Parliamentary Commission on Banking StandardsWritten evidence from Phil Hodkinson

Introductory Note

As requested by the Parliamentary Commission, I have sought to keep my answers brief and I have focused on my areas of responsibility. I have prepared this submission based on my present recollection, noting that I left HBOS some five years ago in December 2007, and without having had an opportunity to obtain access to contemporary documents in the time available.

Personal

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

1. I joined the board of HBOS plc in September 2001 and retired from the board in December 2007.

2. From September 2001 to March 2005 I was the Divisional CEO of the Insurance & Investment Division.

3. From April 2005 to December 2007 I was the Group Finance Director.

4. Prior to joining HBOS in 2001, I had worked in the insurance industry for 20 years. I am an actuary by profession.

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?

1. My understanding is that the Bank of Scotland has accepted the facts relied upon by the FSA in reaching its conclusions in relation to the Corporate Division between January 2006 and December 2008. In so far as I am familiar with the facts through my roles as Group Finance Director and on the Board until December 2007, I would draw a clear distinction between the early part of the period under review and the latter part when the problems emerged. However, I am unable to comment on the latter part of this period.

2. As the FSA commented in their Final Notice, the full severity of the global financial crisis and its effect were not reasonably foreseeable in the early part of the period under review. As I recall the Corporate Division’s lending growth in 2006 and 2007 was similar to that of other major UK banks and the proportion of lending to the construction and property sector remained relatively stable at about a third of the portfolio. Although the profit growth of the Corporate Division was strong in this period, this was due to the realisation of equity participations in the existing investment loan portfolio not new lending growth. Improvements were also made in this period to the categorisation of risk within the Corporate Division’s loan book as part of the move to the Advanced Internal Ratings Based Approach to Credit Risk under Basel II which the FSA approved in late 2007. In my view it was not evident or necessarily the case at least in this period and when viewed at the time that the Corporate Division was pursuing aggressive growth without taking sufficient care to mitigate the risks.

3. In the second half of 2007, following the onset of the liquidity crunch, there were clear efforts by management in all divisions to tighten credit controls and restrict new lending in the face of the uncertainty prevailing in the economy and wholesale funding markets at the time. In the case of the Corporate Division, I recall that it was accepted by the Board that asset growth would necessarily rise temporarily because there was an existing pipeline of approved loans awaiting drawdown and because the syndication/refinancing markets, ordinarily used by the Corporate Division to reduce retained asset growth, were closed.

4. As noted above, given that I had left HBOS by December 2007 and some of the issues that emerged were only visible at a divisional level, I’m not in a position to comment on the trends and problems that emerged in the Corporate Division’s loan book in 2008, but from what I have read I would broadly agree with the conclusion that a significant contributory factor must have been the exposure of the Corporate Division’s loan book to the UK construction and property sector which appears to have suffered disproportionately in the economic downturn.

5. The position of other divisions was I believe different to the Corporate Division. Retail, for example, in 2006 and 2007 had consciously reduced net lending growth in the mortgage and unsecured lending markets in response to increased competition and lower risk-adjusted returns, and following the onset of the liquidity crunch in 2007 there was therefore a shorter pipeline and new lending was quicker to turn off.

(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?

1. My present recollection is that the public rationale for the merger of Halifax and Bank of Scotland in 2001 was to create a new challenger to the big four high street banks in the UK. Already the leading provider in the UK retail savings and mortgage markets via the Halifax retail franchise, the new Group set out to grow market share in other mainstream banking and insurance markets by offering simple, value for money products, delivered by a motivated workforce, and backed by a combined balance sheet that could provide the capital and funding to support this growth.

2. Although this UK focused strategy was retested and refreshed over time, it remained broadly the same throughout my time on the Board. After a few years, it was added to by signalling an ambition to diversify internationally in targeted overseas markets where it was identified that some well-established UK banking products could be replicated to competitive advantage in some overseas markets, the main ones being Australia and Ireland.

