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.
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.
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.
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
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. 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
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;
diversifying wholesale funding sources by nature, currency and
type of investor;
holding a significant pool of liquid assets; and undertaking stress
tests and scenario analyses.
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,
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.
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
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.
HBOS was forced to supply liquidity to the Grampian conduit, which
was unable to finance itself on the wholesale markets at attractive
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.
The liquidity portfolio was expected to cover outflows for over
one month, assuming no market access,
which was much more than the then regulatory minimum of 8 days
outflows. 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.
These policies would still allow customer lending to be funded
by short term funding of under one year and even under one month
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.
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.
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."
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".
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"
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.
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
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.
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.'"
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.
However, Mike Ellis accepted that these measures were a matter
of judgement and might appear insufficient in hindsight.
Furthermore, the achievement of the revised targets proved challenging.
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."
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.
On 18 September 2007, Lindsay Mackay discussed with the Executive
Committee contingency planning designed to avoid HBOS becoming
"the next Northern Rock."
Initially at least, the management believed that the external
perception was that the bank had "managed its position through
the liquidity crunch extremely well."
It felt regarded as one of the larger Clearing Banks, distinct
from the monoline or smaller mortgage banks.
However, as the crisis progressed, the HBOS credit default swap
levels widened, both in absolute and relative terms.
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.
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
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.
It was the exodus of customer deposits, rather than the wholesale
funding position alone, which was the final trigger for the Group's
2008 Annual Report & Accounts indicates that the majority
of this outflow was by non-bank financial and large corporate,
rather than retail, customers.
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."
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."
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
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
350 HBOS, 2002 Annual Report and Accounts: 'Even
in tough markets, this is the strategy that delivers', p 7 Back
BQ 537 Back
BQq 539 - 540 Back
B Ev w 346 - 349 Back
Q 1328 Back
B Ev w 449 Back
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
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
BQq 345, 437, 440, 472, 529 Back
BQ 529 Back
HBOS, 2008 Annual Report and Accounts, p 27 Back
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BQ 472 Back
HBOS, 2007 Annual Report and Accounts: Delivering our strategy...,
p 97; HBOS, 2008 Annual Report and Accounts, p 28 Back
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HBOS, 2007 Annual Report and Accounts: Delivering our strategy...,p
HBOS, Secret 20/20 vision Group Business Plan 2003 - 2007,
p 61 Back
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B Ev w 326 Back
B Ev w 330, 333-334 Back
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