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

Annex 5: Funding and Liquidity


1. Both Halifax and BoS were significant users of wholesale funding, and HBOS had a significant reliance on wholesale funding from the outset. Both the bank and the regulator recognised early on that this reliance on wholesale funding represented a strategic weakness. However, neither addressed this sufficiently.

HBOS's funding gap

2. The main features of HBOS's use of wholesale funding are summarised in the following table.

3. From its formation HBOS had a large wholesale funding requirement, as both Halifax and BoS were already significant users of wholesale funding even prior to the merger. At the Group's formation in 2001, the Group had a loans/deposits ratio of 143 per cent and a customer funding gap of £61 billion. The Retail Division, which had been substantially derived from Halifax, had customer loans of £137 billion and deposits of £97 billion - a customer funding gap of £40 billion.[350] The rest of the HBOS Group, substantially derived from BoS, had a customer funding gap of £21 billion.

4. By the end of 2008 the loans/deposits ratio had risen to 196 per cent and the customer funding gap had increased to £212.9 billion. The Retail Division's customer funding gap had risen to £112 billion, the Corporate Division had a gap of £78 billion, and the International Division a gap of £54 billion. All three of the Group's principal banking divisions contributed to the increase in the Group overall customer funding gap and the greater need for wholesale funding over the 2001-08 period. Lindsay Mackay, HBOS Treasury CEO from 2004, confirmed that from the beginning HBOS adopted a strategy to increase wholesale funding aggressively to support asset growth.[351]

The profile of its wholesale funding

5. HBOS's wholesale funding included significant sums of relatively short term maturity. Although the proportion of wholesale funding with a maturity of under one year fell from 83 per cent in 2001 to 50 per cent in 2008, the quantum of shorter duration funding increased from £90 billion at the beginning of the period to £119 billion at the end, peaking at £164 billion at the end of 2007.

6. The financial crisis resulted in a shortening of the wholesale funding profile, as maturing longer term funding could only be replaced by shorter duration maturities.[352] This change resulted in the proportion of HBOS's wholesale funding with a duration longer than one year falling from 47 per cent at the beginning of the crisis in mid-2007 to just over 40 per cent one year later.

Failures to reduce a known risk

7. Both the bank and the regulator clearly identified funding as an important issue and a potential strategic weakness from a very early stage. The FD explained to the Group Board in November 2002 that the five-year business plan would make HBOS "the largest wholesale funded clearing bank in the UK", and the CEO acknowledged that funding was a "significant risk."[353] However, as indicated by Sir James Crosby, funding was seen as a risk to growth plans, rather than as a threat to the existence of the bank.[354] The FSA conducted a review of HBOS in December 2002, which drew attention to the liquidity risk and stressed the need for the bank to have a robust wholesale funding plan arising from the Group's projected asset growth.[355]

8. Although the overall strategy was to increase wholesale funding, HBOS took steps to mitigate its reliance, including: increasing the efforts to source customer deposits; lengthening the wholesale funding maturity profile, particularly by increasing the proportion of funds with a maturity greater than one year;[356] diversifying wholesale funding sources by nature, currency and type of investor;[357] holding a significant pool of liquid assets; and undertaking stress tests and scenario analyses.[358] However, none of these steps fully succeeded.

9. HBOS's attempts to increase customer deposits were unsuccessful in reducing its wholesale funding requirement. The Group's loans/deposits ratio increased progressively in every single year, apart from 2003 and 2004. Moreover, as the loans/deposits ratio was over 100 per cent at the beginning of the period and the balance sheet grew progressively, the quantum of the increase in customer funding gap in absolute terms was proportionately greater. Lindsay Mackay explained that the Group attempted to attract high quality retail deposits and avoid "hot, volatile" funds.[359]

10. The Group did diversify its sources of wholesale funding. Wholesale funding included covered bonds, securitisations and senior debt. It also raised funds in different currencies. However, in the event, US dollar funding proved to be relatively volatile over the crisis and the HBOS balances from this source approximately halved in 2008.[360] The proportion of wholesale funding with a maturity of under one year decreased from 83 per cent in 2001 to 50 per cent at the end of 2008.

