Parliamentary Commission on Banking StandardsEXECUTIVE COMMITTEE Tuesday 17 October, 2006 at 9.00am. at The Mound, Edinburgh
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MINUTES |
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Present |
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Harry Baines |
Phil Hodkinson |
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Peter Cummings |
Andy Hornby (Chairman) |
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Jo Dawson |
Colin Matthew |
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Dan Watkins |
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Apologies |
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Benny Higgins |
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In Attendance |
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*** |
*** |
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*** |
*** |
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Peter Hickman (Item 12) |
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1.1 Minutes
The minutes of the meeting of Executive Committee held on 20 September 2006 were approved.
1.2 Oral Business Update
1.2.1 International
Colin Matthew confirmed that overall performance across the Division in the month of September had been adverse to Plan (due, in particular, to EFS, where there had been a mix of lower than planned sales together with some one-off adjustments). But all of the International businesses remained confident of achieving Q2F. ENA, Australia and Ireland were each ahead of Plan ytd. But EFS sales were struggling.
The German market overall had been relatively quiet. The Group was holding its market share, but the final quarter was the key period for achieving the necessary sales volumes. John Edwards would update ExCo in December in relation to the situation in EFS. The Australian plan in respect of the East Coast physical expansion was nearing completion. Final numbers would be available by the end of the month.
1.2.2 Retail
In Benny’s absence, Andy Hornby commented that Retail had been in line with Plan in the month, with a boost to Nil from unplanned sales of credit card portfolios, although this had been offset by implementation of the agreed reductions in credit card default charges. Operating expenses continued to be favourable to Plan. Overall, there were signs that income was coming under increasing pressure. Mortgage performance was relatively weak; retention was not obviously improving. But it was too soon to decide whether or not recent retention initiatives were being effective. Sales volumes in credit cards and General Insurance needed attention, but savings inflows remained strong (and September had been a record month for inflows).
Impairment trends were beginning to improve. However, there appeared to be the beginning of a tendency to accept greater risk to help drive lending volumes: and this needed to be kept under review. A Mortgages Strategy paper would be prepared in time for the January ExCo and Board—to include review of retention issues, as well as LTV and other risk parameters.
1.2.3 Corporate
Peter Cummings confirmed that Corporate performance was adverse to Plan in the month, but this was entirely due to timing differences. The results for the month were in line with the latest forecast and Corporate remained on track to achieve Q2F. Investment gains to be recognised in the balance of the year included those in respect of Paymentshield, which was due to complete by the end of November, The pipeline of potential future deals continued to be strong. Corporate remained well ahead of Plan overall ytd, reflecting higher than plan Nil, in particular.
1.2.4 Insurance & Investment
Jo Dawson confirmed that earlier trends continued in respect of Insurance and Investment as a whole. The Division was ahead of Plan overall both in the month and ytd—with insurance being ahead largely due to a strong performance in household, which more than offset reduced creditor volumes. Motor volumes remained disappointing. Motor profits were also behind plan, and competition was tough. Investment profits were behind plan ytd, reflecting the new business strain from higher volumes of investment business and a number of one-off impacts, partially offset by very strong above plan performance in SJP. The future relationship with ELAS was being considered. Sales performance in bancassurance was improving—but there were early indications of potential persistency issues in the intermediary channel. Further attention needed to be directed to retention issues, as well as to “gross” new sales.
Household sales volumes were improving but prices were falling resulting in lower GWP. PPI sales process changes were beginning to be implemented and were being well received—but first party sales remained well behind plan take-up rates/volumes, which was particularly acute in mortgage-related sales (TMPP).
1.2.5 Group Finance Director
The Asset Management result in the month was positively impacted by the Chip IPO. Underlying trading in Treasury was behind Plan in the month.
Group UPBT ytd was now well ahead of both Plan and the prior year, largely due to strong Nil in Corporate; growth in operating income in International; the impact of unplanned non-operating income in Retail—with higher than planned impairment losses, offset by lower than Plan expenses in Retail. Underlying expenses growth remained in line with external targets.
