Parliamentary Commission on Banking StandardsEXECUTIVE COMMITTEE AWAY DAYS

Thursday, 25 and Friday, 26 October 2007 Four Seasons Hotel, Canary Wharf, London
MINUTES
Present
Harry Baines	Peter Hickman
Peter Cummings	Phil Hodkinson
Jo Dawson	Andy Hornby (Chairman)
Mike Ellis	Colin Matthew
Philip Gore-Randall	Dan Watkins
In Attendance
***

Day One—25 October 2007

1. Funding and Liquidity

The proposed Funding Plan had been compiled primarily from a Treasury perspective, and involved considerable stretch. The Plan envisaged more proposed issuance than had been achieved in 2006 (the most benign year by far for issuance in the recent past). Under present conditions, this level of proposed issuance would not be achievable. It was a key assumption that securitisation markets, in particular, would re-open in the course of 2008. The Funding Plan assumed sizable issuance in every non-holiday month, and was aggressive, not conservative. The Funding Plan also assumed that it would be possible to get “other* (for example, Corporate) securitisations away.

The Early Warning Indicator relating to the amount of money market funding due in less than one month (with £50 billion as the EWI) would remain “red” through to late 2008, even after proposed asset reductions. Even after assumed asset reductions, there was an underlying assumption that securitisation markets would open in H1 2008. If that did not happen, there would need to be further discussions with Retail, in particular—unless the “slack” was taken up by other markets (for example, Covered Bonds—although there was also an assumption that record levels of Covered Bonds would be issued in 2008, in any event).

If securitisation and syndication markets remained closed, there would be significant impacts on the wider economy, that would slow down deal flow and the rate of asset generation. There would be significant pent-up demand, if and when markets re-opened—and it could be difficult for some time to get volumes away at attractive prices. Non-mainstream issuance could also be more difficult/expensive.

If opportunities arose to get more issuance away (both capital and funding) they would be taken. Realistic views would need to be taken about pricing, as the situation developed, and would be monitored by Mike, Colin and Peter in conjunction with Treasury. An early view would need to be taken—by March/April 2008, to assess whether markets were then performing in line with key assumptions in the Funding Plan.

Colin Matthew commented that there were some possible upsides that could mitigate the funding pressures identified in the Funding Plan—for example, if the market for synthetic conduits reopened, or if a strategic long term funder could be found. It was also important to maximise utilisation of available markets. Other than in these relatively limited respects, the draft Funding Plan was not overly conservative. HBOS was regarded as a quality and consistent issuer. The Grampian situation reinforced this view. The Funding Plan assumed smaller “lot sizes”, resulting in the need to make more issues of smaller individual size. But external perceptions of HBOS were positive—and needed to be reinforced (including through a targeted IR campaign in the balance of the year, and the early part of 2008).

Corporate syndication markets (in relation to private equity and commercial property) were effectively closed, largely due to uncertainties concerning the pricing for risk. Only distressed sales—or sales in special circumstances—were taking place. There was a significant overhang of existing deals. Commercial property transactions had slowed considerably, with potential transactions failing on economic terms. The position was unlikely to improve unless at least some of the more significant players—including RBS and Barclays—returned to the markets, although for other reasons this might not be a priority for them.

Increased levels of monitoring in relation to the Group’s Funding position were working well. The quality of information about asset generation, selldowns and syndications needed to improve, however. In particular, there needed to be monthly forecasts in relation to both assets and liabilities, including in relation to work-in-progress, selldowns and syndications, to give a realistic view, in real time, of both gross and net positions—within hard agreed limits, that were systematically enforced.

The base case had been stress tested—and a re-run of similar conditions in September 2008 could lead to a very uncomfortable situation, but would be “survivable” by the Group. HBOS—specific concerns, rather than market-wide issues, would be much more difficult to cope with, however. (Although these were also highly unlikely).

The current draft Business Plan already reflected the assumption that Retail deposits would be used to support asset generation in other parts of the Group. Deposit generation other than through “business as usual” could be a source of funds that would support asset generation in other parts of the Group, to protect or enhance Groupwide Pbt. This possibility needed to be kept under review.

