Parliamentary Commission on Banking StandardsWritten evidence from Peter Hickman
The responses below outline the position to the best of my recollection, given the limited time available to prepare these responses and the lack of access to relevant documentation following my departure from Lloyds in January 2009. A more comprehensive and accurate record of the relevant policies and procedures, including the Group strategy planning process, implementation and subsequent monitoring, can be obtained by the Commission from the Lloyds Banking Group.
Personal
Briefly summarise your role in the management of HBOS, giving the dates when you joined and left.
1. I joined HBOS in November 2004 as “Director, Group Finance”. In this role, I had responsibility for the Group’s central accounting, financial and regulatory reporting, tax and financial systems and reported to the Group Finance Director. Around 2006, I assumed responsibility for the performance and planning team in addition to my other responsibilities. This small team supported the Group CEO and the Group Finance Director in developing the Bank’s annual plan and budget.
2. With effect from 1 September 2007, I became Group Risk Director and I joined the Group’s Executive Committee and reported to Andy Hornby, the Group CEO. I was not a main Board director of HBOS at any point.
3. I left HBOS in January 2009.
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. Given the nature of my role before September 2007, I do not consider that I am in a position to comment on the FSA’s conclusions in respect of the period before I became Group Risk Director or the development of the risk framework until that time.
5. So far as the period after September 2007 is concerned, I generally believe that the FSA’s conclusions are influenced by hindsight and some of the criticisms do not fully reflect the practicalities of responding to this time of extreme stress and market disruption. In particular, I believe that the criticisms which are made in the FSA Final Notice focusing on Group Risk as failing to reduce lending by the Corporate division do not properly take into account the steps being taken by the Group at that time. Clear targets had been set by the Group Finance Director in Autumn 2007 which required the Corporate division to reduce substantially its new lending. These were overseen by the Group Capital Committee (see paragraph 14 below) and I believe there was regular reporting on the Bank’s balance sheet and funding position by the Group Finance Director to the Board. Most divisions met these targets although Corporate exceeded them for several months. However, there were very real concerns that if the Bank, including the Corporate division, was seen to have ceased to lend in a dramatic way this could have triggered a loss of confidence in the Bank at a time when customers and the markets were speculating on the Bank’s funding position. Indeed, these concerns were borne out in March 2008, when a direct instruction by a senior banker to a group of Corporate bankers to stop new lending was reported the next day in the Scottish press and may have precipitated the potentially catastrophic fall in the HBOS share price that occurred the next day. The damage from that fall was only contained when the FSA issued an assurance as to the Bank’s health otherwise it may have caused the Bank to fail that day. Therefore, whilst with hindsight, sharper reductions in lending by the Corporate division look to have been appropriate, at the time, given the targets set by the Group Finance Director, overseen by the Group Capital Committee and the market nervousness, the position, in my view, was more complex than described in the FSA’s Final Notice.
(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. Given the nature of my role before September 2007 and my non membership of the Executive Committee or the Board, I had only a partial perspective on the development of the Bank’s strategy and then only from the very end of 2004 when I joined the Bank. However, from my role I was aware that there was sensitivity to the Bank’s unusually high dependence on wholesale markets for funding and an ambition to grow revenue whilst controlling overall balance sheet growth. This led to the Bank encouraging all divisions to develop non interest income streams and grow deposits rather than simply depending on lending growth. The rate of lending growth in the period from the end of 2004 to 2007 was lower than in the years immediately following the merger and, in fact, I do not believe the overall rate was particularly high when compared to other banks during those years. In addition, as part of the Bank’s planning processes, considerable work was done analysing the Bank’s funding sources to ensure that the balance sheet growth was consistent with expected availability of longer term funding and deposits.
7. During my time as Group Risk Director, given the market conditions, the focus was not on growth but on seeking to control the balance sheet albeit whilst avoiding adverse market reaction and, during the earlier months of the crisis, trying to sustain the Bank’s franchise and maintain some lending to customers. However, during the crisis, the repayments of loans across the divisions reduced sharply as did the ability to sell down debt into the market whilst customers also drew down on existing facilities. Therefore, despite a sharp fall in new lending, controlling the overall balance sheet was much harder.
