Parliamentary Commission on Banking StandardsEXECUTIVE COMMITTEE AWAY DAYS Monday 5 and Tuesday 6 June 2006 Gleneagles Hotel, Auchterarder
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MINUTES |
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Present |
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Andy Hornby (Chair) |
Benny Higgins |
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Harry Baines Peter |
Phil Hodkinson |
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Cummings Jo |
Colin Matthew |
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Dawson |
Dan Watkins |
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Apologies |
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James Crosby |
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In Attendance |
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*** |
*** |
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*** |
*** |
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Peter Hickman (All) |
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DAY ONE |
ACTION |
1. Introduction
Andy Hornby introduced the Sessions planned for the Away Days by confirming that Day One of the Away Days would focus on the organic plans and issues for each Division—with exploration of inorganic possibilities taking place on Day Two. Project Holly and Capital Management would also be considered on Day Two, and the debate would focus, in particular, on the Group’s positioning around Holly in the context of the Interim Results, and the market’s general view of the Group’s growth ambitions and prospects.
Overall, the Group had outperformed its peers over the past four years, driven in particular by strong performance in Retail and Corporate. Current Plans would reverse this profile, however—with the strongest planned growth being in l&l and International. This approach begged the issue of whether sufficient emphasis was being given to growth ambitions in Retail and Corporate. This, in turn, led to a key question for consideration at these Away Days, namely:
“what is the right level of growth that HBOS should target in the core UK businesses?”
The Group continued to have a range of competitive strengths:
the safest balance sheet in the sector;
multi-brand distribution capabilities;
strength in bancassurance;
the Integrated Finance proposition;
low cost: income ratios;
strong capital ratios; and
a strong top team.
It was right to question, however, whether these advantages were being sufficiently leveraged.
Conversely, the Group had a range of strategic weaknesses;
unsatisfactory customer service levels;
lack of sufficient credit risk capabilities;
over-reliance on wholesale funding;
lack of England and Wales SME share, notwithstanding the ambitions set out at the time of merger;
an unclear strategy in the Intermediary investment market;
lack of International diversification;
potential inorganic opportunities that looked very hard to deliver, in the current climate; and
lack of “strength in depth” in the senior talent pool.
The Business Plan 2007–2011 needed to address these shortcomings. Challenge sessions prior to finalisation of the Business Plan would consider the extent to which individual Plans, and the cumulative Business Plan, gave appropriate priority to this objective.
2. Current Position
Phil Hodkinson’s presentation considered:
the Group’s current absolute performance position;
HBOS relative performance compared to peers; and
the market’s views and expectations.
The high-level financial analysis of the current position reflected both Holly and Chip, and assumed continuation of the buyback programme throughout the period of the current Plan (even though there was no commitment to do so). Numerous other potential impacts—including Drive, Regulatory Tide, branch expansion and other issues—were not yet reflected in the numbers, however.
Not surprisingly, 2006 and 2007 financials were the best developed: later years were higher level estimates. The current (2006–2010) Plan showed:
a likely strong outturn in 2006—but insufficient growth and performance in 2007;
relatively modest RWA growth in Retail and Corporate, in particular. There was no suggestion in this Plan of an early return to significantly more aggressive rates of UK growth;
returns on Equity that continued to drift upwards during the Plan period, suggesting that the Group had the choice of pursuing additional opportunities for growth, rather than simply pursuing returns;
the cost: income ratio falling below 40%. Achieving this in 2007 would be the internal (albeit not necessarily the external) commitment. Keeping costs growth below 6%, to produce strong positive JAWS, was important. Savings should, in part at least, be used to help fund and fuel further or future growth;
funding that was not yet a constraint, but which could become a constraint by the end of the Plan period as much of the Group’s funding capacity was utilised simply to renew and replace existing levels of funding. The sources of funding needed to continue to expand. Expansion into non-Sterling sources of funds would increase the need to manage FX risks, of course;
a continuing strong Capital position. The Group’s current external positioning was to have a level of gearing of about 25%, plus or minus 2%. This was primarily a matter of internal discipline, rather than a source of concern for the market. This level of gearing left the Group with a relatively high level of leverage capacity. The gearing level could be allowed to rise significantly (on an interim basis) in the context of a major acquisition. Current levels of gearing would support an acquisition of up to c. £4 billion, without the need for further equity, taking gearing towards 35% on a temporary basis, without undue strain. This compared well with other UK banks but was weaker than many European and US banks;
assets and ROE growing broadly in line with UK competitors, with Nil growth ahead of the peer group, due to the relative immaturity of the Group’s businesses.
The cost: income ratio and dividend cover were strong. Concerns for investors in relation to UK banks in general, and HBOS in particular, included:
the sustainability of returns;
growth prospects; and the timing of any move to a more aggressive rate of growth;
managing the funding gap;
international ambitions, based on internationalising UK strengths—which meant low risk—but probably only slow growth;
acquisition risk; and
the new management team at HBOS, (which was associated with acquisition risk, in particular).
The correct management approach was to “ignore” the market—and to do “the right thing” in management’s view—albeit informed by the market’s expectations.
