Parliamentary Commission on Banking StandardsWritten evidence from Sir Charles Dunstone

I am writing to respond to the questions contained in the appendix to your letter of 9 October 2012. I have not been provided with any documents (save for having read the FSA Final Notice) and my responses are to the best of my recollection; please note it is now some years since the events in question.

1. Personal

I was recruited in 1999 as a non-executive director to the Board initially of Halifax, and later HBOS following the merger in 2001, by Dennis Stevenson and James Crosby. They were attempting to modernise the service and experience for our retail customers and to make high street banking much more approachable and straightforward. They felt that my experience of building up Carphone Warehouse would give useful insight into providing an advice-led and service intensive retail proposition.

I was very clear with both Dennis and James that I was not experienced in the financial services market and that much of the bank’s activities would be completely new to me.

I became a member, and then Chairman of the Retail Risk Control Committee in 2001 and worked closely with the retail banking team for my entire tenure. I found them to be a professional, open and honest team with extremely good knowledge particularly of the mortgage market place. I have not been surprised to learn that even since the merger with Lloyds, the retail bank has continued to perform strongly. I have however been surprised by some of the revelations about other parts of the bank, particularly the Corporate division and, with the benefit of hindsight, have to conclude that perhaps the levels of rigour, experience and professionalism I found in the retail division were not as strong elsewhere.

I retired from the Board in April 2008. Having served for nearly nine years, the Chairman and I agreed it was good corporate governance to stand down at this time.

I have tried to answer the questions as comprehensively as possible, but without access to papers it is all from memory and many of the events were a long time ago.

2. Growth of Business

(1) Before the merger in 2001, Halifax had an extensive retail business which had grown in the years pre-merger but did very little corporate banking. Bank of Scotland on the other hand had a well established corporate banking business. The merger of Halifax and the Bank of Scotland enabled the Corporate division of the merged group to use the stronger, combined balance sheet to grow its corporate business in a way which had not been possible pre-merger. This was one of the synergies of the merged group.

It is correct to say the Corporate division did grow strongly. The strategy was not to the best of my recollection simply to increase market share but to allocate funds to get the best return for shareholders—to do the best with what was available to the Group. This was part of a wider strategy or goal of making the best use of available funding, writing/doing sensible business, strengthening the balance sheet and meeting the expectations of the financial markets. Furthermore, as the smallest of the five big banks (post merger) we knew we could not compete with their balance sheets. The business tried to get a sensible balance between sustainable growth and the obvious synergies that were created by the merger. As such, as far as I recall, there was not obviously an “aggressive” growth strategy within the Corporate division.

We were aware of the high concentration of commercial property lending but my recollection is that it was not lending for the purposes of highly speculative property development but was predominantly funding of occupied premises. It was the collapse of the wholesale funding market which had the effect of firstly removing the critical source of funding upon which the Group was heavily dependent (as were all other financial institutions), and which then also caused the commercial property market to lose value and in many cases become distressed because of lack of liquidity. The collapse of the wholesale funding market was not foreseen by HBOS nor by the industry generally, the Bank of England or the FSA.

With the benefit of hindsight, it now appears that the Corporate division did engage in lending which involved a mix of high concentration in real estate or leveraged loans, individual large exposures, equity participation and lower rated exposures. Whilst I was aware of the concentration in commercial property and of certain equity participation transactions, I do not recall being aware of the vulnerability of these loans to a collapse of banking liquidity and a severe economic downturn.

(2.) See 2(1) above in relation to the Corporate Division. As to the Retail division, its growth ambitions were measured and modest. Indeed the Retail division faced sharp investor criticism for reducing our market share targets in mortgages when we felt the market was becoming overheated. Prior to the merger our policy was not specifically growth-led, but was designed to make banking more accessible, with longer opening hours, open plan branches and a range of good value, easy to understand products. We created new brands for modern customers with Intelligent Finance and its offset model and *** to bring online competition to the insurance market place.

Treasury grew insofar as it was needed to help fund the other divisions.

In relation to the International division, there was a desire to move away from the dependence upon the UK market which was perceived as being more competitive than Australia and Ireland. We had inherited businesses in both of those markets in the merger with Bank of Scotland. The Banking environments in both Australia and Ireland were viewed as providing good potential for a new entrant such as HBOS.

(3.) Growth strategies were devised at the divisional level and by the Executive team around the practicalities of the business the Bank could process and manage, combined with our ability to fund these plans. This was part of the Business Plan and annual budgeting process. In addition, each division would present to the Board at least once a year on its progress, ambitions, aims, market environment, the challenges it faced, etc.

The Business Plans were devised and presented by the Executive team and approved by the Board after robust debate and scrutiny. The Board also approved the annual budgets presented by management which included the allocation of funding. Compensation incentives were also devised to ensure the executive team was rewarded for long term performance rather than exceeding short term targets.

(4.) To the best of my knowledge, its strategy had the full support of the shareholders.

(5.) Yes, the non-executive directors challenged the Executive team most often on the ability of the organisation to effectively manage the growth of transactions, particularly in the Retail division.

(6.) I was not close to this.

3. Risk Management

(1.) There was an overall risk framework which was annually approved by the Board. There were Risk Control Committees for each division of the Bank as well as a Group Risk function. I was chairman of the Retail Division Risk Control Committee. To the best of my recollection, this committee also included Peter Cummings, an executive director from another division, Kate Nealon (another non executive director), an independent member (in our case, John Ormerod, former senior partner of Arthur Andersen), Oliver Poole, previously a senior officer of the FSA, Retail division operational risk representatives, executives from the division, either the Group Risk Director or a member of his team, representatives of the Retail risk department, internal audit and the external auditors. From time to time, Tony Hobson, the Chairman of the Audit Committee, would also attend. The Committee would meet quarterly and its minutes were made available to the Board as well as the Audit Committee. We considered how the business was conducting itself operationally from a risk perspective, carrying out constant stress testing etc.

