Parliamentary Commission on Banking StandardsExecutive Committee Away Day

31st October & 1st November 2006. at Rudding Park Hotel, Harrogate
MINUTES
Present
Harry Baines	Benny Higgins
Peter Cummings	Phil Hodkinson
Jo Dawson	Andy Hornby (Chairman)
Dan Watkins	Colin Matthew
Apologies
	In Attendance
***	Lindsay Mackay (Item 12)
***	***
Peter Hickman (All)
	ACTION

DAY 1

1. Introduction

Andy Hornby introduced the Away Days by commenting that the initial session, led by Phil, would involve detailed consideration of the overall Plan financials. Divisional presentations would then focus on strategy, initiatives and risk.

The two days would conclude with consideration of the January Away Day and the key issues for consideration with the Board, building on the Plan discussions, but looking at issues over a longer (five year) time horizon.

2. Update on Economic Scenarios

Peter Hickman explained that the economic scenarios agreed earlier in the year in respect of compiling the Plan remained largely valid. The only potentially material change related to the timing and extent of assumed base rate moves.

The FSA were keen that HBOS, and all financial services groups, subjected their Plans to “extreme” stress test scenarios. The FSA considered it critical that firms could demonstrate that the potential implications of severe adverse scenarios had been considered.

Key assumptions of the core planning scenario included:

real GDP growth at 2.5% in 2006, rising slowly to 2.6 in 2007, before easing back (with a long term average of c. 2.7%);

growth in real consumer spending restrained below long term trend levels ~ but due to increase from 2.2% in 2007 to a range of 2.4%-2.6% in the latter years of the Plan period;

house price inflation probably likely to grow slightly faster than the original assumption. London was proving to be a real outlier in terms of price rises. Assuming slightly higher growth rates was a less conservative scenario from the Group’s perspective—unless growth occurred too soon and/or too quickly;

personal insolvencies continuing to grow, but with a plateau in the later years of the Plan period. The key issue was whether current levels of personal indebtedness were sustainable in the longer term. Getting on to the “housing ladder” was a major challenge for a growing section of the population. The economic section of the Plan would consider the risks posed by high personal indebtedness, which was also a key feature to be flexed in Stress Tests. A view of the relative impacts on HBOS, compared to the peer group, would also be emphasised;

short term interest rates would reach 5% in 2006 with a 25 bps increase in late 2007—and broadly stable rates thereafter, falling gradually in the later years of the Plan period.

Key economic variables had been reviewed for the Group’s main overseas markets. There were no material movements in any of the key variables that required the basis of the Plan to be reassessed.

3. 2006 Q3F & 2007–11 Business Plan

Peter Hickman also explained that key assumptions within current thinking included:

an additional provision of c. £100 million in respect of endowments. It should now be possible to “draw a line” under this issue, but the figure of £100 million was not yet agreed and a different number might be required in order to achieve “closure”;

there would be an annual central contingency of £75 million in 2007 and beyond—50% allocated against non-interest income; and 50% allocated to “other income”;

a share buyback of £500 million in 2007—rising to £750 million p.a. thereafter, after assuming £300 million p.a. for acquisitions;

the short term implications of CRD would be ignored in 2007.

Based on these assumptions:

PBT would grow by 18% from 2005–06 (boosted, in part, by Drive) and c. 8% from 2006–07;

UPBT would grow by 14% from 2005–06 and 10% from 2006–07, with steadily improving cost: income ratios;

growth in impairments would broadly level off;

eps would grow by 17% in 2005–2006 and by 12% from 2006- 2007;

Tier 1 capital ratios would remain above 8%, with ROE increasing to 21.2%;

SVA would grow in double digits throughout the Plan period.

In summary, 2006 would be a very strong result—to be followed by a more sluggish result in 2007 in particular in relation to income, which would grow by only c. 8% in 2007 (and costs by 7%—leaving tighter positive “jaws” than in recent years). The market should be educated in advance (probably as part of the December pre-close) about the likely one-off consequences of the Drive disposal in 2006. The 2006 result should be ahead of consensus. The 2007 consensus would inevitably move upwards once the 2006 result was announced. The weakest part of the 2006 result was probably the slightly slower growth in non-interest income in 2006. Net interest income currently looked too flat in 2007: a curious outcome, that needed further investigation.