Buybacks were no longer “flavour of the month”. Once established and “institutionalised”, they tended to suggest to the market a lack of growth prospects. On balance, the market would prefer growth, albeit at lower returns, rather than higher returns at the expense of growth. The Group had the ability to grow more quickly in targeted areas, due to its capital strength, strong ROE’s and low cost: income ratio, should it choose to do so. Stronger growth—even if overall Group returns were slightly diluted as a result—could be strategically compelling.
In 2007, in particular, there needed to be greater emphasis on income generation. Current cost plans in total were probably about right, although costs were not necessarily being incurred in precisely the right places.
HBOS and RBS had the strongest capacity to self-finance growth—with LTSB the weakest. In a European context, HBOS was the 10th largest by market capitalisation: European banks had far lower ROEs; were growing at about 10% p.a. in terms of RWA’s; and were making lower payouts to shareholders. The UK market remained less consolidated than in most other European countries. UK PE ratios—HBOS was at 8.7%, alongside RBS—a UK average of 10—compared with an average of c. 12 across European banks.
The overall aims of the Planning process should be to achieve:
double-digit upbt growth in all years. In 2007, in particular, there needed to be more income (particularly as impairment charges were a continuing threat to profit) although ROE’s were currently planned to increase in 2007 in a way which suggested that greater—albeit perhaps slightly less profitable—growth was possible;
continuing costs discipline. Current outliers in terms of costs growth were international, Treasury, and Asset Management. Investment would be targeted primarily at areas of revenue production. Although it also needed to be recognised that not all cost growth could be directly linked to revenue generation ~ given increasing regulatory costs, in particular;
planned initiatives being SVA enhancing (over a reasonable timescale);
maintaining dividend cover around 2.5 times.
The preliminary conclusion was thus that growth should be increased in targeted areas, and that some consequent dilution in overall returns could be acceptable. This preliminary conclusion would be explored further during the Away Days.
3. Economic Assumptions
The Group’s internal view of likely macro economic developments during the Planning Period was broadly in line with the core view of Capital Economics, and this would in due course inform the creation of the Planning Framework later in the month. Key components in terms of the assumed general economic environment included:
UK GDP growth around 2.5 times, as a core assumption;
a “soft landing” in terms of house prices. The housing market was still relatively robust. Growth was likely to slow to close to zero in the early years of the Plan period, but was unlikely to go into major reverse, before returning to a gentle ongoing rate of growth. Long term demand continued to outstrip supply (largely due to ongoing planning constraints) leading to continuous upward pressure on prices. First time buyers (“FTB’s”) were now largely excluded from the market and, to a significant degree, had been replaced by private lettings (and “buy-to-let”). The implications of the increased scale of the private letting sector needed to be considered carefully. This type of market structure could be more interest rate sensitive than the “traditional” structure given the level of investor interest in private letting. On balance, the Group’s house price inflation assumption was likely to be closer to the Capital Economics view than the “consensus view”;
affordability continued to be an issue. Capital Economics continued to place significant emphasis and reliance on the assumed swiftness of the Bank of England’s reaction to economic developments, and the market’s response to interest rate changes. But there was significant affordability stretch;
consumer spending, where no early or strong rebound in consumer demand was anticipated;
personal insolvencies, where the Capita! Economics view of the rate of reduction in insolvencies was likely to be over-optimistic. The traditional indicators of likely insolvencies were probably no longer valid—and the assumed ongoing level of insolvencies assumed by Capital Economics looked too benign. With this likely continuing trend in mind, scorecards needed to be directed heavily at total indebtedness. But it was difficult for the business to differentiate with confidence between those likely to become insolvent and those who would not;
interest rates and inflation were likely to remain relatively static. The Plan should assume low volatility in rates—rather than assume that multiple rate moves would provide the opportunity to manage margins;
unemployment was likely to increase, but not to a degree that should cause significant issues.
These issues also needed to be considered in an International context for the International businesses, but there were unlikely to be any major issues in any individual overseas territories—although affordability could become stretched in Australia or Ireland if rates rose considerably.
The Planning Framework would set out the chosen planning scenario. The Up and Down scenarios would then be based on flexing the ‘‘consensus” view—not the Group’s chosen planning view—to avoid overlays of either excess conservatism or optimism. The Up and Down scenarios in the UK were materially driven by the implications of overseas developments—US market conditions, for example—and would include consideration of a technical recession, The five year outlook for asset prices looked relatively benign—but shorter term peaks and troughs could well be materially away from the assumed smooth trajectory.
Guidance would be provided alongside the Planning Framework in respect of the likely impacts of Basel II on plans—and a “shadow” Basel RWA plan would need to be created with effect from 1 January 2007. Targeting businesses on SVA, with its emphasis on the capital employed by individual businesses, should in time focus business units appropriately on the impacts of Basel.
This relatively “flat” economic planning scenario posed real challenges in relation to the lack of opportunities to exploit counter-cyclical opportunities, and the lack of opportunities to unwind current excess levels of personal indebtedness, an issue for Retail and Corporate, in particular.
