Parliamentary Commission on Banking StandardsWritten evidence from an FSA Official

Personal

1. Please outline your career history and experience prior to assuming responsibility for ***.

My role *** commenced in April ****. HBOS was supervised *** until the acquisition by Lloyds in late 2008. Prior to my role in *** I held various roles within the FSA ***.

***

Supervisory Approach

2.1 How many resources were devoted to the supervision of HBOS? Did that change during the period 2002—2008? How does this compare with now?

The HBOS supervision team comprised a manager and a team of five, increasing to seven, supervisors over the review period. The combined resources covered both prudential and conduct of business for the HBOS group. The Manager also supervised one to two other, retail groups over the period but would have devoted the majority of their time to the HBOS group.

In addition, specialist internal resource was also available to the team such as the Risk Review Teams that specialised in areas such as credit, market, operational and insurance risk, the conduct risk team and the financial crime teams.

From late 2007 onwards the resources devoted to HBOS (and other UK retail banks) were steadily increased in response to the financial crisis and changes to the supervisory approach to large banking groups. For comparison purposes, 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.

2.2 How many banks came under the supervision of ***? How many supervisors/teams reported to ***? How much of *** time was dedicated to HBOS issues?

During the review period there were approximately 15 groups in *** covering prudential and conduct of business issues for financial groups including banks, insurers and asset managers. Up to *** teams reported to *** and there were approximately 40 to 50 staff (supervisors and administrative support) within *** over the period. A proportionate amount of *** time was dedicated to HBOS issues although *** became more heavily involved in HBOS liquidity and contingency planning from late 2007 as the financial crisis gathered momentum.

2.3 What procedures were there for supervision teams to gain understanding of developments and views outside their particular responsibilities, such as trends in commercial real estate, outside perceptions of the companies they were supervising, best practice etc?

Within the FSA, two areas provided analysis of areas such as commercial real estate; Risk Assessment Division and Risk Review Division. The first area’s view of risk would be considered as part of the preparation for ARROW risk assessments and, the latter area’s information fed into both firm specific work, including assessment of Basel work, and occasional peer group reviews. There was also a banking sector risk map that was reviewed and challenged by a divisional risk group that was chaired by the Director of MRGD. The FSA also employed senior advisors, usually retired market practitioners, who provided supervisors with support and challenge on regulatory issues and the approach taken.

The FSA also published the Financial Risk Outlook (FRO) outlining the perceived risks within sectors. The FRO was sent to firms asking them to consider the issues raised. Externally, the supervision teams had access to broker reports and publically available information.

2.4 Did HBOS have a constructive relationship with the FSA supervisory team? How did the interaction work? Did the relationship change during the period 2002—2008?

My role *** commenced in April ***. Prior to this and during *** period in the role, my recollection is that HBOS had a generally open and constructive relationship with the FSA. The ARROW risk assessments in 2006 and 2008 demonstrate the open dialogue between HBOS and the FSA. This, together with the firm’s responses to the Risk Mitigation Programme, resulted in the FSA placing reliance on HBOS’ senior management and risk functions 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”.

Interaction with the firm, outside of the risk assessments (ARROW reviews), was by the supervision team largely through Close and Continuous meetings, follow up to Risk Mitigation Programme issues and through an annual strategy meeting with the Director of MRGD.

2.5 The FSA’s report, “The Failure of the Royal Bank of Scotland” explained that the FSA could grant a bank a regulatory dividend when, in the FSA’s opinion, it demonstrated that it was “well managed, had effective control systems and had dealt openly with the FSA”. From your recollection, was HBOS granted a regulatory dividend by the FSA at any point during the period 2002—2008?

See the response to 2.4 above. I do not recall HBOS plc having received a regulatory dividend of the type referred to in the RBS report.

2.6 How often did you, personally, meet with the Board of the bank during the period 2002 –2008? What kinds of issues were on the agenda?

The standard practice at the time for a major retail group was for the Head of *** and *** to present the ARROW risk assessment findings and risk mitigation programme to the Board of the firm. *** presented the *** and *** ARROW findings and risk mitigation programme to the Board.

2.7 How often did *** have interaction with the executives of the bank? Who were the relevant executives? What kinds of issues were on the agenda?