In the Business Plan 2007–11:

there would be strong growth across all Divisions, except that Retail would be a relatively “weak” result in 2006 (4% p.a. growth although this should still look good compared to the peer group);

this picture would be largely repeated in 2007 (6% p.a. growth in Retail, although again this should still look good in relative terms) with materially slower growth in the International businesses—impacted both by the Drive disposal and the costs of continuing investment;

over the Plan period, the Divisional distribution of profitability would remain broadly similar—with no fundamental change planned—although Corporate’s annualised lending growth would overtake Retail during the Plan period, in due course consideration should be given to the issue of how the market reflected and valued different sources of profitability—and whether being “Retail led” was a “better” or “worse” position than being “Corporate led”. In 2006 the UK earnings of HBOS would probably exceed those of any other UK bank;

Retail margins should be relatively flat between 2006 and 2007, but Corporate in particular was forecasting a material! fall in margin between 2006 and 2007. There was a mismatch between the projected growth in lending and net interest income on the one hand and the apparently assumed reducing margins that needed further consideration. Corporate should be well placed to beat these margin assumptions. Further consideration would also be given to the projected rate of growth in net interest income in 2007 before the Plan was finalised;

consideration should also be given to the question of whether incremental RWA growth was truly value/SVA enhancing. This was believed to be less of an issue in International, but in Retail, this could a real challenge in the Mortgage Market, for example. Total lending growth across the Group could be marginally too high, although International markets were strong and could support even higher levels of growth;

costs growth at 7% in 2007 was acceptable, but operating income was due to grow only 8% (after Drive) leaving not much margin for error. The costs: income ratio should improve in each year of the Plan period. But there was limited room for manoeuvre in terms of costs growth before this trend would be put in jeopardy;

costs allocation and other adjustments influenced the costs growth picture in 2007. Corporate’s underlying rate of costs growth was close to 11% (rather than 5.5%)—although this was planned to fall back significantly (to c. 3%) in 2008. The absolute level of costs growth in 2007 was not a material problem, except when compared with projected income growth of only 8%. For external audiences, there would be a shift in focus towards cost: income trends rather than absolute costs growth targets; although 2007 would be a challenging year, and further consideration would need to be given to the right cost: income ratio outturn for 2006, to establish the correct trajectory;

2007 would also be a challenging year in relation to the presentation of margins generally—which were beginning to be competed away;

impairments would be better than the £1.9 billion external positioning. Corporate impairments could prove to be on the light side, but were currently believed to be sufficient—in both absolute and relative terms. Total impairments would continue to rise between 2006 and 2007—in absolute terms and as a percentage of advances, which was probably not in line with the market’s expectations, and was driven by projected further increases in both Retail secured and unsecured impairments (The secured level of impairments could well be better than the Plan assumption—but there was no room for complacency in relation to unsecured impairments—and this was likely to be a common theme across the sector). Presentation of impaired trends needed further careful thought. Separately, work would be carried out to look at the potential impacts of improving the unsecured position;

in 2006, “margin erosion” was a bit stronger than in recent times and “income diversity” was slightly disappointing—but the credit and costs positions were both acceptable;

in 2007 the “drivers of profit” showed significant margin erosion, but there was slightly improving “income diversity”, a good “costs efficiency” result and improving “credit losses”—but with an offset due to Drive and other factors. This again suggested that current margin erosion assumptions were probably too great;

for 2007, the Plan assumption was for a share buyback of £500 million, although there could be some scope to increase this if the Group outperformed the Plan and/or other factors fell in favour of a larger buyback (eg not using the full central contingency, or the “acquisition buffer”). An initial announcement of £500 million could well give rise to a market expectation that the programme would increase to £750 million in due course;

funding was not an issue in 2007, but could become an issue beyond then. Marginal asset growth both potentially damaged margins and could exacerbate funding pressures.

In terms of key questions:

there needed to be a full explanation of the impact of the Drive disposal;

the costs growth story in the Plan was at the right level, but tight;

margin trends may not yet properly reflect the true result of planned levels of asset growth. Corporate margin in 2006 reflected provision release plus the impact of ***—meaning that the move from 2006 to 2007 was relatively flat. Retail marginal lending, to maintain market share, was arguably at too great a cost in terms of margin.

For 2006:

the total Operating Costs outcome would be moved to a figure that would produce an increase of up to 6.1%;

the position in terms of impairment losses (in Corporate and International) would be looked at again;

in combination, an increase in 2006 of £5 million and an increase in impairments of £20 million would still give growth in UPBT (rounded) of 14%, and growth in UPBT of 11% between 2006 and 2007. Further consideration would be given to these and other potential impacts in 2006, and the consequent result for 2007;

the position in relation to Retail impairments would also be looked at again.

