Parliamentary Commission on Banking StandardsWritten evidence from William Lindsay Mackay
I have provided responses to the Commission’s questions to the best of my recollection, given that the events which are the subject of this review took place up to 12 years ago. Having left Lloyds in March 2010, I have not had access to any documentation or had the opportunity to consult with others in respect of the questions posed. Subject to these factors, I have responded as fully as I have been able in the limited time available and in light of existing commitments. Where possible, I have referred the Commission to documents which will outline the position more comprehensively and more accurately. All numbers are, again, to the best of my recollection and have been provided with a view to assisting the Commission in its work, but should not be relied upon without verification from appropriate records.
1. Personal
I joined Bank of Scotland in June 1984 from university and worked within the Treasury and Financial Markets business at the Bank in London until the merger with Lloyds Bank completed in January 2009.
I started as a trainee in the dealing room in 1984 working my way up through corporate sales, foreign exchange, money markets and derivatives. I was appointed Chief Manager, responsible for the London Dealing Room of Bank of Scotland, in 1995 and, following the merger with Halifax Bank, was appointed Head of Funding and Liquidity in 2001 reporting to Gordon McQueen, Divisional Chief Executive Treasury. In January 2003 I was appointed Head of Treasury taking the additional responsibility for Sales and Trading, that is all “front office” activity.
I was appointed Divisional Chief Executive HBOS Treasury Services plc in January 2004, following the retirement of Gordon McQueen; I was not appointed an Executive Director on the Group’s Main Board.
As Divisional Chief Executive Treasury, I initially reported to George Mitchell, Chief Executive Corporate Division until his departure in December 2005. My reporting line then moved to Phil Hodkinson, Group Finance Director and, around Q2 2007 following his decision to leave at the end of that year, my reporting line moved to Colin Matthew, Head of Strategy and International Division. Gordon McQueen, George Mitchell, Phil Hodkinson and Colin Matthew all held Executive Director positions on the Group’s Main Board.
I held the position of Divisional Chief Executive through to the completion of the merger with Lloyds Bank in January 2009.
The key management committees of Treasury Division are noted below. Formal papers and minutes were always maintained for each and I have included my status on each committee in brackets.
Treasury Board (member).
Treasury Risk and Control Committee (member).
Treasury Management Committee (chair).
Treasury Business Committee (chair).
Treasury Risk Management Committee (chair).
Treasury Credit Risk Committee (member).
Outside of Treasury Division, I was a member of the Group Capital Committee (Group Alco), I chaired the Group Funding and Liquidity Committee (a sub-committee of the Group Capital Committee) and a member of the Group Insurance and Investment Risk Control Committee.
I remained with Lloyds Bank until March 2010.
2. Growth of Business
(1) With the benefit of hindsight, I broadly agree with the FSA’s Final Notice against Bank of Scotland published on 9 March 2012. With regard to section 2.6 (3) and 2.7 (3) on distribution, Treasury was working with Corporate to develop our existing capital markets capability to drive improved distribution of Corporate loans. With this objective, Corporate and Treasury agreed to transfer the loan distribution team from Corporate to Treasury to align this with our capital markets capability. The transfer took place just after we were hit by the market dislocation in Q3 2007. The plans were set out in the 2008 Treasury Business Plan, although continued deterioration in market conditions in 2008 inhibited progress.
(Please refer to the Treasury Business Plan 2007 document (covering years 2007–2011) and Treasury Business Plan 2008 (covering years 2008–2012).)
(2) HBOS was formed from the merger of Bank of Scotland and Halifax Bank in September 2001. The underlying strategy was to create a “challenger” bank to the existing “big” four UK banks and to grow market share in the UK, in particular with Business Banking (originally a separate Division to Corporate), Retail Banking Division and Insurance and Investment. However, I was not involved in determining the strategy of the new organisation; this was a matter for the Group Executive and the Board of the Bank.
The thrust of this strategy was maintained in subsequent years although Business Banking Division and Corporate Banking Division were merged and a new International Division was formed with the focus on “targeted international growth” in particular in Australia and Ireland.
Each Division of the Group was required to submit a five year business plan annually in October for support by the Group Executive Committee, and then approval by the Group’s Main Board in November or December, which set out plans in detail.
The Group funding plan (produced and owned by Treasury) and the Group Capital plan (produced and owned by Group Finance) together supported the Group Business plan.
For avoidance of doubt, the Treasury Strategy was to support the Group Strategy by providing the necessary funding required to support the Divisional Business plans and to provide financial services to the Group and Group (Divisional) customers.
(Please refer to the Group Business Plan document 2002 (covering years 2002–2006) and each subsequent year to 2008.)
