Parliamentary Commission on Banking StandardsWritten evidence from Jo Dawson
Introduction
1. I welcome the opportunity to provide evidence to the Commission to assist it in its important work on improving Banking Standards.
2. In my responses below, I have tried to respond as fully as I am able given the timescales. Obviously, a number of the questions relate to events many years ago. The responses which are set out below are based on my recollections and publicly available information as I have had no access to any of the relevant documents or papers from the time. I have therefore sought, wherever possible, to highlight relevant documents which I assume the Commission will be able to obtain from Lloyds Banking Group, if it has not already done so. These documents will undoubtedly provide a far more comprehensive and accurate response to a number of the questions.
Personal
Briefly summarise your role in the management of HBOS, giving the dates when you joined and left.
I joined Halifax in June 2000 as General Manager Retail Sales, reporting to the Chief Executive Retail Distribution (Andy Hornby).
Between June 2000 and December 2004, my role evolved to include Bancassurance, Small Business Banking, Wealth Management, Retail International (Holland/Spain) for Halifax initially and then for the combined HBOS operations in these areas following the merger with Bank of Scotland in September 2001.
In January 2005, I was appointed to the newly created role of Group Risk Director by James Crosby (then Group CEO) and became a member of the Group’s Executive Committee.
In March 2006, I was appointed to the role of CEO of the Insurance & Investment division reporting to new Group CEO, Andy Hornby.
In May 2006, I was appointed to the HBOS Board as an Executive Director with responsibility for the Insurance & Investment division.
In September 2007, I was given additional Executive responsibility for Retail Distribution following the departure of Benny Higgins who had been the CEO of the Retail division. Responsibility for Retail Products (the other part of Benny Higgins’ role) and Retail P&L was given to Dan Watkins who joined the Board.
In January 2009, when HBOS was acquired by Lloyds TSB, I was the only HBOS Executive Director to join the new Lloyds Banking Group Executive Committee when I took on the role of Wealth & International Director, reporting to the Group CEO, Eric Daniels.
3. Some of the Commission’s questions are directed to me as a former Group Risk Director of HBOS. It will be noted from the above that I held the position of Group Risk Director for a short period from January 2005 to February 2006. I was in that role for a period of two months (January-February 2006) of the “Relevant Period” as defined by the FSA in its Final Notice dated 9 March 2012 (the “Bank of Scotland plc Final Notice”).
Growth of the Business
(1) On 9 March 2012, the FSA published a Final Notice against Bank of Scotland which concluded that the corporate division of HBOS had pursued an aggressive growth strategy without taking sufficient care to mitigate the risks. Would you broadly agree with that assessment?
4. With the benefit of hindsight and on the basis of the information set out in the Bank of Scotland Final Notice that would appear a reasonable assessment.
5. Much of the data cited by the FSA in the BOS plc Final Notice was not available to the Board and is at odds with the tone of the reports and assurances which were provided to the Board during the period by the Corporate division. For example, the Bank of Scotland plc Final Notice highlights that internal business plans prepared by the Corporate division, which were submitted to the Board as part of the overall Group Plan, suggested that (paragraph 4.61):
“(1.)
(2.)
(3.)
6. However, the Bank of Scotland plc Final Notice also acknowledged that (paragraph 2.16):
“(1.)
(2.)
7. These projects were focused around delivering improvements in risk management as set out in the Basel II Capital Accord and subsequent regulatory guidance from the FSA. The FSA gave its approval to the use of the “Advanced” Basel II approach for the Group (including the Corporate division) at the end of 2007.
Was a similar strategy pursued across other divisions?
8. At the time of its creation in September 2001, HBOS outlined a strategy focused on organic growth in its selected markets. Each division was broadly focused on identifying and pursuing profitable growth in selected markets/business areas where the division believed it enjoyed some form of competitive advantage. Each division was required to understand the risks of its strategy and put in place appropriate controls and monitoring to manage those risks.
9. Within Insurance & Investment, for which I was the divisional CEO from March 2006, our strategy (in the period 2006–2008) centred on improving the earnings quality and profitability of the division, becoming the UK’s leading Insurance & Investment business. That involved growing some product lines (eg Household Insurance, Bancassurance), withdrawing from others (eg Group Pensions, Travel Insurance), reducing the risk profile of the business and the capital required to support it (where as a result we were able to return £1.1bn of capital to the Group in 2008).
10. A key area of focus for me as the CEO of the Insurance & Investment division was the major programme to improve overall Financial Capability and Financial Risk Management in the division, encompassing over 400 individual actions. I commenced this programme when I became the CEO of the division having been made aware of a large number of unresolved external and internal audit points, some dating back many years, as well as issues raised by the FSA in their 2006 Group RMP (Risk Mitigation Programme). The FSA was fully involved in agreeing the scope, priorities and timescales for the programme and received regular updates on progress. At the end of the period, a detailed report was submitted to the FSA on 17 December 2007 including independent assurance from KPMG.