Underlying PBT growth of c.14% would be a good outcome for the full year, but the Group needed to remain committed to Q2F. A strong 2006 increased the scale of the challenge in 2007, which would clearly be a tough(er) year. The Group Business Plan for 2007–2011 looked as if profits growth of c. 10% in 2007 was achievable. The latest forecast for end 2006 was a Tier 1 capital ratio of 8.1% (assuming Drive completed before the end of the year), given increasing profit and reducing assumptions in relation to Asset growth. Corporate would continue to manage its sell-down position in the balance of the year in accordance with “business as usual” principles. A year end Tier 1 position of between 8.0% and 8.1% was the preferred outcome. Costs growth in 2007 was likely to be c. 7.2% in total; at least 1% of this was due to Project Holly initiatives.
The capital position in 2007 would be impacted by a new capital regime that affected the treatment of securitisation. This would reduce reported capital ratios by c. 25 bps. But this was an interim position under Basel II, that should not adversely impact the Group’s planning and assumptions for 2007. The buyback programme for 2007 was likely to be set at an initial level of £500 million.
The cost: income ratio forecasts were now c. 40.5% for 2006; reducing to 39.8% in 2007; and down to 38.6% in 2008.
1.2.6 Company Secretary
The Competition Commission (“CC”) had published its Preliminary Findings and Possible Remedies concerning its review of the PCA Market in Northern Ireland. The Findings produced little surprise: the CC believed that competition was not fully effective in this market, as evidenced by low rates of switching and high fees. The Proposed Remedies were mainly focussed on improving disclosure and transparency—none of which should come as a shock for HBOS (which would consider extending these remedies, voluntarily, to the whole of the UK).
Discussions continued with HMT in relation to Dormant Accounts.
Consideration was being given to a challenge of the Umpire’s decision in relation to the ELAS reinsured book.
A discussion had taken place with HMRC concerning their planned “Offshore Project”.
1.2.7 Group Risk
Dan Watkins confirmed that Secured impairment performance in Retail continued to improve: unsecured was no worse than Plan. HBOSTS were considering moving into credit derivatives—which was a cause of potential concern for the FSA, although the HBOSTS approach was detailed and well thought out. The FSA’s concerns were not ‘‘personal” to HBOS, and were largely around settlement of deals and weaknesses in documentation—operational risks that were (the FSA believed) common across all major counterparties.
There had been positive feedback in respect of the Group’s SAR efforts, in particular in relation to positive results in relation to “people smuggling” activities. The FSA had issued a “Dear CEO” letter in relation to Stress Testing, and the FSA had made it clear that Waiver Applications that did not comply with “good practice” in terms of Stress Testing would be rejected. The FSA were keen to ensure that firms produced truly “stressed” scenarios for their Stress Tests.
1.2.8 CEO
A proposed Agenda had been circulated for the ExCo Away Days in early November, including a “6 slide” presentation format. At the end of the Away Day there would be discussion of the proposed January “Strategy Session”.
A recent round of visits to institutional shareholders by Andy and Phil had revealed that investors now had greater confidence in the sector—and had moved from an “over bearish” view to potentially an “over- bullish” approach. Concern around impairments was reducing. Investors were keen to understand the true value of investment businesses. The Group’s focus on organic growth; on International businesses; and its costs discipline were all strong “positives” in terms of investor sentiment (and, in particular, the costs story), which underpinned their views of HBOS as a lower risk bet
2. Strategic Reviews
2.1 HBOS Financial Services Strategic Review
Jo Dawson explained that the UK life, pensions and investments market comprised a significant growth opportunity upon which HBOS was uniquely positioned to capitalise. Long-term demographic trends indicated an ageing population with increasing wealth, for whom asset accumulation, management and release were major issues. Medium term trends, with increasing interest rates, also suggested a shift from borrowing to saving—driving market growth potential further. The Group had the largest liquid savings franchise in the UK and over 20 million existing customers—giving unrivalled access to potential customers. We had a market-leading bancassurance business; however, the HBOS *** intermediary business had recently lost focus and share over recent years.