*** presented the **** and *** ARROW findings and risk mitigation programme to the Board. Outside of this, *** participated in a number of introductory meetings with the firm’s senior management in ***. *** also participated in a small number of Close and Continuous meetings largely with the Head of Risk Management and the Finance Director; my recollection is that there would be approximately two meetings per year. These meetings focussed primarily upon progress of issues from the Risk Mitigation Programme. In addition to these meetings, *** also attended the annual strategy meetings chaired by the *** and attended by the firms CEO and Finance Director. These meetings focussed upon the firm’s progress against its strategy.

*** engagement with the firm’s senior management increased proportionately during late 2007 and 2008 as the financial crisis gained momentum, these meetings were particularly focussed on liquidity and contingency planning these meetings were mainly with the Finance Director.

2.8 Which other areas of HBOS did the FSA interact with on a regular basis?

The majority of contact with the FSA would have been conducted with, or through, the supervision team. HBOS would also have had interaction with the thematic areas of the FSA both from a prudential perspective (Risk Review Division, Basel Team) and from a conduct perspective (TCF Team, Thematic Review Team) as well as Policy Division. The firm would also have interaction with the Chair and CEO of the FSA through industry for a and firm specific interaction.

The supervision team’s interaction with HBOS would have been be driven by the Risk Mitigation Programme and the Close and Continuous schedule and would have encompassed most parts of the Group.

Control Framework and Risk Management

3.1 Following the 2004 ARROW report, a S166 report was commissioned and undertaken by PWC. Did that report address *** concerns about the control framework? Was there a change in the supervision team’s focus after the PWC S166 was issued?

The FSA agreed the scope of the s166 review specifically to challenge and review the risks identified during the January 2004 Interim ARROW risk assessment. That report was undertaken by PWC in the first half of 2004 and completed in July 2004. The skilled persons report concluded that the group risk framework was fit for purpose and the firm accepted, and undertook to implement, the report’s recommendations. Progress against these recommendations was reviewed as part of the December 2004 ARROW. The supervision team had also assessed controls over the first line of defence through the Sales Culture Review within the retail business undertaken by Group Risk and the third line of defence, Internal Audit, through a review undertaken by PWC on behalf of the Audit Committee, both of which provided comfort on the adequacy of the control framework. On that basis the FSA placed reliance on the group risk functions to take forward the mitigation of a number of issues. The Interim risk assessment of June 2006 continued this judgement that good progress had been made, but there remained control issues in the HBOS group.

By the time of the full ARROW risk assessment in 2008, attention had shifted to the external environment, including the funding difficulties faced by HBOS and other banks.

The FSA’s assessment of the risk function at HBOS during the period under review was described in the statement made by the FSA on 11 February 2009, following issues raised at the Treasury Select Committee on 10 February 2009. The FSA stated that:

“The FSA conducted a full risk assessment of HBOS (known as an ARROW assessment) in late 2002 which identified a need to strengthen the control infrastructure within the group;

We then decided to commission a “skilled persons report” from PWC on the HBOS risk management framework, using formal information gathering powers under section 166 of the Financial Services and Markets Act 2000: their extensive report revealed a need for improvements in the HBOS risk management environment;

The FSA then conducted a further full risk assessment of the HBOS group to cover all of the group’s business, formally recording its assessment in December 2004, the assessment was that the risk profile of the group had improved and that the group had made good progress in addressing the risks highlighted in February 2004, but that the group risk functions still needed to enhance their ability to influence the business, which we saw as a key challenge.

The FSA continued to pursue concerns about the risk management framework. As a consequence, we wrote to HBOS again on 29 June 2006 with a further interim ARROW risk assessment. In that letter we made clear: that whilst the group had made progress, there were still control issues. We made clear that we would closely track progress in this area; the growth strategy of the group posed risks to the whole group and that these risks must be managed and mitigated.

3.2 With hindsight was it appropriate to accept the changes to the HBOS practices in 2004 and reverse the increase in the ICR?