The Treasury Business plan was a comprehensive document covering:
The operating plan, including financial performance, ALM, Capital Markets, Sales and Trading, Credit.
Overseas offices: New York, Sydney.
Finance, including financial control, regulatory control, legal, compliance and operational risk.
Risk, including market risk, credit risk and risk assessment.
Technology.
Operations.
Human Resources.
Treasury Division had three core functions:
Funding the Group and managing the liquidity position of the Group.
Providing Financial Services to the Group and its Customers.
Making a profit.
The order of these functions is important as it reflects the relative importance of each, given that the second two functions may conflict with the first. The Treasury Division always sought to prioritise Funding and Liquidity and this approach was consistently applied since the formation of HBOS. Treasury Division was required to provide the necessary funding and liquidity support and to provide financial services to other Divisions of Retail, Insurance and Investment, Corporate and International. Revenue in Treasury was largely driven by activity emanating from elsewhere in the Group as opposed to “discretionary” treasury activity.
Within treasury, the Treasury Strategy document was ultimately approved by the Treasury Management Committee, which I chaired, and included the Head of Treasury (front office), the Head of Sales, the Chief Operating Officer and the Head of Risk. This followed a comprehensive process to ensure that all risks and issues were reviewed and understood. Detailed oversight of the day to day operation of Treasury took place at the Treasury Business Committee, which I chaired, which included the members of the Treasury Management Committee and the Head of Technology, Head of Finance, Head of Operations, Head of HR, Head of Legal and Head of Compliance. The Treasury Risk Management Committee, which I chaired, reviewed all market risk and liquidity and the Treasury Credit Risk Committee, chaired by Group Risk, reviewed all credit matters.
(3.) As noted in 2 (2) above, Divisional Business plans were submitted to the Group Executive Committee for support prior to going before the Group’s Main Board for formal approval. Prior to review and challenge by the Executive Committee, each Division would go through a plan challenge meeting(s) which would typically include the Group Chief Executive, the Group Finance Director and the Group Risk Director with the objective of ensuring appropriate balance and to optimise the Group’s overall plan. The Main Board would also separately review the Group’s funding plan.
(4.) Prior to the market dislocation in July 2007, I am not aware of any investors who did not support the strategy. However equity investors were managed by Group Investor Relations in Edinburgh in conjunction with the Group Chief Executive and the Group Finance Director and would be best placed to assess this.
(5.) I was not a member of the Board and therefore I am not in a position to comment on whether there was unanimity at Board level. However, I am aware that prior to the market dislocation in July 2007, there was some concern at senior management level over the long term strategy of the Group and our ability to manage within the scarce resources of capital and liquidity adequately in the latter years of the plan. With responsibility for the funding plan, Treasury made this clear in the Group funding plans 2006 (covering years 2006–2010) and 2007 (covering years 2007–2011) where our wholesale market capacity is discussed in some detail.
In addition, having discussed the position with my line manager the Group Finance Director and with Group Risk, I presented papers to the Group Executive Committee around February 2007 with proposals to strengthen asset and liability management. I recall that a paper from Group Risk was presented at the same meeting addressing Risk Strategy.
Immediately following the market dislocation in July 2007, it was clear that the growth strategy was not sustainable and a repositioning of the business would be required.
(6.) We did not originate loan business within Treasury. With regard to Treasury strategy and communication each function built their part of the plan to ensure that the necessary resources were in place to adequately support activity and the entire plan was reviewed holistically by senior management to ensure that it was fit for purpose with regard to Treasury Division and the Group.
With regard to day to day operation of Treasury, no activity would be sanctioned that was inconsistent with our strategy and any new activity required formal sign-off prior to taking forward; for example, no new product could be introduced by the front office without the separate sign-off by each area that may be impacted, including legal, operations, finance, technology, compliance and risk.
Communication to Treasury personnel took place at a number of levels including via line manager, at team level, at function or business area level as well as at Divisional level.
3. Risk Management
(1.) Key risk categories within Treasury were:
Market Risk: governed by the Group Market Risk Policy for trading and banking activity. A Dealing Manual set out dealer and desk mandates. All processes were documented, including Value at Risk methodology, P&L, stress testing and model building. The Group Market Risk Committee was the senior committee providing oversight.
Credit Risk: governed by the Group Credit Risk Policy Statement and monitored by the Group Wholesale Credit Risk Committee, a sub-committee of the Group Credit Risk Committee which was the senior committee providing oversight.
Operational Risk: captured within Treasury’s operational risk profile
Compliance : governed by various policies and evidenced by particular compliance reviews
Liquidity Risk: the liquidity policy statement and framework approved by the Group Capital Committee (Group Alco) including daily mis-match, maturity profile, qualifying liquidity assets and supported by a funding plan (updated quarterly).
