Parliamentary Commission on Banking StandardsWritten evidence from Mike Ellis

Please respond briefly in writing to the following points and questions, focussing on your own areas of responsibility during the period of your involvement in the management of HBOS. Please identify (and if you have copies of them please produce) any documents relevant to your answers. Please respond as best you can from your present recollection. If there are matters that you cannot speak to, for example because they relate to a period before or after your involvement, please explain why.

I have responded to the questions you have posed to the best of my recollection, knowledge and belief. I have sought to respond as fully as I have been able in the limited time available, in light of existing commitments and given that the questions relate to events which took place a number of years ago. In addition, to the extent possible, I have referred the Commission to documents which will provide a more comprehensive and accurate record of the position at HBOS during the relevant period. Unless stated otherwise, my comments should be taken to relate solely to the periods of my employment with HBOS.

1. Personal

Briefly summarise your role in the management of HBOS, giving the dates when you joined and left.

1.I was the Group Finance Director of HBOS from September 2001 to October 2004, responsible for Group Finance, Group Risk and Internal Audit. The latter part of my role had a direct reporting line to the Group Audit Committee.

2.Responsibility for Group Finance and Group Risk was separated in October 2004 and I handed over responsibility for Group Finance at that time. I handed over responsibility for Group Risk on my retirement from HBOS at the end of 2004.

3.I rejoined HBOS as an Executive Director on 24 September 2007 and in January 2008 I took on the role of Group Finance Director, responsible for Group Finance and Internal Audit (which continued to have a direct reporting line to the Group Audit Committee), until the acquisition of HBOS by the Lloyds Banking Group (LBG) in January 2009.

2. 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? Was a similar strategy pursued across other divisions?

4. I was not employed at HBOS for most of the period covered by the FSA review and I cannot therefore comment on the FSA’s conclusion. However, when I re-joined HBOS towards the end of 2007, we began to rein-in growth ambitions although it was recognised that some business would need to be written.

5. In this regard, it should be noted that the increase in corporate advances in late 2007/early 2008 referred to in the Bank of Scotland Final Notice will also have reflected the completion of business already in the pipeline and difficulties in selling down exposures during that period. In addition, the Group sought to protect some international growth but ultimately this had to be reined-in.

(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?

6. In the early days following the merger of Halifax and Bank of Scotland, there was an emphasis on consummating the merger, delivering the merger synergies and achieving profitable growth in line with the announcement which had been made to shareholders at that time. As a result, growth in profitability throughout this period was driven primarily by the delivery of very significant cost and revenue merger synergies.

7. The planned asset growth across all divisions including Business Banking, Corporate Banking, Insurance & Investment and Retail was in keeping with the rationale for the merger and the delivery of synergies.

8. The primary focus of Treasury was on funding and liquidity but it also managed an asset portfolio to generate additional returns and provide secondary liquidity.

9. By the end of 2004 when I left HBOS, the merger synergies had substantially been delivered and I believe that growth plans were to be moderated.

10. When I returned to HBOS in late September 2007, the annual planning process for 2008 and future years was well underway but it was recognised that the plans would have to change if the global financial crisis persisted. Indeed, this is what happened and subsequently growth ambitions were reined-in.

(3.) Please explain how the growth strategy and targets were devised and developed. What involvement did the board have in those processes?

11. I should emphasise that the business strategy was not all about asset growth and I describe the planning process briefly below.

12. The business planning process was, in many ways, a rolling process with quarterly forecasts for the current year and planning for the next three to five year period, leading to Board approval in November or December.

13. Each business unit/division would produce their plans which would be subject to challenge within the relevant division and, subsequently by Group Functions (mainly by Group Finance but also Group Risk). The main risks would be covered in each business unit/division plan and, in overall terms, within the Group Business Plan.

14. The Group CEO would be involved as he saw fit, sometimes in detailed challenge sessions and, at other times, during one-to-one meetings with divisional CEOs.

15. Various executive committees would review key aspects of the plans eg the capital, funding and liquidity plans would require review and endorsement by the relevant executive committees. Key risks to delivery of the plan were, at various times of the year, presented to divisional risk committees.

