Parliamentary Commission on Banking StandardsWritten evidence from Clive Briault

Personal

1.1 I was the Managing Director, Retail Markets, and a member of the Board and of the Executive Committee of the Financial Services Authority (FSA) from June 2004 to April 2008. I reported to the Chief Executive and to the Board of the FSA. The organogram on page 2 reflects the FSA’s organisational structure in 2006–2007.

I was also a member of the Committee of European Banking Supervisors (CEBS) during 2004–2006, and chaired the main CEBS sub-committee on the implementation of the EU Capital Requirements Directive.

Prior to June 2004 I had been:

Bank of England—1980–1998
FSA Director of Central Policy Division—1998–2001
FSA Director of Prudential Standards Division—2001–2004.

The Retail Markets Managing Directorate of the FSA had approximately 800 staff (out of around 2,000 for the FSA as a whole) and a budget of approximately £80 million during this period. The responsibilities of Retail Markets included:

1)The supervision of all regulated firms whose business was predominantly with retail customers. This represented approximately 16,000 firms, ranging across the major UK banks (Barclays, HSBC, Lloyds, RBS, Santander and HBOS); smaller retail banks and the building societies; life insurers (including Aviva, Legal and General and Prudential); general insurers with retail business (home, motor, health, travel); retail facing asset management and other investment firms (including Fidelity and Invesco); and investment, mortgage (from late 2004) and insurance (from early 2005) advisers and brokers.

2)The conduct of business policy division (which was responsible, for example, for introducing new rulebooks for general insurance and mortgage brokers during this period).

3)The FSA’s Treating Customers Fairly, Retail Distribution Review and Financial Capability initiatives.

4)The liaison between the FSA and other bodies such as the Financial Ombudsman Service, the Financial Services Compensation Scheme, the Office of Fair Trading, consumer organisations, and relevant trade bodies.

The supervision of HBOS (as with the other 50 or so major retail firms undertaking banking, insurance or asset management) was undertaken within the Major Retail Groups Division (MRGD), which was one of the five Divisions within the Retail Markets Managing Directorate. The Director of MRGD reported to me.

During this period MRGD had a staffing level of approximately 150. MRGD was split into three departments, so each Head of Department was responsible for approximately 50 staff and for the supervision of approximately 15–20 groups. The Heads of Department reported to the Director of MRGD. HBOS was supervised by a team that reported to a Manager; who in turn reported to a Head of Department. This is set out in the organogram below:

Additional resources for the supervision of firms were available from FSA-wide functions, in particular the Risk Review Teams that specialised in areas such as credit, market, operational and insurance risk; and from Retail Themes, which undertook thematic reviews of (mostly) conduct of business issues.

External resources were also available, including in the form of commissioning reports from third parties under section 166 of the Financial Services and Markets Act, 2000.

Although I was not routinely involved in the day-to-day supervision of any individual firm, I did:

a.hold regular (fortnightly) bilateral meetings with each of the five Directors reporting to me, and at my meetings with the MRGD Director we discussed firm-specific issues;

b.receive regular management information relating to whether ARROW risk assessment visits and risk mitigation actions had been undertaken on time, and to the evolution of impact and risk scores across the regulated firms;

c.become involved in the supervision of specific firms through being consulted on major supervisory decisions; chairing and attending some ARROW review panels; and meeting senior executives of firms;

d.attend the weekly Firms and Markets Committee, at which significant firm-specific issues were raised; and

e.from the autumn of 2007 to early 2008 I attended meetings between the FSA, the Bank of England and the major UK banks to discuss market conditions.

I have responded to the best of my recollection in preparing the answers below.

Supervisory approach

2.1 The FSA did not formally measure the balance between prudential and conduct supervision.

For the supervision of the HBOS banking sub-group during 2004–2006 I would estimate that at least 60–70% of the supervision resources were directed towards prudential issues, and that this was typical for major retail banks during that period. This increased significantly during the period (mostly in 2007) when—as part of the full implementation of the Basel 2 capital accord—significant resources were devoted to the assessment of whether banks, including HBOS, should be granted permission to use their internal models to calculate capital requirements against some of their risks. And this increased again from August 2007 onwards when the primary focus was on funding, liquidity and capital. In my view, despite the claims of some commentators, the FSA did not spend devote too many resources to conduct issues relative to prudential issues ahead of the financial crisis.

However, for the reasons given under question 4.1 below, and with the benefit of hindsight, before the financial crisis emerged in August 2007 the FSA may have allocated too large a proportion of the resources devoted to prudential supervision to capital relative to funding and liquidity. This was by no means unique to HBOS—this applied across the supervision of both retail banks and wholesale (investment) banks.

