Parliamentary Commission on Banking StandardsGROUP MANAGEMENT BOARD Tuesday 20th January 2004, at 11.00 a.m. The Mound, Edinburgh

MINUTES
Present
James Crosby (Chairman)	Ian Kerr
Mike Ellis	Colin Matthew
Phil Hodkinson	George Mitchell
Andy Hornby
In Attendance
***	***
***	***

1. Minutes

The Minutes of the meeting held on 15 December 2003 were approved, subject to minor amendments.

2.1 Oral Business Update

2.1.1 IID

Phil Hodkinson confirmed that December profits were strong; higher than the 11+1 forecast. STF’s had also improved as stock markets strengthened in the month. Investment sales in the full year were slightly ahead of 2002, with particularly strong sales in the UK. This would be a good result compared to peers; the business was likely to be equal first or second largest (by a small margin) in 2003 in terms of UK sales. Bancassurance in total was well ahead of 2002 and Plan.

General Insurance sales were ahead strongly in the full year—with increased penetration of the PLRC product, particularly in the second half of the year. Profits in the month were strong. Motor insurance sales at *** were ahead 65% in the year; total sales had increased by 80%.

The Asset Management business would also be ahead of the 11+1 forecast, with assets up for the year. SJPC had performed strongly in the latter part of the year and was only down 4% for the full year.

2.1.2 Treasury

Treasury profits were around £235 million for the full year, well ahead of the 11+1 forecast, and ahead of 2002, but behind the restated Plan. There had been a relatively slow start to the year. This was not unexpected. The New York office had received its licence—and was on track to open for business in March. An issue of $500 million lower tier 2 replacement funding had been completed successfully during the close period. Discussions were continuing in relation to potential Tier 1 issuance. Lindsay Mackay had made a strong start in his new role. ***’s appointment was also key, and had been well received.

2.1.3 Retail

Retail were on Plan in December and profits were ahead £85 million for the full year. The mortgage market remained buoyant. If this continued, the business was likely to trim its market share target. Buy to let remained strong—in part fuelled by ongoing concerns about pensions. The range of buy-to-let investors was widening.

The 50% stake in the Halifax Cetelem joint venture was likely to be sold. Consideration was also being given to selling most of the remote ATM estate, which required significant internal infrastructure support.

The FSA had investigated the Group’s handling of endowment claims. Their concerns were not in relation to pre-A day cases. They had sampled a limited number of post-A day files, and appeared to be adopting a different stance to the Ombudsman in relation to “suitability”. Their findings and approach were not consistent with a recent internal, wider ranging, Regulatory Risk review (that had been carried out with assistance from KPMG and Ernst & Young), or the fact that Retail’s record with post-A-day complaints that progressed to the Ombudsman was very strong. The aim would be to persuade the FSA to discuss individual files in detail—to resolve queries and to confirm that the stance being adopted was in line with the FOS approach. Adverse publicity in relation to *** was likely to result in increased complaints in relation to SLAC policies, where the Group shared the cost of tied sale complaints.

2.1.4 Group Services

lan Kerr confirmed that Group Services had ended the year better than the 11+1 forecast. The FBS transfer had completed smoothly. There had been a serious disruption to IT service [full day’s systems failure] earlier in the month which had impacted large parts of the business on Monday 5 January. Pay discussions had commenced with the aim of containing the cost increase within 3%.

2.1.5 Corporate

George Mitchell confirmed that Corporate Banking would achieve profits in the full year of £876 million. Overall asset growth had slowed significantly in H2, following some repayments *** and *** and sell downs (a total of £3 billion in the full year)—which would assist the funding gap in 2004, but meant 2004 would start slightly behind internal expectations, and increase the earnings challenge.

2.1.6 Business Banking

Business Banking had ended the year well, with a good December, producing £404 million profit in the full year and strong growth in both assets and liabilities. There remained good work in progress at the end of the year. Heads of Terms had now been agreed with LVL in relation to amending the terms of the joint venture arrangements.

The new management structure of the Australian Group would be announced shortly, with legal restructuring following in due course. Progress had been delayed by the need to consider various local tax issues. *** would leave the business later in the year. Recruitment of a potential head of the overall HBOS Australian operation, to be based in Sydney, was now underway.