2. Financial Overview And Key Issues (2007 Q3F And 2008–2012 Business Plan)

The full years’ underlying eps in 2007 now looked as if it would be c.108.6p, a result that would be ahead of current consensus (c,6.5p), although H2 2007 could be behind both H1 2007 and H2 2006. Consensus had fallen, but further significant falls were relatively unlikely, and there was some risk that consensus could increase before the end of the year. There was some disconnect between consensus PBT and UPBT—but the Group’s focus would remain on underlying eps.

Key adverse moves during 2007 included:

additional funding costs; higher deposit balances; and other impacts in Retail;

further flood costs in Insurance and Investment; and

Treasury mark-to-market (or mark-to-model) losses, in relation to the trading book.

There were still some significant downside risks. The “mark-to-model” situation was not yet fully accepted by the auditors. Having to mark to actual recent market prices could involve a further c. £100 million adverse. There was a risk to Corporate’s forecasts of c. £75 million due to the timing of realisations, as well as a potential mark-to-market loss in relation to Quintain, where the position was not yet agreed. There were other potential issues—wholesale funding costs, higher levels of deposit balances, and other factors, which were being dealt with as business as usual—including a possible unilateral move in relation to savings rates. There were two possible realisations in the US, which could involve downside risk of US $50m, as well as pressures in EFS. The phasing of growth in l&l needed to be looked at, in relation to Investments, in particular (and possibly also in EFS). A view needed to be taken of the position in relation to a range of tax issues, and the appropriate tax rate for the Group.

Given these various downside risks. It was probably more realistic to target eps of c.107 pence per share, (or slightly higher). This would amount to a year on year increase of c.7%.

For 2008, there were two major issues:

asset growth, which need to be constrained beyond the initial submissions by c. £10 billion. The precise implications of this needed to be understood following resubmission of the International Business Plan; and

costs growth, where the initial submissions produced an unacceptable result.

It was critical to deliver a reduction in asset growth of £10 billion across the Group. Responsibility to deliver this reduction would fall on the International businesses, for the reasons discussed—and would be built into a revised International Plan. The precise impacts on the International business were not yet clear. There were some prospects of significant deposit raising across the various businesses. But the ability to reduce costs by £100 million in 2008 would be very challenging, not least as some costs growth was already committed. The situation would be established with a high degree of confidence within the next week or so.

Further deposits were critical to building future flexibility—and generating additional deposits could allow possibilities for greater asset growth—but this would need to be reviewed as the year unfolded. There could be no guarantees that higher liability growth could be used to generate higher asset growth, particularly in 2008, given the range of downside risks and stretch already implied in the Funding Plan, although the aim would be to allow for greater asset growth if greater liabilities were generated, and all other aspects of the Funding Plan were performing in line with expectations. Consolidating and improving the Group’s total net funding position was a key priority. Higher liability generation was a critical short and long term objective in any event. Improved experience in relation to Funding would not necessarily flow through to higher lending.

Costs growth in excess of 9% could not be allowed to materialise. In times of lower asset growth it was important to stick within a 7% target for 2008. If the International businesses could not deliver cost reductions of c. £100 million, further moves would need to be considered in other Divisions. The treatment of currency movements in relation to the overseas businesses also needed further attention.

If the external market had changed fundamentally, rather than temporarily, there would need in due course to be a more fundamental review of the Group’s Operating Model and structural cost base.

3. Business Initiatives

It was proposed that a number of key initiatives would be explored in depth during the course of the next year, including:

the approach to Business/Commercial Banking in England and Wales. Expanding the Group’s presence in England and Wales had been a strategic priority since merger. Significant progress had been made in identifying the appropriate aims and objectives. These had moved away from a “monolithic” approach towards a highly focussed, more flexible, and heavily customer-focussed approach. But reviewing the strategy in depth, to ensure that there was appropriate understanding, coordination and resources across the Group, and that the correct customer segments and product propositions were targeted, was worthwhile. Philip Gore-Randall would lead this review;