Looking forward, the bancassurance business was facing some capacity constraints and a more competitive environment. Financial controls and risk management capabilities also required significant investment. The strategic ambition was to continue bancassurance growth rates in an increasingly challenging environment and to reposition the intermediary business for greater value growth.
*** commented that, to achieve the full potential of this business, there would be increased focus on:
driving profitable book growth, through revitalising the intermediary proposition; defending and extending market leadership in bancassurance; and paying increased attention to retention;
improving risk and financial management capabilities, where the quality and capacity of systems/processes and controls was already being upgraded;
improving customer service and reducing unit costs, becoming “easy to do business with”, for both intermediaries and customers, including extending e-commerce capabilities;
improving resourcing and leadership capability, developing people capabilities; being more systematic in talent management and leadership development, and addressing the current over-reliance on contractor and temporary support.
Recovering focus in the intermediary channel was particularly key. The Group had grown share strongly between 1996 and 2001, following the acquisition by Halifax of ***. Since 2001 there had been some major issues and distractions—including the demise of key products (“with profits”) along with systems and service failures. Market share had slipped backwards. The position had more recently improved, but there was still a lot that needed to be done. The approach for the future would focus on individual asset accumulation; plans to be mass market in Group Pensions would be shelved; (the business would, in effect, abandon new sales for Group Pensions). New Group Pensions business generated an unacceptable return on capital: managing the back book was key; but further investment in writing new Group Pensions business was not thought worthwhile given the Group’s lack of any competitive advantage in this area.. There would be a future bias for value rather than simply share; backed by a strong investment proposition and robust service; with an increased emphasis on retention.
A lot of work was required to achieve these objectives—including increasing the productivity and effectiveness of the salesforce, and an overhaul of the investment proposition. The intermediary business had the ability to be a profitable sector of the investment market but the Group’s performance in terms of new business margins needed to improve, through a focus on higher margin products sold through quality intermediaries. By the end of the Plan period the aim was for intermediary sales to deliver one third of sales and one quarter of value creation within HBOSFS, where actual reported profits were forecast to triple over the planning horizon. The increase in market share of the intermediary channel was not huge: but growing in a growing market segment (which was the core objective) involved less risk of provoking a backlash from competitors. Accounting treatment did not help, but the strategy aimed to address the current imbalance between the intermediary and bancassurance businesses, to produce an attractive profit trajectory.
*** commented that financial and capability credentials also needed to be strengthened considerably, but good progress was now being made. A high performance, high quality, culture was required. Whilst increasing focus on the intermediary market, momentum in bancassurance also needed to continue. Bancassurance remained a key strength of HBOS, and was still a platform for significant growth..
The biggest vulnerability in terms of bancassurance related to capacity (the availability of sufficient quality people and branch space to house them) and systemic risks (if the design of products and/or processes were defective). The success of bancassurance reflected strong new business margins; highly productive salesforces; simple no-load products; lead generation from within Retail; a well-oiled sales process; and straight through processing.
In the intermediary market, reliance on *** needed to be de-risked, and the business needed to share investment performance risk across a range of providers, focussed on both “Absolute Return” funds as well as more traditional beta & alpha fund management styles.
2.2 Strategic Review of Corporate Division
Peter Cummings explained that within the past 12 months Corporate had moved to an overarching operating model built around “Asset Class Management”—with the aim of using specialisation to develop a deep understanding of key markets; as well as providing the clarity required for a distribution platform that could be used in all market conditions, allowing asset generation activity to be maintained. Key Asset Classes had been identified for their homogenous characteristics ~ allowing focus on common traits; to produce consistency of management; maximise expertise; pool market intelligence; and drive value.
There were five clear aspirations for the next five years:
to be best in class in respect of the chosen Asset Classes;
to grow share in respect of trading business relationships (including SME’s);
to be the best real estate bank in the UK;
to have the ‘‘best in class” approach to risk management; and
to hit annual profit of £3 billion by 2010.