3. From 2001–2005 I led the development and growth of the Insurance & Investment Division. This involved bringing each of the life assurance, general insurance and asset management businesses previously owned by Halifax and Bank of Scotland under common management and then developing simple, value for money products to gain market share (eg no-load investment products that had no up front charges or early surrender penalties).

4. The Retail Division’s strategy was essentially a continuation of the Halifax retail strategy. Its aim was to maintain its market share in the savings and mortgage markets, where it was already the leading provider, and to build market share in those markets where its share was less well developed, for example in the current account and credit card markets. Again, there was a focus on developing simple, value for money products.

5. The Corporate Division’s strategy, essentially a continuation of the Bank of Scotland’s strategy, was to target growth in particular asset classes in the UK corporate and business banking markets where its specialist skills and customer relationships offered good risk-adjusted returns. As part of its strategy, asset growth was moderated by “selling down” its loan book via the syndication/refinancing markets, and there was an increased push to grow in SME business banking.

6. The Treasury Division was created from the merger of Halifax’s and Bank of Scotland’s treasury divisions. Its strategy was first and foremost to manage the Group’s funding and liquidity requirements. It also provided products (eg currency and interest rate swaps) to customers of the Corporate Division (a continuation of Bank of Scotland’s approach) and managed a proprietary trading book of debt securities (continuing Halifax’s development of this book).

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

1. The strategies for each division were developed by the executive management teams of each division and each were presented to the Board for challenge and approval. Once the strategy for each division had been reviewed and approved by the Board, the divisional management teams would then develop business plans to give effect to their strategies within an overall planning framework of the cost, capital and funding resources provisionally allocated by the Board to each division. This Group Planning Framework was separately approved by the Board prior to the development of detailed divisional business plans.

2. The divisional business plans that emerged from the planning process were subsequently reviewed by the relevant divisional board (including non-executive directors who sat on those boards) and by the Group CEO with input from Group Risk and Group Finance. After a number of iterations, which might for example involve a reallocation of cost, capital or liquidity resources between divisions, the finalised business plans of each division were encapsulated within an overall Group Business Plan which was pulled together by Group Finance and presented to the Board by the Group CEO for discussion, challenge and approval.

3. As part of the Group planning process, stress tests and risk assessments of the divisional business plans and Group Business Plan were conducted by Group Risk. After review and approval by the Board, the Group Business Plan and associated stress tests were also shared and discussed with the FSA.

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

I believe that the merger and subsequent strategy of HBOS had good support from shareholders. During my time as Group Finance Director, my discussions with investors indicated that they were interested in not just profits and dividends but more generally the sustainability of results, risk adjusted returns, capital and liquidity. Our shareholder communications provided them with information that would enable them to assess these factors (eg key risks, assets by sector, sensitivities to interest rates and equity markets, VaRs, LTVs, debt security ratings, etc).

(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?

1. My recollection is that after proper debate and discussion there was general unanimity within the Board and senior management about the Group’s strategy. It was not uncommon for the Board to ask for further work to be done on particular strategies or plans before approving them. As an example, during my time as Divisional CEO of the Insurance & Investment Division, the introduction of “no-load” investment products (ie no up-front charges and no early surrender penalties), an innovative move within the market at the time, was rigorously debated and stress tested before being approved. Similarly, when our general insurance business introduced an innovative “flood cover guarantee” further examination was called for.

2. There was one well publicised exception to this view of general support for the Group’s strategy during my time on the Board which to the best of my recollection occurred in 2004 when the Head of Group Regulatory Risk at the time raised concerns about the Retail Division’s sales culture and growth. As far as I can recall these concerns were reported to the Board and subsequently reviewed by the FSA (via an independent third party review), and it was concluded that management had taken the concerns seriously and that appropriate action had been taken.

(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?