(3.) Please explain how the growth strategy and targets were devised and developed. What involvement did the board have in those processes?
8. I will comment on this primarily from my perspective as Director, Group Finance from the end of 2004 to September 2007. The Bank had an intensive annual planning process whereby, within overall parameters set by the Group, the divisions would develop their plans. These plans were then discussed with the Group CEO and/or the Group Finance Director. In parallel with those plans, the Group Finance team would assess the capital consequences of the plan and the Treasury division would assess the funding consequences and availability and produce a Group Funding Plan. The final plans were then debated by the Executive Committee at an off-site meeting before being presented to the Board for approval.
(4.) To what extent did the growth strategy have the support of major shareholders or investors in HBOS?
9. I do not consider that I am in a position to comment on the extent of major shareholder and investor support for the growth strategy.
(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?
10. On the basis of those Board meetings which I attended and other discussions, I was not aware of any contrary views being expressed.
(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?
11. The strategy of growth applied most strongly during the period before I joined the Bank and to a lesser extent whilst I was Director, Group Finance. Given the nature of my responsibilities, I am not able to comment on the communication of the growth strategy to more junior staff involved in lending. In terms of my own team, being responsible for areas such as taxation and elements of the Bank’s capital management, the strategy was typically communicated to my team as part of the Bank’s annual planning process. All staff would also receive regular information through the Bank’s intranet site.
Risk Management
(1.) Please briefly describe the processes and policies within the bank for managing risk at a divisional and group level.
12. I currently have no access to any documentation on the risk policies, limits or processes at HBOS during my time as Group Risk Director nor have I had any for nearly four years. The risk management even at Group level covered a wide array of risks including operational, insurance, credit, liquidity, market, foreign currency, interest rate risk and the prevention of financial crime. The Commission should obtain copies of the various policy documents and risk reports from that period in order to obtain an accurate and complete picture.
13. I will briefly describe the management of liquidity risk for the Group and credit risk in Corporate, being the two risk areas that have come under most scrutiny since thecrisis.
14. Taking liquidity risk first. The Bank, being aware that it structurally had a significant dependence on wholesale markets, had established a policy framework, approved by the Board, which was substantially more conservative than that required by the FSA. Whilst I was Group Risk Director, the Bank’s liquidity position was overseen by the Group’s Funding and Liability Committee reporting to the Group Capital Committee chaired by the Group Finance Director and attended by the divisional Chief Executives and myself. Most significantly, at the time, the FSA’s Sterling Stock Liquidity Policy required banks to hold five days’ liquidity to meet expected outflows during a period of actual or perceived problems with the bank. HBOS, had set a limit that, in broad terms, required it to hold liquid assets which were sufficient to meet one month’s expected outflows for all currencies. This meant that the Bank held a much larger liquidity portfolio than the regulations required and led it to avoid reliance on very short term wholesale funding of less than one month’s duration.
15. Turning to credit risk, generally the Bank operated a three lines of defence model for risk management:
(a.)
(b.)
(c.)
16. This meant that the divisions, including Corporate, were primarily responsible for identifying and managing risks supported by their own sizeable and very experienced risk functions, credit risk committees and credit sanctioning processes. For Corporate, those credit sanctioning processes set clear authority levels for loan approvals. Above a certain level of exposure for an individual loan commitment, a second Board Director had to approve the loan but below that level the approvals could be given from within the Corporate division.
17. The Group Risk function had no authority to approve individual loans but it did set a series of limits for Corporate and other divisions to operate within. These limits covered, inter alia, products, industrial sectors, and country limits. In addition, Group Credit Risk conducted selective reviews of portfolios and reported on credit quality and processes. During my time as Group Risk Director I worked with the Corporate division to implement portfolio management which was designed to introduce tighter limits by portfolio that would be more responsive to economic or market conditions. For each of the major risk classes there were Group Risk Committees that set policy and limits. These comprised the most experienced members of the divisional and Group Risk functions.
(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?
