Parliamentary Commission on Banking StandardsWritten evidence from Colin Matthew

In preparing this response, I have sought to answer the questions to the best of my ability giving my present recollection. I am mindful that I left HBOS nearly four years ago, and that some of the events under consideration took place a significant time ago. In view of the limited time available, I have not been able to obtain access to any contemporaneous documents in order to aid my recollection. I have taken on board the request to be brief and I have focused on my own area of responsibility, as head of the International Division.

Personal

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

I joined the Bank of Scotland in 1966. I joined HBOS when it was formed in 2001 (coming from the Bank of Scotland) and was a member of the Board from its formation. At the same time I became the Executive Director in charge of Business Banking, where I remained until 2006. In January 2006, I became Chief Executive of the Strategy & International Division and at the end of March 2007 I also became Chief Executive of the Treasury & Asset Management Division. The International Division consisted of businesses primarily in Australia and Ireland, but it also had interests in the USA, Germany, Holland and Spain. I left HBOS in January 2009 following the change of ownership to Lloyds Banking Group.

Growth of the Business

(1.) On 9 March 2012, the FSA published a Final Notice against BOS 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?

HBOS’s general long term strategy was one of growth. In terms of overall growth of the lending book, as far as I can recall, HBOS was broadly consistent with its competitors. However, there were certain higher risk areas in which growth was sustained at higher levels, for example, in the UK leveraged finance market, which was part of the Corporate Division.

As head of the International Division, my focus was on that Division as opposed to the Corporate Division. The International Division had a long term growth strategy but started from a much smaller and more diverse base and market share position than the Corporate Division. Also growth within the International Division was spread across a number of different markets and jurisdictions. Individual hold levels across the larger deals in the International Division, by which I mean the amounts by which we were exposed on an individual loan transaction, were significantly smaller than in the Corporate Division.

There was a risk management framework in place in the group which consisted of various processes and committees, which I explain in more detail in the Risk Management section below. Unfortunately, as liquidity froze and markets dislocated during the unprecedented market turmoil, it became impossible to implement risk mitigation measures such as selling down risk positions or obtaining support for trading out strategies. In part, this was caused by the fact that many of the larger loans within the Corporate Division were syndicated and required consensus within the syndicate as to what action should be taken. Inasmuch as the Corporate Division found itself in this position it had not anticipated the severity of what was to come and had not mitigated potential risks. With the benefit of hindsight, significant action to mitigate risks should have been taken earlier, particularly in respect of the higher risk parts of the lending book, albeit the extent of the market dislocation and the magnitude of the prolonged financial downturn was not foreseen by most institutions, commentators, or investors. By contrast, the loans within the International Division tended not to be syndicated loans. Trading out strategies in respect of such loans could be implemented where appropriate without needing to seek approval from other syndicated lenders, making risk mitigation somewhat easier albeit the market conditions were still very difficult.

(2.) Please describe the bank’s strategy for growth generally, and in the international division in particular. How did that strategy develop during your involvement?

The bank had a long term growth strategy from 2001 onwards. From its inception the two principal asset growth (ie lending) divisions in HBOS were Retail and Corporate. Insurance & Investment was the principal non asset growth division.

The international businesses were put into one division in 2006. In line with the group’s general strategy, the International Division sought to achieve measured growth within its various markets. As stated above, the starting position in terms of market share was relatively small. The principal jurisdictions for the International Division were Australia and Ireland. In these markets the growth strategy involved a desire to increase both deposits from, and loans to, retail, SME and corporate businesses using branch based and online strategies.

(3.) With hindsight can the strategy fairly be criticised as too optimistic given existing competition by local lenders? How much board oversight was there of the international division?

I do not think the International Division’s growth strategy was in general too optimistic. Across the international businesses competition was strong. However, coming from relatively small national market shares and using local relationships we found ourselves able to grow assets. Indeed, we could have grown more quickly but chose not to do so. Growing deposits proved to be a longer term proposition.

The HBOS Board received updates in the monthly management information pack and also received special reports and presentations from the international leadership teams. Furthermore, non executive Board members sat on the local (for example, Australian) boards and also sat on the International Risk Control Committee. Moreover, the local Boards also had their own local non-executive directors who were experienced in their local markets.

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

There was a well developed rolling financial planning exercise led by the group CEO and the group Finance Director. After detailed discussions with Divisional Heads and the Executive Committee the proposed group plan was taken to the Board by the group CEO and the group Finance Director for discussion and approval. Each Division had detailed 1–2 year plans and more high level 3–5 year plans. From these the Board formed a good understanding of the principal strategies for each Division.

(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?

It was well understood by the Board that HBOS had a long term growth strategy. As with any properly functioning board there was debate and challenge among members, however, as far as I can recall there were no fundamental disagreements over the long term growth strategy. To the best of my recollection, some of the issues that were raised during Board discussions were our ability to fund growth, our ability to sell down risk positions and the level of our exposure to UK property lending.

(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?

The long term strategy was well publicised across the group. As far as I can recall it was referred to in the group’s annual reports and other public announcements. Across the International Division we had divisional and local strategy sessions where the various teams were brought together and the Division’s plans were disclosed. For example, I recall local strategy training sessions in Australia. As far as I can recall, loan originators were made fully aware of the strategy, although they had no sanctioning powers (by which I mean powers to authorise lending).