For 2007:

the projected fall in margin looked overdone, based on 12% asset growth (or 14% excluding Drive), and needed to be examined again, for accuracy and consistency—as well as with respect to the relationship between planned growth rates in net interest income and non-interest income, in both 2006 and 2007.

4. Retail

Benny Higgins confirmed that planned levels of income growth in 2007 would be demanding, and, if achieved, would look a good result compared to the peer group. Any greater income growth would be a valuable source of relief, and would allow a range of other issues to be tackled. Separately, further work was being carried out to identify possibilities for growing income faster than the current assumptions.

Overall, the aim in Retail would be to:

have a more stable market share trend;

push harder in respect of savings inflows;

write high quality business in unsecured lending, but not chase market share;

grow banking numbers towards a 15% plus market share; and

put greater efforts into the attack on the sub £1 million “S” end of SME.

Key strategic themes included:

growing the Mortgages and Savings businesses, re-establishing the leadership position in banking, and getting the timing right around the personal lending businesses, whilst growing a stronger presence in SME;

refocusing on values—setting higher standards for customer service—which required increased emphasis on lower cost (and lower risk) processes—as well as re-invigorating colleague advocacy;

sales management and risk management capabilities—which needed to improve dramatically;

the regulatory agenda, which would become increasingly challenging.

Branch expansion was a commitment for 2007, although the precise phasing and profit and loss impacts would be examined further. Principal repaid was a continuing issue that needed close attention and better—bottom up—analysis and forecasting. Fresh leadership and greater interaction with the rest of the Retail group would help recovery in relation to the Cards businesses. But the largest challenge related to income growth. Income growth needed to be of the right quality however—recent experience had shown that some of past income growth had been at the expense of quality, and this experience should not be repeated. General Insurance cross sales, take up rates and sales management were a major untapped opportunity. There could be greater emphasis on both household insurance and TMPP.

On the downside, the Plan did not reflect the possible loss of income that could follow from various regulatory interventions.

Chasing market share in unsecured lending was not sensible in the next 12–18 months timetable, as the focus should be on quality—but, in the longer term, a 15%~20% market share target remained credible.

The potential for using the Bank of Scotland brand to garner deposit volumes—to supplement BM—was being examined. The core Halifax savings business was extensively margin managed and was unlikely to be used as a source of aggressive inflows.

The Retail plan assumed that the *** joint venture would move to a 50:50 structure: although the key issue was to make the joint venture work. Inspiring high performance out of the business was a challenge.

There was a strong transactional push towards more centralisation in Retail—which needed to be managed in a way that did not damage innovation and income growth, or the potential for income growth. The multi-brand approach had clear strengths—but core processing within and across brands could be rationalised or made more efficient.

There was a significant people agenda in Retail, given depletion of the talent pipeline—as colleagues had moved within the Division and/or across Divisions within the Group. Refilling the talent pipeline was a major challenge, as was improving the quality of systems and processes.

The mortgages business was hugely (c. 80%) dependent upon the Intermediary channel. This was a natural mathematical consequence of the shift of the market away from “first time buyers” to “buy to let”. But consideration needed to be given to the Group’s position vis-a-vis the Intermediary sector. There needed to be improved processes to capture buy-to-let businesses, and to drive cross sales through the Intermediary channel. Something approaching branch levels of cross sales needed to be achieved via Intermediaries—and the future use and role of branches in the mortgage market needed further consideration.

Recent mortgage retention initiatives were having a very positive impact on retention levels—although not necessarily to the extent anticipated by the Group’s Plans. Others following the HBOS approach could help the success of these HBOS initiatives. The H2 2006 net lending performance would be a cause of real interest for investors, and would show a smaller H2 than H1 share.

5. Investment and Insurance (“L&I”)

Jo Dawson commented that the l&l Plan was ambitious and challenging, with tight costs control. Delivery of major parts of the Plan was, of course reliant, upon Retail sales performance. The Investment businesses were projected to grow strongly (13% in 2007; 15% in 2008 and beyond). There was increasing visibility of retention issues—with the market likely to move to a greater focus on “net” and “gross” positions. Sales in household were scheduled to grow strongly, although price pressures adversely impacted the growth in income. The *** plan was not yet finalised—but the motor business continued to struggle. ***’s put option become exercisable from 2007 onwards (the HBOS call did not arise until 2012). The future of the *** relationship, and the approach to that business—and the value to the Group of having an in-house provider of motor insurance—was highly complex. Synergies with the rest of the banking—and insurance businesses were very limited. In the interim, pending further consideration of these strategic questions, it was critical to ensure that the plans for this business were credible and robust.