4. Corporate
Peter Cummings confirmed that the business was on track to deliver its Q1F—which assumed RWA growth in the full year (2006) of c. 6% and UPBT growth of c. 11.4%. The position at the half year would be managed to be broadly in line with this full year forecast. The current plan had UPBT growth of only 5% in 2007—which looked too low. Significant further revenue growth would require a major shift in asset growth assumptions (into double digits—11 %-12% at a minimum probably)—not merely an additional £1bn-£2bn of assets (which would still be single digit in terms of asset growth). The current Corporate book had a c. 30% rate of chum. Simply to stand still, c. £24bn of assets had to be written each year. As the Group had a very low share of the SME market, the Group did not share in overall SME growth. A step-change in performance thus depended upon being able to originate larger deals, in turn, distribution capability needed to strengthen. The Group had a material dependency on capital markets—and in seeking to lead larger deals was likely to have to take capital underwriting risk, unless or until the Group’s capital market capabilities were further advanced.
Project Pace was directed at increasing SME share in England and Wales in a sustainable way. The immediate push post merger had been focussed excessively on “quick-wins”—and had largely become focussed on commercial property. Delivering real inroads into the SME market in England and Wales was dependent upon having a credible branch presence.
Relationship Banking could probably generate up to £2 billion of RWA’s—and a reduced sell-down appetite to increase that to c. £4 billion per annum—but a step change in terms of income required a far greater push on asset growth.
Basel II would not lead to any material change in RWA’s, There was likely to be a higher minimum capital requirement in respect of the equity portfolio, but this would be offset by a lower minimum capital requirement for property and motor portfolios.
Key objectives of the Corporate Plan included:
delivering the Basel agenda—both in terms of initial implementation and subsequent business as usual usage;
building greater management/leadership strength in depth;
leading the way on CSR, given the greater emphasis being placed by organised and articulate investor and pressure groups on CR issues; and
delivering cost discipline.
Key themes included:
completing the move to the preferred Asset Class Management model;
delivering the England and Wales SME ambition, through Project Pace;
becoming clearly “best in class” in chosen niche markets;
and, in particular, being the best property bank in the UK.
The core issue for Corporate during the 2007–2011 Planning period thus related to the preferred speed of growth. Present growth plans were relatively pedestrian. UPBT growth of c. 20% year on year—based on 17%-20% (origination) RWA growth, with net c. 11 %-12% RWA growth would be stretched, particularly in current conditions, but should be ultimately sustainable. Corporate’s strengths were in execution and delivery: but not in true origination. To achieve this rate of growth, additional people capabilities were probably the most pressing need; pricing/margins in commercial property would also need to reduce; and more risk would be taken in some asset-backed environments. There would not need to be any increased hold risk in leveraged markets, although there needed to be a general step change in distribution capability—in part through delivery of the planned capital markets initiative; in part through the addition of specialist “sales” or distribution skills; and through widening the contract base for sales/distribution. Any increased growth was likely to increase the Group’s exposure to commercial property. Although a cyclical downturn in commercial property could produce short-term earnings pressure, these were assets that could be “worked out” over time, and that, in the absence of large scale lending against purely speculative developments, should not lead to major impairments. No material “correction” was foreseen in relation to commercial property, in any event (except in some overheated market sectors).
The upshot was a belief that the Corporate Plan should focus on high single digit UPBT growth, rather than low single digit growth with associated higher RWA growth.
5. Retail
Benny Higgins confirmed that Impairments and the potential implications of Regulatory interventions could introduce real stretch during the Plan period—and from 2008 onwards this could well be material
In relation to the mortgage market, compared with current Plan, there was a growing belief that the Group should push for a higher share of gross and net lending. A move to a 25% net lending share was acceptable in risk terms and would reaffirm the Group’s clear market leading position. (A move to or close to a 30% share would take the Group into uncomfortable (from a risk perspective) territory). Such an increase in share was predicated on the assumption that mortgage retention performance could be improved significantly (otherwise a 25% plus net lending share, at acceptable cost and risk, was unrealistic).
The Unsecured lending business was facing a series of significant challenges—internally in terms of capabilities, as well as external. Consumer over-indebtedness affected the “unsecured’* population the most. Actions were being planned to help address the consequences of any shock that would tip customers over the indebtedness edge. But the impacts of any interest rate, unemployment or other shocks were likely to affect unsecured personal loans the most. The Group had more expertise in relation to credit card capabilities than in relation to unsecured personal loans—which latter sector was thus the major source of exposure. Pushing ahead aggressively in this business against this scenario, was highly dubious.
Current thinking suggested that there should be less emphasis on unsecured lending volumes—although this ignored the value of PPI sales. The Group’s position on undrawn balances also needed careful thought, in post-Basle II environment. The planning assumption would probably be to no more than maintain market shares in unsecured markets, whilst making sure that PPI take-up-rates were appropriate.
In the longer term, the answer would be to get back on the “front foot” in relation to PCA’s. A stronger emphasis on banking products would help during the transition period needed to address unsecured credit issues. There also needed to be increased emphasis on savings deposits, albeit with some margin strain. The strength of the bancassurance business needed to be exploited fully.