3. Board Strategic Reviews

3.1 HBOS with Profits Strategy

The paper presented by *** and *** set out current thinking in relation to the strategy for managing the *** With Profits Sub Fund (the “Fund”). A preliminary report would be submitted to the Board in January, with a further report later in the year, once firm recommendations could be made.

In 2003 the Board had agreed that:

The Fund would remain open to new business (primarily to avoid

damage to the intermediary franchise);

the business would price With Profits products realistically,

which was likely to lead to a move away from sales of With Profits towards less capital intensive products;

the investment mix of the Fund should be protected as far as practicable, to retain the prospect of benefiting from increasing financial strength once stock markets recovered (although the likelihood of a significant upside was now reduced).

This strategy had been implemented successfully. Dependence on With Profits had reduced significantly (particularly in the UK). As at the end of 2003 the free asset ratio was around 7% and the equity backing ratio was likely to be in the region of 55% (slightly behind, but broadly in line with major peers—and customers’ reasonable expectations). Guarantee costs should peak in about 2004, and had been reserved within the business. The worst case scenario assumed that all customers secured full value for their guarantees—which was unlikely to occur in practice.

Future key strategic objectives were to:

meet contractual obligations to policyholders (including resolving the approach to guarantees );

meet policyholders’ reasonable expectations;

Fund in a manner consistent with communications to policyholders); and

provide good returns for policyholders, within the constraints of the existing capital base (except in extremis, no further capital support would be sought from the Group).

Given these objectives, the current *** view was that it remained in the interests of policyholders and shareholders to manage the Fund through the current market environment, rather that close match assets, or close to new business. This was the approach most likely to unencumber the Group’s capital—enabling the growth of unit linked business to be supported and, ultimately, allowing the contingent loan to be repaid and/or dividends to be paid. This strategy required only modest growth in the FTSE index, and prudent growth in bonuses, with significant growth in the Fund occurring by 2007. More work was needed before the timing of loan repayment and dividend paying capacity could be forecast. Close matching at present would damage the interests of both policyholders and shareholders.

This approach was consistent with the strategy approved and adopted in 2003—but if the market fell away quickly, prompt action would be taken to protect the business.

*** was likely to be facing many of the same issues as ***—but even greater, given the scale of ***. The *** business remained heavily dependent upon With Profits business: but it was clear that customers had turned against With Profits products. The brand had been and could remain strong, if swift action was taken. Employee benefit consultants had removed *** from “buy” lists and IFA’s were unlikely to place significant new money with *** in the near term. The future of the *** business, whether demutualised and independent, or acquired by a bank or bancassurer, could well depend on a move into unit linked products for future sales, possibly following significant divestitures.

3.2 Stress Testing—the Impact of Economic Scenarios

It had been agreed that the Group Business Plan should be subjected to “highly unlikely but not implausible’’ stress tests. (“Likely” events should be the subject of sensitivity analyses built into Plans). The aim would be to devise two economic scenarios: Divisions would then be asked to assess the potential impact on their Business Plans (including the mitigating effects of management action). The results would be presented to the Board in due course (target April).

External consultants (Capital Economics) would devise the scenarios (intended to be challenging to a UK-based full-service financial services group) and the economic statistics that would prevail under those scenarios. GFR would manage the process, collate responses, interpret the results—and, in conjunction with the Group Finance Director, consider possible additional issues arising at a consolidated Group level.

3.3 Risk Management Development and Risk Appetite

The Board was responsible for setting the Group’s appetite for risk and for approving the strategy for managing risk. Mike Ellis’s paper considered how the Board discharged these responsibilities and outlined planned developments in relation to risk management. As *** explained, some competitors had invested more money into formal risk management measures and techniques. This did not necessarily indicate more (or less) robust management—but was an issue that was likely to be highlighted by the regulator, particularly if failures occurred.

No single document or statement set out the Group’s appetite for risk. This was. set within the Group’s overall risk management framework, and included the:

Reservation of specific matters to the Board, in the Board Control Manual.

Group Business Plan, which comprised a full exposition of the Group’s business strategy—including in relation to risks, financial sensitivities and stress testing.