Key strategic themes included:

exploiting opportunities for growth—in bancassurance, high net worth, household insurance and TMPP;

improving value generation, through a refocused intermediary strategy, as well as increased focus on retention and persistency; and

building people and infrastructure capabilities.

Key initiatives included:

delivering 15% p.a. bancassurance growth;

doubling market shares by 2011;

improving the position in relation to TMPP; and

building on progress to date in relation to retention and persistency—which had received insufficient attention in FS businesses historically.

Key risks included:

capacity constraints and recruitment needs in Bancassurance;

an adverse mix in sales, that could negatively affect profits;

market pressures on pricing, impacting average household premiums;

major weather events, or other adverse impacts for household insurance;

sales performance in Retail;

delivering the Intermediary strategy—which, in part, relied on improving or moving away from dependency on *** investment performance; and

the impacts of FSA and OFT reviews of the PPI market.

Work was being carried out to investigate potential options available in relation to the future of the With Profits Fund in ***.

The burden of these objectives, initiatives and risks was such that there was a huge challenge around the l&l Plan. The senior management team had been strengthened considerably, but further strengthening was required, to build strength in depth. Work to improve the TMPP proposition was a major priority. Greater attention needed to be given to incentive or performance structures that rewarded retention performance and stock levels, as well as new sales.

6. Corporate

Peter Cummings confirmed that the eventual outturn for 2006 was likely to produce 19% growth in UPBT, and this growth rate would be repeated in 2007, before falling to 12% p.a., in the later years of the Plan period, with positive SVA, and reducing cost: income ratio. The deposit plan was particularly challenging. Asset growth in 2006 would be just below 10%, probably—depending upon precise timing and/or the rate of selldown activity—and then between 9%~10% p.a. in later years of the Plan period (with 10% in 2007). The main criterion would be risk management, rather than aiming for any particular profile in terms of Asset growth. Net interest margin and net interest spread should be broadly stable throughout the Plan period.

IFRS required revaluation of assets through a revaluation reserve, that would potentially accelerate the recognition of gains or losses, and thus distort trends—the alternative to fair value MTM would be to treat a number of investments as “associates”—rather than simply recognise “profits” as they arose—but this was not considered to be an attractive proposition. The implications of this accounting treatment, and the impact on trends, in particular, needed further consideration.

Key strategic themes included:

embedding further the Asset Class Management model;

driving SVA;

continuing costs discipline;

building sound credit quality and sound credit processes;

continuing to grow executive and leadership capability; and

leading the way on CR.

The Division’s key themes and strategic objectives were underpinned by a range of initiatives, directed at embedding the Asset Class Management model; improving capabilities; and improving the quality of MI. Change within the Relationship Bank was a potential Risk to the Plan, as well as:

historic under investment;

a demanding regulatory agenda;

retention of key people (where the market in London, in particular, was very difficult);

margin pressures; and

asset growth, particularly as there were increasing pressures on structures, and margins, in Real Estate markets. Continuing to exploit distribution was key to success in the ISAF environment.

There was good confidence in the Division’s ability to deliver further strong growth in 2007. Funding was a challenge—and the increasing shortfall in self funding exacerbated the Groupwide position. At this stage the Group did not have the infrastructure (or colleagues) to tackle the “M” components of the SME market in England and Wales. The Group’s analytics and Ml capability also did not support an aggressive attack on SME’s. Building the necessary infrastructure would start in earnest in 2007. The SME profit pool was huge and potentially available: but the Group was not yet in a position to exploit the opportunity.

People issues were one of the largest Risks facing the Corporate Plan. Amongst other challenges, further thought needed to be given to remuneration structures to support appropriate specialist populations—within Corporate and across the Group—albeit with an element of longevity built in, to aid retention, and reward sustained performance. There needed to be greater focus on retention aspects of specialist incentive schemes.

Integration of the *** businesses had gone well. This was clearly a *** takeover of the Group’s vehicle financing businesses: the senior team was largely ***, based in Cheadte.

7. International

Colin Matthew reported that total UPBT would grow by close to 36% in Overall the Division would deliver 22% Asset Growth and c. 20% UPBT (adjusted for Drive) in 2007, with continuing strong growth thereafter during the Plan period.

In Australia—in local currency, there was continuing strong Asset Growth throughout the Plan period, with relatively modest UPBT growth in 2007 and 2008, reflecting the investments being made—with very strong UPBT thereafter.

In ENA, UPBT had grown by c. 42% in 2006—if adjusted for Drive. Growth in 2007 would be in excess of 40%—with continuing strong growth thereafter.