11. When I assumed responsibility for Retail Distribution in September 2007, I supported Dan Watkins (CEO Retail Products) in refocusing the Retail strategy away from mortgage market share targets so as to reduce risk and focus more on earnings quality, increasing the share of liquid savings and capturing larger share of primary current accounts. That change in strategy was approved by the Board and communicated externally to investors. This refocus was well underway at the time of the acquisition by Lloyds TSB just over a year later.
12. The strategy for international growth was primarily focused on English-speaking markets which were culturally similar to the UK and were therefore considered lower risk from an execution perspective (compared with, say, Asian or South American markets). The strategy in these markets was primarily one of organic growth as opposed to acquisitions. The key to this organic growth was to leverage perceived UK expertise, skills and success in specific areas of business.
(2) Please describe the bank’s strategy for growth generally, and in the corporate, treasury, international and retail divisions in particular. How did that strategy develop from the creation of the bank in 2001 to its merger in 2008 with Lloyds TSB?
13. When HBOS was formed in 2001, the Executive team and the Board set out a strategy to deliver growth in earnings and return on capital through proactive competition with the aim of becoming The New Force in Banking.
14. The Group produced a Group Business Plan each year which set out financial targets for each division together with key strategic planning themes, operating plan priorities, risks and mitigations. I would suggest the Commission obtains copies of these documents for a full description of the strategies of each division (and thus the Group as a whole) and how they evolved over the period.
15. I did not have access to the detailed business plans for the Treasury, International and Corporate divisions and am therefore unaware of the detail of how growth was to be delivered in these divisions.
16. Within the Retail division, my recollection of the key elements of the strategy back at the time of the merger in 2001 is:
(a.)
(b.)
(c.)
17. As will be seen from a review of the Group Business Plans over the period 2001–2008, the essence of the Retail division strategy remained unchanged although it became increasingly difficult to deliver the financial targets as competitive pressures increased, margins reduced, cost efficiencies were harder to find and the impact of high levels of “churn” in the intermediary mortgage market significantly impacted mortgage profitability.
(3.) Please explain how the growth strategy and targets were devised and developed. What involvement did the board have in those processes?
18. I am not aware how the original HBOS strategies and targets were drawn up at the time of the merger between Bank of Scotland and Halifax in September 2001.
19. In subsequent years, the annual planning process generally started in April when the Group CFO (following discussion with, and agreement from, the Group CEO) would send out a “Planning Framework” to the divisional CEOs and Group function heads.
20. Some years this would be preceded by a Board Away Day where, amongst other things, we would hear from market commentators (eg Capital Economics) regarding the economy, expected house price and commercial property inflation, as well as discussing competitor trends and inorganic growth options. At these Away Days, the divisional CEOs would also share their initial thoughts on high-level plans, priorities and risks for the following year.
21. The “Planning Framework” set out assumptions about the market and economy and an indicative strategic direction for each of the divisions together with a set of five year targets, both balance sheet (assets and customer deposits as applicable) and P&L for each division and central function and key planning themes that each division and function had to address in their plans.
22. Each division and function was required to develop a detailed plan on how it could deliver the financial targets and planning themes set out in the Planning Framework. The detailed plans produced by the divisions were, from recollection, submitted back to the Group CEO and CFO in August/September each year and an iterative set of discussions and challenge sessions ensued between the individual divisions and the Group CFO, CEO and Group functions.
23. For the Insurance & Investment division, I was always clear in the “challenge” process with the Group CEO and CFO what was acceptable, what was not achievable and the risk implications of the strategy which we were adopting. I presumed that other divisional CEOs were similarly disciplined and did not agree to targets which could not be achieved within acceptable risk parameters.
24. There was then a final review by the divisions and the Group CEO and CFO at which decisions were taken on the options and plans and a final Group Financial Plan was drawn up. This plan was then “stress-tested” between divisions and Group functions both in respect of key sensitivities (eg GDP, unemployment, house price inflation and commercial property price assumptions) and also, increasingly, as part of formal stress-tests directed by the FSA.
25. In parallel with this process, the Treasury divisional CEO (who was the Group CFO during 2006 and 2007) and the senior management team in the Treasury division developed the funding plan setting out how that element of the balance sheet which was not funded by customer deposits would be funded. This funding plan, which was usually presented to the Board and the FSA at the same time as the overall Group Plan also covered options and risks. From recollection, these plans also included the results of stress-tests including both “whole of market” stresses and “name specific” tests, such as the impact of a one and two notch downgrade by a rating agency. A review of copies of these documents will inform the Commission’s consideration of how the Group’s funding strategy evolved, including the Group’s focus on diversifying the sources, and lengthening the maturity profile, of its wholesale funding.
