Parliamentary Commission on Banking StandardsWritten evidence from D a vid St r a c h a n

1.1 From the end of April 2006 until early April 2008 I was Director of the Major Retail Groups Division (MRGD) at the Financial Services Authority (FSA). I reported to the Managing Director of Retail Markets during that time. MRGD was responsible for the supervision of over 50 of the UK’s largest, predominantly retail financial services groups and had around 150 staff. MRGD was divided into three departments, each of which had a Head of Department (HoD) who reported to me. Each department had in turn a number of supervisory teams headed by a Manager responsible for the supervision of one or more financial services groups.

I was not routinely directly involved in the day-to-day supervision of HBOS plc, or any other of the groups supervised in MRGD. I was however involved through chairing ARROW (the FSA’s risk assessment framework) and other panels and on specific issues when needed. I also had regular bilateral meetings with the HoDs to discuss issues that were emerging within their portfolio of firms. I also attended the FSA’s weekly Firms and Markets Committee at which major issues relating to individual firms were raised.

In the answers set out below I have, as requested, responded as best I can from my present recollection.

2.1 My response can only cover the period of my appointment. In the early part of that period, my estimate (as far as I am aware there are no precise figures) is that over 50% of supervisory time was spent on prudential issues, although a significant amount of this will have been devoted to assessing HBOS plc’s readiness for Basel II model approval. In the latter part of the period, as the crisis emerged and deepened, liquidity and capital came to dominate the prudential agenda.

2.2 At the time in question, the team supervising HBOS plc was also responsible for supervising one other, smaller banking group. The combined resources of this team were one Manager and around five supervisors covering banking prudential, insurance prudential and conduct of business across both groups. The majority of the team’s time would have been spent on the supervision of HBOS plc. In addition, HBOS plc had a share of the HoD’s and my time. Specialist resources were also available—the FSA’s credit, market and operational risk specialists (who spent much of their time on Basel II approval work until the summer of 2007); the FSA’s team of conduct risk specialists; and the FSA’s anti financial crime specialists.

The FSA Board’s report into the failure of the Royal Bank of Scotland plc (RBS) indicates that, in June 2011, the RBS supervision team had three managers and 20 supervisors, ie 23 in total, as compared with five in 2007. This gives an indication of the increase in supervisory resources for that group over the period.

At the outset it is important to note the conclusions that the FSA reached on its general approach to supervision in its review of the failure of RBS. These are summarised on page 289 of that report which sets out the deficiencies that had been identified, with hindsight, in the FSA’s general approach to the supervision of high impact firms (which HBOS plc was). I have not repeated the detail in what follows, but have made some references. However, the findings in relation to the general supervisory approach that emerged from the RBS review provide essential context for my responses.

2.3 My recollection is that the FSA judged HBOS plc to have an open and constructive relationship with it and that was my experience from my own dealings with the group. This comes across in the findings of ARROW risk assessments in 2006 and 2008, where it is clear that the dialogue between the management of HBOS plc and the FSA was held to be open. This resulted in the FSA placing reliance on HBOS plc’s senior management to deliver some actions within the group’s risk mitigation programme. This is consistent with the then prevailing supervisory philosophy, as described in the FSA’s report on RBS (para 676) which describes this practice as being distinct from the concept of “regulatory dividend”. I do not recall HBOS plc having received a regulatory dividend of the type referred to in the RBS report.

2.4 I did not meet the Board of HBOS plc (or of any other bank). The HoD and supervision team presented the findings of the full ARROW reviews to the Board as a whole. The supervision team would also have had meetings with Board members as part of the ARROW discovery work and as part of the series of “close and continuous” meetings.

2.5 The main interactions with the HBOS plc executive team were carried out by the HoD and the supervision team. I met the Group CEO, Group COO, Group FD and Group Risk Director. I also participated in several meetings during the crisis period which members of the HBOS plc senior executive team attended along with their counterparts from the major banks to discuss market conditions and measures that could be taken to deal with the dislocation in markets.

2.6 Through the ARROW risk assessment process and the ensuing close and continuous cycle the FSA interacted with a wide range of senior stakeholders across the group as a whole. In some years this meant over one hundred meetings. These meetings included the CEO and the senior executive team as well as the heads of the main business lines, finance, the key control functions (risk, compliance and internal audit) and operations/IT. As the crisis escalated there were discussions between the FSA Chairman and CEO with their counterparts at HBOS plc.

3.1 This question pre-dates my period as Director of MRGD.

3.2 The FSA’s focus was on the effectiveness of risk management rather than on any particular form or structure it took (in this case risk management within the divisions). HBOS plc’s risk management was considered to be strengthening over the period, but that there were a number of weaknesses which were being addressed by HBOS through a series of programmes and projects. This is apparent from the ARROW letters and the associated risk mitigation programmes. Much of the supervisory focus was therefore directed at making sure that these improvement programmes remained on track. The FSA’s statement of 11 February 2009 about the risk function of HBOS plc, following issues raised by the Treasury Select Committee, gives additional background.

3.3 The effectiveness of the Group Risk function is an important component of the ARROW risk assessment process. This would therefore have been reviewed by the supervisors as part of their work. Any specific issues or concerns would have been raised either in close and continuous meetings or included in the ARROW risk mitigation programme.

3.4 HBOS plc’s application for Basel II model approvals (for both credit and operational risk) was a high priority for the supervisory team and the FSA’s risk specialists. This was also the case for most of the major UK banks. The FSA put in place a panel process (the Decision Making Committee) for granting model approval for all banks and this is discussed in Appendix 2F of the FSA’s RBS report. This was to ensure consistency. The supervisory team and the risk specialists had identified particular challenges for HBOS plc’s Basel II application from an early stage (pre-dating my time as Director of MRGD) and had made it clear to the group what work needed to be done to overcome gaps and shortcomings. This led to significant additional resources being devoted by HBOS plc to the approval work. Notwithstanding this, there was some delay to the final approval of the models.