In Ireland, the Retail rollout would continue throughout 2007—but the underlying business remained strong and UPBT would grow by c. 20% in each of 2007 and 2008.

Strategic themes included:

in Australia, the Retail East Coast expansion, as well as completing the HBOSA integration;

in ENA, organic growth of the Corporate businesses, with investment in people and infrastructure in EFS. As previously discussed, ExCo would receive a full presentation in relation to EFS in December; and

in Ireland, completion of the Retail expansion, as well as growth in the underlying commercial businesses.

Key objectives included:

people issues, margin management and infrastructure development in Australia;

people issues, a deposit strategy and pursuing retail/bancassurance strategies in ENA;

people issues, the Retail rollout and developing wealth management in Ireland (with particular reference to real estate wealth management).

Key risks included:

recruitment needs;

competitive pressures;

the state of local economies;

credit trends; and

regulatory developments.

These were all believed to be challenging Plans. Australia had been supported by appropriate investment—and initial costs growth estimates had been too high, but had now been reduced. Both Australia and Ireland needed to press hard on deposits. Australia had done so already: this included SME deposits, even in the absence of a branch network. In Ireland, the SME base still deposited through branches: some of this would be picked up in the longer term, with Retail deposits being picked up in the short term. It might be appropriate to seek higher levels of deposits in Ireland and Australia—which could also help build brands and brand awareness.

The senior management team in EFS was being strengthened. This would pay dividends in due course.

Reporting the results of the International business in 2007 for 2006 could raise the issue of currency hedging—where the current policy was to hedge the Plan very early in the New Year; each month IFRS required MTM, which produced volatility; but any variations would unwind by the end of the year—but there would still be differences between one year and the next, based on relative currency movements across years.

8. Treasury and Asset Management (“TAM”)

Phil Hodkinson commented that there were strong parallels between Treasury and Asset Management:

their core disciples were about delivering ALM and investment performance respectively:

both businesses needed to capitalise on the value of recent investments;

and both businesses needed to support growth in other parts of the Group;

both businesses had outsourcing and Project Holly deliverables; and

both businesses were facing real retention issues.

Key investments in Treasury included increasing capabilities to raise funds offshore in due course (three to five year timeframe). Invista had increased the cost base following its IPO—but was envisaging strong fees and profits growth, as well as strong performance. UPBT was forecast to grow strongly throughout the Plan period. In the Fund Management business as a whole, although the absolute levels were small), and expenses would continue to grow as reserves and UPBT grew, in part, reflecting the costs of *** scheme. The treatment of *** expenses was being considered. The Group’s relationship with the Fund Management business was challenging, and equity performance had been disappointing for some considerable time. There had been serial failures to address shortcomings in equity performance, and current attempts to address performance were probably the “last chance”.

In Treasury, there was a growing issue of double-digit costs growth, to fund investment in capabilities. One third of costs increases related to the costs of being in London; one third related to investments in capabilities; the balance was investment in international capabilities (supported by strong revenues). Funding capacity needed to keep pace with the Group’s growth and needs. But it was also a legitimate objective that UPBT should grow at least at the same rate as the Group as a whole, given the importance of Group flows to Treasury.

9. Group Items

Andy Hornby commented that the key items would be covered in the presentation in Day Two. Key issues included flat costs generally (which for Group Services was very tight) but at a central level revisions to remuneration arrangements (which would be allocated to business areas in due course).

DAY TWO

10. Inorganic Options

Colin Matthew’s paper presented an overview of potential inorganic opportunities together with a review of other transactions that might occur or could be considered.

At present HBOS was around the tenth largest European bank: in theory, combinations between other players that were subject to current speculation could move HBOS materially down the “league table”. But few of these potential combinations would have any material impact on the UK retail banking and financial services market, and may have little impact on funding and/or capital raising capabilities—although the resulting greater financial “muscle” could enable these players to make further acquisitions. In a Corporate context, combinations affecting LTSB and/or ABN Amro could give rise to challenges.

For HBOS there were some (limited) in-fill opportunities in various markets (particularly l&l markets), but no truly transformational deals for the Group as a whole, at present.

Inorganic moves in the UK could (subject to price) be attractive in theory: or could present potential challenges for HBOS if third parties were to combine. Internationally, there were some limited potential targets, including in Australia and Ireland—albeit most of these were unacceptably expensive and/or would be subject to a material interloper risk, particularly from interlopers who would have significant synergies.

In the future, markets, winners and losers could change dramatically—particularly following the emergence of Chinese and other Asian banks.

In the UK:

the Group needed to be in a position to react quickly to any developments concerning Lime;

the Group would like to grow its l&l business, but current opportunities were very limited.