1. In my experience, the Group’s strategy was usually explained to more junior staff in terms that they could relate to rather than using management or market jargon. For example, in the Insurance & Investment Division, staff communications emphasised how it would be possible to offer better value-for-money products and customer service if we ran a more efficient, lower cost business, and thus why our plans included moving workflows between different locations and the introduction of new computer systems.

2. I do not recall how the strategy was explained to more junior staff specifically involved in originating loan business or what steps were taken to encourage them to put the strategy into effect as neither of my roles covered such activities.

Risk Management

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

1. HBOS operated a “three lines of defence” model in common with most large UK financial services companies. In relation to risk management, the first line of defence was divisional management supported by divisional risk specialists and divisional executive risk committees; the second line was the oversight provided by Group Risk and group executive risk committees; and the third line was the Group Audit Committee, supported by Divisional Risk Control Committees and Group Internal Audit.

2. There was a similar structure for the management of financial, capital and liquidity, with the first line of defence being the divisional finance and treasury teams; the second line being Group Finance, the Group Capital Committee and the Group Funding & Liquidity Committee; and the third line being the Group Audit Committee, Group Internal Audit and the external auditors.

3. In this governance model, the Board determined the Group’s risk policies. Standards for managing financial and non-financial risks were developed by Group Risk, and reviewed and approved by the Board. The procedures for monitoring compliance with these policies were set out in the Group Risk Control Manual. Each division was responsible for implementing these group policies, and monitoring of compliance was undertaken by Group Risk reporting to the relevant Divisional Risk Control Committee.

(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?

1. In my experience, both executive and non-executive board directors had a good level of interaction with the risk functions at each level. For example, within the Insurance & Investment Division, my divisional board included a number of non-executives from the HBOS board and other independent non-executives with specific experience of the insurance market. A number of these non-executives sat on the Insurance & Investment Divisional Risk Control Committee, which was chaired by an HBOS non-executive, who in turn was also a member of the Group Audit Committee.

2. Challenges were made by the Board and Divisional Boards to risk analyses, for example the scenarios used to undertake these analyses, although I cannot now recall the precise nature of these challenges other than in respect of some examples that relate to areas of my own responsibility at the time. For instance I recall the Market Risk analysis of the Group’s exposure to the UK stock market supporting management’s proposal to withdraw from selling new with profits insurance business and to rebalance the with profits insurance fund in 2003, and also in 2006 the decision to make a £1bn additional payment to the Group’s Defined Benefit Pension Scheme.

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

1. Key risk indicators and information were reported to the Board as part of the monthly board information pack. This information was reviewed and discussed as part of a standing agenda item on performance at Board meetings to which the Group CEO, Group Finance Director and Group Risk Director would address matters of concern in relation to performance, finance and risk. The chair of the Audit Committee also had a standing agenda item at Board meetings to report on matters arising at committee meetings.

2. In addition, reviews and analyses of specific risk topics (eg market risk, insurance risk, money laundering, risk register, etc) were built into the Board agenda calendar, as were the Group Capital Plan, the Group Funding Plan and the results of stress tests as part of the business planning cycle.

3. In my experience, the Board and risk governance framework emphasised that risk management was first and foremost the responsibility of line management, with appropriate support, monitoring and challenge by Group Risk. It was a key requirement of approval by the FSA in late 2007 for the adoption of the Advanced Internal Ratings Based Approach to Credit Risk and the Advanced Measurement Approach to Operational Risk under Basel II that this approach to risk management was embedded and actively used within the organisation.

4. More detailed divisional management information was provided to each Divisional Board and, specifically in relation to risk, to each Divisional Risk Control Committee. With the benefit of hindsight, some of this more granular information that was available at divisional level might have helped the Board in its overall assessment of risk matters.

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

1. In my view, the Board’s perception was that the Group’s growth strategy was achievable by focusing on value for money products and cost efficiency within the boundaries of the capital and liquidity resources available to it and within the risk policies set by the Board. Significant investments were made in developing the Group’s risk management environment during my time on the Board, especially in relation to credit and operational risk in the run up to advanced accreditation under Basel II.