Key initiatives were in place to improve the Asset Class Management platform, and the Division’s ability to deliver these other strategies and aspirations. Alongside these, Corporate was committed to achieving Advanced status under Basel II, and embedding Basel (I into business processes; building upon its already strong CR reputation; maintaining costs discipline; and increasing focus on SVA. Asset Class Management required the development of key colleagues into ‘‘asset class managers” alive to opportunities such as secondary trading or securitisation; in order to maximise returns.
The market now appreciated that the business had a book of unrealised investment gains that would be harvested over time. But the pipeline was also being topped up by new deals at an even faster rate—so that there should continue to be a strong and continuing pipeline of unrealised gains. Timing of realising gains was largely not within the Group’s control, however. The majority of these unrealised profits were not on the Group’s balance sheet—and would only be added to the balance sheet once there was a transaction or other event that would lead towards crystallisation.
The Credit Risk Appetite was being managed through a more sophisticated environment, moving towards *** tools, with limits and controls on sectors, counterparties, countries and other risk dimensions. Environmental and social risk management considerations were integrated into decision-making processes: the Division was committed to creating and maintaining an inclusive culture, whilst also encouraging consideration of social impacts.
The Board presentation would also refer to the Division on Deposit- gathering capabilities along with the interaction between Corporate and Treasury, that now accounted for a significant potion of Treasury’s revenues; as well as consideration of the key risks; and the activities and potential reactions of competitors. In that respect, RBS was a “volume player” covering all of the market (rather than the Group’s more niche approach). Barclays was the third key player (along with HBOS and RBS) in UK private equity. Barclays were gearing up their Structured Products and tax driven “Barcap” approach, including overseas exposures—but were probably the most direct competitor. Lloyds were trying to grow their business.
3. Corporate
3.1 ISAF—FSA Authorisations on Regulated Activities
*** confirmed that ISAF’s medium and long term strategic plans involved increasing use of the Group’s balance sheet. To maintain origination pace, whilst also maximising efficient use of the HBOS Balance Sheet, however, it was necessary for ISAF to supplement or expand traditional distribution channels, adding a more structured ability in equity and the selective introduction and management of third policy capital. A more developed third party capital platform was necessary given the increasing scale of IF and PTP deals, and would also provide the opportunity to earn recurring management fee income. A number of initiatives were already being pursued in relation to the introduction of third party capital. Selling debt and equity strips was a recurring activity, that was covered by existing permissions: the Group was not “advising” but did arrange, underwrite and manage. There needed to be greater clarity around promoting and dealing, where appropriate systems and controls needed to be in place as the Group developed its approach, introduced additional third party capital, extended its equity promotion capabilities, and/or entered into a broader and larger range of PTP transactions.
To expand and support all of these initiatives a number of authorisations were required from the FSA, and a step change was required in relation to Corporate Division’s Regulatory Risk processes and procedures in order to ensure that all Regulated Activities rules were complied with.
A multi-disciplinary project team would be put in place to secure the necessary individual authorisations and to put the necessary processes and procedures in place. It was likely that the project team, involving both Corporate and Group Risk attendees, would take at least 9–12 months to secure these objectives. There would need to be close alignment with the Group MiFiD Project.
The FSA would be kept advised of the project and the project’s goals. There could be synergies looking across at *** existing authorisations in all relevant areas, and involvement of *** on the Project team could be worthwhile. The FSA’s perception of this initiative could well be that the business and the Group was becoming more systematically involved in “higher risk” activities. Even with enhanced risk management capabilities, this could be seen by the FSA as taking HBOS further up the risk curve. In addition, as the IF model developed, the relationship between HBOS and Private Equity groups would also need to develop-although HBOS maintained an origination capability that Private Equity groups did not have (but which Hedge Funds might well develop).
Separately, it was agreed that any proposal by Corporate to establish a “stake-building” business or other activity directed at acquiring strategic stakes in defined targets would be referred to this Committee for consideration, given the potential cross-Group conflicts and other issues could be examined.