Service issues in Scotland were being addressed, and robust plans were in place—particularly in relation to the “S” end of “SME’s”. In England and Wales, further thought needed to be given. Costs were being squeezed in 2006 and 2007—but the costs position in 2008 onwards was potentially unrealistic, particularly given the need to continue to address service issues, and bring the same focus to “service” issues as had historically been given to “sales”. Appropriate focus needed to be given to numerous small scale back office issues in addition to front line service issues, where significant progress had in fact already been made (although perception lagged reality).
A move to 25% net lending market share assumed a fall in margin, which thus negatively impacted SVA (unless or until the capital charge reduced in a post- Basel II world). A number of issues would need to be addressed in order to achieve this level of net share. The market had changed dramatically since merger—in particular, in terms of the distribution mix, and the death of the FTB market. Intermediaries now accounted for c. 80% of business: the FTB market had fallen dramatically. The TMPP product was overly-complex, and the sales process was, as a result, over-long and difficult. The Group needed to get more branch business; the PFA model for mortgage advisers could be the better approach, particularly post mortgage-regulation, and would be investigated. Intermediary cross-sales of Gl products needed to improve significantly. The TMPP product needed to be simplified—which would help both branch sales and intermediary take-up rates. There needed to be further investment in technology support to the Intermediary market. Intermediaries were now much more technology-enabled. A robust B2B solution with local support was critical to success in the Intermediary market.
Growth in mortgages would primarily come from the specialist areas, where the multi-brand model was key. Improved retention performance, reducing attrition to or below the share of stock, was critical to achieving this level of net share, and would also help protect margin. True underlying retention needed to improve. In turn, this should also help with General Insurance retention.
Equity release was an extremely difficult area, with severe potential reputational and regulatory risks. The position would be kept under review, but this was not currently considered to be an attractive sector. Buy-to-let was probably the most attractive of the so-called “specialist” markets.
In summary, the key objectives for the 2007–2011 Planning round for Retail would include the following:
Mortgages: The business would move net share towards share of stock levels in 2007, and further towards 25% in future years, depending upon “principal repaid” performance;
Unsecured generally: The aim would be to grow broadly in line with growth in the market, whilst also looking hard at PPl take up rates;
the PCA offering needed to be rejuvenated;
SME (Project Pace) was a key cross Divisional imperative;
and service enhancements were also key
6. Insurance & Investment
Jo Dawson commented that the current Plan for the investment businesses probably did not fully reflect the implications of the move to IFRS. The overall levels of profit should be deliverable, but probably not in the shape that the current Plan assumed.
On Insurance, the 2007 numbers were probably too low in respect of profits, although the sales line would undoubtedly be stretched. The most significant vulnerabilities related to the motor insurance business. The General Insurance business was cost and capita! efficient, and highly SVA generative. The general aim would be to increase the pace of growth. But the position in relation to “motor” needed to be addressed.
Bancassurance was a very successful business. That success needed to be leveraged further. BOSIS appeared to have recovered from the initial IHT shock. It might be appropriate to migrate more PFA’s from the general network to BOSIS. Further distribution capabilities also needed to be developed, alongside some increase in PFA capacity.
In relation to the Investment businesses, the strategy for the Intermediary business was unclear. The first priority was to stabilise and strengthen the control environment. Thereafter, a more targeted product proposition was appropriate, rather than an across the board “waterfront” approach. The business needed to be refocused on value generation. Exiting the Intermediary sector was not realistic. Disentangling the Intermediary business from the bancassurance business would be messy, and leave the remaining business with fixed costs that could not be covered through earnings elsewhere. The Intermediary business also represented valuable diversification ~ particularly as the growth in “with-profits” had stopped, and the business was now more capital efficient. It should be possible to offer a profitable but selective suite of products—enhanced, if necessary, by externally purchased products. A significant proportion of the current proposed growth in the Intermediary Investment businesses was targeted on the Group Pensions market, however, where care needed to be taken.
In summary, General Insurance had significant upside, and bancassurance was very strong. Key planning themes included:
investing in extending the Group’s leading position in bancassurance;
refocusing the Intermediary strategy on specific markets, based on value creation;
improving customer service through greater standardisation; less customisation; and reduced cost;
further reviewing the position in relation to With Profits;
improving financial controls and risk management;
reducing complexity; and
strengthening the leadership team.
The general growth profile of this business remained very attractive, although the motor insurance business was underperforming. The SJP business also needed to be more ambitious––growth in the Partnership had stalled. The TMPP proposition needed to be redesigned, and simplified. The impact of the Retail approach to unsecured credit sales was also critical.
In relation to the Intermediary business:
strategic options in relation to the future of the With Profits business needed to be explored;
there needed to be greater emphasis on personal as opposed to Group Pensions;
the Investment proposition needed to be clarified; and
the Intermediary proposition needed to be improved—and the position in relation to the protection market should be explored (potentially in partnership with a third party), as a route to building share in the more profitable sectors. The focus should be on targeted segments of the market. Significant investments had been made to date in this business but enhanced B2B technology (across both Retail and l&l) could provide significant support.