2. The Board also recognised the importance of ‘tone from top’. This was evidenced by the involvement of directors at all levels of the risk management process and by a number of decisions the Board took to reduce risk. For example, during my time as Divisional CEO of the Insurance & Investment Division, we withdrew from the UK with-profits and annuity markets, which at the time were rich sources of growth but also carried increasing risks as a result of stock market volatility and uncertainty over longevity. Similarly, the sale of Drive, a profitable US sub-prime auto business, in 2006 was motivated by the recognition that the Group felt it lacked sufficient credit risk expertise in this market. Other examples I can recall were the £1bn payment made to the Group’s Defined Benefit Scheme in 2006 and the steps taken to lengthen the maturity profile of wholesale funding on a number of occasions at a cost to margins and profits.

(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?

Formal models were developed to stress test business plans, and capital and liquidity requirements. The most significant of these were the Basel II models for capital adequacy, which were developed by each of the banking divisions with external help, scrutinised by Group Risk and approved by the FSA. These models essentially tested that the bank would have sufficient capital in extreme downside scenarios specified by the Basel II rules. To arrive at this conclusion required the credit risk associated with each loan to be assessed and then the effect of various downside scenarios to be modelled. The capital required was calculated to sustain the bank through such downside scenarios. HBOS was accredited by the FSA as having achieved the advanced approach to both credit and operational risk under Basel II in late 2007. During my time on the Board, I recall that HBOS’s regulatory capital ratios were of a similar strength to those of other major UK banks and were very little different under the Basel I and Basel II regimes.

(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?

Throughout my time on the Board, in my opinion, it sought to manage the business within the risk control framework that it thought was prudent and sound. However, with the benefit of hindsight and like many banks, it is now clear to me that HBOS was exposed to risks that were not reasonably foreseeable by either the Board or by the regulatory capital and liquidity regimes at the time.

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?

(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?

1. There was considerable focus by the Board’s Nominations Committee on maintaining a mix of both executives and non-executives with a sufficiently broad range of qualifications and depth of experience to cover the range of the Group’s activities. This experience pool was supplemented at Divisional board and Divisional Risk Control Committee level by the appointment of independent external non-executives with specialist experience and local knowledge.

2. In relation to my role as Divisional CEO of the Insurance & Investment Division, my divisional board had three HBOS non-executives on it and three further independent external non-executives with insurance and investment experience. Similarly, during my time as Group Finance Director, there were two chartered accountants, an actuary and a former bank treasurer on the Board.

3. Overall, therefore, I felt that the Board had sufficient qualifications to oversee and challenge the activities of myself and my executive team. Each director had access to comprehensive Board management information packs, and to detailed reports and analyses on risk matters via their roles on the Board, the Group Audit Committee and Divisional Risk Control Committees.

4. Naturally, as with any board, the Board did seek out and to some extent were dependent on the advice of others. First and foremost the Board looked to the Group CEO and the executive management team in the first line of defence. Second, the Board would seek the views of the second and third lines of defence (ie Group Risk, Group Finance, Internal Audit and external auditor). Third, it would seek the views of those on the Board with direct knowledge of the division or topic (eg those directors on divisional boards or Divisional Risk Control Committees). Other advice, such as legal advice, was sought as necessary.

5. In view of the problems that ultimately emerged in the Corporate Division in 2008, with the benefit of hindsight, I believe that additional corporate banking experience amongst the non-executive directors might have been beneficial.

(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?

During my time as the Divisional CEO of the Insurance & Investment Division, I felt that the central challenge and discipline from the Board and group functions was effective in holding me and my management team to account for the direction and performance of the division. Group functions met regularly with divisional teams to understand and review performance, and sensible steps were taken to ensure that the expertise of the group functions was sufficiently matched against that of my divisional team (for example, by moving a senior accountant from my divisional finance team to enhance Group Finance’s knowledge of embedded value accounting). Where it was not possible to match or duplicate specialist skills, external specialists were often brought in to help in the second and third lines of defence (for example, I recall this was the case for Basel II, and for IT and Treasury audits).