Internationally:

a deal in Australia could be attractive, but looked difficult at this stage. Iceberg should not be implemented in a way that would prevent a future transaction, however;

Canada would be the most logical and attractive “new” or additional territory. In the near future, a Toronto “office” would be established.

11. Basel II

*** explained that Basel II was highly relevant for this Planning period—and the potential impacts on the Group’s businesses needed to be considered, on a five year view:

as the Group moved from a Standardised approach to an Advanced approach, the buffer would grow and exceed the Basel I buffer in due course. By 2011 the Basel I buffer would be £14.9 billion ~ and £18 billion under Basel II. Maintaining the Basel I level of buffer would in theory allow capital release of £3 billion by 2011 (subject to regulatory intervention);

capital ratios would improve through the Plan period (except for due to the rate of RWA growth planned). At some point the Group needed to decide its desired level of Tier 1 capital (taking into account the changes planned for 2012). It was essential to from a Group (as opposed to a regulatory) view of the level of capital that the Group should maintain. The views of rating agencies also needed to be taken into account

across the peer group, HBOS should continue to be at the strong end of the spectrum (and getting stronger, relative to the peer group, under Basel II);

under Basel II, Retail (residential mortgages) and Corporate (property backed) businesses would be the most positively impacted—with Corporate (general) initially a small loser, and equity investments being significantly worse;

for Retail, mortgages and credit cards were the most affected products. The mortgage market as a whole and HBOS in particular were moving up the risk curve as the market moved in relation to LTV and specialist lending. The recent arbitrage in favour of specialist lending could, however, favour increased emphasis on lower risk business—and there could be real pricing differences between higher and lower risk lending. Cross sales would become even more critical in this environment. Managing undrawn credit lines in credit cards needed to improve significantly—and should be pursued to improve management of credit risk in any event;

Corporate had a similar issue in relation to undrawn exposures, which highlighted the importance of limit management—and might ultimately produce pricing differences in terms of undrawn lines in structured/PTP/MBO deals, and the Group may need to lead the market. The models should reduce the otherwise significant increase in capital requirements in respect of equity investments. Basel II led towards a conclusion that the group should hold more property assets;

the Treasury capital requirement was modest within the overall HBOS context. The value of capital relief on mortgage securitisations would diminish—but securitisations would still be needed for funding purposes. The Group did not believe that it had any material concentration risks, such as would impact Pillar II capital requirements. Diversification away from a concentrated position would be rewarded under Basel II—if the models did assume concentration risk. Fundamentally Basel II should not threaten investor appetite for HBOS securitisations—although the Covered Bond market may well develop further, and the interplay between investor requirements in the securitisation and Covered Bonds market remained to be seen;

growth of the mortgages business in Ireland could be a positive. There were regulatory challenges in Australia given the slightly different views of APRA and these “home/host” issues would need to be resolved in due course. In ENA, the Group should have competitive advantages in the US compared with non-Advanced Regional banks (in the absence of “special deals” for Regional banks);

in l&l initial indications were that there was significant surplus capital within the HBOSFS Group—although dividend and other blocks needed to be resolved before capital could be released to the rest of the Group. There was an established pattern in paying up capital out of the GI businesses. Market risk was the key risk for these businesses, representing 60% of the assumed capital requirement; and

the key business issues across the Group arising out of Basel II thus related to:

the potential erosion of mortgage margins;

diminution of the value of capital relief on mortgage securitisations;

stronger limit management in relation to undrawn lines; and

the need for the Group to make its own decisions concerning the level of capital the Group should hold, rather than or in addition to the regulator’s view of capital requirements.

by Q1 2007 each Division would need to absorb the business impacts of Basel II. Initial SVA targets would be based on Basel I—although progressively this should move to SVA on a Basel II basis—probably by mid-year. The transition needed to take account of the behaviours that would follow from the move to Basel II. There would be parallel running under Basel I and Basel II during 2007 as a whole, to ensure that the full implications of Basel II were properly understood;

PWC had been engaged to review the review the draft Waiver Application—to check both accuracy and fitness for purpose (in terms of the quality of the explanation and argumentation in favour of Advanced status).

12. Funding

Lindsay Mackay explained that the Funding position during 2006 had been subject to significant change. Customer Deposits were increasing in absolute terms over the Plan period but, as a percentage of the Group’s actual requirements would fall—and would end the Plan paid at about 43% of requirements (down from c. 50% at the time of the merger. Pre-merger, Halifax had been around 70% self funded). Divisional funding gaps (excluding securitisations) would nearly double over the Plan period (although the “quality” of that funding had probably improved).

