Announcement", HBOS Press Release, 27 February 2009, p17 Back

339   Ibid., p17 Back

340   Ibid., p17 Back

341   HBOS, 2008 Annual Report and Accounts Back

342   Ibid., p 42 Back

343   HBOS 2008 full year results press release, p 15 Back

344   "HBOS plc Preliminary Results 2008: Stock Exchange Announcement", HBOS Press Release, 27 February 2009 Back

345   HBOS, 2004 Annual Report and Accounts: Making growth work harder for shareholders, p 11 Back

346   HBOS Annual Reports and Accounts for the years 2003 - 2008.  Back

347   Interest margins on unsecured lending would, of course, have been materially higher to compensate for this fact. Back

348   HBOS, 2008 Annual Report and Accounts, p 7 Back

349   This calculation is still likely to hold true, even if the £1,155m of charges taken by HBOS against mis-selling of payment protection insurance in 2011 are included. Back

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Prepared 5 April 2013