26. The final Group Plan was then presented to, and approved, by the HBOS Board in November/December.
27. The Group CEO and Group CFO submitted the final Group Plan to the FSA and met with them to discuss it in more detail. I did not attend these meetings.
28. During the course of each year, quarterly reviews of the progress of each division against the final Group Plan (including reforecasting) were undertaken initially by the Group CEO and CFO and the divisional CEOs and CFOs. The combined Group “Quarterly Reforecast” documents were also presented to the Board for approval.
29. In addition to the Group Plan, Funding Plan and Quarterly Reforecasts, there was a schedule (drawn up by the Chairman and Group CEO) of papers and presentations to the Board by key business units which would go into the detail of strategy, progress and plans for these businesses. Generally, members of the senior divisional teams would attend the Board meetings to present these papers.
(4.) To what extent did the growth strategy have the support of major shareholders or investors in HBOS?
30. Aside from half-yearly results presentations, I did not have any direct contact with major shareholders or investors so I am unable to comment.
31. That said, on the basis of the analysts’ reports which I saw in the period, it was clear to me that there was support for the growth strategy and the clarity provided by committing externally to a series of targets which could be externally monitored.
32. In addition, each year the Board commissioned an annual review of investor feedback by an independent firm. The following extract from the Chairman’s statement on in the 2006 HBOS Annual Report and Accounts (page 5) confirms the view that investors were supportive of the strategy:
“Each year we commission an independent audit of UK and International investor opinion…..Investor comments on strategy, performance, management and prospects are received on a non- attributable basis….
Investor opinion in 2006 was encouraging. First there was a clear understanding and endorsement of our strategy. Our primary focus on UK growth supplemented by careful, organic expansion internationally, looks to be very acceptable to our shareholders, if not racy enough for some tastes”.
(5.) Was there unanimity within the board and senior management about the desirability of the growth strategy? If not, what was the nature of any contrary views which were expressed?
33. As described above, the Board approved the final Group Plan each year which set out the various growth strategies of the individual divisions.
34. I cannot recall any contrary views being expressed during Board meetings although the Executive Directors were often challenged about the capability and capacity of the people within their division to deliver on the strategy.
(6.) Please explain how the growth strategy was explained and communicated to more junior staff, particularly those involved in originating loan business. What steps were taken to encourage them to put the strategy into effect?
35. I am not aware how the growth strategy was communicated and explained to more junior staff in the Corporate, International, Treasury and Asset Management divisions. That would have been the responsibility of the respective divisional CEOs and their management teams.
36. Within the Retail division, the overall plans were developed into more detailed product plans and these were then shared amongst the various distribution channels (eg Direct, Branches, Telephony, and Intermediary). In the Branch channel, the product plans were then devolved to Regions, Areas and finally, individual branches. Senior management in Retail Distribution met regularly with Product Heads in Retail to discuss progress and targets were formally reset on a quarterly basis dependent on progress achieved, competitor activity, risk and quality metrics. There was also an annual conference which would be attended by all branch managers and managers from across the Retail division at which headline plans (but not numbers) and new product and marketing initiatives were shared.
37. Within the Insurance & Investment division, a “cascade” of face to face communications with staff from across the division took place and my senior management team and I would regularly hold “town hall” sessions to update on progress and answer questions on targets, strategies, plans, projects and risk management progress etc.
38. In both the Retail and Insurance & Investment divisions, colleagues at all levels would have clear objectives for the year which would include team and individual objectives. These often included priorities for personal development, leadership and development of teams, customer service metrics, financial targets (eg costs/revenue/margins/volumes) and risk metrics. By way of example, the Retail branch bonus scheme contained both sales and service targets but there was a risk hurdle which meant that unless key risk management activities were completed successfully then any sales or service bonus would be forfeited. From memory, this change was requested by Group Risk.
Risk Management
(1.) Please briefly describe the processes and policies within the bank for managing risk at a divisional and group level.
39. HBOS operated a “three lines of defence” risk model. Whilst the principles of this model remained unchanged, the detail of its implementation evolved during the life of HBOS in response to both external changes (such as Basel II) and an internal focus on continuously improving the capability and effectiveness of risk management.
40. Shortly before my appointment to the newly created Group Risk Director role in January 2005, I recall that the former Executive Director with responsibility for Risk (Mike Ellis who was also the Group CFO) submitted a paper to the Board in November 2004 which sought to clarify the on-going risk management responsibilities of all parties. I remember regarding this paper as helping to set out my remit in this new role.
41. During the 14 months I was in the role, there were further developments in particular around the Executive Risk Committees. These were described in the section on Risk Management in the Annual Report and Accounts. I have attached, as Appendix 1, the relevant extract from the 2005 Annual Report and Accounts which covers the period in which I held the Group Risk Director role.