11. HBOS's £60 billion liquid assets pool also proved ineffective, as the bank was unable to sell or raise funds against it in the crisis, due to the seizure of wholesale markets.[361] Indeed, the market's concerns about potential losses in HBOS's investment and liquidity portfolios actually contributed to the market's increasing concerns about the bank.[362] HBOS was forced to supply liquidity to the Grampian conduit, which was unable to finance itself on the wholesale markets at attractive rates.[363]

12. The bank ran stress tests on its funding model, notably: the assumption of a two notch downgrade; and also the wholesale markets suffering a one in 25 or 30 year stress event, including the complete closure of one of the bank's main funding sources.[364] The liquidity portfolio was expected to cover outflows for over one month, assuming no market access,[365] which was much more than the then regulatory minimum of 8 days outflows.[366] By 2006 it also maintained a policy that a minimum 40 per cent of wholesale funding had to have a residual maturity over one year and a maximum of 25 per cent under one month.[367] These policies would still allow customer lending to be funded by short term funding of under one year and even under one month duration.

13. All HBOS witnesses accepted that management did not expect, still less make contingency planning for, the severity of the financial crisis, including the near closure of term wholesale money markets to banks for over a year.[368] All senior management accepted that their failure to plan for such a severe funding and liquidity crisis as occurred was an error and many of them apologised for it. However, most of them also argued that the scale and duration of the crisis were almost unprecedented and unforeseeable.

A consequence of the bank's strategy

14. As we saw in the introduction to the previous section, the Treasury Division's first priority was sourcing the funding to support the Group's asset led strategy.[369] Management papers throughout the period show that the planned asset growth posed challenges for the Treasury Division in raising the funding to support it, even before the onset of the financial crisis. The 2003-07 Business Plan (drawn up in 2002) cited funding and liquidity as possibly the bank's "greatest single challenge."[370] Lindsay Mackay told the Executive Committee in 2006 that the bank's existing wholesale funding capacity would be reached in 2009 under their current Plan. HBOS had "the highest wholesale funding need of any of the UK banks (and was close to the other Big Four banks combined)." He recognised that, in the longer term, the position was "untenable and unsustainable".[371]

15. Lindsay Mackay stressed that the targets for wholesale funding were agreed with Treasury, rather than dictated to it. Asset growth targets went through several iterations in the planning process, between the lending divisions as "consumers of the funding"[372] and the Treasury Division's view of what was achievable. He claimed that he was always comfortable that the funding targets assumed in the business plans were achievable as he would not have supported a plan if that had not been the case.[373]

16. In the initial period after the merger, the divisional CEO of Treasury, Gordon McQueen was a main Board member. However, his successor as Treasury CEO, Lindsay Mackay, did not sit on the Board, though he was an ExCo member. Lindsay Mackay reported to a succession of main Board members, George Mitchell, CEO of Corporate, then Phil Hodkinson, as Group FD, and subsequently Colin Matthew, CEO of International. At times therefore, Lindsay Mackay as CEO of the Treasury Division was reporting to main Board directors, who were heads of divisions whose asset growth relied on funding Treasury was charged with raising.

The impact of the financial crisis

17. Once the financial crisis began, HBOS did constrain its asset growth. However, several executives said that the reliance on the markets for wholesale funding made the Group cautious about the signals it was sending: being too aggressive in scaling back growth risked worrying the market that the bank might be in difficulty.[374] In September 2007, Philip Hodkinson outlined to the Executive Committee steps to reduce asset growth and increase liabilities, although full-year asset growth would still be above Plan. However, he also indicated, lending "could not simply be 'turned off.'"[375] The Executive Committee subsequently reduced asset growth targets for 2008 by £10 billion, largely in International, with Retail and Corporate asset growth already constrained as much as desirable. In addition, the Group targeted increased liability growth. Funding would be reviewed monthly throughout 2008.[376] However, Mike Ellis accepted that these measures were a matter of judgement and might appear insufficient in hindsight.[377] Furthermore, the achievement of the revised targets proved challenging.[378]

18. Philip Hodkinson said that the responses to stressed conditions, which the Group had prepared and which took effect in late 2007, together with other measures, were working and the Group felt "in good shape."[379] Peter Hickman indicated that the Group's liquidity planning and measures to lengthen the maturity of its funding protected the Group initially and without them, it would have faced difficulties more quickly than it did.