16. The Board would debate and, if they saw fit, approve the full Group Business Plan. In addition, the Board would schedule more detailed reviews of business strategy relating to individual businesses throughout the year, giving the Board the opportunity to explore, in more detail, the individual business strategies. Key risk issues were also reported to the Board periodically for a more in-depth review eg funding plans.

(4.) To what extent did the growth strategy have the support of major shareholders or investors in HBOS?

17. The strategy to be pursued by HBOS in the period following the merger was clearly articulated at the time of the merger and executed according to plan. The focus of shareholders was on the delivery of merger synergies, both cost and revenue synergies as well as growth plans and returns on capital. The rationale for the merger and the subsequent delivery of synergies clearly had shareholder support.

18. Generally, the support for the HBOS strategy is evident from the share price performance as well as analysts’ reports and their “buy”, “sell” or “hold” recommendations. It is my view that HBOS always sought to ensure that business strategy and results were presented clearly to shareholders and investors.

(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?

19. As I have stated, the focus of the business plan was not all about asset growth and my comments relate to the general process rather than this growth alone.

20. At an executive level, the challenge process was robust with different views or perspectives being expressed, but, ultimately, a consensus was reached concerning business plans. For example, I recall that there was considerable debate regarding asset growth and how this might be funded from deposits and wholesale funds.

21. The executive and non-executive directors would also challenge any areas of concern but, again, a broad consensus was achieved. As noted above, the Board would review individual business strategies and other strategic issues, including risk issues, more fully at various meetings throughout the year.

(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?

22. Again, the strategy was not all about growth and there were many key priorities and initiatives to be communicated to HBOS employees. It is worth emphasising that the plans originated within the business units/divisions and were owned by them. It was their responsibility for communicating these plans within the business unit/division. I believe that a range of initiatives were communicated within the divisions and briefings would include risk and control issues, as well as other business developments. Performance of a business unit/division would be assessed against the plan, which cascaded down, where appropriate, to assess team or individual performance.

3. Risk Management

(1.) Please briefly describe the processes and policies within the bank for managing risk at a divisional and group level.

23. The Board Control Manual and other corporate governance document will provide a complete and accurate description of the relevant processes and policies. These can be obtained from HBOS/LBG if the Commission has not already obtained them. However, briefly:

24. The Group operated the three lines of defence model.

(a.)The first line was mainly the business units/divisions which were responsible for running the business within acceptable risk parameters, including the divisional risk polices that required approval at Group level.

(b.)The second line comprised Group Functions which provided oversight.

(c.)The third line was Internal Audit and the Group Audit Committee and its divisional risk committees.

25. Within each business unit/division there would also be the equivalent separation of first and second line functions. So, for example, a division would have its own risk function which would be second line within that division, but this would not be viewed as second line for Group purposes.

26. All third line functions were performed solely at Group level.

27. With regard to policies, these existed at divisional and Group level with divisional risk policies also being approved at Group level. I cannot recall the detail of all these policies, which covered such matters as credit, market, funding, liquidity, insurance, regulatory and operational risks, but a full schedule of all policies can be obtained from HBOS/LBG.

28. The structure of the Group executive risk committees changed from time to time but I believe during my first period of employment with HBOS included a Group Credit Committee, Group ALCO, Group Operational Risk Committee and Group Insurance Risk Committee. Generally, these Group executive risk committees were replicated within each division, where appropriate.

29. After I left HBOS in 2004, a Group Capital Committee was formed which covered funding and liquidity, as well as capital. I believe that, at this stage, the Group Market Risk Committee was created to oversee other risk activities previously considered by the Group ALCO which ceased to exist, but this should be confirmed by HBOS/LBG as I was not there at the time.

30. The Group executive risk committees were chaired by the relevant Group Risk Director and included risk representatives from all relevant divisions. The Group Capital Committee was chaired by the Group Finance Director.

31. At an executive/non-executive level, the Board would receive a monthly Management Information Pack (MIP) that included risk metrics, issues and commentary. As noted above, major risk policies and/or issues would be considered separately by the Board eg funding strategy, quarterly credit reports.