The issues driving the FSA’s decision to increase the ICR by 0.5% were set out to HBOS management. Three issues drove this decision; firstly, adequacy of the risk management framework; secondly, in relation to the control culture in retail; and, thirdly, control of commercial property in the corporate book. The first was addressed by the s166, the second by a review produced by Group Regulatory Risk and the third through the ARROW risk assessment. The December 2004 ARROW concluded that all three issues had been substantially addressed and, whilst there remained some issues still to be followed through, the ICR could be reduced. This was agreed by an internal ARROW panel chaired by the ***. After the adjustment, HBOS’s ICR was not an outlier compared to peers and it was at the top end of the range ICR’s for its peers. This was an appropriate action given the supervisory approach at the time and based upon the assurances we had received from the s166 skilled persons’ review.

In hindsight, my view is that the quantum of capital discussed was too small and would not have been sufficient to prevent the firm’s eventual failure and the effectiveness, rather than the implementation, of the actions in response to the report should have been validated (the current supervisory approach would require a further report to validate not just the implementation of agreed actions but also their effectiveness).

3.3 What were the supervision team’s views on the framework for controlling risk within the firm, which involved devolution of risk management to divisions?

The approach taken by HBOS was not unusual. The supervisory approach at the time was to consider the effectiveness of risk management rather than on any particular form or structure it took. Initial concerns around the effectiveness of the risk management framework were tested through the use of the s166 skilled persons report which concluded it was fit for purpose. Based upon this assurance, the ARROW assessments reflect the supervision team’s view that HBOS plc’s risk management continued to develop although there were a number of weaknesses which were being addressed by the firm through a series of programmes and projects.

3.4 Were you able to assess the competency of the Group Risk function? Was the Group Risk function effective at managing risk in the firm? Was it equally capable/effective in monitoring all of the main divisions? Were their concerns listened to and addressed?

See previous responses to 3.1 and 3.3. I am not aware of any meetings with Group Risk where they raised concerns that were not listened to.

Were you satisfied with the bank’s internal ratings approach? Was it applied across the bank’s entire portfolio?

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.

Early in 2006 the FSA set out “key lines in the sand” which were consistently communicated to firms and which the FSA judged each application against. These were initially senior management understanding, the “use test” (senior management use of the models in decision making), stress- testing and proper assessment of likely losses upon borrower default in an economic recession (downturn Loss Given Defaults- LGD). They were subsequently expanded to include documentation, self-assessment and validation. In addition, various modelling issues arising from our reviews were discussed with the industry through the relevant standing groups, covering downturn LGD and long-run probabilities of default for example.

The supervisory team and the risk specialists had identified particular challenges for HBOS plc’s Basel II application from an early stage 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. Whilst the Retail IRB (Internal Ratings-Based) approach and AMA (Advanced Measurement Approach for operational risk) waiver submissions were approved in 2007 there were material concerns over their corporate credit risk modelling and the waiver was passed subject to conditions for the general corporate model, and with the Property Investment Model on roll-out.

3.5 What was the supervisory team’s relationship with the firm’s external auditors? How often did you/the supervision team meet them? What was the nature of the discussions? Were serious concerns over asset quality raised and if so, when? Were there any concerns over the validity of the accounts?

The supervision team would meet with external auditors, periodically, usually as part of the discovery work for an ARROW risk assessment. These meetings would focus on the Management letter and any areas of concerns with the firm which the auditors may have. During this period there was a specific discussion on changes to provisioning methodology as a result of new IAIS standards in 2005 and a meeting in early 2008 to seek the auditor’s views on the re- valuation of Asset Backed Securities. My recollection is that the auditors were generally content with the approaches taken by the firm.

No material concerns were raised by the external auditors over the validity of the accounts.

3.6 How often did you/the supervision team meet with the bank’s internal auditors? What issues were discussed?

Meetings with the firm’s internal auditors would be been in line with the Close and Continuous schedule of meetings. Key issues discussed would be progress on the risk mitigation programme, the annual audit plan and any specific issues arising from this.

3.7 What did you perceive to be the risks in the Corporate and International divisions?

There were a number of risks identified in respect of these two divisions. Given the ambitions to grow both areas, the key concern was the effectiveness of risk management to control the risks inherent in this growth. This risk was partially mitigated through the s166 skilled persons report but additional concerns were taken forward within the Basel preparations work. In particular this focussed upon the effectiveness of risk grading, credit decisioning and stress testing and resulted in conditional approval of the Corporate IRB waiver and the resultant risk mitigation programme that was put in place to ensure improvements within credit risk management within Corporate.