The plans of the motor insurance business were unlikely to be satisfactory. There needed to be stronger Retail support, particularly through ***—with improved service levels from ***. The *** relationship should be capable of being successful, in terms of motor sales, without being an undue distraction.
7. Australia
Colin Matthew explained that the Group’s approach to the Australian market sought to demonstrate that HBOS could grow outside the UK—essentially through leveraging UK competitive advantages, replicated for the Australian market, to produce sustainable shareholder value. The core businesses (Asset Finance and Structured Finance) needed to continue profitable growth whilst the new “strategic” businesses (Retail, Commercial and l&l) were built. In the longer term the aim was to become a major Australian Financial services company with market shares in the 15%-20% range in chosen segments. In due course a business case to support a physical expansion of the East Cost needed to be developed. Core challenges included:
delivering growth in the strategic businesses whilst ensuring a balance between the growth of the business and growth of the infrastructure;
maintaining current high levels of colleague morale; and
whilst also dealing with intensified competition from incumbent banks.
In Australia, an inorganic “banking” route to establishing a branch network would be difficult. An alternative route (for example purchase of a different type of retail network) could also be pursued, if not available, however, branch rollout would be difficult, costly and slow—and likely to be vulnerable to attack by competitors. The East Coast expansion initiative would be considered at the Board in June.
8. ENA
ENA (including Drive) showed good growth in 2006 and 2007 with slower UPBT growth thereafter. The cost: income ratio was low and reduced further throughout the Plan period. The overriding view was that there remained substantial potential to develop this business, both in Europe and North America. Europe could be developed through increased market share in Corporate; and enhancing products in EFS (subject to the need for further investment in people and risk management). The Retail models in Europe could be leveraged further
Historically, the European Corporate business had been based on UK- centric business being written in Europe. In the future, there was a greater intent to growth European-sourced Corporate business. Investment in risk management needed to keep pace with development of the business.
In North America, there needed to be further investment in people, alongside some expansion of the office network, and growth in Regional Banking. The figures for 2006 were stretched—but 2007 could be stretched further. The Corporate business in the UK had been volatile historically—but in the US, through 12 locations, there had been a stable but very conservative business. There had also been insufficient attention historically to deposit-gathering. ENA was the only proposed deviation from the core RWA plan. Australia and Ireland should remain in line with that Plan, as agreed. Basel preparations in Australia and ENA were broadly on track. In Ireland, outputs were not yet sufficiently robust. The aim was to deliver all Basel projects in 2006.
9. Ireland
Ireland remained on track to continue strong historical performance in the core Business Banking operation whilst delivering the agreed Retail initiative. Consideration had been given to additional initiatives—but the intention at present was to stick with current plans. Slower growth was not realistic, given the current views of the strength of the Irish market. But nor was it yet time to consider accelerating Home Loans or other growth. The key aim was to maintain the current momentum, pending launch of the Irish PCA in early 2007. Overall, PBT was planned to grow by 23% per annum compound over the Plan period.
The largest potential change from existing Plans related to the possible approach to North America—where a less conservative and more aggressive approach was being proposed—in terms of pace, growth and ambition. Investment would be required in terms of people, and distribution capabilities. In Ireland 2006–2007 would continue to be a big year for delivery of the Retail initiative.
10. Treasury & Asset Management
The Treasury business was broadly around Plan levels. The benefits of recent investments were now starting to come through, but more should be demanded (higher income, but lower costs).
The Asset Management business financials would be affected by Chip and other initiatives. The key aim was to progress further towards preparing the business for sale. Progress on fixed interest and LDI was key to realising value. The “peak” in terms of value/potential was likely to be reached, if all went well, in 2 or so years’ time. The volatility in the value of this type of business was likely to be significant, however, with the eventual “price”, based on a multiple of funds under management, would be heavily influenced by sentiment at the point of sale. Expenses were material at this stage—in part, reflecting the internal LTIP costs and in part continuing investment in the LDI proposition. The Group’s aim was to achieve value through preparing the business for IPO/sale at an appropriate time. Inessential or non value-adding activities should stop. Further steps would be taken to explore the possibility of progressive sales of parts of the business and break up of the business into individual components compared with a potential sale or IPO of the whole.
11. Capital Economics—Economic Discussion
There were major international risks to the UK economy.
North America presented significant economic risks to the UK, and other economies—with its huge current account deficit, low savings levels, and risks to asset prices. Capita! Economics believed that there would be a gentle slowdown rather than an outright collapse and recession—with US interest rates coming down in 2007. The recovery in Europe was broadening and now reaching consumers. Eurozone interest rates were likely to rise to 31/2% by late 2006. If the US were to slow down in 2007, EU rates may fall back in 2007—but in the short term, general interest rate pressures were upwards (including in Japan).
A major adjustment was also necessary within China, where there would be a significant switch from investment to consumption. This switch had already started, but Capital Economics did not share the view of some commentators that Chinese growth was about to collapse. Interest rates in China were about to rise. And the total size of the Chinese economy (c. the size of the UK—and, thus, small in global terms) needed to be kept in perspective.