32. As part of the third line of defence, the Group Audit Committee established divisional risk committees that comprised independent directors, some of whom may have been main Board directors, some external people and some senior executives from other divisions. These divisional risk committees and the Group Audit Committee provided further oversight of the executive management of risk. Both divisional and Group Risk executives would attend these divisional risk committees.

(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?

33. Generally, the Board agreed the overall risk management framework and key risk policies. Full details are set out in the Board Control Manual and other relevant corporate governance documents.

34. The monthly MIPs included risk metrics and commentary on key risk issues which would be debated by the Board as and when necessary. In addition, separate reports were submitted on key risk issues to facilitate more in-depth debate eg funding and liquidity.

35. Appropriate senior management from Group Risk would attend Board meetings when such specific reports were to be discussed.

36. Following separation of responsibility for Group Finance and Group Risk, the Group Risk Director was a member of the Group Executive Committee and a regular attendee at Board meetings, given the frequency of risk issues on the agenda for discussion.

37. As noted above, both divisional and Group Risk functions attended the divisional risk committees which were sub-committees of the Group Audit Committee. These sub-committees provided for more direct interaction between the executive risk functions and members independent of the division.

(3.) Was the quality of management information sufficient to enable the Board to make sound risk judgments?

38. Yes, broadly speaking, but this is not to say that some improvements were not necessary. HBOS strived for continuous improvement, sometimes at the request of the Board and sometimes driven by the Group Functions’ pursuit of best practice. Where weaknesses in management information were identified, projects or processes were put in place to mitigate such risks, although as recognised in the Bank of Scotland Final Notice more work was being undertaken in this area.

(4.) What was the board’s perception about the risk involved specifically in HBOS’s growth and gain in market share?

39. The Board debated the risks involved in all HBOS’s activities as part of the business planning process and more fully when strategic reviews of specific business areas or risk issues were reviewed in greater detail. The plans were clearly articulated and the Board was fully supportive and aware of the risks involved, including the risks to delivering merger synergies.

40. From memory, market share was discussed in the context of developing business banking (SMEs) and, at times, mortgages and savings given the Group’s market leading position in these particular markets. However, I would not view the development of market share as a driving force elsewhere in the Group during my time with HBOS.

(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?

41. I cannot now recall the detail of all the formal models used by the bank. Full details should be obtained from HBOS/LBG. However, the following are some examples:

(a.)Different credit risk rating models would apply depending on the business of each division.

(b.)Group Risk, ALCO and Treasury would use net interest income (NII) models and value at risk (VAR) models to manage interest rate and market risks.

(c.)The Insurance & Investment division and Group Risk would use more actuarial or solvency based models to manage risk.

(d.) Operational risk models would focus on loss events and near misses.

42. HBOS developed advanced IRB models under Basel II, but this took place mostly during the period I was not employed by HBOS. I believe the governance of such models was under the remit of the Group Capital Committee or a sub-committee/working group of that committee and models developed by divisions would be subject to review by Group Risk.

43. Group Risk also oversaw Group-wide stress testing in accordance with scenarios agreed by the Board. The details of this stress testing will be available in the papers submitted to the Board.

(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?

44. The Board and executive were aware of the risks involved in the business, although it is fair to say that the full extent of the global financial crisis had not been envisaged. Stress tests looked at the serious downside of specific stress events, such as a fall in house prices, stock market crises or a rise in unemployment and Group-wide scenarios which combined stress events. The impacts of different scenarios and stress testing were considered and, I believe, understood by the Board. However, the global financial crisis which unfolded was much worse in terms of scale, depth and duration than the stress scenarios which were used by HBOS as well as those which are likely to have been employed by many other banks and the regulators.

4. 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?

45. Please review Board biographies for details of qualifications and experience of the individual members of the Board.

46. I have commented above on the information provided to the Board and further detail can be obtained from HBOS/LBG.

47. Non-executive board members received advice from the executive. All Board members received external advice if this was considered appropriate or requested. Inevitably, some directors may have required more advice on specific subjects than others but all were capable of forming their own views and judgements. For example, self-evidently, someone with a treasury or insurance background would require less advice in those areas than someone from another background.