4. I&l
4.1 ELAS Relationship Pathfinder
The HBOS Group had had a complex relationship with ELAS since the 2001 acquisition of the Society’s Operating Assets. ***’s paper:
summarised the status quo; and
examined a range of possible future issues that would need to be considered or dealt with as ELAS management sought to achieve an “exit strategy”.
The 2001 acquisition had provided the opportunity (for Halifax) to add bulk to its then Long Term Savings business; acquire a market-leading sales force; achieve significant cost savings through access to a high quality processing platform; and double funds under management at *** (now ***). Since the outset, however, there had been a difficult relationship with the ongoing ELAS business and management, which had proved to be a significant management distraction for HBOS (and HBOSFS, in particular). In relation to key aspects of the original deal:
earnings in respect of the reassured (non profit and unit linked) policies had been lower than anticipated due to a range of factors, including higher than planned expense levels; quicker than anticipated run-off of the book; and stock market falls between 2001 and 2004. Earnings would fall further as the book continued to mature. The Umpire’s recent decision in relation to the level of premium payable by ELAS was (subject to challenge) a further disappointment;
earnings generated in respect of asset management (under the 10 year contract negotiated in 2001) would be less than originally anticipated, as most of the ELAS assets had been switched from equities to fixed income investments (earning much lower fees) in the early years of the contract. Also nonprofit annuities were due to transfer to Canada Life in early 2007 (although an “income shortfall” compensation payment had been agreed in respect of this transfer);
HBOS provided third party administration services for the ELAS closed book “at cost”—potentially in perpetuity. Truly recovering all relevant “costs” was a major challenge, and there was no real incentive for HBOS to increase efficiency, as the costs incurred would be borne by HBOS but the true benefit enjoyed by ELAS;
there were complex arrangements in relation to the ELAS Pension Scheme, which required ELAS to “top up” employer contributions made by HBOS—and obliged ELAS to remedy any Scheme deficit in 2016.
In addition to the above there were a range of other financial disputes in relation to matters that had arisen since 2001.
Solvency risk for ELAS was now materially reduced, and the ELAS management team were keen to find a “final solution” that would enable them to exit the business. Various disposals were being planned as the initial steps towards achieving “closure” of ELAS, and in respect of which ELAS required support from HBOS. Any “final” solution would need to include resolution of existing arrangements between the parties, including the administration agreement. One possibility included assisting ELAS to convert the with profits fund into a unit linked fund—with consequent flows of income to HBOS. Unitisation would be an extremely complicated process, with no guarantee of a satisfactory outcome. It was proposed that (assuming ELAS management would co-operate) further detailed consideration be given to the unitisation option. This proposal would be discussed at next week’s Board meeting,
5. ENA
5.1 Ireland—Retail Update
Colin Matthew’s update in relation to the BOSI Retail initiative confirmed that, after a difficult start:
the Irish Retail business was on track to acquire 40,000 customers by early 2007;
22 branches were now open; two more would follow by the end of the year; with a further 22 to be opened in due course;
the (market leading) PCA would be launched in the first half of 2007. This had been designed as a key customer acquisition vehicle, and PCA success would be critical to the success of the BOSI Retail project;
the decision to re-brand the Retail business “Halifax” (from November 2006) would give BOSI additional leverage for growth.
Key remaining challenges related to the branch programme and the IT aspects of the PCA launch.
In terms of branches, all 46 branches should be open for business by the end of 2007—although a number of sites were yet to be acquired. The measured rollout of the Retail offering had produced no major mistakes and no adverse PR—and had been the right approach to take. The branch rollout was proceeding more slowly than originally envisaged—but over 13,000 new Retail customers had already been acquired. Increasing emphasis was also being placed on telephone and internet channels, and good results had been achieved in both.
Delivery of a strategic IT infrastructure had proved challenging—even with support from across the Group it had proved necessary to delay the PCA product launch beyond the originally planned date, in particular due to the complexity of the project, and the need for extremely thorough acceptance/integration testing.