Risk Management Policy Statements as approved by the Board and monitored by the Executive Risk Management Committees.

Regular review of Operational, Regulatory and Reputational risks. The quantification of Operational Risks needed further work, to reflect the true likelihood of multiple adverse events occurring in any one year, and the management actions that would be taken.

Later in the year, the feasibility of making a single statement of, or adopting a single methodology for quantifying, risk appetite would be reconsidered. This, in turn, was likely to require an assessment of the capital required to support the Group’s plans, based on a full understanding of the overall HBOS risk profile. However, no undue reliance would be placed on any single statement of risk appetite, it would be recommended to the Board that it should maintain focus on a variety of risk issues. The previously adopted measure—that the business would be conducted in a way that safeguarded a level of profitability of least 95% of planned profit (save in truly exceptional circumstances) was not directly correlated with the limits and risks being accepted by the Group, under its various Policies, and also needed to be reviewed.

There were numerous key regulatory developments in course of implementation or being considered—including introduction of International Accounting Standards; the new Prudential Source Book; the implementation of Basle II; new solvency requirements for life companies; and the introduction of general insurance and mortgage regulation. A full risk management development calendar had been arranged for the Board and Audit Committee, to ensure appropriate governance and oversight, as these developments progressed.

4. Group Finance/Risk

4.1 Year End Update

The full year’s result would be very close to the Restated Plan and usefully ahead of the median consensus (by about £30 million), before changes in investment RDR’s and short term fluctuations. Exceptional were less than planned. Year on year pbt growth was 14% without STF’s, and 27% including STF’s.

Cost increases in the full year were currently likely to be ahead of 9%. Margins were down by 5 bps or so, although the final calculations were not yet. complete. The target ROE would be flat from 2002 to 2003, taking into account the full year’s impact of the equity raised in 2002. Endowment provisions were sufficient overall, but the treatment between Group and Retail, and the precise disclosure requirements, needed further consideration.

Synergies were likely to end up well ahead of Plan, although further detailed consideration was required, particularly in relation to the level of claimed Revenue synergies. The true underlying position would be investigated in detail by each Division.

4.2 Final Dividend 2003

No final decision would be made about the Final Dividend at this stage. The Group’s policy on dividends was clear and a recommendation in line with that policy would be submitted to the Board on 24 February.

The Group was at the bottom end of its Plans in relation to capital ratios, particularly in relation to Tier 1 capital. The Group Business Plan did not assume that a scrip offer would be made. A widely taken up scrip offer would increase the challenge involved in achieving the 20% ROE target. Nonetheless, on balance, a scrip offer would be recommended to the Board in conjunction with the 2003 Final Dividend, given the Group’s capital position, and the benefit of adding incremental amounts of true Tier 1.

4.3 Proposed Bad and Doubtful Debt Provisions—12 Months to December 2003

Each business had considered the appropriateness of the overall level of provisions held. Overall credit quality remained sound—with total provisions equivalent to 0.39% of average customer advances (an improvement compared with the position at mid 2003); closing provisions at 0.80% of advances (an improvement compared to end 200.2) and a reduction in non-performing assets as a percentage of advances. This would be a better result than the market was expecting.

Within Corporate Banking, the trend was in the right direction. There had been no deterioration; (arguably) the overall quality of earnings had improved, in Retail, provisions had grown significantly—all in respect of credit cards and unsecured loans. Improvement within Business Banking was a mixture of good underlying performance and strong asset growth.

4.4 2004 Business Plan—Phasing Analysis

The trend of performance would be improved if the results in the first half of 2004 were increased by a sum in the region of £50–£80 million, compared to the second half of 2004, to increase credibility and the market’s likely view of the deliverability of the 20% ROE target. The timing of discretionary items would be amended, as necessary, to achieve this result.

4.5 Restated Financials for Group Bonus Purposes

The three proposed adjustments in relation to Group cost targets, for colleagues other than the Senior Executive, namely:

cost of actual bonus payments above/below the original Plan;

cost variances in relation to the LTEBS; and

increase in costs attributable solely to foreign exchange movements in Australia and Ireland

were agreed.