19. Successive Executive Committee and Board papers during the financial crisis indicate management took the funding position seriously. The day after the announcement that Northern Rock had been granted emergency Bank of England assistance, HBOS set up a Contingency Planning Group, and the CEO indicated planned business growth was no longer prudent.[380] On 18 September 2007, Lindsay Mackay discussed with the Executive Committee contingency planning designed to avoid HBOS becoming "the next Northern Rock."[381] Initially at least, the management believed that the external perception was that the bank had "managed its position through the liquidity crunch extremely well."[382] It felt regarded as one of the larger Clearing Banks, distinct from the monoline or smaller mortgage banks.[383] However, as the crisis progressed, the HBOS credit default swap levels widened, both in absolute and relative terms.[384] The Group suffered an attack from short sellers on 18 March 2008, which led to the withdrawal of some deposits that stabilised after an FSA statement. The market was also concerned with the structure of the HBOS balance sheet, notably its loans/deposits ratio and the absolute size of its wholesale funding.[385]

20. Peter Hickman asserted that the purpose of most liquidity planning was "to get you through a short term crisis." He believed that the Group "weathered a remarkable storm very well." Lindsay Mackay indicated that in the second quarter of 2008 funding conditions appeared to be easing somewhat. However, by October 2008, the extended closure of markets at the long end, and then the total closure of markets to essentially all but overnight funding and the withdrawal of customer funds following the Lehman bankruptcy exhausted the Group's resources.[386]

21. As the crisis continued, the inability to raise term wholesale funding led to a progressive shortening of the wholesale funding duration. Lindsay Mackay also said that, following the Lehman bankruptcy, HBOS suffered £30-35 billion of customer deposit outflows, which were bigger than the wholesale funding strains and could not be offset by additional wholesale funding, as by this stage, the Group had actually significantly exceeded its planned assumptions for wholesale funds.[387] It was the exodus of customer deposits, rather than the wholesale funding position alone, which was the final trigger for the Group's collapse.[388] The 2008 Annual Report & Accounts indicates that the majority of this outflow was by non-bank financial and large corporate, rather than retail, customers.[389]

22. Due to its inability to fund customer withdrawals and maturing liabilities, HBOS was forced to accept ELA assistance from the Bank of England on 1 October 2008 - 14 months after the beginning of the financial crisis and over 12 months after Northern Rock's announcement that it had been granted emergency Bank of England support.

23. Michael Foot explained that HBOS's liquidity problems "were in significant part caused by doubts about the quality of its asset book. Liquidity does not dry up for no reason - it dries up in some places more than others."[390]

24. The combination of poor quality, illiquid assets and wholesale funding compounded the risks involved in each. Both Andy Hornby and Lindsay Mackay accepted that HBOS's use of wholesale funding to support commercial property and other assets where competitors were also wholesale funded did "not make sense" and "was a major strategic weakness."[391]

25. Liquidity and funding were the immediate but not underlying cause of HBOS's collapse. HBOS had the highest wholesale funding need of any of the UK banks (and was close to the other Big Four banks combined). In the words of the CEO of the bank's own Treasury Division, in longer term, the position was "untenable and unsustainable". The Group's extraordinary reliance on wholesale funding made it particularly vulnerable to the liquidity crisis. The prolonged closure of markets to term funding progressively shortened the duration of the HBOS wholesale liabilities, as maturing funds were only able to be refinanced at short maturities. This was compounded by the market's concern over HBOS because of the size of its wholesale funding. After the Lehman failure, HBOS then suffered from the complete closure of markets and a sudden withdrawal of customer deposits, particularly from corporate and overseas customers.

26. Both Halifax and BoS had been significant users of wholesale funding. HBOS's reliance wholesale funding was identified as a strategic weakness right from the start, by both the Group and the regulator. The bank's Board and Executive Committee and supervisors regularly reviewed this risk, and they were all aware that HBOS had a disproportionate reliance on wholesale funding compared with other large UK banks.