2.2 Between June 2004 and August 2007 the resources devoted to the supervision of the HBOS group (which included a major insurance firm) were approximately:

a supervision of team of around 5 people (shared with one other smaller bank)

a Manager (devoting most of their time to the HBOS group)

a proportionate share of the time of the Head of Department and Director of MRGD

additional internal specialist resources, for example to assess the application from HBOS for Basel 2 internal models approval

the use of third party resources, for example the PWC and KPMG reviews in 2004 and 2005 respectively.

The supervision team of a larger and more global bank (for example HSBC and Barclays) would have been larger than the HBOS supervision team.

Between August 2007 and April 2008 the resources devoted to HBOS (and to other UK retail banks) were increased substantially in response to the liquidity and funding pressures they faced.

I am not in a position to comment on the supervision resources that would be devoted today to a comparable institution to HBOS.

2.3 The relationship between the FSA and HBOS was constructive.

I would have been briefed on any significantly unconstructive relationships by the MRGD Director at our regular bilateral meetings. In addition, during 2006 (if I recall correctly) a new procedure was introduced across all high impact firms in the Retail and Wholesale units to gather two-way feedback immediately following the conclusion of the ARROW risk assessment process. This involved the CEO of a firm being interviewed by the FSA CEO, relevant MD or relevant Director. I undertook a significant number of these interviews, but my meetings did not include HBOS.

The main interaction with HBOS would have been through the supervision team, including in particular:

1.Intensive engagement during the ARROW risk assessment process.

2.The so-called “Close and continuous” interaction with the senior management of firms supervised by MRGD, based on quarterly meetings with firms’ senior management.

3.Numerous reactive and proactive issues, where issues would be taken forward as necessary by the supervision team in response either to events at HBOS or to undertake FSA initiatives.

These interactions are described in section 3.1.1 (pages 255–256) of the FSA’s report on the failure of RBS (December 2011).

The FSA could presumably provide a list of all meetings between the FSA and HBOS during the relevant period.

I do not recall HBOS being granted a “regulatory dividend”. Indeed, the implementation of a higher Individual Capital Requirement in March 2004 demonstrates the opposite.

2.4 I did not meet the Board of HBOS.

The standard practice for a major retail group was for the supervision Manager and Head of Department to present the ARROW risk assessment findings and risk mitigation programme to the Board of the firm. Some individual Board members would also typically be interviewed by the supervision team as part of the risk assessment process. I would be updated on any significant issues through my regular bilateral meetings with the Director of MRGD.

After August 2007 the FSA also contacted the Chairmen of the Boards of a number of UK retail banks to ensure that the Boards of these banks were focusing sufficiently actively on steering their banks through the difficulties of the evolving financial crisis, and on contingency planning.

2.5 From the autumn of 2007 to early 2008 I participated in joint meetings between the FSA, the Bank of England and the major UK banks to discuss market conditions. Prior to that I had very little involvement with the executives of HBOS, although I did meet James Crosby regularly at FSA Board meetings.

I did not discuss HBOS specific issues with James Crosby, but we did meet a couple of times to discuss the FSA’s Retail Distribution Review. These meetings took place when James Crosby was no longer the CEO of HBOS.

2.6 As noted in answer to question 2.3 above, the supervision team had contact with a wide range of HBOS staff, through ARROW risk assessments, the Risk Mitigation Programme, Close and Continuous meetings, and numerous other contacts. These amounted to a very large number of meetings and telephone discussions each year.

Control framework and risk management

3.1 The judgements of the supervisory team on HBOS’s control framework are clear from the ARROW risk assessments from 2002 onwards. These judgements were also subject to internal review through the FSA’s Review Panels.

The ARROW risk assessment in late 2002 had identified many of the issues that defined the supervisory approach throughout the relevant period (at least until the financial crisis began in August 2007). These included the importance of (i) the quality and effectiveness of HBOS’s control infrastructure keeping pace with the growth in the business and the associated risks; (ii) the additional and independent layer of challenge from the Group Risk function; and (iii) an achievable and robust plan to secure adequate access to wholesale funding.

The Interim risk assessment concluded in January 2004 reiterated the importance of the control framework and informed HBOS that the FSA was commissioning a skilled persons report on the risk management framework within the HBOS group under section 166 of the Financial Services and Markets Act. That report was undertaken by PWC in the first half of 2004 and completed in July 2004.

The judgements based on that review, and on other work undertaken by the FSA during 2004, are contained in the ARROW risk assessment letter sent by the FSA to the Board of Directors of HBOS on 21 December 2004. This concluded that the HBOS group’s risk management framework was fit for purpose, but the Group Risk functions still needed to enhance their ability to influence the business.