In the UK, consumer confidence had been low in 2005—due to a squeeze on disposable income/discretionary spending. Capital Economics did not share the view that consumer confidence would shortly bounce back strongly, however. The relationship between Mervyn King’s view of disposable income and consumer spending was not accepted.
The UK housing market was characterised by challenging measures. Affordability, house price to earnings ratios and other measures all suggested that asset values should be under pressure. Real house prices were now well adverse to trend levels. The relationship between house price inflation and the savings ratio was also a guide to future levels of consumer spending. If house prices rose broadly in line with earnings (as was forecast), this was likely to be accompanied by an increase in savings—and, thus, a period of subdued consumer spending. Unemployment had recently been rising consistently, and this was likely to continue (but would remain low by historic standards). The public sector had created numerous jobs—this trend was likely to slow down, and reverse. The Pensions “crisis” was also likely to led to softer demand—as consumers were likely to move to save more for retirement.
All of these factors supported a period of below trend consumer spending growth.
Business Investment indicators did not suggest that business would make up for softness in consumer demand. There could be some improvement in exports—but recent performance had been poor. The consumer demand was likely to grow at below trend levels for some time. Inflation was likely to remain low and could even fall back further. Unemployment was likely to continue to increase, but relatively gently.
The interest rate environment was difficult to read. The prevailing view was that the next move in the UK would be upwards, although this was not beyond doubt. If the Capital Economics view of flat or falling inflation was correct, it would be difficult for the MPC to increase rates—and the next move (in 2007) could be downwards, not upwards. Perversely, a stronger than anticipated economic performance could give rise to pressures for interest rate increases.
The US Dollar should fall on FX markets, as should Sterling probably. The two currencies were relatively weak. On balance, the downward risk was greatest in the case of the US Dollar. The Sterling/Euro rate should shift against Sterling. There remained a risk that the Euro would ultimately collapse, although this would be very difficult against a background of (gradual) recovery.
The housing market remained a significant ambiguity. If the economy was stronger, the housing market could be strong—although there was a real risk that a stronger economy could lead to higher interest rates—and, thus, a threat to house prices. With low interest rates, small increases could still post a significant risk to the housing market/prices.
Asset markets in general were under pressure, in the Capital Economics view. All asset classes had shown strength in recent years: through a growth in liquidity, low interest rates, and low bond yields. Oil producers had recycled money into other asset markets. East Asian demand had increased. Interest rates had been extremely low across the world, which had led to a huge stimulus that had fed through to “over buying” of all asset classes. All asset classes looked expensive: fixed interest securities; equities; and commercial property. All asset values looked risky. Notwithstanding the Capital Economics view, of a likely “soft landing” there remained a risk of a material correction at some point, as, for example, the house price to earnings ratio returned closer to the long term historic average.
The Capital Economics core scenario still foresaw a soft landing for both residential and commercial property prices, resulting in continuing low nominal value increases over the next 5 years or so. This view was subject to the position in relation to interest rates, which could post a material risk. There were no obvious counter-cyclical opportunities. The Chinese economy had been growing strongly, but was still tiny. Japan represented a far more material issue for world economies. Hedge funds had been heavy borrowers in Japan of cheap money. Japan was now moving towards the structural changes necessary to support growth—but Japan was unlikely to return to its former growth rates—due to a falling and ageing population and much reduced productivity. Political factors were unlikely to have a major impact, in the short-term at least.
Personal bankruptcies had grown exponentially. There had been a fundamental shift in the volumes of personal insolvencies, which, even if they fell from current peaks, would continue at a far higher level than had been seen previously (although, in absolute terms, the volumes and values remained small).
There was no official Capital Economics view in respect of Ireland and Australia ~ but, in general, interest rates represented some risk to house prices in those markets.
Day Two
12. Economics Follow Up
in summary, as discussed with Roger Bootle on the prior afternoon and evening, the Capital Economics core view was that:
GDP growth during the Plan period would be around Song term trend levels;
there would be a minor tick-up in unemployment (which would remain low by historic standards, however);
interest rates would remain broadly low (with one move downwards likely in 2007);
there would be no collapse in asset prices, even given high absolute and relative values across all asset classes;
there would also be no short term bounce back in relation to consumer spending;
and no significant recession in the US, although a slowdown, with some risk to equity prices;
the Chinese economy would continue to grow; and
there would be soft landings for both residential and commercial property prices.
The key risk to this relatively benign picture for residential and commercial property values arose out of interest rates—which could rise, in particular, if the economy grew faster or stronger than anticipated. The structural shift represented by the demand for REIT property assets could offset any relatively minor increase in interest rates. But a large rise could put house prices, in particular, at material risk.
The choice for the Group was between the consensus forecast and the Capital Economic central view. There was on either view the distinct possibility of an extended period without any base rate moves. Capita! Economics views of property prices were probably more realistic—allied with only one rate rise in 2007, followed by a rate fall in 2008, and this would be the core approach adopted for the purposes of the Planning Framework.