42. In essence, the “three lines of defence” and their respective roles were:
(a.)
(b.)
(c.)
43. During the period when I was Group Risk Director, the Group Risk function supported the four Executive Risk Committees (which had representatives from all Divisions as well as Group Risk, Group Internal Audit and Group Finance) in developing high-level policies for the following key risk areas:
Group Credit Risk policy statement.
Group Large Exposures policy statement.
Group Provisioning policy statement.
Group Market Risk policy statement.
Trading Book policy statement.
Liquidity policy statement.
44. Divisions either adopted the Group Risk policy statements or tailored statements to their own requirements, provided that the Group Policy Minimum Standards were observed.
45. I do not have copies of any of these policy statements and regret that I cannot now recall their detailed content nor, indeed, whether the list of policy statements reserved to the Board for approval changed subsequently.
46. During my tenure as Group Risk Director, it became apparent that there was a lack of clarity of responsibility within the “second line” for Capital and Funding related issues and risks. As a result and as set out in the attached extract from the 2005 Report and Accounts (Appendix 1), it was decided that the CFO (Phil Hodkinson at the time) should chair a new Capital Committee together with its sub-committees covering Group Funding & Liquidity, Share Market Activity and Regulatory Capital Adequacy.
“This serves to clarify and reinforce that the prime responsibility, ownership and accountability for managing and controlling all matters relating to funding and capital rests with the Group Finance Director”.(HBOS Annual Report and Accounts 2005- Appendix 1)
(2.) How much interaction did the board have with the risk function? What involvement did it have in determining processes and policies? What challenges were made of risk analyses presented to the board?
47. The Group Risk function attended almost every Board meeting to present an item. In addition to the Group Risk policies mentioned above, which the Board approved, there was a quarterly Credit Trends Risk Report which set out the credit risk performance and trends in each division and highlighted challenges and issues. It would be useful for the Commission to review these papers as they show areas of concern which were brought to the attention of the Board. There were also regular updates on progress on the Basel II project throughout the period.
48. During my time as Group Risk Director, I also ran a series of longer, separate, Board sessions for the Non-Executive Directors to raise awareness and understanding of the principles, implications and “use test” requirements for Basel II approval.
49. From recollection, in my time as a Board Director (March 2006—December 2008), Group Risk continued to submit these regular papers and, as the deadlines approached, the volume of papers and presentations from Group Risk around the Basel II programme also increased. In addition, the divisions, in liaison with Group Risk, submitted reports on key risk management programmes within their divisions such as (i) the “Financial Capability Review” in the Insurance & Investment division (for which I was CEO) referred to earlier; (ii) “Project Dome” in the Retail division which was focussed on improving operational risk controls; and (iii) risk programmes in the Corporate division following the emergence of significant failings in the management of high risk accounts in the Reading office of the Corporate division. However, the Group Audit Committee (and the divisional Risk Control Committees—effectively divisional Audit Committees with both the Chair and membership drawn from non-executive directors) remained the main fora for the discussion of these and other risk management issues.
(3.) Was the quality of management information sufficient to enable the Board to make sound risk judgments?
50. The quality of management information varied considerably between the divisions. It was recognised that there was a lack of reliable management information and data in the Corporate division which impeded progress on Basel II model development, sign-off and ultimate Basel II accreditation. Improving this data was a key priority for the Corporate division during the period 2005–2008 although it is fair to say that progress was slower than desired.
51. The management information shared at Board level was generally high-level summaries, including a monthly Large Exposure report which set out the largest Group counterparties, the high-level pricing terms and risk rating. The CEOs of both the Corporate (Peter Cummings) and International (Colin Matthew) divisions spoke to this report.
52. The Board also received a monthly management information pack (known as the “Blue Book”) which, in addition to setting out financial results and key ratios from the previous month compared with plan figures, also contained a detailed report from each division in which they updated the Board on key priorities and plans and any emerging issues. There was also a Group Risk section which included reports from each of the Group Risk functional areas on both oversight activities and reviews completed in the previous month as well as an update on regulatory issues and recent FSA meetings.
53. Aside from the Group risk policies, there were few specific “risk judgements”, as such, which were put to the Board for approval. From my perspective as CEO of the Insurance & Investment division, I did, for example, seek HBOS Board approval of the Reinsurance strategy, after this had been debated and agreed by the independent Insurance Company Board which I chaired.
54. The Board was not involved in the sanctioning of specific lending decisions; under the federal model, these were the responsibility of the division and the divisional CEO with larger credits approved by credit committees with membership drawn from the Corporate & International divisions. I also understood that both the Chairman and Group CEO had sight of any significant or high-profile cases.
(4.) What was the board’s perception about the risk involved specifically in HBOS’s growth and gain in market share?