Colin would lead a detailed examination of the optimal approach to Deposit raising overseas;

the Capital Markets initiative was already under development, but would be reviewed by January 2008—to understand the extent to which this was necessary to support development of Corporate’s business. This initiative needed to be Corporate focussed, to reflect Corporate’s needs—and not simply judged from a Treasury or purely theoretical perspective;

the possibility of greater Partnering in Lending needed to be explored, to understand the extent to which this approach could assist asset growth without undue balance sheet strain, utilising the Group’s strengths in origination; underwriting capabilities, and servicing transactions, whilst also reducing reliance upon banking syndication markets. Peter and Colin would report back to ExCo in December;

in addition to the normal Divisional Reviews each year, there would also be specific reviews of particular areas, as identified, where in-depth reviews would be led by Group Finance and the appropriate Divisional teams, to ensure consistency of scope, approach and financial reporting; and

full reviews would also take place of Technology/IT and Risk Management, where a Group wide investigation would be carried out, that could challenge the Operating Philosophy, and test and strengthen the underlying control infrastructure.

In terms of PFG, the proposal was to close down the programme, subject to completion of existing business cases. Costs for implementation would be managed through Divisions and functions within agreed budgets (with PFG related severance payments controlled through Group HR). This would lead to apportionment of the existing (small) PFG “shortfall” across the Group. Separately, procurement savings would still be pursued—and Philip Gore-Randall would report back to ExCo in December in relation to additional procurement savings (that would, in future, flow through to Divisions). The future treatment of costs associated with PFG would be considered further.

Consideration of the implementation phase of Basel II, and the move towards release of capital in due course, would require considerable efforts, and would also be included in the programme of reviews in 2008.

4. Corporate Banking

Peter Cummings outlined the key aspects of the Corporate Plan, and key risks, including:

growing underlying non-interest income, particularly with respect to investment gains, would be challenging, given the anticipated slow down in markets;

growth in loans and advances to customers would be in the region of 7% in 2008, given the anticipated end 2007 position;

there was some concentration risk in the Corporate balance sheet in relation to commercial property, yet Commercial property was a significant driver of the wider UK economy;

deposits growth was in line with expectations, and deposits were proving “sticky”;

there could be some upside in relation to an increase in margins, although this would relate only to future growth in assets—which would be constrained, due to slower growth and an assumed reduction in the levels of churn.;

provisions/impairments were assumed to continue to grow in absolute terms, although with a flat bps assumption, (which could be overly optimistic);

pbt assumptions, particularly with respect to realisations, were probably aggressive—if term and syndication markets remained closed until mid 2008, the Division would need to slow asset growth further. In those circumstances, it would be appropriate to adjust expectations in terms of non-interest income; and

in recent years Corporate had grown assets (gross) by 18% to 20%, to produce a net increase in the region of 9% to 10% per annum. Business was already being turned down.

The development of a Capital Markets capability was essential to enable Corporate to compete with its major peers—in relation to Real Estate, PFI and Private Equity, in particular. The initiative was largely concerned with adding necessary skills and resource.

The Asset Class Model would lead in due course to significant efficiencies across Corporate. Visibility and transparency in relation to the Asset Finance businesses had already improved significantly, for example, enabling clear(er) strategic choices to be made—including in relation to the vehicle finance (distributor/dealer) business, which was not a high value adding business. The lower end of the commercial property book, broker led, was also of poor quality, with significant overhead and a poor cost Income ratio. The position in relation to these and other businesses would be reviewed during 2008.

The Division was clearly exposed to the wider UK economic climate, as well as to the slowing rate of back book churn. In due course, if difficult external conditions persisted, there could be significant people retention issues. The control environment and change management capabilities needed to improve further, although progress had been made. During 2008, it was likely that a Chief Operating Officer would be appointed into the Division.

The underlying health of the Corporate Division was good, and the Division had a significant role to play in the future development of the Group. The Division had had an extraordinarily successful start to 2007, derailed only by recent turmoil. ISAF, Oil and Gas, Infrastructure and other business lines had all performed well—although ISAF continued to generate the greatest share of the outperformance. Good deals were being laid down for the future—including in relation to Social Housing; house building and aspirational housing; and other sectors. Third Party Capital raising needed to proceed, although current timing was probably not ideal.