The Risk Mitigation Programme attached to the April 2008 ARROW set out an in depth review of credit risk and provisioning to be carried out by the FSA. This work raised significant concerns about credit risk management and processes. This resulted in a revised Risk Mitigation Programme being issued and our concerns were discussed with the Corporate and Group CEOs and escalated to the Board.

3.8 Was the supervision team aware of the several criticisms made of the Corporate Division’s asset quality in the FSA’s Final notice to BOS of 9 March 2012; in paragraphs 4.21, 4.22, 4.26, 4.34, 4.38, 4.109?

My understanding is that the supervision team had material concerns around Basel implementation across Corporate and these concerns were set out in the April 2008 ARROW. The attendant Risk Mitigation Programme set out a number of actions requiring improvements to: credit controls; reconciliations for syndicated loans; controls over equity stakes; leverage loan valuations; remuneration risks; and, set out a number of reviews that the FSA would undertake. The FSAs’ review raised significant concerns about credit risk management and processes. This resulted in a revised Risk Mitigation Programme being issued and our concerns were discussed with the Corporate CEO, Group CEO and escalated to the Board.

The supervision team referred this issue to Enforcement for further review. The Final Notice covered the period between January 2006 and December 2008 and was a forensic review of all information available, including information that was not available to, or disclosed to the supervision team at that time.The supervision team’s work during 2008 reflects the issues set out in the Final Notice.

Capital Adequacy

4.1 What was the HBOS capital add-on in 2008 and how did this compare with the other major UK banking groups? How did any capital add-on change between 2006 and 2008?

During 2007 there had been a technical change in the way that the FSA gave individual capital guidance to firms, with a move towards specifying this as amounts of capital rather than as a percentage of risk weighted assets. Detailed analysis was undertaken early in 2008 of the capital position of the major UK retail banks, including HBOS. This is described in paragraph 726 (page 273) of the FSA’s report on the failure of RBS.

During 2007 the supervision team undertook a supervisory review and evaluation of HBOS. This resulted in two capital add-ons. Firstly, in respect of stress testing and capital planning for £500m; and, secondly, in respect of pension risk for £742 million.

4.2 Please outline any issues that arose in relation to the bank’s waiver application to use its internal model under Basel II? In particular, what was the nature of any concerns in relation to its corporate portfolio?

Refer to the answer to 3.4.

4.3 From your recollection, what was the impact of Basel II on HBOS’s regulatory capital position? Did it result in an increase or decrease in regulatory capital?

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 £309bn and Tier 1 capital £23.8 billion.

Underlying this, the risk weights on the corporate book increased whilst there was a new operational risk requirement; but these were more than off-set by falls in the risk weights on the mortgage book. The net impact of the changes to RWAs and capital is for the Tier 1 ratio to marginally increase by 0.3% to 7.7%; the total capital ratio marginally decreased by 0.1% to 11%.

Funding and Liquidity

5.1 In your view, was the approach to managing the bank’s liquidity position adequate (both in terms of the bank’s own approach and the regulatory approach)?

Overall, HBOS managed their liquidity in line with FSA rules and requirements. The 2002 ARROW Risk Mitigation Programme challenged the firm to diversify funding sources to support their growth ambitions. This required a funding plan aligned to the business plan ensuring the firm had a stable and diversified spread of sources and maturities. The firm termed out funding maturities and sources of finance. In addition an FSA led review was undertaken of their asset and liability management across the group. The issue remained on the supervisory agenda however as the FSA’s reports into Northern Rock and RBS showed, the FSA’s pre-crisis approach to the supervision of liquidity had fundamental weaknesses. These weaknesses were common globally. During this period there was an absence of global or EU banking liquidity standards and the international prudential regulation was primarily focussed on the implementation of Basel II. The FSA’s report on the failure of RBS also refers to this.

From August 2007 onwards the position changed completely, with both individual banks and the FSA focusing much of their attention on funding and liquidity risks.