55. I can only comment on how I, as a member of the Board from May 2006, perceived the risks involved in the various strategies. The Commission will no doubt seek similar input from other former Directors.
56. Given the mortgage exposure in the Retail division and the commercial property exposure in the Corporate division, I was keen to ensure that external economic consensus on trends in both UK house price inflation and commercial property prices were consistent with the growth plans proposed by the divisions and that the divisions had undertaken appropriate sensitivity analysis in their planning process.
57. On more detailed risk issues implicit in the strategies of other divisions, I took comfort from reassurances provided by the respective divisional CEOs to both the Executive Committee and the Board that their businesses were growing and winning market share within agreed risk parameters and that other competitors were being more aggressive in pricing and terms.
(5.) What formal models were used by the bank to analyse risk? Who was responsible for creating and maintaining those models? What use was made by group risk management and by the board of the results? What kind of stress scenarios were run?
58. I cannot now recall the full detail of the formal risk models used to analyse risk. The focus was on the development and use of the risk models required for Basel II, such as “Probability of Default” and “Loss Given Default”. Given the different businesses and asset classes within each division, it was the divisions who were responsible for the development of appropriate models although these were subject to both support and guidance from the Group Risk function and also review and feedback from the FSA.
59. Looking at each of the key risk areas:
(a.)
(b.)
(c.)
(d.)
(e.)
Regarding stress-tests, these evolved over the period (from 2005–2008) with input from both the FSA and eventually the Bank of England as the global financial crisis deepened. In both Credit and Operational Risk areas, HBOS was very focussed on achieving “Advanced” status under the new Basel II regime and thus a large number of models were developed within the divisions, reviewed by both Group Risk teams and external advisers (and, in some cases, the FSA) and then stress-tested to meet with the Basel II requirements. This was an on-going process during the period 2005–2008 and, whilst hampered by challenges around the quality and availability of data in the Corporate division, the models they developed were the basis on which the FSA granted the Group “Advanced” status under the new Basel II regulations in December 2007.
(f.)
(6.) If, as seems to be the case, the bank became exposed to an excessive level of risk, do you think (applying hindsight if necessary) that that was because there was a decision to take that level of risk or because the true level of risk was not appreciated?
60. Aside from the strategic risks of the specific growth strategies themselves and the detailed credit, market and operational risks outlined above, in my view, the key risk to the HBOS business strategy and growth plans was the ability to fund the balance sheet. A review of the annual Funding Plans presented to the Board will show how these issues were considered.
61. During the period from 2004 to 2007, whilst progress had been made to diversify the sources of wholesale funding (including use of securitisations, covered bonds etc) in order to minimise the risks in the event of dislocation in any particular funding class or market as well as to extend the maturity profile of the Group’s wholesale funding (reducing the risks of reliance on short-term markets and disruptions to short-term markets). However, the progress which had been made was insufficient to cope with the loss of confidence in HBOS (and many other banks globally) as a counterparty that led to a total and extended freeze on virtually all wholesale funding markets in 2008 following the collapse of Lehman’s in the USA.
62. With the benefit of hindsight, it is fair to say that whilst we had appreciated the risks of certain funding markets being closed for a period and had taken steps to diversify funding sources to mitigate this risk, we had not prepared ourselves for a total wholesale market closure for such an extended period of time because these circumstances were not considered at the time to be a possible, let alone probable, scenario—indeed, it was unprecedented in modern times.
(7.) What risk issues did you raise whilst Group Risk Director? What consideration was given to group risk issues by the board? What actions followed? Did you assess the following: asset quality concentration; large exposures; equity participations; treasury assets; liquidity risk?
63. During my period as Group Risk Director, in addition to continuing to build capability within the team and building effective relationships with the divisions, my key areas of focus were (as directed by the Group CEO):
(a.)
(b.)
(c.)
64. I and my team also acted as the key interface with the FSA and I met with the FSA supervision team every two weeks or so to update on progress and get their feedback on issues from around the Group. Without doubt, the key areas of challenge, both from the FSA and from my own Group Risk team, was the quality of Credit Risk Management within the Corporate division—whether in the Large Loan Sanctioning process (which was changed following FSA feedback and implemented during 2005) or the robustness and accuracy of models being developed given the lack of available accurate data.
65. Whilst not established as a priority at the time of my appointment, it is relevant to note that sadly during my time as Group Risk Director, London was subject to the terrorist attacks in the July 2005 bombings. This understandably and appropriately introduced a significant new area of focus and activity around the Group and for the Group Risk team. We worked alongside Government departments, the Bank of England and the FSA to ensure that business continuity and disaster recovery processes and procedures were robust (and adequately tested) to ensure any future attack could not destabilise the financial markets and payments infrastructure in the UK.