With regard to the Group Bonus Scheme for Senior Executives, various adjustments to PBTE, ROE and EPS, based on the Quarterly Forecasts and Restatements reported to the Board during the year, would deliver very close to 100% of a very challenging Plan. A potential alternative approach was to make no adjustments at all to the Plan. In due course, if any adjustments were to be made, these would need to be considered by the Remuneration Committee, which would in turn seek views from the Chairman of the Audit Committee.

And achieving marginally less than 100% of this very challenging Plan constituted very real success.

4.6 Group Risk Policy Statements

Some further, relatively minor, changes were required—but the four Group Risk Policy Statements (Group Credit Risk; Group Market Risk; Trading Book; and Liquidity Policy) would be submitted to the Board for approval at its meeting on 27 January.

4.7 Regulatory Change Programme

Following the two-day workshop held earlier in the month in relation to the various, major, group-wide, regulatory change projects, relating to International Accounting Standards (“IAS”), the Prudential Source Book (“PSB”) and Basel II, it was proposed and agreed that:

these programmes needed to be driven and directed by a strong central team;

decision making needed to cut through the Group’s management structure, to deliver rapid progress;

there needed to be rapid escalation of any issues or concerns that arose; and

a Regulatory Development Steering Committee (“RDSC”) would be formed, to oversee progress; ensure dependencies were taken into account; review priorities; and. ensure impacts on business as usual were fully appreciated;

a Regulatory Development Programme Director (probably an external consultant) would be appointed to drive the overall process, support the RDSC, and run the Programme Office for the combined PSB/IFRS projects;

to ensure that issues were resolved speedily and progress was made, the Chairman of RDSC would have authority to direct that appropriate actions were taken by all parts of the Group (subject only to a “right of appeal” to the Chief Executive).

These measures would be communicated by GMB members to their relevant teams. In March or April each GMB member would present and confirm to the Chief Executive and the Chairman of the RDSC their approach to and progress in implementing regulatory developments within their areas of responsibility.

4.8 Report on Relations with Regulators

Group Regulatory Risk (“GRR”) had relationship management responsibility for the FSA, at a prudential supervision level, and for overseeing other relations with the FSA, and relations with other regulators.

The Group’s relationship with the FSA was in a challenging phase, and needed ongoing careful management to ensure that the FSA did not reach incorrect conclusions about the HBOS business approach and culture, and its risk management capabilities.

The assessment of the relationship with regulators was noted, and the central liaison and management role of GRR was affirmed.

4.9 FSA—Group Arrow Risk Assessment

The Audit Committee had considered this issue and had been supportive of the executive’s position and did not believe that growth had outpaced controls. It was essential, however, that the Group’s responses to the FSA continued to be measured and robust.

The Group’s growth, in contrast to the peer group, was clearly viewed by the FSA as a cause for potential concern. The language and tone of the FSA’s recent communications was probably stronger than the approach being adopted by the FSA in relation to other financial services companies that were, by definition, not growing as strongly as HBOS. Meetings had been arranged with the FSA to discuss their letter of 15 January. There would be little dispute about the detailed recommendations in terms of the FSA’s proposed Risk Management Programme. Indeed, the Group would commit to prompt delivery of agreed RMP’s. But the conclusions drawn by the FSA would be disputed strenuously.

The FSA had a very different view, in particular, in relation to management of the Corporate Banking Business and their assessment of the Corporate Banking commercial property position was a key driver between their approach to ICR. The FSA had commissioned a S.166 skilled persons report on the risk management framework within HBOS to provide them with a detailed, independent, view of the adequacy of the risk management functions, at both a Divisional and a Group level. The outcome of that report would be a key factor in deciding whether and when the ICR would be returned to its previous level.

4.10 Capital Injections into Subsidiaries

Capital injections needed to be made in Halifax plc, Bank of Scotland and capital Bank plc, to ensure that satisfactory capital ratios were maintained, and appropriate recommendations would be made to the Board at its meeting on 27 January.

5. Corporate

5.1 Capitalisation of Subsidiary(ies) of HBOS Treasury Services Plc and Novation of Swaps

As in 2003, there was an opportunity to monetise a number of high coupon interest rate swaps, eliminating the MTM exposure, and replacing them with swaps at prevailing market rates—to reduce the credit exposure to a heavily utilised credit line—novating the swaps into one or more SPVs—which would then be sold—producing additional profit.