Key changes to the Plan submission, to be worked through over the next few days, included reducing the scale of assumed realisations. The size of the (centrally held) contingency should also be reviewed, and probably increased.

5. Retail

Dan Watkins confirmed that Retail profit would go materially backwards in 2007, due largely to adverse experience in relation to:

Mortgages.

Fee income (largely as a result of regulatory pressures).

Impairments (where there had been a catch up).

During the Plan period, the aim was to grow liabilities ahead of asset growth, leading to the Division become self-funding well before the end of the Plan period.

In the near term, income growth would probably be behind the peer group, largely as the rate of asset growth was being constrained. This had led to the imperative within the Plan to identify new profit streams, and new businesses to be invested in, to deliver future profit pools.

Some other peers also had far greater levels of excess costs, that could be cut over the next few years, to boost profitability.

There was ample room for irrational behaviour in current market conditions. Some competitors might accept lower margins, and treat this as an investment to grow market share. This could adversely impact the Group’s assumptions in terms of margin. Savings spreads were of even greater importance, however. In theory, there could be even greater pressure in relation to savings margins (although this had not been the experience in recent years). Developing and exploiting the multi-brand strategy was key to success. The savings back book was still vulnerable to attack, but the risks of “bulk” attack had probably receded.

Getting the Group off its net lending target was an opportunity, but also challenged the team to identify and deliver the “right” mix and timing of gross lending. The focus had shifted to profitability rather than simple gross or net lending shares—although it remained key to remain in the market to protect the franchise (number one mortgage lender and, to keep a pipeline of “‘mainstream” mortgages, for securitisation purposes as well as specialist mortgages, for margin/return.

Rationalising and extending the Banking proposition—improving retention, getting closer to Private Banking, driving service, closing Cardcash—was also a challenge for 2008. Activity levels were huge, notwithstanding the pressures on net growth and income, given levels of churn. The balance sheet was still hugely dependent upon mortgage lending. Even though other assets could and should grow, they were likely to remain dwarfed by mortgage assets. And the need to constrain asset growth would inevitably constrain profit growth. The liability plan was already very challenging—but if the Division could deliver more, it would.

The underlying business remained strong and attractive—but constrained in growth terms whilst abnormal funding pressures persisted. Disintermediation could have a huge impact on retention and profitability—but this still looked unlikely. Directionally the Group should aim to adjust the balance away from intermediaries towards direct during a period when asset growth was constrained—and this would be a by-product of the drive for profitability.

New unsecured business was believed to be of high quality, although there was still some overhang from prior years that was impacting the apparent performance in relation to unsecured lending.

In terms of colleague morale and motivation, there needed to be greater performance management; more simplicity and rationalisation of future colleague bonus schemes; and greater consistency between schemes in different parts of the business. There would also be further investigation of:

activities that should be stopped;

areas where costs should be cut back; and

improved efficiencies in customer facing areas; as well as

activities that merited further investment.

The key priority was to deliver both 2007 and 2008 numbers, whilst also investing for 2009 and beyond.

This was still a very stretching plan—with real pressures around savings, banking—and houses prices (with particular reference to buy- to-let).

6. Insurance & Investment

Jo Dawson commented that cross-sales of l&l products, and emphasis on l&I growth, offered a real opportunity to help the Group’s overall growth rate whilst asset growth was constrained.

The investment businesses were projected to have double digit growth throughout the Plan period, with GI growing by mid single digits. Overall, pbt would show double digit growth throughout the Plan period, although the rate of growth would tail off in later years. Repayment insurance would demonstrate the most modest growth (1^st party) over the Plan period; but third party sales should grow more strongly, (although third party profitability was only modest, and the longer term aim could be to exit/sell this third party business).

Growth rates in both the Investment and Insurance businesses were likely to be ahead of the market/peers—although household sales still lagged well behind mortgage stock share, and there was much more room to grow.

Significant amounts of capital had been repatriated over the period 2005–2007, and the aim would be to continue to repatriate capital throughout the Plan period.

Key priorities for the Division included:

accelerating growth in bancassurance, including through developing the BOSIS in-house wealth management offering;

refocusing the *** Intermediary Strategy;

developing multi-brand, multi-channel Household Insurance;

improving retention; and

and building capability in IT, Finance and Customer Service.