66. Whilst progress was made during 2005 on the issues outlined above, as well as in responding to and addressing a significant number of other regulatory developments, I was aware that there are always improvements which can be made to the effectiveness of the risk management framework across the Group. To ensure divisions were focused on improving the effectiveness of risk management, I asked the Group CFO (Phil Hodkinson) to include a planning theme around “risk infrastructure” in the 2006 Group Planning Framework issued around April 2005. This ensured that all divisions and group functions would have to develop and include plans around this theme in their submissions for the 2006 Group Plan.
67. It is important to note that the Group Risk function did not, under the governance framework, have the right of veto on any decision nor was it involved in the sanctioning of any individual credit decision. Risk management was, first and foremost, the responsibility of the divisional CEO. My role as Group Risk Director and that of my team was to challenge and seek to influence the divisions and where any concerns persisted, these were reported in the regular Board reports, Risk Control Committee or Group Audit Committee papers or directly to the CEO.
68. The Group was clearly aware that its strategy, which was built upon perceived sources of competitive advantage, meant the Group was exposed to UK house price inflation/deflation and commercial property prices.
69. At the time, Group Risk had no role in assessing individual Large Exposures, Equity Participations or Treasury Assets. The high level Group Liquidity Policy was developed by Group Risk in liaison with the Treasury division and Group Finance and approved by the Board but its implementation was delegated to the Treasury division.
(8.) How much challenge of the individual divisions were you able to effect and what was the outcome?
70. Given the advisory/oversight role afforded to Group Risk, the ability to challenge individual divisions effectively depended on the quality of relationships between the Group Risk team and the divisional CEOs and their teams. The relationship between Group Risk and the Corporate division (led by George Mitchell until December 2005) was probably the most challenging of these.
71. In my view, significant progress was made on all the areas outlined in question (7) above during my period as Group Risk Director through a combination of effective influence of the relevant divisions and functional leadership provided by the Group Risk team. However, as noted above, it was clear to me that improvements could always be made to the effectiveness of risk management.
(9.) What qualifications did you have for the role of Group Risk Director? Did you feel qualified for the role?
72. I was invited to apply for the new position of Group Risk Director by the then Group CEO (Sir James Crosby). The role (then defined as Executive Director with responsibility for Risk) had previously been carried out by the Group CFO, Mike Ellis, who was retiring. Given the scale of the challenges around Basel II and TCF, the Group CEO had decided to create a new Executive role rather than ask the incoming Group CFO, Mark Tucker, to continue to look after both functions.
73. Egon Zehnder (Executive Search Consultant) was instructed by the Group CEO to assess the internal (of which I was one of four) and external candidates. Whilst the role was a new one, there was an established Group Risk team which was to sit below this new appointment.
74. I was advised that I had been selected based on:
(a.)
(b.)
(c.)
75. In recognition of the fact that I had limited experience of the Corporate and Treasury divisions and risk models, a former risk partner with Ernst & Young (Tim Pagett) was also recruited to work directly for me to support both my learning and also to help drive forward the Basel II programme.
76. Shortly before I took up my duties, one of the former senior managers in the Group Risk function raised a concern with the FSA and Group Audit Committee as to my suitability for the role. The Group Audit Committee commissioned KPMG to conduct an extensive review. The KPMG report confirmed my suitability and was shared with the FSA. Whilst I never saw the report, it was not until it was submitted to the FSA that I received formal approval from them of my new role.
77. The issue was raised again by the individual in a submission to the Treasury Select Committee in February 2009. In response, the FSA issued a statement on 11 February 2009; a copy of which is at Appendix 2.
78. At the time, I believed that, with the support of the former Ernst & Young risk partner and the existing Group Risk team (with authority given to recruit and strengthen the team as necessary), I was capable of doing the role as it was envisaged—one of influence rather than authority.
Board Qualifications
(1.) What qualifications and what information did the board have from which it could judge the risks and challenge risk analyses? To what extent were board members dependent on advice from others?
79. I cannot comment on the individual qualifications of other Board Directors.
80. In relation to the information available to it, as mentioned in previous answers, the Board received regular reports including the high-level Risk Policies for approval, quarterly Credit Trends Report, monthly Large Exposures schedule, monthly “Blue Book” management information pack and oral updates from the Chairman of the Group Audit Committee. A full schedule and copies of Board papers can be obtained from Lloyds Banking Group.
81. More detailed analysis and discussion of risks and controls was undertaken by the divisional RCCs: sub-committees of the Group Audit Committee comprising only Non-Executive Directors) and the Group Audit Committee. The Board also received advice from the Group’s auditors (KPMG) who attended the RCCs and Group Audit Committee and from the FSA which also attended a Board meeting every 18–24 months to report directly on any concerns and priorities and to feedback on where HBOS was in relation to its competitors.
(2.) Do you think (with hindsight) that the board had sufficient qualifications and information to oversee the executives, particularly in the corporate, treasury and international divisions? How did that position differ between the executive and non-executive directors?