27. The Group did take measures to mitigate its wholesale funding reliance: increasing the emphasis on raising customer deposits; lengthening the average maturity, by increasing the proportion of funds with a maturity of over one year; diversifying the sources of its wholesale funding by type and currency; holding significant liquidity. However, these measures were secondary to the continuation of asset growth. In particular, the absolute size of wholesale funding with a maturity of under one year increased during the 2001-08 period. The benefits of lengthening the maturity of funding went to supporting asset growth, rather than reducing the exposure to short term funding in absolute terms. Elements of the liquidity pool were invested in assets which increased their yield, but proved illiquid and a source of impairments in the crisis. The Group's strategy was based on asset growth. Although Treasury was actively involved in business planning and believed it could raise the funding required, its status was secondary to the lending divisions. Regulatory liquidity standards then applying were inadequate.

28. The stress tests the company itself ran, including a one in 25 year event, were also inadequate, although more conservative than regulatory standards then applying. However, even more conservative funding assumptions would have been unlikely to include the severity of the financial crisis.

29. The management took the financial crisis seriously and reacted relatively rapidly, slowing asset growth and seeking to grow deposits more rapidly. However, its ability to take mitigating action was constrained by: the collapse in wholesale market liquidity; other banks also targeting deposit growth; a desire not to increase market concerns by reacting more aggressively to constrain asset growth in particular. Management could have been more aggressive in its response to the crisis, although such action would have been unlikely to have affected the outcome.

30. In the early stages of the crisis, the Group's position was not regarded as being as vulnerable as some smaller mortgage banks. It finally succumbed to liquidity pressures more than a year after Northern Rock received Bank of England assistance and 14 months after the beginning of the crisis. However, as the crisis continued market concerns towards HBOS specifically progressively increased. Elements of the Group's investment portfolio proved less liquid than expected and even contributed to asset quality concerns.

Although liquidity and funding were the immediate causes of the HBOS collapse, they were not the fundamental issue, which was solvency, or at the very least, failure would just have occurred at a later stage, as the subsequent impairments threatened solvency. Furthermore, if HBOS's problems had been limited to funding, no equity injections by HMT or LBG would have been necessary and there would have been no losses to the UK taxpayer; liquidity support alone would have been sufficient and such support that the company did receive has been repaid. Furthermore, there is a strong likelihood that the liquidity and funding pressures were exacerbated by the market's concerns over solvency, including its ABS portfolio and the nature of its loan book, concerns that proved to be correct, in addition to concerns over its funding structure.

350   HBOS, 2002 Annual Report and Accounts: 'Even in tough markets, this is the strategy that delivers', p 7 Back

351   BQ 537 Back

352   BQq 539 - 540 Back

353   B Ev w 346 - 349 Back

354   Q 1328 Back

355   B Ev w 449 Back

356   The proportion of wholesale funding with a maturity of under one year decreased from 83 per cent in 2001 to 50 per cent at the end of 2008. Back

357   The Group's wholesale funding included covered bonds, securitisations and senior debt. It also raised funds in different currencies. However, the US dollar funding proved to be relatively volatile over the crisis and the HBOS balances from this source approximately halved in 2008. Back

358   BQq 345, 437, 440, 472, 529  Back

359   BQ 529 Back

360   HBOS, 2008 Annual Report and Accounts, p 27 Back

361   BQ 440 Back

362   BQ 472 Back

363   HBOS, 2007 Annual Report and Accounts: Delivering our strategy..., p 97; HBOS, 2008 Annual Report and Accounts, p 28 Back

364   Bq 440, Q 1450 Back

365   Q 544 Back

366   Ibid. Back

367   B Ev w 243 Back

368   Qq 1288, 1464 Back

369   HBOS, 2007 Annual Report and Accounts: Delivering our strategy...,p 60 Back

370   HBOS, Secret 20/20 vision Group Business Plan 2003 - 2007, p 61 Back

371   B Ev w 319 Back

372   BQ 549 Back

373   BQq 548, 550, 567 Back

374   BQq 355, 496 Back

375   B Ev w 326 Back

376   B Ev w 330, 333-334 Back

377   BQ 356 Back

378   B Ev w 433 Back

379   BQ 440 Back

380   B Ev w 321 Back

381   B Ev w 325 - 326 Back

382   B Ev w 422 Back

383   B Ev w 325 - 326 Back

384   B Ev w 427 Back

385   BQ 472 Back

386   BQq 533, 572 Back

387   BQq 533, 571 Back

388   BQ 571 Back

389   HBOS, 2008 Annual Report and Accounts, p 26 Back

390   BQ 1069 Back

391   BQ 573, Q1448 Back

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Prepared 5 April 2013