18. As Group Risk Director, I presented to the Board on a quarterly basis. In addition, I attended most Audit Committee meetings where audit and control issues would also be discussed. In general, the Board delegated the determination of the risk processes and policies but would formally approve the key risk policies. The debate when I attended Board meetings tended to be about the extent of the risk within the Group’s portfolio and portfolio performance rather than policy issues. At Audit Committee, the discussions would cover the effectiveness of the controls and progress in remedying weaknesses identified. For example, my predecessor and I provided regular updates to the Audit Committee on the |Bank’s preparedness for Basel II and the status of the improvements that were required. These included regular comments on the status within the Corporate division where the programme was most challenging and the required improvements greatest.
19. In addition, each division had a divisional Risk Committee, which I believe was chaired by a Board member and reported to the Audit Committee. The role of the divisional Risk Committee was to obtain assurance about the internal controls and risk management framework within the divisions. The Chief Executive of the division would attend those meetings as typically would the head of risk for the relevant division, and representatives of Internal Audit and Group Risk. These meetings provided the opportunity for the Board member to gain a more detailed understanding of the risks and risk management within the divisions. The relevant Board member would then update the Audit Committee on the discussions at their divisional Risk Committee.
(3.) Was the quality of management information sufficient to enable the Board to make sound risk judgments?
20. Until the second half of 2008, I do not recall having any general concerns about the quality of the management information which was provided to the Board although clearly there were significant stresses on the traditional metrics throughout my time in the role as Group Risk Director. However, from that point, the economic environment deteriorated rapidly and the losses from the Corporate portfolio escalated well beyond those previously predicted. In addition, the pace of economic decline and the number of exposures becoming impaired meant that the Corporate division provided less visibility on the likely losses than it had during normal conditions.
(4.) What was the board’s perception about the risk involved specifically in HBOS’s growth and gain in market share?
21. As described above, during my time with the Bank, there was considerable focus on the Bank’s funding sources and a strategy to seek revenue growth whilst controlling balance sheet growth. As far as I am aware, there was no disagreement with the Bank’s approach or about the risks that the Bank was taking.
(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?
22. During the years leading up to December 2007, a very substantial investment was made in formalising risk models in order to be able to use those models to calculate the Bank’s capital requirements for credit and operational risk under Basel II. In this regard, this was less of a challenge for the Retail division which had several decades of data on its portfolio’s performance and which had traditionally used models extensively to make business decisions. The Corporate division had a more fundamental challenge as its lending had historically been based on assessment of the loan relationship by experienced lenders and credit committees rather than statistical modelling of the portfolio. Moving to Basel II required Corporate to carry out considerable work on its models, data and processes. Those models were developed by the divisional risk teams but had to undergo a formal approval process by the Group Credit Risk Committees and intense scrutiny by the FSA before they could be used for capital purposes. These models were then used for calculating the Bank’s capital requirements for these risks from 1 January 2008 onwards.
23. The Bank ran regular stress tests based on a macro economic stress scenario set by Group Risk and agreed with the Board. The divisions then used these macro economic inputs to calculate the likely impact on their profitability and capital. The outcome from these stress tests were then discussed with Group Risk and reported 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?
24. The Bank chose certain businesses which were known to be higher risk but where the Bank believed that the returns, even once adjusted for expected losses, justified the risk. Examples include the Integrated Finance business (which took equity stakes and lent money to leveraged businesses) or buy to let mortgages.
25. However, the losses which were sustained in the Corporate division in the second half of 2008 were substantially higher than those indicated by the stress test scenarios. The financial crisis was different in nature to the scenarios which had been modelled and was exceptional in impact especially on businesses such as leveraged buy outs and commercial real estate to which Corporate was exposed. However, even taking this into account, with the benefit of hindsight given the level of losses suffered compared to those modelled in the stress tests, I think it is fair to say that the true level of risk in certain businesses in the event of a serious crisis was not fully understood.
(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?