Persistency/retention was a significant risk, and could involve significant volatility. A series of initiatives were targeted at improving retention, supported by improved and up to date Ml. Persistency had recently worsened in relation to bancassurance, in addition to Intermediary products—and this trend needed to be addressed/reversed.

There were major change programmes affecting most parts of the Division during 2008. This was a significant risk to the business; in addition to persistency; regulatory pressures; the increased intensity of competition; and large “weather events”.

The reinsurance position in relation to Gl was believed to be appropriate (arguably, the level of retained risk was too cautious—and, perhaps, could be increased). The level of reinsurance would continue to be kept under review.

The motor business (***) was projected to double over the Plan period in terms of sales, and current sales trends could well be exceeded.

The *** business now had some real momentum—its value and performance had improved materially. Various options were being considered in relation to the With Profits business. Care needed to be taken in relation to the shared infrastructure between *** Intermediary business and the bancassurance business.

Various conversations had taken place with SJP in relation to the possibility of extending the capacity of that business. Further conversations would take place in 2008; the downside risks facing SJP were increasing, and were probably now higher than in recent years. Investment performance, and persistency, were very strong in SJP. But the investment approach (although consistent) was conservative. The value of SJP did not fully feed through into the valuation of HBOS. The management team at SJP was now working well, but the strategic approach to this business needed to be revisited.

7. Treasury

Colin Matthew confirmed that the 2008 profit numbers for Treasury were largely driven by the degree of stretch in the Retail, Corporate and International Plans, rather than through third party business. If markets remained closed, to the detriment of Corporate and International, Treasury would also suffer, given the extent to which Treasury’s income depended upon, or derived from, Group flows.

The up swing in income between 2007 to 2008 (before going slightly backwards in 2009) was driven by an assumed recovery in credit trading, compared with 2007. There were still no assumed impairment losses on Treasury’s book (including with respect to the Grampian book).

Net interest income in 2007 and 2008 was impacted through “extra costs of funds” (above LIBOR). Grampian was now funding itself in the money markets. There was increasing funding flowing through the overseas treasuries, growing over the Plan period.

Key focus was on ALM activities, and supporting Group flows. There was limited proprietary trading—but conduits typically contributed £70–£80 million per annum. The position in relation to trading revenues, including Grampian and other conduits, would be reviewed during the course of 2008. The proper accounting and other treatment of liquidity assets also needed to be reviewed.

Priorities for this business included:

managing the Group’s funding and liquidity position;

providing financial services to the Group and the Group’s customers; and

making a profit.

8. ***

Colin Matthew introduced the presentation which was based purely on *** (rather than ***).

The Plan forecast strong revenue growth from 2008 onwards—based on a refocus on income and profit generating growth, and the “right” type of funds under management (taking account also of the strain arising from the *** With Profits and ELAS positions). Significant emphasis was still based on LDI and FI mandates—but with increasing focus on equities—which were forecast to more than double over the 2007–2012 period.

The business had been successful in diversifying its sources of revenue, and had the capacity to do more. There was much more to do in Europe, in particular. Distribution capabilities needed to increase—and it was possible that inorganic opportunities would be pursued, to build distribution capabilities.

The Group was well positioned in relation to LDI. But 2007 performance in relation to fixed income had been poor. In due course there needed to be greater transparency in relation to product and channel profitability, however. A development for 2008 would be the creation of a Seed Capital Pool, to help kickstart new funds (on a temporary basis) that would not cross a period end.

Retention of key talent continued to be a major challenge. Other issues included recent fixed income performance; market volatility; asset leakage—and the performance of the outsourcing arrangements with Northern Trust.

The proposal to increase *** fees for 2008 would involve a switch of between c. £20 million per annum and c. £25 million per annum between *** and the FS businesses. Precise timing would be agreed in due course.

The Invista business did not forecast performance fees, but estimates had been prepared for the Plan period—which showed single digit growth in underlying pbt over the Plan period.

9. International

The International businesses were due to reconsider and resubmit their Plans. One of the real challenges, through that process, would be the need to keep the respective management teams fully “onside”.