Significant progress had been made in recent years to expand the sources of funding available to the Group. There was confidence that this Plan could be funded—albeit with only limited room for shippage in case of above Plan asset growth. The Group had successful MTN and CP programmes alongside extensive securitisation capabilities, with growth in both funding vehicles and the geographic and investor markets that could be tapped.

There was no shortage of short-term wholesale money. There had been strong growth in recent years in the Group’s deposit raising abilities. But profit pressures in Retail in particular had argued against establishing an “unprofitable” permanent attack that would simply seek to “hoover up” deposits. Internally transfer pricing these deposits to Divisions whose Assets were growing most strongly could help address that issue.

There had been a steady increase in the Group’s wholesale funding needs over recent years. But according to this Plan, the Group would reach its current wholesale funding capacity by 2009 in the absence of other actions. There were additional risks that emerged from the quantity of the Group’s capital forecasts and volatility in capital requirements. Growth in requirements had been exceeded by Santander (who was now effectively being treated as an “A” rather than “AA” bank) based on asset growth in Latin America, in particular. But HBOS had the highest wholesale funding need of any of the UK banks (and was close to the other Big Four banks combined).

Key challenges related to:

capacity—including the ability to convert potential capacity into actual capacity;

planning—where accuracy needed to increase and volatility reduce; and

optimisation—where there were significant improvements that could be achieved.

Timing issues were important: to open up new markets, develop new instruments, and generally to put actions in place today to improve future capacity/capabilities. HBOSTS would give further consideration to the options available to the Group to make material improvements to the position and/or to optimise the Group’s origination. In the longer term, the position was untenable and unsustainable: the Group had benefited in this respect in recent years by decisions made (for other reasons) to reduce the rate of asset growth.

In Corporate, deposit raising plan should be stretched further (taking into account the quality of deposits to be raised). More work would be required to “rebase” Corporate ambitions in this area. In the International businesses, there needed to be a change of mindset, to do more deposit raising than currently planned. In Retail, current deposit plans were probably more conservative than asset growth plans (although growth in 2006 had been ahead of the market). The deposits target in Retail was critical.

Over the next three years a more fundamental “breakout” option should be considered seriously—starting in the UK, and possibly rolling out to other geographies in due course. Urgent consideration would be given to the possibilities of pursuing such an approach, led by Benny, with input from HBOSTS and Group Finance (and this project should also consider the relative cost of this approach compared with other possibilities), although cost was not the sole criterion, as growing capabilities and achieving a fundamental shift in the approach were also critical. “Overpaying” for SME deposits (particularly at the “S” end) should also be considered. The earlier debate around the quality of marginal asset growth, and whether the right levels of asset growth was being pursued, was also highly relevant.

Work planned to take place within Divisions to build capabilities (for example to add new asset classes for securitisation) needed to proceed according to Plan—or shift only following review and approval of changes through Group Capital committee and/or its sub-Committees.

The deposits plans for Corporate and International would be clarified by the end of the month. Emphasis would be increased on the importance of deposit raising. The potential Retail and SME “breakout” strategies would be completed within three months (by the time of January ExCo). The total Funding Plan, including full consideration of all of the options available, would be submitted to ExCo in February aiming for a full review at the Board in April.

13. Risks

*** explained that the key theme of the Plan was on organic growth, with some evidence of moving up the risk/reward curve, and little evidence of profit optimisation. There was a continued (and potentially increasing) concentration in property exposures. There was clear stretch on the credit risk environment in all Divisions except Treasury. Growth ambitions were underpinned by key assumptions—which could prove to be overly-optimistic. Higher funding costs and/or funding constraints could constrain the Group’s freedom to manoeuvre.

The regulatory burden—both “tide” issues and the move to principles- based regulation—were increasing—as were the risks of retrospective legislation.

Stress testing (on a 1.25 year view) had only a relatively small impact on Group profitability (c. £5.5 billion -v- £6 billion)—using the “downside” scenario developed in conjunction with Capital Economics, The scenario was believed to be extreme, but the impact was not, particularly in terms of the relatively modest reductions in earnings/lending volumes that resulted. Further work would be carried out by the Risk and Finance teams to test the nature of the stressed scenarios that would be examined; the robustness of the views taken of changes in economic and trading circumstances, and the impacts on revenues and costs flowing from those stressed conditions.

*** would also lead the development of a “Super-downside” scenario, in conjunction with Groupwide risk and Finance teams—to identify the stresses and strains (which could well be different for each of the Group’s businesses) that would be tested—with the overriding assumption that all of these negative scenarios occurred at the same time.