82. With hindsight, whilst having a Board with more banking experience and better management information would have been desirable, it would also have been necessary for Board meetings themselves to be longer to allow sufficient time for Directors to challenge management to a much greater degree. From the perspective of the Executive Directors, it is my understanding that under the federal model and Group Operating Philosophy, the Group Executive Committee was an advisory committee whose role was to support the CEO, rather than a decision-making body. As such, authority to challenge individual executive directors in the Executive Committee rested with the CEO rather than other members.
(3.) Was the central challenge and disciplining of divisions effective? How did it operate and was there sufficient expertise outside of the divisions to make it effective?
83. The Group Operating Philosophy and governance structure relied heavily on the individual competence, integrity and openness of the divisional CEOs. Whilst the Group functions, including Group Risk would challenge divisional CEOs, any “disciplining” was to be carried out by the Group CEO and the Group CFO through the quarterly business review sessions held with each of the divisions.
84. With the benefit of hindsight, I now believe that for a federal model to work requires stronger central functions that have both the capability and authority not just to challenge but to “veto or enforce” as necessary. Also, it may be necessary for those central functions to have regular scheduled “private” sessions with the Non-Executive Directors to ensure that they were fully aware of all material issues and concerns.
The Divisions
(1.) As mentioned above, the corporate division was singled out for criticism by the FSA. Do you think that any of the following had a major effect on the problems eventually suffered by the corporate division and by the bank as a whole: (a) the degree of concentration risk in corporate loans (eg in real estate or leveraged loans); (b) the scale of individual large exposures; (c) the proportion of low-rated or unrated exposures; (d) finance provided by way of equity participation; (e) the size of the corporate division relative to the overall balance sheet of the group?
85. With the benefit of reading the Bank of Scotland plc Final Notice, it is difficult not to concur with the FSA’s conclusions that concentration risk, individual large exposures, the proportion of low-rated assets and the “one stop shop” approach (where the Corporate division provided both debt and equity to a single counterparty) ALL contributed to the problems seen in the Corporate division. However, I must emphasise that the FSA had access to a lot of information which I have not previously seen and much of which was not available to the Board whilst I was a director.
86. In respect of the size of the Corporate division balance sheet relative to the whole Group, from recollection, the Corporate division balance sheet represented about a third of total Group assets. I do not consider that this is out of line with what one might expect in a universal bank model. In the latter years (2007–2008) it did, however, become increasingly clear that the Corporate division was struggling to sell down the level of assets it had planned to do with the consequence that net asset growth was higher than desired.
(2.) Was the bank’s approach to corporate lending significantly different from that of its competitors? How? Why?
87. I am not in a position to provide a detailed comparison of the approach of the HBOS Corporate division to that of other lenders. I was aware when I became Group Risk Director in January 2005 that the FSA had expressed concerns around the Large Credit Sanctioning process in the Corporate division which it considered out of line with competitors and best practice. As a result, the Corporate division revised its approach and a new process was implemented in February 2005.
88. The strategy of providing both equity and debt to the same counterparty was uncommon in the marketplace and was frequently quoted by the Corporate division leadership team and, indeed, the Group CEO, as a source of competitive advantage. Whilst I was a Board director, in the period 2006–2008, I took comfort from reassurances provided by the Corporate division CEO, Peter Cummings, to the Board that the division was adopting a cautious approach whereas some other competitors were adopting a far more aggressive and risky approach to the market.
(3.) Large losses were recognised in 2008 in the Treasury and Asset Management Division. When and by whom was the decision made to develop/expand a proprietary risk taking and revenue generating function in treasury, as opposed to liquidity management?
89. I was not aware of, and do not recall the Board approving a strategy to develop/expand the proprietary risk taking and revenue generating function in the Treasury division.
90. Over the years, it had always been stressed that the Treasury division’s key objectives were (a) to fund the Group and manage liquidity on behalf of the Group; and (b) to support the Group’s customers in providing them with Treasury products to meet their business needs; and (c) only then, to undertake a small amount of proprietary trading. The fact that the Group’s average Trading Risk VaR (as mentioned above) was only £6 million a day in 2005 and, I believe, had a daily limit of £20 million, would support the view that this was not an area the Group had, at that time, elected to expand.
91. I understood that the losses in the Treasury division which were recognised during 2008 were the result of “mark to market” adjustments in the assets held in the “funding” portfolio rather than from proprietary trading activity.
(4.) Please explain the strategy which led to the bank building up such a large structured credit/ABS portfolio. Who devised and who approved the strategy? What was their capability/experience in understanding these instruments?
92. I was completely unaware of this strategy until it started to emerge as an issue in 2008 with the concerns around Alt-A securities backed by USA housing assets.