In Australia there could be a significant backlash, following recent publicity concerning branch expansion, and the early successes of the new branches. Slowing commercial business would have an immediate impact on profitability. The possibility of reducing hold levels in the Corporate businesses, whilst maintaining origination, would be explored.

In Ireland, there would be similar concerns, in relation to the ongoing rollout of the branch network, but the rollout was further advanced, and c.33 branches would be open by the end of the year. BOS I had a market share of c.20% of the Irish commercial market—and pulling back would be difficult. Mortgage growth would need to be curtailed. The possibility of selling down or sharing Corporate transactions would also be explored.

In ENA, the US and Canada both had the capability of producing significant profitable growth. EFS already had challenges, in its 2007 and 2008 Plan. The Deposit Raising initiative in Germany made strong strategic sense. Options in relation to the Dutch and BHH businesses would be considered.

The International costs targets would be reduced to £50m—leading to a likely costs increase for the Group as a whole of close to 7.5% year on year. Which also meant that the cost of the proposed investment in IT (to be considered on the following day) would need to be found from elsewhere with Business Plans, and could not be additionally funded.

Day Two—26 October 2007

10. IT Review

Philip Gore-Randall explained that the Group’s spend, which had been increasing in recent years, and was now c. £1 billion per annum, was believed to be broadly in line with the peer group, although accurate comparisons were difficult. The overall impression, however, was that the Group was not making real progress in terms of service performance. The “Service Excellence” initiative that had recently been launched was now addressing the right issues in terms of service risks and IT resilience—and improvements should follow.

There remained a relatively significant number of major service risks—and resolving the outstanding service risk exposure would need expenditure of c.£22 million, spread over two years (some of which was capital spend). Without that refocused effort, specifically directed at these risks, there were no current bau plans to address these issues. During 2007, these issues had been responsible for five of the eight level 1 crises experienced. The additional cost requirement for 2008, prioritising spend to address critical areas as early as possible, would be c.£10.6 million (indicative split c.£2 million Corporate and c.£8 million Retail). Although working on all of these issues during one year, and having the right capabilities as well as capacity, would also be a significant challenge.

There was also a concern that some underlying critical systems should be replaced in total, over a three-five year timescale, rather than “patched up”. But the need to improve service performance and resilience was more urgent than this—and could not wait to be addressed through building new systems.

The full review of IT would consider the right approach to improving systems resilience; the replacement of systems; the prioritisation of resource; and maximising the “value” of the HBOS IT investment spend. There also needed to be a full examination of how to improve the quality of reporting of IT issues and concerns to senior operating management, from both the Group and Divisional IT teams, with particular reference to medium term requirements.

It was agreed that the necessary funding would be provided in 2008–9 to ensure that these critical issues were addressed. Offline conversations would also consider the availability of the right quantity and quality of resource, capabilities and capacity as well as how the cost would be split between Group and Divisions (recognising the need to understand what would have to be stopped to do this and the need to minimise the impact.

11. Other Group Functions/Services

Philip Gore-Randall’s areas of responsibility were primarily demand led. Most of the cost in Service areas (Payment Services and Business Services) was reallocated to Divisions. The step up in Payment Services costs reflected the Faster Payments requirements, and the costs of the new industry—wide infrastructure. Most of the other increases in the demand—led functions simply reflected the net increase in demand. In terms of Property, the proliferation of properties needed to be addressed—and old or unnecessary properties needed to be disposed of, as appropriate.

The current regulatory view of HBOS was increasingly one of “accident prone-ness”. This would be addressed largely through addressing and improving service issues and resilience, but was likely to be a difficult perception to shift.

All of the other Group budgets were likely to be reduced from the figures initially submitted.

12. Business Risks

The largest current business risk undoubtedly related to liquidity issues.

Additionally, there were increasing signs that the external macro- economic climate was changing, which could have risk (particularly credit risk) implications. This was already reflected through a change in the Group’s risk appetite—as evidenced by the agreed approach to curtailing growth, and by deliberate moves away from higher risk sectors. In terms of the current risk appetite, the dashboard was largely green, with some concerns about the overall operational risk control framework (which were being addressed) with funding and liquidity being the most significant outstanding risks.