The assessment of the risks of increasing the size of the loan book/credit appetite was separately a matter for the Credit Committee. This process also fed into the annual Business Plan process mentioned above. The annual Business Plan included plans and targets for each division. There was a Group Director of Risk who reported to the Group Finance Director. He also had a team under him. A Group Risk Report was included in the board packs for each Board meeting, of which I recall about 10 took place per year.

(2.) The divisional Risk Control Committees regularly reported to the Board and the Audit Committee and processes and policies were company-wide and well understood.

(3.) I believe the quality of management information was very good. In addition, the culture of the organisation was very transparent and open, and in particular in my role on the Retail Risk Control Committee, I never felt that facts or bad news were being kept from me.

(4.) As I have previously mentioned, the strategy or goal was making the best use of available funding, writing/doing sensible business, strengthening the balance sheet and meeting the expectations of the financial markets. We did in fact seek to reduce market share in Retail on certain occasions. The Board was also focused on the ability of the organisation to manage the integration post-merger, whilst balancing business levels and funding.

(5.) We regularly ran stress tests based on a wide variety of internal and external factors. These were all shared with the Regulator. There were countless models used for which, without reference to past paperwork, I could not give a detailed list of the relevant factors but they included major falls in the property market, very high inflation, and significantly increased levels of unemployment. In addition we looked at exceptional risks such as the impact of a bird flu epidemic. In the Retail Risk Control Committee, we had representatives from Group Risk who were running stress tests as well as those run by management and the Retail Risk team. In this particular committee, the stress tests were largely focused on our customers’ ability to maintain their loan repayments in a severely deteriorating economic environment. I had great confidence that the correct stress tests were being undertaken, that they were properly understood and that we operated with a very safe and wide margin above the results. The problems that the bank subsequently faced were caused by the collapse of the wholesale funding markets. Collapse of the wholesale funding markets was not modelled in so far as I recall.

(6.) Applying hindsight, the answer is the latter; the risk of the collapse of the wholesale funding market was certainly not appreciated nor predicted.

(7.) The approval was given by the Credit Committee to the Retail division who then decided how to optimise the marketing and pricing of it. The attraction was that it was the fastest growing segment of the market, with higher margins and our experience on collections was very good. The specialist lending tended to be managed by separate brands such as Birmingham Midshires, whose team was left largely intact after the takeover and was perceived to have specialist skills in these areas. Their performance was closely monitored and they were allowed to grow if the credit and risk results remained positive.

(8.) I became aware of PPI as a product as soon as I joined the Retail Risk Control Committee. The view of the Bank was that it was a fair and useful product. So far as I recall, the reported instances of mis-selling were rare and it did not generate a meaningful level of complaints about it. I subsequently instigated the process described at 3(9) below.

(9.) From memory, I would guess in around 2005 I instigated a policy/process whereby we studied all new products in the Retail Risk Control Committee before launch to make sure that we were comfortable with the proposition, selling strategy, process for delivering the product and that they offered good value and met the FSA’s requirement of ‘treating customers fairly’.

4. Board Qualifications

(1.) There was a large Board from a background of mainly financial institutions, many with international experience. For example, the executive directors were often career financiers such as James Crosby and Michael Ellis and a number of the non-executives also had extensive financial services experience. When the risk framework procedures were presented every year, the board robustly challenged management plans and assumptions.

(2.) I do, the list of Board members is a matter of public record.

(3.) There were very regular board presentations from every division. In addition we had the Risk Control Committees which themselves reported to the Board. In addition, beyond the main Board non-executive directors, we also had external members of the Risk Control Committees on the Retail Risk Control committee.

5. The Divisions

(1.) With the benefit of hindsight, I think it is fair to assume that the following factors proved problematic: (a) concentration risk in corporate loans (real estate and 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. HBOS was seen as the Bank for entrepreneurs. Therefore we were led into areas of business in which our clients wanted to participate. We used equity participation to improve margins in the increasingly competitive corporate market place. My understanding was that this type of loan and focus on particular segments had always been the operating model of the Bank of Scotland and that they were expected to continue to operate in the same manner post the merger.

(2.) The bank had a smaller balance sheet than rivals and had built its niche by supporting entrepreneurially-led organisations.

(3.) I had left by April 2008 and I am not aware of the details; the primary responsibility of Treasury was always to manage funding.

(4.) To the best of my recollection, I was unaware that it had built up large portfolio.

(5) Please see the answer to section 3 answer (7).

(6.) See my comments on this at 2(2) above.

6. Wholesale Funding

(1.) The aim of the Board was to take a balanced approach to funding from both shareholders, deposits and the wholesale markets. The merged organisation had a big dependency on wholesale funding, We paid special attention in trying to ensure we had long dated credit instruments and good relationships with a wide source of funders.

(2.) The Bank worked hard to mitigate its risks in three ways that I remember, a real focus on improving the length of maturity on our wholesale loans, a very unpopular Halifax rights issue in around 2001 (I cannot remember the exact date), which demonstrated that the capital markets would be very disapproving of another capital raising, and a big focus on growing retail and commercial deposits. We had Treasury reports every month and it was monitored closely.

30 October 2012