26. Two weeks after I became Group Risk Director, Northern Rock was required to seek liquidity support from the Bank of England. Thereafter, conditions were very difficult indeed, initially for funding and treasury assets then later for credit. Whilst I was Group Risk Director, risk limits were steadily reduced, early in the crisis targets for balance sheet size requiring reduced lending were set by the Group Finance Director in consultation with me and portfolio risk management for Corporate implemented. The portfolio risk management approach that was developed with Corporate risk was designed to provide more effective control of asset concentrations in that it was responsive to market conditions. These portfolio management approaches reinforced and supported further reductions in risk within Corporate from March 2008 onwards. The large exposures and equity participations were discussed at Group Risk Committees and during the crisis additional controls were established.
27. The Treasury assets were already of significant concern when I became Group Risk Director as the market for higher risk asset backed securities became wholly illiquid very early in the crisis. I do not believe that any meaningful additional purchases of higher risk assets were made. These assets were subject to frequent and extensive review during the financial crisis. However, with the markets effectively shut for the higher risk assets, there were no realistic options to reduce the risk and, in reality, there was no choice but to hold them and look for ways in which to use them as collateral for securing funding.
28. Liquidity risk was also an area of intense concern from when I took over as Group Risk Director as the funding markets had already become dysfunctional. Throughout my time as Group Risk Director, given the stress the Bank was under, this was subject to daily scrutiny and reporting and regular discussion amongst the Executive team.
29. These issues were discussed extensively within the Executive team and in the various risk committees which I chaired.
(8.) How much challenge of the individual divisions were you able to effect and what was the outcome?
30. Group Risk played no part in sanctioning individual loan decisions. Other than those individual loan decisions, I believe that whilst I was Group Risk Director I was able to provide appropriate input to the Bank’s business decisions. During much of this period the Bank was under extreme stress and the main focus was to take decisions which we, as a team, believed would best help the Bank to manage its way through the crisis.
(9.) What qualifications did you have for the role of Group Risk Director? Did you feel qualified for the role?
31. Prior to joining HBOS, I had been an audit and consulting partner at Ernst & Young specialising in banking for 19 years. As a result, I consider that I had a good understanding of operational risk, market and currency risk and valuation modelling of assets as well as having had some experience of credit risk issues. Further, my role as Director, Group Finance had provided insight on interest and liquidity risk through my role on the Group Market Risk Committee.
32. The Group Risk Director role had a very broad remit as set out in paragraphs 12 to 17 above. As a result, I considered that I was qualified for the role of Group Risk Director albeit inevitably with significantly more experience in some areas than others. To the extent that there were any areas with which I was not fully familiar, I was expected and able to draw on the experience and expertise of others in support. This support was strengthened when Tim Thompson joined the bank from Barclays in early 2008, bringing a fresh and experienced perspective on corporate credit risk. He was recruited in 2007, by my predecessor, to oversee the implementation of portfolio management and then I appointed him as head of Group Credit shortly after he joined given the particular challenges we were facing.
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?
33. The members of the Executive team had considerable, and overlapping, experience. Both Peter Cummings and Colin Matthew each had extensive business and corporate lending experience and Colin Matthew had previously been responsible for the Treasury function. Dan Watkins and Jo Dawson had previously been Group Risk Directors and both had extensive experience in retail banking and Andy Hornby, the Group CEO, had run the retail business. Mike Ellis had many years of experience in the Halifax and previously had responsibility for Group Risk when it had reported to the Group Finance Director.
34. So far as the Board’s qualifications are concerned, with the benefit of hindsight, whilst they had wide ranging business experience, it appears that there was a lack of banking experience amongst the non-executive directors. The non-executives were, therefore, dependent on the advice of others particularly the Executive directors.
35. The information which was available to the Board is available in the board packs which were prepared for each Board meeting.
(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?
36. See paragraphs 33 to 35 above.
(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?
37. As this question is asked under “Board Qualifications” I will attempt to answer it in the context of the Board’s challenge and disciplining. In my view, the divisional Risk Committees provided an effective opportunity for the Board to discuss and influence divisional risk decisions.
38. Further, the annual planning process provided an opportunity for both the Group CEO and Group Finance Director, who were not aligned with any division, to challenge the various divisional plans.
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?