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 in 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.

I am unable to comment on the underlying causes of the problems experienced in the Corporate Division’s loan book as they emerged after I retired from the Board. However, from what has been reported it would appear that a significant contributory factor was the exposure to the UK construction and property sector (which as I recall was about a third of the loan portfolio) and also that there was a fall in the value of equity participations held by the Corporate Division in its investment loan portfolio.

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

1. My understanding was that the Corporate Division’s lending philosophy during my time on the Board was similar to other banks in that it judged credit risk first by assessing the strength of a business’s cash flows and its prospects, and only then took into account the nature and value of any security. I also recall that Corporate lending growth prior to my departure was similar to other UK banks and that the mix of lending to various sectors had remained relatively stable over this period. The size of the Corporate loan book relative to the Group’s overall balance sheet (about one fifth of the total) was equally not thought to be unusual.

2. There were aspects of the Corporate Division’s approach that were reported to be conservative relative to other banks (eg it did not adopt a “covenant light” approach) but there were also some recognised differences in the customer base (eg an understandable geographic bias towards Scotland and lower market share amongst large UK multi-nationals) but as far as I can recall I was not aware that there were other aspects of the loan book (eg the scale of individual large exposures) that might have contributed to the problems that emerged in 2008.

(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?

1. I believe that the decision to develop a debt security trading book and to generate revenue by offering ancilliary treasury services (eg interest rate swaps) within the Treasury function predated the HBOS merger in 2001; as far as I recall these activities had been developed by the previous Halifax and Bank of Scotland treasury functions and their continuation would therefore have been proposed by the Group Treasurer at the time of the merger and approved by the Board.

2. The losses recognised in 2008 happened after I left HBOS and therefore I am not in a position to comment on them specifically. That being said, my understanding is that many banks suffered losses in 2008 as a result of fair value accounting adjustments in respect of asset backed securities and floating rate notes as a result of these securities becoming highly illiquid and their pricing indeterminate, following the collapse of Lehmans in late 2008. I recall that a small accounting adjustment of a similar nature was made at HBOS in late 2007 whilst I was still Group Finance Director. At the time, no actual losses had been incurred but market prices of some debt securities had fallen reflecting growing concerns about US sub-prime. Fair value mark-to-market adjustments of this type of course affected many banks, even though in HBOS’s case the credit quality of the securities remained strongly rated and HBOS had virtually no exposure to sub-prime within these securities. The Treasury trading book was small relative to the Group’s balance sheet and operated within narrow daily VaR limits.

(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?

As part of its strategy for managing liquidity, the Treasury Division maintained a substantial “liquidity portfolio” of assets, mostly debt securities, that could be used as collateral with central and other banks in the event of periods of stress. Roughly half of these assets were part of Treasury’s trading book and the other half part of its banking book. The assets in this liquidity portfolio comprised CDs, FRNs and ABS. The Treasury Division was an active arranger of retail mortgage securitisations, and thus had a good level of expertise in the ABS market. The Group Wholesale Credit Committee monitored the credit risks associated with the debt security portfolio, the ABS component of which (about a third of total) was virtually all AAA rated.

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

I can’t recall precisely when the policy to grow specialised mortgage lending was devised, although my recollection is that Bank of Scotland had been active in this market prior to the merger and hence it is likely to have been approved at or around the time of the merger. It was I recall regularly revisited by the Board when discussing and approving the Retail Division’s strategy.

(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?

1. The strategy for growing the International Division was to target overseas markets where some of the well established UK products and systems could be replicated at relative low cost. While the systems and processes were transplanted from the UK where possible, the senior management teams in each market were predominantly recruited locally. Although there was less initial success in certain overseas markets (eg Spain), in the primary locations of Australia and Ireland there was good initial success in growing the business despite existing competition.