(2.) I am not in a position to comment on how the Board interacted with the risk function. However, I am aware that the Treasury Risk and Control Committee provided the forum to test and challenge the Treasury risk function. This would provide feedback to the Audit Committee and the Board, although I was not directly involved in this process.
(3.) With regard to treasury, I am not aware of any issues concerning the quality of management information.
(4.) As indicated above, I was not a member of the Main Board; however, I was asked to attend the Main Board on certain occasions, for example to present the funding plan in conjunction with Group Risk. There was generally a healthy discussion around wholesale funding markets, our market capacity and liquidity position. The Board was provided with our estimated wholesale market funding capacity, how our utilisation changed over the five year planning period and under stress.
(Please refer to the Group Funding plan 2006 (covering 2006–2010), 2007 (covering 2007–2011) and 2008 (covering 2008–2012).)
Following the market dislocation in July 2007 the Group Capital Committee, chaired by the Group Finance Director, moved from monthly meetings to weekly meetings to review market developments and to consider what action may be appropriate. This also allowed the Chairman, and the Head of Strategy and International, to keep the Main Board fully appraised.
(5) The following models were delivered by Treasury Finance and Group Risk and approved the Group Risk Committee and by the FSA:
Basel II (credit risk) framework, underling models including credit stress testing.
CAD2 (market risk) including market risk stress testing.
The models were used as part of our daily business and evidenced through the reporting framework used by the relevant committees. Standard stress tests were run which were set out by Group Risk in line with policy.
(6.) All credit risk positions held within Treasury were within approved limits which were sanctioned at the Group Credit Risk Committee (GCRC), the senior most committee with detailed analysis and oversight from the Group Wholesale Credit Committee (a sub-committee of the GCRC).
All credit exposures held within Treasury Division were rated by a minimum of two external rating agencies. However, these were not relied on. The Treasury Credit team provided our own “internal” rating to each credit exposure based on our own analysis and modelling of underlying risk. There was a rigorous process in both assessing and approving the risk. The internal rating was generally more conservative than the external agencies being equivalent to the lower of the external ratings or indeed weaker.
The weighted average rating by external rating agencies on our structured credit portfolio in Q1 2008 was between AA and AAA. I believe that we provided clear external disclosure on the portfolio both with regard to credit quality and composition, with our 2008 results, at the time of the rights issue in 2008 and at the half year and year end 2008.
4. Board Qualifications
(1.) As noted in 3 (4) above, I was required to attend the Main Board on certain occasions and would be called in for the particular agenda item in question, as appropriate. Therefore, my insight into the workings of the Board is limited. However, on the basis of what I observed, I was not aware of particular board members being dependent on advice from others.
(2.) For the reason outlined above, I am not in a position to comment on the qualifications of the executive and non-executive members of the Board. With regard to the information provided to the Board concerning the Treasury division, as far as I am aware the Board had all the information required.
(3.) With regard to Treasury, my experience suggests that the challenge was effective.
There were three lines of defence under the Main Board:
1. Divisional Chief Executives supported by the Divisional Risk Committees
2. Group Functions under the Group Chief Executive, being the Group Capital Committee (and sub-committees), Group Credit Risk Committee, Group Market Risk Committee, Group Insurance Risk Committee, Group Operational Risk Committee.
3. Audit Committee; Divisional Risk Control Committees; Group internal Audit
The key Treasury Credit Committee was chaired by a senior executive from Group Risk, a separate function from Treasury and independent and senior to Treasury Risk, to seek to ensure suitable challenge and oversight.
5. Treasury Division
(1.) As noted in 2 (2) above Treasury has always been run as a profit centre since the merger in 2001, and as noted above, this was ancillary to funding and liquidity management, which was the priority of the Treasury division following the merger in 2001.
(2.) The proprietary interest rate trading business, which had been established in Halifax Bank prior to the merger in 2001, was closed in 2005 to concentrate on managing flow business emanating from the Group and Group customers. Market risk limits were reduced accordingly.
With regard to liquidity, the Group was required to hold certain qualifying liquidity assets to meet our regulatory liquidity requirements. In addition, we held additional liquidity assets as part of our prudential liquidity consistent with our internal limit framework and specific counterparty limits.