13. Project Holly
The aim of Project Holly was to produce c. £400 million of annual savings by the end of 2009, at a total implementation cost of c. £350 million, phased over 2006–2010. Holly was not an end in itself; it was an opportunity to reaffirm the Group’s cost leadership credentials, whilst also providing greater scope for future investment in growth. External positioning of Holly in relation to future growth needed careful management, however—and the “link” between Project Holly and the Group’s ability to grow should not be over-emphasised.
There needed to be further engagement with Divisions, but buy-in was improving as engagement increased and detailed plans began to emerge. The key immediate issue was the phasing of anticipated spend and the production of planned savings. This issue, with particular reference to Procurement savings, would be considered at the Executive Committee later in the month. It was essential to have a consistent view across the Group in respect of this issue. Deferring the Procurement related spend and benefits would increase 2007 costs growth to 6.2% (from 6.0% as originally planned).
At this stage, £280 million of the £400 million target had been identified as specific initiatives, and these would be incorporated in Q2F, in respect of 2006 and 2007. The balance of £120 million was provisionally allocated as £60 million to business areas originally “out of scope”, and £60 million to in-scope workstream ‘‘stretch’’. Of this balance:
£26 million should be produced via the Procurement workstream (with £10 million of this being attributable to the Electronic Records Management Project); and
the remainder would be allocated in accordance with the methodology proposed in David’s paper. In relation to the International businesses this was still regarded as realistic, and not a threat to their respective growth ambitions.
Messages in relation to Project Holly across the three constituencies of colleagues, investors and Press needed to be co-ordinated. Some external audiences could regard major cost-savings initiatives as evidence of under investment in the future growth of the business—and this potentially negative impression would need to be addressed head- on.
There was no intention around the announcement of the Interim Results and/or Project Holly to signal any shift in the Group’s underlying strategy. The Interim Results should be materially ahead of expectations, and should be well received. Those Results would also demonstrate ongoing capital discipline and costs discipline. There would be no express or detailed presentation about Holly at the time of the Interims. Instead, this would be covered at an in-depth Divisional Seminar (led by the Four Divisional CEO’s) in September. The Seminar would both ‘‘introduce” the “new top team” and allow more in-depth coverage of individual Divisional issues than was normally possible around a Results announcement. This approach in turn assumed a relatively simple and straightforward Results presentation at the time of the Interim Results—by the CEO and GFD only—rather than Divisional presentations.
14. Capital Management
The Group’s relatively cautious position in relation to growth and growth opportunities was now broadly out of favour with the market. The Group’s discipline was supported by the market, and the market liked the Group’s fundamentals. But the Group’s level of caution had become “unfashionable” as investors now more clearly favoured growth. The unsecured credit issue was a small blot on the landscape and “fixing this” early would be well received.
The Group’s message to the market had been clear: share buybacks were the current—and temporary — response to the generation of surplus capital by the Group. When management judged the time to be right, buybacks would stop and capital would be deployed to fund faster growth. But pre-signalling additional growth—rather than simply delivering faster than anticipated growth, and explaining the position after the event—was difficult, both with a view to concerns about the “new management team” and to impressions of bowing to external pressures. Although the Group could and should be prepared to discuss in general its confidence in certain areas. At around 20% ROE, the Group’s sustainable, self-funded, growth rate was in the region of 14%. Some surplus capital would still be generated even at the higher growth rates previously discussed.
The current level of share buybacks had been accompanied by an increase in the Group’s gearing to forecast 26.3% by end 2006 (compared with the 25% +/- 2% target), and this (all other things being equal) would continue in 2007 (and plateau in 2007/2008 before falling thereafter).
A key decision was the signal at or around the Interims in relation to the size of the 2006 buyback programme—and whether the programme would “increase” to £1 billion, or be held back at £750 million. This decision would be materially informed by the likely 2006 outturn in respect of asset growth. If the outturn was likely to be at or very close to 10%, beginning to wean the market away from buybacks, through holding the 2006 programme at £750 million, was probably the preferred option. Q2F needed to establish the likely growth rate with clarity. No decision needed to be taken at this stage, but a decision would be necessary by the time of the Interim Results. If the growth rate for the full year in terms of assets was likely to be at or very close to 10%, a “reduction” of the current programme to £750 million looked likely.
Separately, the market’s assumption that the Group’s current growth rate was low—and that any acceleration would be rapid and immediately significant—needed to be addressed.
15. Risks
Dan Watkins’ paper concentrated on “internal” HBOS risks to the Plan, rather than the macro economic or other ‘‘external’1 risks to the Plan previously discussed. These internal risks included:
Credit risk, including:
in particular Retail unsecured, Retail secured and Corporate. The quality and validity of the outputs of models needed to be verified. Credit risk management capabilities needed to be enhanced across the Group;
in relation to concentrations of risk, for example, in respect of commercial property, interest only mortgage lending, and specialist lending market shares. The Planning process should lead to increased clarity in relation to exposures to certain key sectors;
other issues, for example underwriting/distribution appetite and capabilities; Treasury activities that were moving up the risk curve; and Basel II. HBOSTS remained low risk compared to many peers, but was less low risk than hitherto.;
indirect exposure to hedge funds, through lending to counterparties who had direct hedge fund exposure.