39. With the benefit of hindsight, I believe it is reasonable to conclude that the degree of concentration of the Corporate portfolio including to commercial real estate, the scale of individual large exposures, the proportion of low rated or unrated exposures and finance which was provided by way of equity participation all contributed to the substantial losses which were suffered during the crisis. However, in my view, the size of the Corporate division was not out of line as a proportion of the Bank’s balance sheet when the Bank is compared to its competitors.
(2.) Was the bank’s approach to corporate lending significantly different from that of its competitors? How? Why?
40. The Bank’s approach differed in a number of respects to the approach of its competitors. I would point to the following:
(a.)
(b.)
(c.)
(d.)
(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?
41. During my time as Group Risk Director from September 2007, the focus was on using the Bank’s portfolio to secure funding not to generate revenue nor do I believe there were any meaningful additions to proprietary portfolios during this time. Any discussion or decision to “develop/expand a proprietary risk taking and revenue generating function in treasury” was taken prior to that time and I am not able to comment on them.
(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?
42. See paragraph 41 above. I do not consider that I am in a position to comment on the strategy which led to the Bank building up the structured credit/ABS portfolio. This portfolio had been acquired by the time I became Group Risk Director.
(5.) How was the policy to grow specialised mortgage lending devised and approved?
43. The policy to grow specialised mortgage lending was devised and approved before I became Group Risk Director. I am not therefore in a position to comment. During my time as Group Risk Director I regularly challenged the risks in this business given the impact of the crisis and, in consultation with the Chief Executive of Retail Banking and the Group CEO, a number of changes were made to reduce the risk profile of the specialist portfolio.
(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?
44. In relation to the International division:
(a.)
(b.) Australia: the initial decision to build a business in Australia had been taken before I became Group Risk Director so I am not in a position to comment. The main strategic efforts during my time with the Bank were to attempt to extend the BankWest business to the east coast where the combination of HBOS Retail experience and BankWest’s capabilities were believed to provide an opportunity to develop a franchise in an attractive banking market and provide some geographical diversification.
Both of these strategic steps were discussed and agreed during the Bank’s planning process. There was considerable support provided from across the Group to these efforts including oversight by Group Risk consistent with other businesses. Given the scale of the investment and the profile of these efforts I presume they would have been discussed at Board meetings but am unable to confirm this.
45. The extent of the financial crisis generally but particularly in Ireland was truly unprecedented and unforeseen. With the benefit of hindsight, given the substantial losses which were sustained in Ireland and Australia, it is reasonably easy to criticise the strategy or its execution. However, whether the strategy was flawed based on the facts and expectations before the crisis is more debateable.
46. I cannot comment on the degree of Board oversight since I was not a member of the Board.
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.
47. I will comment on the wholesale funding for the period from the end of 2004 when I joined the Bank and from my perspective as Director, Group Finance, the role I occupied during the bulk of this period. As part of the Bank’s annual planning process, there was considerable work done on the longer term funding requirements from the Bank’s strategy and an assessment undertaken of whether the Bank’s planned balance sheet growth could be funded and the sources to be targeted. Very substantial efforts were made to diversify the sources of the Group’s funding, including to put in place longer term funding programmes such as covered bonds and securitisation programmes and to extend the geographic reach of the Bank’s programmes. In addition, a key element of the divisional plans was for each division to grow their deposit bases to constrain their dependence on wholesale funding. As described above, the Bank’s funding position also led to efforts to grow revenue which did not rely on balance sheet growth.
(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?
48. As described in paragraph 47 above, the Bank’s annual planning process set the size of the Bank’s overall wholesale funding and assessed whether that funding would be available. The Bank was very aware that it had a high dependence on wholesale funding and established liquidity policies that were very much more conservative than the regulatory requirements of the time (see paragraph 14 above). The design of these policies meant that the Bank avoided reliance on very short term wholesale funding particularly less than one month duration. These limits were constantly monitored by the Treasury division and overseen by Group Risk and reported to the Group Funding and Liquidity Committee. In addition, the Bank had several stress scenarios for its liquidity position that were monitored at least monthly.
As described in paragraph 47 this exposure also led the Bank to develop longer term sources of funding such as covered bonds which, during the crisis, proved to be more predictable from a liquidity perspective than deposits from customers and banks.
5 November 2012