The Interim risk assessment of June 2006 continued this judgement that good progress had been made, but there remained control issues in the HBOS group.

By the time of the full ARROW risk assessment in 2008 attention had shifted to the external environment, including the funding difficulties faced by HBOS and other banks.

The FSA’s assessment of the risk function at HBOS during the period under review was described in the statement made by the FSA on 11 February 2009, following issues raised at the Treasury Select Committee on 10 February 2009. The FSA stated that:

“The FSA conducted a full risk assessment of HBOS (known as an ARROW assessment) in late 2002 which identified a need to strengthen the control infrastructure within the group;

We then decided to commission a “skilled persons report” from PWC on the HBOS risk management framework, using formal information gathering powers under section 166 of the Financial Services and Markets Act 2000: their extensive report revealed a need for improvements in the HBOS risk management environment;

The FSA then conducted a further full risk assessment of the HBOS group to cover all of the group’s business, formally recording its assessment in December 2004, the assessment was that the risk profile of the group had improved and that the group had made good progress in addressing the risks highlighted in February 2004, but that the group risk functions still needed to enhance their ability to influence the business, which we saw as a key challenge.

The FSA continued to pursue concerns about the risk management framework. As a consequence, we wrote to HBOS again on 29 June 2006 with a further interim ARROW risk assessment. In that letter we made clear:

that whilst the group had made progress, there were still control issues. We made clear that we would closely track progress in this area;

the growth strategy of the group posed risks to the whole group and that these risks must be managed and mitigated.”

3.2 Firms took a number of different approaches to how they organised their risk functions and to the balance of resources between group and local risk management functions. The FSA took the view that there was no single “right answer” here. Instead, the FSA exercised judgement on whether the particular risk framework adopted by a firm was capable of working effectively (for example, in terms of the resources devoted to risk management and the independence of these resources), and whether it worked effectively in practice.

My response to question 3.1 above provides more detail on the HBOS risk function.

3.3 The Group’s risk management framework was the subject of the third party report commissioned from PWC in 2004, and this also formed one basis for the continuing focus of the supervision team on risk management within HBOS throughout the period 2004–2008. The judgements reached by the supervision team are contained in the ARROW risk assessments over the relevant period and are summarised in response to question 3.1 above.

3.4 The FSA’s approach to internal ratings based (IRB) model approvals is described in Appendix 2F (pages 336–337) of the FSA’s report on the failure of RBS. This included an FSA-wide set of formal procedures for granting approvals.

The specialist team set up by the FSA to review IRB model approval applications had concerns about whether a number of banks met the tough criteria for approval, including HBOS (in particular with regard to its modelling of corporate risk exposures). This resulted in series of meetings being held by the specialist team and line supervisors with these banks, resulting in some cases in (i) some models not being approved; (ii) some models being approved subject to conditions; and (iii) limits being imposed on the extent to which model use could reduce regulatory capital requirements.

HBOS raised some concerns about the FSA’s review of its model for corporate credit risk.

3.5 I did not meet with the external auditors of HBOS, and I do not recall the external auditors raising concerns.

I did not meet with the internal auditors.

However, I expect that the supervision team met with both the internal and external auditors as part of their supervisory engagement with HBOS.

3.6 Based on my discussions with the Director(s) of MRGD my view was that the supervision team understood the business activities undertaken by HBOS and appreciated the risks involved in these activities, including commercial property lending, corporate lending and equity positions, and in the international operations of HBOS. These risks were covered by the supervision team as part of the ARROW assessments.

There were also policy discussions in the FSA during 2004–2007 on the capital requirement treatment of private equity positions taken by banks generally, and that during these discussions I argued—as a member of the FSA’s Regulatory Policy Committee—in favour of a harsher (deduction from capital, rather than risk weight the asset) capital treatment for these positions than had been proposed by the Prudential Policy Division (which was part of the Wholesale Markets unit of the FSA).

Capital

4.1 The capital add-on for HBOS did not change significantly in 2006 or 2007, although by the end of 2007 there had been a technical change in the way that the FSA gave individual capital guidance to firms, with a move towards specifying this as amounts of capital rather than as a percentage of risk weighted assets.

Detailed analysis was undertaken early in 2008 of the capital position of the major UK retail banks, including HBOS. This is described in paragraph 726 (page 273) of the FSA’s report on the failure of RBS.

HBOS announced a rights issue at the end of April 2008.

4.2 For the reasons described under question 3.4 above, I would assume that the impact on the bank’s required regulatory capital was relatively small.