A range of potential risks had possibly not been sufficiently addressed in the Plan, including:

financial crime, and the risks for HBOS in particular;

TCF;

embedding a risk culture that could deal effectively with principles-based regulation;

people risk, particularly in a range of specialist roles, as well as retention risks generally;

the scale and extent of change across HBOS; and

possible moves to a new model in the mortgage market.

14. People

*** explained that there were a number of key issues facing the Group:

there was insufficient strength in depth in the senior management cadre (Levels 7 plus)—given the scale of the total change agenda across the Group, in addition to business as usual;

a relatively small number of individuals had historically led major change programmes—and there were no obvious successors to deliver the change agenda in the future;

any inorganic moves in the next few years would exacerbate the situation dramatically. The Group would struggle to deal with bau, planned change and inorganic activity;

the Group was losing (or failing to achieve) planned improvements, due to its current inability to deliver major Tier 1 Projects on time and on specification.

The Group did not properly position itself as an employer of choice for the level 1 and 2 population across the Group—with consequent impacts on service quality; training resource; recruitment costs and general inefficiencies—in particular as a result of the significant levels of turnover. The quality of line management at levels 3–5 was also critical.

Talent management and feeding the talent pipeline were key. External talent hire exercises had largely (if not exclusively) been led from the top but past high quality hires had been resistant to the most recent waves of recruitment, in part failing to recognise the scale of investment they had received following their own recruitment. There needed to be a mixture of specific hires who were experienced and targeted for specific roles and other “non specific” but talented hires. The Group could not afford to hire only individuals who were “easy to manage”. There should also be emphasis on recruitment at levels 5 and 6 as well as 7 plus. The process of bringing in hires at this level was time- consuming, but necessary. Greater emphasis at levels 5 and 6, without “turning off” existing talented colleagues at 5 and 6, was essential. Planned remuneration changes at levels 7 plus raised the bar for performance management and made it essential that only high performing individuals were retained at these higher levels.

There was relatively little experience of managing complex change programmes—and the most experienced current individuals had not been “replaced” or “restocked”. There needed to be more balance in internal views of the value of good Project Mangers, more use of talented colleagues in Project Management as well as in customer- facing or revenue driving roles. There also needed to be greater visibility across the Group of the project management community, as well as some high profile appointments into that community, and development of those colleagues.

There needed to be further examination of the scope and scale of specialist schemes—although introducing a move towards a more disciplined approach to these schemes could take some time to achieve. The possibility of withdrawing “standard” HBOS remuneration features to colleagues in these schemes would also be considered.

Proper management of the Level 1 and 2 population was currently patchy: recruitment, money, management working environments and other issues were all part of the picture. The structure of remuneration at these levels would also be considered further in due course. Responses to Level 1 and 2 issues needed to be properly co-ordinated across Divisions, although probably needed to be managed from within Divisions. The core remuneration packages needed to be fully co-ordinated: with local delivery in respect of specific issues—including hygiene factors. *** would circulate a proposal in relation to a thorough review of Level 1 and 2 issues.

15. Summary and Finale

Andy Hornby commented that the strengths of the Plan included:

continued double digit earning growth;

continued strength in capital ratios;

improving customer source in Retail;

improved clarity about the intermediary Strategy for Investments;

developing the Integrated Finance and Asset Class Management models;

developing the Australia business; and

increasing international profits to 20% of the Group (even after Drive).

Weaknesses of the Plan included:

income pressures in Retail;

continuing failure to break through in England and Wales SME;

no clear vision for the wealth management businesses;

continuing challenges in motor insurance; EFS challenges to ENA profitability;

Insight and Treasury still with high costs growth;

liability growth too slow to ease funding constraints; and

no obvious low risk inorganic deals.

There were clear needs for step change in respect of a range of “people” issues—including:

the need to address Level 1 and 2 issues;

improving Total Reward for Levels 7 plus;

allied to much more rigorous performance management at Levels 7 plus;

filling real competence gaps in project management and credit risk management, in particular;

leveraging the strength of Union relationships into a source of competitive strength; and

pushing the abilities of producing the “Best Top Zoo” in the UK banking.

Within the next five years, HBOS needed to resolve its customer service issues; increase market shares across various products; taking ISAF capabilities into a new stage of its development; and making a real breakthrough in SME; with a cost: income ratio in the low 30’s.

The Agenda for the Board’s Away Day in January 2007 would consider these issues along with break-out strategies for each Division (based on a five-year-plus view).