Risk Management

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

The International Division had a centralised UK based credit risk team who sanctioned higher value loans and assisted in higher value high risk loans. Other bodies were also charged with considering risk; each country had local credit and operational risk committees and in Australia and Ireland there were local boards made up of local non executives and non executives and executives from HBOS. There were also local regulators in each country, such as APRA in Australia. As far as I can recall the local regulators were aware of the broad strategy and met with the local management to discuss this and other relevant issues. Additionally, there was an International Division Risk Control Committee made up of HBOS non executives and executives which reported to the Group Audit Committee. There were also regular independent risk based reviews by Group Internal Audit.

(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?

Board members would have first hand interaction with the risk function as firstly some of them would sit on international risk committees and secondly the risk heads would present during periodic board presentations. Also, Board members received reports from the Group Audit Committee.

HBOS processes and policies needed to be implemented locally and adapted where necessary to local conditions. The HBOS Board and all subsidiary boards (eg BankWest in Australia) needed to approve risk processes and policies. As far as I can recall, risk analyses to the Board produced questions from Board members covering issues such as sector exposures and credit risk migration queries, to systems failure risk.

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

As far as I can recall, the management information that was available to the Board, whilst reasonably high level, was generally sufficient to enable the Board to make sound risk judgments, when supplemented as necessary by other information and updates from the heads of the divisions. The Head of Risk would report on the main issues at Executive Committee and Board meetings. As referred to in question 3(1) above, non executive directors from the HBOS Board sat on the Divisional Risk Control Committees.

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

To the best of my recollection the Board understood the long term growth strategy and that any strategy involving growth would entail a certain level of risk. For example, the Board recognised the level of exposure to the UK residential and commercial property market. In the case of the International Division, as stated above, strategies would also need to be approved by the local boards, for example, in Australia.

(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?

There were many models that were used within the group. They varied across the divisions as they were tailored to their own particular needs. They were run by the divisions but, to the best of my recollection, they could not be implemented until Group Risk had signed them off as fit for purpose. Risk analyses were considered by the Board and also Divisional Risk Control Committees who raised queries as appropriate. Stress scenarios formed part of the annual planning process and were included in the group plan submitted to the Board for approval. As I recall, stresses such as unemployment levels, interest rates, house prices and wholesale funding capacity were considered.

(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?

At a macro level I do not think we were taking excessive risk compared to our competitors although HBOS was more active than others in certain higher risk sectors, for example the UK leveraged finance market. In the International Division the levels were deemed appropriate at the time and there were risk management controls in place. Few people appreciated that markets could freeze up in the way they did, effectively nullifying any risk mitigation strategies such as selling down loans or trading them out. As stated above, I joined the Bank of Scotland in 1966. I had never experienced such market conditions as those which arose in 2007–2008.

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?

Board members had a range of backgrounds and a number were drawn from Bank of Scotland and Halifax pre the creation of HBOS. As one would expect with any board, some members were more experienced than others, albeit each member brought their own unique skill set and experience to bear. All could take some comfort from the roles played by the Group Audit Committee and by the non executive directors on the Divisional Risk Control Committees. The Board received comprehensive information packs and strategy presentations, albeit they did rely on others for specific advice, for example technical or legal advice.

(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?

Board members would have expertise in a particular business or businesses but, with the benefit of hindsight, I think that HBOS may have benefited from having more non executive Board members who had a banking background, particularly as markets began to dislocate during 2007–2008.

(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?

On a day-to-day operational basis the central challenge came principally from the Group CEO, Group Finance Director and the Head of Group Risk. The Board would also challenge executive colleagues when it was aware of an issue that necessitated challenge.

International Division

(1.) How much consideration was given to the wholesale funding requirements of the International Division?

It was recognised that the International Division was a user of wholesale funding. Considerable attention was paid to the funding needs of the group, including the International Division. As part of the International Division’s management and implementation of group strategy, it was initially more effective for the group to provide funding from the centre (ie central Treasury) but as the International Division’s businesses grew they were expected to grow customer deposits in order to help provide funding. As mentioned above, customer deposit growth proved to be slower than planned.

(2.) How much scrutiny did the International Division receive?

Scrutiny of the International Division was through the processes outlined above and also periodic visits from, for example, the Group Chairman, Group CEO and the Group Finance Director. The division also had local regulators such as APRA in Australia.

(3.) How were the growth strategy and targets for the Division set?

Strategy and targets came initially from the local organic plans and were updated as overseas expansion was planned, however, they were always required to fit into the overall HBOS plan (the International Division was a relatively small part of the group). So the process was essentially from the bottom up within an overall group framework and then finalised with the group CEO and the group Finance Director as the overall group plan took shape.

(4) Did you feel international was competing on price or risk?

The International Division’s strategy was not to compete on price, but instead to focus more on building relationships and good customer service. As far as I can recall, as regards risk, we would probably have a higher percentage exposure to commercial property lending than local banks but we were successful, pre the market dislocation, in selling down loan deals to local banks.

26 October 2012

Prepared 4th April 2013