Funding and liquidity

4.1 HBOS was by no means alone in funding itself to a significant extent from the wholesale market. The extent of this funding was well known to the supervisory team, and indeed the increasing reliance of many banks, both retail and wholesale, on wholesale funding was generally known to the senior management of the FSA. The focus of supervision ahead of August 2007 was not on trying to reduce this reliance, but rather on how banks managed their liquidity and funding.

In this context, the supervision team encouraged HBOS to diversify its sources of funding; to improve its controls over its overseas treasury operations; and to integrate its treasury systems. Meanwhile, HBOS itself took steps even ahead of August 2007 to lengthen the average maturity of its wholesale funding.

From August 2007 onwards the position changed completely, with both individual banks and the FSA focusing much of their attention on funding and liquidity risks.

I believe that there are four main reasons why supervisors paid (with the benefit of hindsight) too little attention to funding and liquidity risks ahead of August 2007:

1.Secured borrowing by banks (including covered bonds, securitisations of assets, sale and repurchase agreements) had developed and grown since 1970, making it easier for a bank such as HBOS to raise funding and to meet its liquidity needs.

2.Funding and liquidity was largely ignored by the international Basel Committee on Banking Supervision before 2007. Unlike capital requirements, the Basel Committee had never constructed any quantitative ratios or limits for funding or liquidity (Appendix 2D (pages 320–321) of the FSA’s report on the failure of RBS also refers to this).

3.Although the FSA did publish (in 2003, while I was Director of the FSA’s Prudential Standards Division) a Discussion Paper on revised quantitative liquidity requirements, the FSA Board decided not to take this forward, following push-back from the industry. The FSA stated that “Industry feedback to DP24 showed that liquidity regulation needed a more international approach. So we decided not to pursue our own reform until the outcome of international work on liquidity was clearer”. (Quotation from FSA CP 06/10 “Strengthening Capital Standards”, May 2006)

4.The Financial Stability Reports published ahead of August 2007 did not identify liquidity and funding as a particular risk to financial stability.

4.2 This is covered in my answer to question 4.1 above.

4.3 The funding and liquidity positions of banks were monitored very closely by the FSA after August 2007. This included frequent reporting of liquidity positions; regular discussions with the banks on their liquidity position and other developments; and detailed contingency planning by both the authorities and the banks—by the banks for raising capital and funding, and by the authorities for providing liquidity. In addition, in early 2008 the Government introduced legislation to enable to take banks into temporary public ownership.

4.4 I do not recall to what extent holdings of asset-backed securities were discussed with HBOS before mid-2007, but once the impact of the problems with US sub-prime mortgages had begun to have a negative impact on the market values of asset-backed securities this was closely monitored by the FSA across all banks. This was an important element of the assessments undertaken by the FSA in the first half of 2008 of banks’ capital positions, including HBOS.

4.5 HBOS did have stress testing arrangements in place during 2004–2008. Some improvements were identified in a Risk Review Team visit in 2006, and these were communicated to HBOS.

The FSA also ran its own stress tests, and highlighted—including through the FSA’s annual Financial Risk Outlook publication—areas that firms’ stress tests should cover. For example, in response to the risks perceived in around 2006 that UK house prices might fall by 20% (as had occurred in the late 1980s/early 1990s), banks and building societies would have been expected to stress test the impact that such a fall might have on their profit/loss and capital adequacy.

Although not explicitly about stress testing, a speech I gave to the Council of Mortgage Lenders in April 2007 clearly picked up on this theme:

“In calibrating these scenarios, there are some extremely relevant pointers as to what can go wrong: not just in the history of the last UK housing boom and bust at the end of the 1980s/early 1990s, but also in the fall-out that we are currently witnessing in the US sub- prime mortgage market—which may cost lenders in excess of $150 billion. Reference points issued by us for assessing downturn Loss Given Defaults suggest that when lenders are calculating their Loss Given Defaults on mortgage portfolios they should allow for a 20% reduction in house prices, and a further 20% reduction from forced sale after a property has been repossessed; and should allow for 35% of loans in default to end up in repossession.”

Provisioning policy

5.1 and 5.2 I do not recall concerns about provisioning policy. My reading of the enforcement notices against HBOS and Peter Cummings is that these concerns surfaced after I had left the FSA.

Corporate Governance

6.1 and 6.2 The effectiveness of corporate governance as a risk mitigant was a significant element of the ARROW risk assessment. The risk assessments during the relevant period indicate that corporate governance was thought to be effective at HBOS. There was some banking experience among the non-executive directors and a considerable amount of wider corporate experience.

20 November 2012

Prepared 4th April 2013