2. Board oversight of the overseas operations was achieved through a combination of Board non-executives sitting on the local regulated entity boards, regular reporting of each territory to the main Board, and regular visits by group executives and functions to the relevant overseas locations.

(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?

1. The central challenge to divisional strategies and business plans came from the Group CEO supported by the group functions (ie Group Finance, Group Risk, Group HR, etc) ahead of presentation to and challenge from the Board.

2. The Group’s approach to managing market risk and asset quality was set out in the Group Market Risk and the Group Credit Risk Policies. These policies were approved by the Board and compliance with them was monitored by the Group Market Risk and Group Credit Risk Committees.

3. The Group’s approach to liquidity was set out in the Group Liquidity Policy which, alongside the Group Funding Plan, was approved by the Board. Monitoring of compliance with the Group Funding Plan and Group Liquidity Policy was undertaken by the Group Funding & Liquidity Committee.

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

1. The central challenge to the Corporate Division’s risk management process came from Group Risk (in particular the Group Credit Risk Committee), the Corporate Divisional Risk Control Committee and the Audit Committee.

2. I’m not able to say how frequently corporate loan applications were rejected as I was not involved in the credit approval process. I was not one of the board directors authorised to sign off large loans when they exceeded the Corporate Division’s delegated authorities under the Group Large Exposures Policy.

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?

1. My recollection is that part of the rationale for the merger between Bank of Scotland and Halifax was that Halifax’s large retail deposit base and mortgage book would provide the opportunity to expand the combined group’s access to wholesale funding markets.

2. The wholesale funding strategy subsequently developed in stages, each designed to broaden the range of wholesale funding, including retail mortgage securitisations, the issuance of commercial paper, the launch of covered bonds, and the geographic expansion of the Treasury function to Sydney and New York, although I do not recall the precise timing or order of these moves. As mentioned earlier, another significant source of wholesale funding was the syndication/refinancing of corporate loans shortly after origination.

3. In the development of the bank’s wholesale funding strategy, there were deliberate moves (from memory in 2004 and 2006) to lengthen the term of funding, even though at the time these moves came with a significant cost. A key performance indicator was the proportion of funding that had a maturity of over 12 months which prior to the liquidity crunch of late 2007 had been increased to roughly half of all wholesale sources. There were also a number of successful efforts during this period to increase retail deposits, also at the expense of margins, so as to reduce the Group’s reliance on wholesale funding growth.

4. The Group’s funding strategy was set out in the Group Funding Plan which alongside the Group Liquidity Policy was approved each year by the Board. This plan was developed by the Treasury Division and scrutinised by the Group Funding and Liquidity Committee, which comprised the Group Treasurer, the CEO of the Treasury Division, Group Finance and Group Risk, and also by the Group Capital Committee, which was chaired by myself during my time as Group Finance Director. The Group Funding Plan recommended the overall amount of funding that should be budgeted and allocated to the lending divisions when developing their business plans. In doing so it took into consideration the available sources of future funding and projections of the future maturity/refinancing needs of the Group in the years ahead, including sensitivity and stress tests of the plan.

(2.) What specific consideration was given to 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?

Monitoring and control of the Group Funding Plan and Group Liquidity Policy on a day-to-day basis was undertaken by the Group Funding & Liquidity Committee. This committee monitored mismatch limits, maturity profiles, asset class limits, early warning indicators and the regulatory liquidity stock ratio. It also undertook liquidity stress tests, including the scenario that wholesale markets might be closed to HBOS and that retail deposits could be lost in the event that HBOS suffered a credit downgrade. Systemic market scenarios in which certain wholesale funding markets were closed to most banks were also included in these stress tests but none of the scenarios envisaged that most wholesale markets would close entirely for most banks simultaneously and for an extended period of time, which as I understand it, was the case in late 2008 following the collapse of Lehmans.

30 October 2012