Business risks, including:
misselling risks. Implementation of the Customer Contract was key, and needed to be embedded in business as usual as quickly as practicable;
fraud risks, where the Group needed to have a more holistic approach to fraud detection and prevention. The Group was vulnerable to being targeted by fraudsters. There needed to be greater visibility in respect of fraud and fraud prevention, and enhancements to authentication that were customer friendly but effective;
systems issues, including in relation to manual processes, where increased automation, allied to simplification and rationalisation, were increasingly necessary to address risks of human error or other risks arising out of manual processes;
international expansion, which increased risks to the business, and needed to be accompanied by improvement in the risk infrastructure;
Regulatory Tide issues, where a firmer view needed to be taken of the next steps and likely impacts.
HR/People Risks were a major risk across the Group—both in terms of attracting and retaining the right talent, and in meeting volume recruitment needs. These areas were being addressed through the revised Resourcing Strategy.
16. Options For Further Growth
Colin’s paper considered a range of potential approaches to Inorganic issues, both as a source of future growth, and to provide future opportunities for sustained inorganic growth. In summary, it was agreed that:
limited, highly controlled, due diligence would be carried out in relation to a possible UK transformational transaction;
consideration would be given to the scope for adding scale inorganically in the Gl business;
preliminary work would be carried out in relation to potential Australian transactions, in the (unlikely) event that valuations shifted favourably;
consideration would be given to the most attractive third (non- UK) economy, for International expansion; and
some very preliminary work would be carried out to assess the likely potential in key Asian markets.
None of the above were a substitute for organic growth, which remained the focus of the Group Business Plan, and the key deliverable.
17. Planning Themes
Peter Hickman summarised a number of key themes that had emerged from the discussions over the previous two days including the following:
Corporate
pursuing high single digit growth;
completing the move to management by asset classes;
developing further origination, sales and distribution capabilities;
defining and delivering the SME (Project Pace) approach;
positioning the Division properly in relation to the commercial property market;
upgrading credit risk management capabilities (including Basel 11).
Retail
raising net lending share ambitions to a level around or ahead of share of stock (which would involve improving B2B offerings and Intermediary technology solutions);
building on progress in savings and bancassurance;
re-establishing leadership in banking products;
improving returns, through increased focus on Gl cross sales;
growing unsecured lending in line with the market;
Project Pace;
addressing service issues;
upgrading risk management capabilities;
generally improving ecommerce capabilities.
I&l
improving value generation and defining the Intermediary proposition; reviewing With Profits strategy; and investing further in General Insurance;
increasing, risk management capabilities, processes and controls;
making more of key Joint Ventures, including ***, *** and ***;
dealing with PPI, in all aspects, including in light of the Group’s appetite for unsecured lending growth.
International
ensuring the infrastructure kept pace with business development and growth;
in Australia, East Coast expansion, and delivering the Retail initiative;
in ENA, accelerating growth in the Corporate franchise and developing capabilities in EFS;
in Ireland, delivering the Retail initiative, with good service, whilst maintaining Business Banking growth.
Asset Management
maintaining leadership in LDI and fixed income;
focussing investment in value adding activities, discontinuing activities that do not add to the enterprise value of the business.
Treasury
ensuring payback on investments to date;
growing infrastructure and controls to reflect the changing risk profile.
Q2F was scheduled to come to ExCo and the Board in July. The Planning Framework would reflect the agreed change of emphasis in the approach to 2007 (and 2006) asset growth—the asset growth values of which also needed to be reflected within Q2F to the extent possible. The supporting language/framework for the Planning Framework would be developed in advance, for distribution to Divisions in late June, ahead of defining the financial consequences, to assist in Plan preparation.
17. Conclusions
Andy Hornby summarised the constructive discussions during the two Away Days. These had confirmed that:
the focus of Plans for 2007 would be on a “selective growth” in the UK;
in particular, further growth would be pursued in relation to:
mortgages (growing net lending towards, and beyond, stock share—provided that retention could be improved markedly);
liquid savings and bancassurance (where success to date needed to be maintained, and leveraged further);
banking (where the initiative needed to be regained);
household insurance (where cross-sale and retention performance needed to improve, and the potential of this business needed to be exploited further);
wealth management (where SJP needed to become more ambitious);
Integrated Finance and infrastructure Finance (where further profitable growth could be pursued at acceptable risks and returns);
there would be continuing caution, however, in relation to Retail unsecured lending; some aspects of Corporate relationship banking and Investment sales in the Group Pensions area;
International growth ambitions needed to be delivered;
key problem issues in relation to SME banking in England and Wales; the Investment Intermediary proposition; and Motor Insurance needed to be tackled and resolved;
inorganic work would focus on defined narrow, target areas;
more needed to be done to exploit the Group’s key strengths and competitive advantages, including in relation to:
balance sheet strength;
bancassurance;
Integrated Finance;
low cost: income ratios; and
capital strength.
whilst also addressing key “weaknesses”, that included:
customer service levels;
credit risk management capabilities;
reliance on wholesale funding;
SME presence in England and Wales;
Intermediary strategy in the Investment businesses;
lack of international diversification;
the lack of “strength in depth” in the senior talent pool.