Investment in structured credit was originally established in Halifax Bank Treasury (with assets of around £18 billion in 2000) with development of activity post merger being documented in the Treasury five Year Business Plan prepared annually (as referred to in 2 (2) above) with approval of the strategy and plan from the Group Executive and Main Board with specific limit approvals at the Group Credit Risk Committee and Group Wholesale Credit Committee, as appropriate. Prior to merger, Halifax Bank operated the Pennine Conduit which held the majority of bond positions, and around 2003 or 2004 (after the merger) was replaced by the Grampian Conduit. Bond positions held in Grampian were reported on balance sheet and, for avoidance of doubt, attracted the same capital treatment. Although I was not at Halifax Bank prior to the merger, it is my understanding that the structured credit portfolio was originally established to utilise surplus liquidity and provide diversification.
In 2008 we held a structured credit portfolio of around £40 billion with roughly half within credit investment held within Grampian and half within the Group’s prudential liquidity portfolio. The strategy was to hold prudential liquidity assets to complement our regulatory liquidity assets to provide additional protection.
We held a further £40 billion in interbank assets and government assets for liquidity or around £60 billion of liquidity assets in total.
With regard to the credit team in the Front office, Treasury Risk and Treasury Finance & Middle Office I had no reason to doubt the quality and capability of our teams. Feedback from our regulators on our management, including the FSA, the Australian Prudential Regulatory Authority (APRA) and (in the United States) the Office of the Comptroller of the Currency (OCC) as well as internal feedback was consistent with this view.
(3.) and (4.) As noted in 2 (2) the Treasury strategy was to support the Group strategy which was the driver behind the increase of wholesale funding.
(Please refer to the Group Business Plan document 2002 (covering years 2002–2006) and each subsequent year to 2008.)
In summary, we had particular growth targets in each Division that required to be supported by wholesale funding. Treasury was responsible for assessing our wholesale funding market capacity and ensuring that the funding plan could support the Group operating plan with oversight from Group Risk, the Group Capital Committee and ultimately the Main Board.
The balance sheet grew from around £300 billion in 2001 to £575 billion by December 2006 with around £210 billion in wholesale funding. Wholesale funding grew to around £240 billion by July 2007 and about £300 billion by December 2008.
In 2001 around 15% of our wholesale funding had a residual maturity beyond one year or about £20 billion. We set about lengthening the maturity profile as a strategic imperative and this was captured within liquidity policy documents and monitored by the Group Capital Committee and Group Funding and Liquidity Committee.
By 2006 policy provided that a minimum of 40% of our wholesale funding be maintained with a residual maturity in excess of one year and this ratio was over 45% when the market dislocation struck in July 2007 and continued to be above 40% a year later.
Policy also provided that a maximum of 25% of our wholesale funding have a residual maturity under 1 month, that is the size of liquidity portfolio exceeded the size of our outflow over 1 month. The% of wholesale funding with a residual maturity of under 1 month was around 20% when the dislocation struck in July 2007. This would allow the Group to survive for a full month without having any access the market which, we believed, was conservative relative to our competitors at that time. The amount of wholesale funding maturing within one month peaked at around £65 billion during the crisis in 2008.
Treasury operated an Investor Relations team (IR) focussed on debt investors and this team worked closely with Group Investor Relations, the senior function, which concentrated on equity investors. Treasury IR team provided a clear communication route for investors. The Grampian Conduit (see note (2) in this section) funded through the Asset Backed Commercial Paper market. When market conditions deteriorated investors reduced the duration of their holdings. In September/October 2007 the decision was taken not to replace maturing Grampian ABCP unless we could achieve suitable term and funding was provided directly. An announcement was made to the market to this effect to ensure that investors were kept fully informed.
The purpose of the £60 billion liquidity portfolio was to provide funding in times of funding stress through our normal channels. The main source of liquidity was through the repo market which was achieved satisfactorily throughout the crisis although margins applied were eventually wider than the stress levels we had assumed.
The large increase in wholesale funding required in 2008 was chiefly caused by a run on the Bank after the collapse of Lehmans, with significant outflow of retail funds suffered in Retail and Corporate of around £35 billion. The announcement of the merger with Lloyds coupled with overt action by the Treasury and Bank of England, in particular our ability to issue government guaranteed paper, allowed the “run” to be brought under control as customer confidence improved.
The Group Capital Committee (GCC) and the Group Funding and Liquidity Committee (a sub-committee of GCC) provided oversight.
(5.) as noted in section 2 (2) above generation of profit was the third in importance of the three core functions with generation of revenue in treasury largely driven by activity emanating from elsewhere within the Group as opposed to “discretionary” treasury activity.
As noted in section 2 (2) The Treasury Business Plan was submitted annually for approval and set out a detailed revenue forecast discussing all activity in Treasury and associated risks.
As noted in 3 (5) the two core risk models used in Treasury were Basel II (credit risk) and CAD 2 (market risk) both implemented in conjunction with Treasury Finance and Group Risk.
30 October 2012