Savings had proved to be “the” success story. Deposits had already reached Euros 80 million from c. 7,000 new customers. Mortgages and personal loans had also made a good start. The new mortgage products were not purely being sold through branches, but were also contributing to growth of the intermediary channel. Credit cards had not met anticipated sales levels, in part due to the peculiar dynamics of the Irish market. The launch of the PCA in 2007 should give credit cards a material boost, however. The launch of the Retail proposition was already having material “spin-off” benefits for the ongoing commercial business, which continued to perform strongly.
It had recently been announced that *** would leave the Irish business in 2007 (and move to Australia). A senior individual had been recruited from the retail business of Bank of Ireland.
6. Group Risk
6.1 Operational Risk Review
*** explained that the Group’s Operational Risk Strategy developed in 2002, which was not the norm in the sector, had aimed to:
apply a consistent framework across the Group;
deliver a single system suite, to be implemented in all Divisions;
design one model process, to measure operational risks; and
enable HBOS to achieve AMA capability under Basel II.
The first three of these ambitions had now been realised, and the Group now had an industry-leading framework that delivered AMA capability. Considerable work had been carried out since the FSA’s last review of Operational Risk in HBOS and the FSA had been advised of the outcomes. The Group would apply for AMA status in Q4 2006, and continue to embed the Operational Risk Approach in to the business throughout 2007. It was estimated that the Group’s initial regulatory capital requirement for Operational Risks would be c. £1.5 billion—although with potential to reduce this through effective delivery of improved risk controls and the inclusion of enhanced risk mitigation techniques. This regulatory capital requirement was unlikely to deliver initial benefits to HBOS beyond the “standardised approach”, but this initial level should reduce in due course and the Group’s approach genuinely helped manage risks better within the business, and reduce the incidence of unexpected (Operational) losses. It was thought that only Barclays and HBOS would be in a position to apply for AMA status at “Day One”. This represented an element of additional risk (particularly as the US had delayed implementation) in that the FSA would be establishing a “benchmark” at the time of considering the HBOS (and Barclays) applications.
6.2 Provision of Dedicated Business Continuity Space in Greater London
A full review had been carried out of the availability of suitable dedicated Business Continuity Space in Greater London, including consideration of the respective merits of using third party providers and/or building appropriate internal capacity, it was recommended that *** be retained to provide appropriate recovery sites for the Greater London needs of Retail, Corporate, *** and St Andrews Group. A solution had been provided as a matter of urgency earlier in the year in respect of Insight. A more geographically diverse solution was potentially available from ICM, but at greater cost, and the SunGard proposal (for 12 business areas and 733 seats) was supported, given the infrequency of the likelihood of invocation; the efficiencies that being in Central London would provide; and the levels of cost.
7. Any Other Business
8. Papers for Comment
8.1 Basel Implementation Update
The Programme remained Amber, with a good level of confidence that the Waiver Applications would proceed at the end of November. A positive meeting had taken place recently with the FSA, to update them on progress. However, there were still a number of detailed challenges coming out of the FSA, from time to time. Individual challenges were addressed as they arose, but these very detailed challenges were sometimes at odds with the “big picture” view being taken by the lineside team. More fundamentally, the FSA were translating concerns about specific sectors (for example, commercial property) into challenges and criticisms of models.
8.2 ARROW II
ARROW II had been developed to give the FSA a “tuneable” risk model, allowing it to calibrate the model in response to developments—the results of which would determine the intensity of the FSA’s supervisory relationship.
The following papers were circulated to members of ExCo for comment and were noted, namely:
9.1
10.1
11.1
12.1
12.2
12.1 Schedule of Advances
Schedules of Corporate Banking and International Operations significant Advances were considered and would be submitted to the Board on 24 October 2006.
12.2 Next Meeting
The next meeting of the Executive Committee would be held on Tuesday 21st November 2006 at The Mound, Edinburgh commencing at 9am.