3.5 I did not meet HBOS plc’s external or internal auditors (or any other bank’s auditors). The supervisory team met the external auditors in 2007 and 2008. I recall that the supervisory team had additional discussions with the external auditors around the end of 2007/early 2008 in connection with valuations in the treasury credit portfolio. I do not recall any serious concerns over asset quality being raised with the FSA by the external auditors while I was Director of MRGD. The supervisory team had contact with the internal auditors during the ARROW process and subsequently as part of the series of close and continuous meetings. The internal audit function was, I believe, judged to be largely effective.

3.6 My recollection is that the main risk from the international business was the planned pace of expansion. This was raised with senior management with a focus on making sure that HBOS plc had effective controls in place to support the planned growth. This focus on controls rather on the underlying strategy was consistent with the FSA’s approach at the time. Since then the FSA has moved to place business model viability at the top of its supervisory agenda. Risks in corporate banking were identified and pursued in large part through the ARROW process and the Basel II application and approval process. These risks were raised in ARROW assessments along with the need for senior HBOS plc management to deliver the required control infrastructure.

4.1 I do not have access to this information. This could be provided by the FSA.

4.2 The HBOS plc 2007 financial statements indicate that risk-weighted assets (RWAs) under Basel I were £330 billion and Tier 1 capital was £24.4 billion. Under Basel II, RWAs were £309 billion and Tier 1 capital £23.8 billion.

4.1 As is clear from the FSA’s reports into Northern Rock and RBS, the FSA’s pre-crisis approach to the supervision of liquidity had fundamental weaknesses. This, in my view, was due to a combination of factors: the prevailing opinion (not only in the UK but also elsewhere) that funding markets were diverse, liquid and resilient; the absence of a global or EU standard for bank liquidity; and the relative weight being attached to capital (through the implementation of the Basel II framework). This meant that while banks might have met the FSA’s formal liquidity requirements (and I think that HBOS plc did meet them) this did not leave them able to withstand the liquidity crisis that affected markets from the middle of 2007 onwards. (Self-evidently, the major UK retail banks were not alone in this regard, with similar problems affecting both retail and wholesale banks from many other countries.) Against this background, and in common with discussions with other banks operating in the UK, liquidity was not a priority in supervisory contact with HBOS plc before the crisis emerged. That said, this subject—including the bank’s own liquidity policy—would likely have been covered in the close and continuous meetings with the HBOS plc treasury function. Clearly, from the summer of 2007 onwards liquidity became the main focus of supervision.

4.2 I am not aware of any supervisory actions to reduce HBOS plc’s reliance on wholesale funding prior to the summer of 2007. However, HBOS plc had taken steps to lengthen the maturity of its funding. Clearly, from the summer of 2007 onwards there were intensive discussions with HBOS plc and other banks about their funding position and what steps could be taken to diversify funding sources and decrease reliance on short-term wholesale funding.

4.3 From the onset of the crisis banks were subject to more frequent, ultimately daily, liquidity reporting requirements to the FSA. The supervisory team was in close contact with HBOS on its liquidity management and the options open to the bank. In addition, HBOS plc senior executives participated in meetings held by the FSA and the Bank of England to discuss conditions in the money markets and measures that could be taken to alleviate them. Contingency planning accelerated in Q1 2008 and by the spring the FSA and HBOS plc were engaged in discussions about additional capital raising (rights issue announced in April 2008) and options for managing the group’s businesses should the crisis persist. As Ian Plenderleith has noted in his independent review of the Bank of England’s provision of emergency liquidity assistance in 2008–09, by spring 2008 a comprehensive contingency plan had been prepared by the FSA, in conjunction with the Bank of England and HM Treasury.

4.4 The treasury credit portfolio was a particular focus of supervision from late 2007 onwards.The FSA’s concern was primarily the liquidity and the valuation of the portfolio. The portfolio was, I believe, subject to a more detailed review by the FSA’s risk specialists during this period.

4.5 HBOs plc did have stress testing arrangements in place. My recollection is that the FSA had identified some gaps in HBOS plc’s approach and had required them to be filled. The FSA therefore imposed an additional capital add-on in respect of this as part of its assessment of HBOS plc’s individual capital guidance while these gaps were being addressed. This would have been in Q4 2007. The FSA did not, as far as I recall, dictate the scenarios and assumptions that should be used in this context at that time. (The introduction of a common macro scenario came later.) However, it did compare the severity of scenarios and assumptions used by the major UK banks in their macro-economic stress test to ensure some comparability and consistency. HBOS plc would have been subject to this peer review.

5.1 I am not aware of any concerns being raised about HBOS plc’s provisioning policies. The FSA would have seen this at the time as primarily a matter for the group and its auditors.

5.2 I am not aware of any concerns having been raised about provisions for corporate exposures.

6.1 The risk assessments at the time indicate that the FSA considered corporate governance, and—by extension—the Board to have been effective. This implies a judgment that the Board did have adequate banking expertise. However, as part of its supervisory enhancement programme put in place after the publication of its report on Northern Rock, the FSA recognised the need for more intensive, senior-level engagement between the FSA and the firms it supervises on governance issues. This involves much more direct assessments of governance and board effectiveness, including in some cases through testing of outcomes. The changes to the FSA’s approach are set out in paras 769 to 771 of the FSA’s RBS report.

6.2 The risk assessments at the time did not, as far as I recall, indicate any concerns about the lack of effective challenge by the Board.

20 November 2012