Further consideration needed to be given to disclosure issues relating to the proposed transactions. Subject to satisfactory resolution of those issues, this proposal would be recommended to the Board in due course.

6. Group Services

6.1 Review of Executive Talent Management and Development throughout 2003

Consideration of this issue had been interrupted by the internal reorganisation: although that reorganisation had also provided the opportunity to make a number of challenging moves for talented individuals. There were still some significant gaps in knowledge in relation to succession, however, and further action was required.

It was agreed that time would be devoted to a Group-wide review of the level 7 and above population, as well as other high potential colleagues, at the March GMB—which would continue into the late afternoon/evening, if required, to give this issue appropriate attention.

7. Company Secretary

7.1 Board Control Manual

The revised version of the Manual, updated to reflect:

the requirements of the New Combined Code; and

the organisational restructure, with improved layout and functionality

would be recommended to the Board for approval at its meeting on 27 January.

7.2 HBOS Plc AGM 2004

Formal approval to the items of business that would be transacted at the Company’s AGM in April—all of which were likely to be “routine” matters—would be sought at the Board’s meeting on 27 January.

Consideration was given to the possibility of holding one or more business presentations at the 2004 AGM—but GMB’s views, on balance, did not support that proposal. The Chairman’s views would be sought.

7.3 Non-Executive Directors Fees

A pragmatic approach was recommended in relation to the review of fees with effect from 1 May 2003 (that would also deal with the issue of fees with effect from 1 May 2004). Considerable research had been undertaken, which suggested that the core Board membership fee was relatively significantly “off the pace”. Committee duties were fully remunerated, however. The recommendations would be discussed with the Chairman in due course.

8. Any other Business

8.1 Board Strategic Reviews 2004

The programme of Strategic Reviews played a key role in building the Board’s understanding of the Group—its constituent businesses; the strategic challenges they face; and the legal, regulatory, economic and competitive environment in which they operate—and were a key component of the Board’s exercise of proper governance and oversight. It had also been agreed that the programme would form a core element of the Company’s commitment to provide ongoing training and development for Non-Executive Directors.

The approach to Strategic Reviews and the content of the programme needed to be refreshed, however. A revised approach would therefore be proposed comprising:

one comprehensive presentation each year by each of the Operating Divisions, plus Group Services; together with; and

regular reviews of Other Business Issues, together with key risk, monitoring and control issues.

The precise timing of individual events would be looked at again, but the overall approach was supported. Additional items could be added to the programme during the year—as further issues arose or were requested by Directors from time to time.

Section 2—Papers For Comment

9. Group Finance/Risk

9.1 Anti-Money Laundering (“AML”)

The update on Anti-Money Laundering was noted.

10. Group Services

10.1 Group Programme Office Major Change Report—December

The Group Programme Office Major Change Report for December 2003 was noted.

10.2 Offshoring

An increasing number of competitors had announced their intentions to move call centre and other activities offshore—largely to India. Notably, however, some competitors (RBS and Co-op Bank) had publicly rejected this approach.

HBOS had considered various offshoring initiatives, but there was relatively little appetite to move significant functions overseas. There was no need for an urgent decision.

10.3 L8 And GMB Bonus Measures

It was agreed that GMB members should continue to have their entire short term bonus based on HBOS total Group performance. Views as to the approach to bonus targets for other Level 8 colleagues varied. It was agreed that each member of GMB could adopt the approach which best suited their requirements and the requirements of their businesses and colleagues.

10.4 Annual Salary Review—Levels 7 And 8

The proposed approach was noted.

11. Company Secretary

11.1 HRF New Trustee

The Proposal to appoint *** as a replacement Trustee of HRF would be recommended to the Board at its meeting on 27 January.

12. Any Other Business

12.1 Schedule Of Advances

Schedules of Corporate and Business Banking significant Advances were considered and would be submitted to the Board on 27 January 2004.

12.2 Next Meeting

The next meeting of the Group Management Board would be held on Tuesday 17 February 2004 at The Mound, Edinburgh.