5.2 What supervisory action was taken to address concerns about the firm’s reliance on wholesale funding during the period 2002 to 2007?

See response to question 5.1

5.3 Did the FSA have contingency plans in place, or was it aware of the existence of other plans, for managing HBOS’s solvency and liquidity as the 2007/08 crisis developed? How and when did these plans evolve? What was the nature of those plans?

The funding and liquidity positions of banks were monitored very closely by the FSA after August 2007, on a daily basis for a number of firms including HBOS. 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. HBOS specific 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.

5.4 Did the supervision team have a good understanding of the risks inherent in the ABS portfolio?

The ABS portfolio was intensively reviewed by supervision and the specialist Risk Review Team from late 2007 onwards. The FSA’s concern was primarily the liquidity and the valuation of the portfolio. The firms external auditors were also consulted on the re-valuation of the portfolio.

5.5 Did the bank have adequate stress testing arrangements in place? To what extent did the FSA get involved in dictating what scenarios and assumptions should be used? Did the FSA run its own stress tests?

In common with all major UK banks, HBOS did have stress testing arrangements in place and these were subject to on-going improvements. Some improvements were identified through a thematic review of stress testing arrangements in 2006 although the overall outcome of the review was that the FSA was unable to conclude that HBOS met the FSA’s comprehensive approach in practice. These findings were communicated to the Group CEO in October 2006 along with examples of good practice.

Capital planning and stress testing was a key feature of Basel II, both within IRB and Pillar 2; and was subject to FSA review as part of the implementation of Basel II during the period. Following the IRB and Pillar 2 reviews in 2007, the FSA had concerns that the severity of the firm’s stresses did not meet the FSA standard. As a result the firm was required to re-run its stresses, and the firm was given a capital add-on.

The FSA own substantive stressing of firm’s complete balance sheets did not start until late 2008; although in late 2007 the FSA had been considering sensitivities to the firm’s capital positions in response to the then emerging market issues.

Provisioning Policy

6.1 Was the FSA satisfied with the firm’s provisioning policy during the period you were involved in its supervision?

Provisioning policy was discussed in meetings with the external auditors, for example changes to IAIS standards. No material concerns were identified from these discussions. During 2008 the FSA became increasingly focussed on the impact that the financial crisis was having upon asset values and the risks posed to credit risk and provisioning. This included dialogue with the firm’s external auditors.

6.2 The Final Notice to BoS of 9 March 2012 states that “the firm adopted an optimistic approach to levels of provisioning despite repeated warnings from HBOS’s auditors and the corporate division’s risk function of the need for a more prudent approach”. Please can you expand on this point? In particular, were the repeated warnings visible to the FSA? How did the FSA respond? Did the bank’s external auditors or corporate division ever raise any concerns directly with the FSA over the level of provisions held in respect of the corporate division’s exposures?

As noted in response to question 3.8 and 6.1, the Final Notice covered the period between January 2006 and December 2008 and was a forensic review of all information available, including information that was not available to, or disclosed to the supervision team at that time. The “repeated warnings” on provisioning came from two sources, KPMG and Corporate’s Chief Risk Officer.

KPMG’s “warnings” are reflected in various reports they produced for HBOS during 2008, in the context of work relating to quarterly reviews, the June rights issue and the November placing and open offer.KPMG regarded the provisions to be at the optimistic end of the range but still within acceptable limits, and as such signed off the accounts. My recollection is that provisioning was discussed with KPMG at meetings in January and September 2008 and that KPMG did not escalate serious concerns about the level of provisioning.

Corporate Risk’s “warnings” relate to meetings with senior management held in October and December 2008. After the December 2008 meeting, Corporate’s Chief Risk Officer informed the supervision team that HBOS had a £2 billion range for corporate provisions and that they ultimately provided at the bottom end of the range.

Corporate Governance

7.1 Did the FSA consider that there was adequate banking expertise on the bank’s board?

The ARROW risk assessments considered corporate governance and Board effectiveness. No concerns were identified. 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.

7.2 Did the FSA think that the Board was in a position to challenge divisions effectively and did it do that in practice?

See 7.1.

28 November 2012