48. Arrangements would be made for directors to spend more time with executives, where they required or requested more training.

49. Generally, HBOS would use consultants and advisers in specific areas where they could add value eg business strategy, model developments, mergers & acquisitions.

(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?

50. In relation to periods when I was a Board director, I think the Board had sufficient information and had put in place effective processes to oversee the executives, including the divisional risk committees. There was more banking and insurance experience within the executive than non-executive, as would be expected, given that the executive were responsible for day to day operations.

51. In hindsight, more banking experience among the non-executives may have been beneficial, but this should not detract from the valuable contributions made by all directors.

(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?

52. Generally, in my view, there was sufficient expertise within Group Risk, which was strengthened post merger and by my successors, to provide effective challenge. However, this is not to say that some improvement could not have been made. I think that the Group Functions were in a position to challenge and escalate issues, although it does not follow that their view would necessarily prevail. Naturally, some challenges were resisted as people held different views and I recognise that it could be difficult on occasions. Indeed, it would be unusual if there was no tension between Group Risk and the divisions as this might imply that the relationship was too close.

5. 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?

53. I cannot comment on the data available to the FSA and their analysis of the same but, with the possible exception of (e), all of the above would have had an impact given the scale of the global financial crisis, lack of refinance and collapse in commercial property prices. In my view, the concentration in real estate and proportion of lower grade exposures would probably have had a greater impact in such circumstances.

54. Of the factors listed, I think the relative size of the corporate division was less important than the absolute size of both corporate and the Group’s overall balance sheet.

(2.) Was the bank’s approach to corporate lending significantly different from that of its competitors? How? Why?

55. The corporate banking credit approval process was reviewed in 2004 and my recollection is that changes were made to incorporate a greater role for divisional credit risk management and a credit risk committee within corporate.

56. There was a higher exposure to real estate, possibly because historically the Bank of Scotland did not have an extensive network south of the border and required the additional security of property.

57. Another point of difference was that the Bank of Scotland prided itself on being a “through the cycle lender”, working closely with its clients during more difficult economic circumstances.

58. HBOS also operated an integrated finance proposition and entered into joint ventures, which were propositions that were not offered by all banks.

(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?

59. While Treasury was a separate business and reported as such from inception, its primary role was to provide funding and liquidity—not proprietary risk taking. The cost of funding and liquidity activities was effectively covered by transfer pricing arrangements.

60. Treasury also managed an asset portfolio to earn additional returns and provide secondary liquidity. The decision to develop an asset portfolio may pre-date the merger (since I believe that the Treasury divisions of Halifax and Bank of Scotland both managed asset portfolios) but would have been approved following the merger by the relevant executive committees and included within the business plans approved by the Board.

61. The annual plans for Treasury were agreed, as was the case with all business units, as part of the Group Business Plan. Treasury also played a key role in the Group’s overall funding and liquidity plans.

62. There were limits, controls and policies in place and oversight by Group Risk and executive committees. The Treasury Risk Committee (a sub-committee of the Group Audit Committee) would also monitor performance risk and controls. Full details of these limits, controls and policies will be set out in the Board Control Manual, corporate governance documents and Treasury/Risk policies that should be available from HBOS/LBG.

63. In terms of losses, it is necessary to distinguish between negative fair value adjustments (which could reverse substantially if securities were held to maturity), from credit impairment on some banking and other debt instruments. I do not have any figures to hand to undertake this analysis but further detail should be available from HBOS/LBG.

64. I believe that following the onset of the global financial crisis, Treasury was no longer growing but continued to provide funding and liquidity.

(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?

65. Please see answer to question 5(3) above. The strategy would have been planned and proposed by Treasury, reviewed and challenged at Group Risk level and by the relevant executive committees and approved at Board level as part of the annual planning process.

66. The focus was on AAA credits that also provided secondary liquidity, as well as investments in similar securities that could provide a positive return. Treasury had considerable experience in ABS, both as an issuer and an investor. Even in late 2008, over 90% of the ABS portfolio would have been single A or better, with approximately 84% still rated AAA.1

(5.) How was the policy to grow specialised mortgage lending devised and approved?