(5.) How was the policy to grow specialised mortgage lending devised and approved?
93. The decision to adopt a multi-brand mortgage strategy allowing the Group to compete in different segments of the mortgage market was taken following the merger with Bank of Scotland. It increased distribution reach and pricing flexibility so the Group could maintain a strong market share but at acceptable overall margins, as mainstream mortgage lending was low margin.
94. The growth in the “buy to let” mortgage market reflected a desire amongst retail customers, off the back of rising UK house price inflation, to invest directly in “bricks and mortar” supported by a strong rental market given the limitations of the UK housing stock. These mortgages were largely distributed via intermediaries who represented 60–70% of all mortgage lending originated by HBOS during the period (both mainstream and specialist).
95. The emergence of “self-certified” mortgages as a customer need reflected the difficulties of many customers who were either self-employed or not in traditional PAYE employment to obtain mortgage finance. These loans were exclusively distributed via intermediaries. Clearly, with the benefit of hindsight, many potential borrowers and intermediaries alike were dishonest about their income levels in their mortgage applications and the banks did not, with the benefit of hindsight, exercise sufficient care in verifying the data provided by customers.
96. Given the overall importance of mortgage lending to both Halifax and subsequently HBOS, from recollection, the mortgage strategy was debated and approved by the Board annually.
(6.) Briefly explain the strategy to grow the international division. With hindsight, can the strategy fairly be criticised as too optimistic given existing competition by local lenders? How much board oversight was there of that division?
97. This was not an area in which I was directly involved. I believe that there was a Board discussion of the decision to develop retail businesses in both Australia (2004) and Ireland (2005) both of which were approved.
98. The Australian retail business was broadly successful in challenging the incumbent banks. It was acquired by Commonwealth Bank of Australia in December 2008.
99. The Irish retail business struggled to make the same progress as had been seen in Australia partly because of a faster competitive response by local banks and partly because of the start of the economic downturn. In my role as Wealth & International Director at Lloyds Banking Group during 2009, I recommended the closure of the Irish retail business which was approved by the Lloyds Banking Group Board.
100. I do not recall specific Board debates around the growth of the corporate lending activities in Ireland and Australia, which were following the approach and focus used in the UK Corporate business and which were, in effect, the lion’s share of both those businesses. Following a visit to Australia in Spring 2005, the FSA raised concerns with both Group Risk and the CEO of the International division about the management stretch and the adequacy of risk management resources in Australia.
101. When I became Wealth & International Director at Lloyds Banking Group following the acquisition of HBOS by Lloyds TSB, my portfolio included the former Bank of Scotland corporate businesses in both Ireland and Australia. In this role and at that time (though not previously when I was a Director on the HBOS Board), I had access to data and information which highlighted significant issues around the quality of the “corporate/commercial” assets in both Australia & Ireland and the need to strengthen risk management capability significantly.
102. Both Ireland and Australia had separate local Boards with independent chairmen and non-executive directors, as required by local laws/regulations and were regulated by both the local regulators as well as by the FSA.
Wholesale Funding
(1.) There was a significant expansion of wholesale funding up to 2008. Please briefly explain how that funding strategy developed from the creation of the bank in 2001 to its merger in 2008.
103. I was not involved in the development or execution of the Group’s funding strategy at any stage. The annual Group Funding Plans approved by Board at the same time as the Group Plan will provide further details of the funding strategy and its evolution over the period 2001–2008.
104. The growth in wholesale funding to support the Retail business was a direct consequence of the UK’s home ownership culture, rising house prices and a low savings ratio. Whilst efforts were made within the Retail business to grow Retail deposits (it had a 13% share), this was clearly insufficient to match-fund its 15%+ share of mortgages. This reflects the structural funding gap in the UK. Indeed, all significant mortgage lenders in the Western world make use of securitisations and covered bonds (or equivalent) to fund their mortgage books.
(2.) What specific consideration was given to the liquidity risks associated with that, including both the size of the wholesale funding and the proportion that was short term? How were those risks monitored/managed?
105. From recollection, these plans considered the likelihood and impact of various scenarios, (such as a one or two-notch downgrade from a ratings agency) or a market-wide event, which could impact on the availability of funding. I do not believe that the total closure of all wholesale markets for such an extended period of time as we saw in 2008–09 was ever seen as a possible (however remote) scenario and was not therefore factored into the contingency plans.
106. As the financial crisis evolved and following the collapse of Northern Rock in August 2007, the level of monitoring and management of day-to-day funding was enhanced with a rolling daily report of daily liquidity requirements for the following 30–60 days provided to both the Executive Committee and the Board and reviewed by the Group Capital & Funding Committee. At the same time, the level of focus in the business divisions on retaining customer deposits (in the context of huge market uncertainty and media concerns around the security of customer deposits) was also increased.
30 October 2012