In terms of impairments, there would be some strengthening of unsecured provisions, although the unsecured P&l charge should soon peak, and then reduce. The secured position was broadly acceptable. Corporate assumed a stable position over the Plan period. The blended overall Group wide figure could be slightly optimistic in the later years of the Plan period.

Prior to the agreed actions that would be taken to reduce asset growth, there would be some deterioration in the extent of the buffer in excess of the regulator’s likely requirements. The agreed asset reductions would improve the position, and the approach to the possibility of further share buybacks would be reviewed in due course. The aim externally would be to keep the Group’s options open.

It was critical to be able to finalise the Basle II position shortly, so that appropriate guidance could be given.

Financial crime was a “hot topic” with the FSA, and there was a (mistaken) FSA perception that mortgage fraud was a significant issue for HBOS (and more so than in the case of the peer group). In reality, the quality of reporting and transparency at HBOS was ahead of peers, and this was creating a misleading impression of the scale of this issue. The Group needed to be robust in its dealings and communications with the FSA.

TCF was a top priority for the FSA. The control infrastructure would clearly be a major issue to be dealt with in the forthcoming ARROW review. The control framework was being strengthened, and it was critical that this continued as part of business as usual. Improvements in the control framework and other regulatory issues needed to be business led, supported by high quality Ml—and not treated as regulatory “projects”.

13. Inorganic Strategy

The key focus of this review was to consider whether any inorganic opportunities could provide a solution, or significant help in relation to the Group’s funding and liquidity concerns.

The Group’s shares were currently of relatively low value. HBOS was therefore unlikely to be able to win auctions. The Group’s cash resources were also constrained. However, the Group needed to be prepared to act quickly and opportunistically if a suitable target/transaction arose.

Various objectives led to a range of potential transactions/partners—depending upon whether the primary aim was to secure growth, boost profit or help funding.

In terms of funding opportunities, the key issue would be to identify a target of appropriate size and cultural fit, operating within a regulatory regime that would allow access to deposits across the enlarged Group. The most attractive geographies were the US, Western Europe and Australia. Smaller targets could help in the short term but would not drive an “ultimate solution”. “Repatriation” of deposits was important—but local funds could help above local growth, even when global repatriation was not possible.

There were a range of attractive acquisition targets in the US, but there were few European acquisitions that would have a significant impact—and most would involve moves to new geographies.

There were a range of possible MOE candidates in Europe, and a more limited number in the US. The UK remained extremely problematic. PE ratios made any deals involving Asian banks very challenging.

The key conclusions emerging from the review suggested that:

there were more MOE than acquisition opportunities;

there were some potentially attractive opportunities in the US, as well as in Western Europe—although the US looked increasingly interesting; and

rebuilding the Group’s trajectory was important, prior to attempting to locate the ideal transformational deal.

14. Conclusion

The Plan (even as adjusted in lines with the discussions of these Away Days) had a number of strengths, including:

respectable eps growth;

adequate capital ratios;

a clear focus on deposit gathering;

the International businesses growing to >20% of Group profit; and

managing the Group’s mortgage business with care, whilst growing Investments, and pursuing investment in Corporate’s Capital Markets capabilities.

The key weakness was funding. The core issue for the management team was to manage the situation, whilst trying to develop less asset intensive growth. Deposit targets needed to be delivered. A “breakout” strategy, ultimately, would be required.

Alongside these challenges:

the Group needed to have realistic costs targets;

the Group’s position in relation to SME, capital markets, wealth management needed to be resolved; and

and International growth objectives needed to be reshaped.

Mike would have monthly meetings with Executive Directors throughout 2008, and beyond, to keep in touch concerning all of the critical Group wide issues.

The Forum and Pre-Forum events would be used to communicate very clear messages—about the Group remaining open for business, but needing to rebalance risk/reward, and pursuing controlled growth—focussed on existing customer relationships in Corporate—given the increase in the cost of wholesale funding. The Group favoured moving to faster growth in due course, when funding costs and conditions were judged right.

The Pbt Plan for 2008 should be deliverable. Delivery of the next three years’ plans would open up inorganic options, and the focus would then shift to identifying options that would help address structural issues.