67. I believe that the strategy for specialised mortgage lending pre-dates the merger between Halifax and Bank of Scotland but would have been further developed by the relevant committees following the merger.

68. The strategy for the merged group would have been developed and reviewed within the retail division, challenged and reviewed by both the retail and Group Credit Risk functions, and approved by the executive retail Board, relevant executive retail and Group Risk committees in the context of the overall Group Credit Policy.

69. Specialised mortgage lending would have been included within the Business Plans approved by the Board, and was reported regularly to the Board as part of the MIP or quarterly credit reports and to committees including the retail risk committee (which was a sub-committee of the Group Audit Committee) and Group Credit Risk Committee. The Board would also review mortgage strategy, including specialised lending, as part of its business strategy review process. Please see relevant documentation that will be held by HBOS/LBG.

(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?

70. The major development of the International division’s strategy (except for acquiring the minority interests in BankWest) took place while I was not employed by HBOS.

71. On my return to HBOS in late 2007, the Group sought to protect international growth given the importance of the strategy, but ultimately the plans were reined-in prior to disposal of some of the operations.

72. As with other divisions, the Board reviewed the International division’s Business Plans and there was a separate International Risk Committee (as a sub-committee of the Group Audit Committee).

(7.) What degree of central challenge was there of divisions, particularly corporate? What was the board’s risk management process in relation to asset quality and liquidity?

73. Please see responses to earlier questions. In my view and based on my own experience, there was appropriate challenge. At times, there was tension over different matters in each division, but ultimately decisions were taken based on full knowledge, discussion, consideration and judgement of the facts and likely outcomes.

74. The Group’s Funding and Liquidity policies and plans and Group Credit policies set out the relevant Board approvals, delegations and processes. The Commission should obtain copies of these documents from HBOS/LBG.

(8.) What degree of central challenge was there of the corporate division’s risk management process. How often were corporate loan applications rejected?

75. With regard to challenge of processes, please see earlier responses. Please also see the corporate credit policy and approval process that should be available from HBOS/LBG. These documents set out the various approval limits and authorities required.

76. Credit approval on an individual transaction basis was generally dealt with at divisional level up to specified limits; additional senior management approval was required for transactions exceeding these specified limits. Therefore, I am not able to say how often corporate credits were declined and/or amended by the relevant authorisers at different levels of the organisation.

77. Group Risk and the Group Credit Committee provided oversight on corporate credit risks as was the case for other divisions. Group Credit Risk and the Group Credit Committee were involved in setting group standards and policy, monitoring performance and overseeing the process.

6. 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.

78. During my first period of employment at HBOS, the funding plans were subject to significant review to reduce the proportions of short-term wholesale funds in favour of longer term wholesale funds in order to secure a firmer funding base, although it was recognised that this involved additional costs. The UK covered bond market was evolving at this time and enabled HBOS to extend wholesale funding maturities, as did the broader securitisation market where HBOS developed considerable expertise. A diversified funding strategy was adopted to avoid placing too much reliance on any single funding source. At the same time, all divisions were required to build a stable deposit base.

79. When I returned to HBOS in late 2007, as a result of the global financial crisis the wholesale markets were not operating effectively, (apart from a few windows in late 2007/early 2008 which allowed some term issuance). This meant that asset growth had to be constrained and greater priority was given to the depositor base.

(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?

80. The Group’s Liquidity Policy (available from HBOS/LBG) will explain in detail the link between funding strategy and liquidity and how these were monitored.

81. In my view, full consideration was given to liquidity risks as was reflected in HBOS’s relatively high proportion of long-term to short-term wholesale funding. Liquidity requirements were driven by both the nature of the deposit base and maturing wholesale funds, plus known lending commitments. Specific limits/ratios were set and monitored by Group Risk and the Group Funding and Liquidity Committee (please see relevant policies).

82. Funding and liquidity was covered in the monthly Board MIP and reviewed regularly by the Board.

2 November 2012