Parliamentary Commission on Banking StandardsMEETING OF THE DIRECTORS held at The Mound, Edinburgh at 10.30 am on 24th June 2003

MINUTES
Present
Lord Stevenson (Chairman)	John Maclean
James Crosby	Colin Matthew
Mike Ellis	Coline McConvilte
Sir Ronald Garrick	Gordon McQueen
Tony Hobson	George Mitchell
Andy Hornby	Sir Bob Reid
Phil Hodkinson	Louis Sherwood
Brian Ivory	Philip Yea
IN ATTENDANCE
***	***
***	***
***
APOLOGIES FOR ABSENCE
Apologies for absence were received from Charles Dunstone.

1. Minutes and Matters Arising

1.1 Minutes

The Minutes of the Meeting of Directors held on 20th May 2003 were approved. The following minutes were noted:

HBOS Treasury Services of 20 May 2003.

Committee of the Board of Directors of Bank of Scotland of 20 May 2003.

Written Resolution of the Board of Directors of 19 May 2003.

Audit Committee meeting of 10 June 2003.

Written Resolution of Special Committee of 17 June 2003.

1.2 Audit Committee Report—10 June 2003

Tony Hobson commented that the outcome of the quality assurance review of Group Internal Audit had been very positive and pleasing. The Function was strong, a fundamental contributor to HBOS governance, and in the upper tier of its peer group. This result was a credit both to the management team, and to the open and transparent management style of the Group. The Board’s appreciation would be confirmed to *** and his team.

2. Chief Executive’s Report and Management Information Pack

A copy of the Trading Statement issued that morning was tabled. This confirmed that the Group’s Interim Results would be consistent with the April/AGM trading statement, and that market expectations would be met in the full year. Initial market reaction had been reasonably positive: stability of margins, delivery of targets, and reassurance on credit issues were well received.

The Group’s trading in the balance of the year would remain broadly around targeted levels, but there would be increased challenges of prioritisation—around allocation of capital, access to funding, and availability of IT resource, in particular. The Planning Process would be kicked off at a GMB Away Day during the following week; and the Planning Framework would be brought to the Board in July. These would begin consideration of these competing priorities and other key strategic issues.

The Government’s position on the Euro gave rise to the possibility that, if UK Euro entry eventually happened, preparation lead times might well be reduced. It was unclear whether the emphasis on the UK housing and mortgage markets, and the stated preference for longer term housing funding, represented genuine Governmental concerns. The position would be kept under close review in the next several months.

An amended version of the revised Combined Code had been produced and circulated for restricted comment. The new Code was likely to be finalised by the FRC by the end of July. The revised draft reflected some well-publicised shifts in emphasis, and a few U turns, but no major surprises.

The Economist survey of London house prices had predicted a significant fall in London prices: but this was not the Group’s view. Earlier dips in London prices now seemed to be levelling off. Across the UK, prices were likely to increase by slightly more than the Group’s original 9% forecast in the full year.

In relation to Divisional performance in the month the Divisional Chief Executives commented as follows:

Phil Hodkinson reported that the *** (high premium) joint venture agreement has been signed with ***, following Special Committee approval, and would be announced shortly—probably the following day. The RBS acquisition of Churchill would add considerable bulk to their existing insurance business, but could give rise to a significant integration challenge, given the different cultures of Direct Line and Churchill. The resulting uncertainty could assist recruitment by ***.

Project Ayr was progressing and was likely to be concluded and announced at the time of the Interim Results, when the market would also be educated as to the financial implications of the switch to in-house underwriting of this risk.

In terms of IID performance insurance sales remained strong, save in respect of creditor insurance—which was holding back profitability. *** continued to perform well, and now had over 600,000 policies in force. Investment sales in May had been disappointing: there was intense competition in the IFA market, as a result of numerous “special offers” being made by competitors; Bancassurance sales had also suffered. Overall UK sales would be 8%-9% ahead of 2002, but overseas sales continued to be poor. Total sales for the year would be flat compared with 2002, and well behind Plan—but this would still probably compare favourably with most competitors.

Andy Hornby confirmed that Retail performance looked very strong, albeit partially helped by a positive wholesale funding environment. Sales were solid in all key areas, with strong margins. The mortgage market remained intensely competitive. Costs were well under control. IF performance was adversely affected by its inability to offer fixed rate mortgages (fixed rates now accounted for 40% of the market) and moderation of its pricing (to ensure that the breakeven target was achieved). Churn of the IF backbook was in line with the rest of the market. All of these factors meant that IF would struggle to achieve its aggressive sales targets. Bottom line results would also be adversely affected by provisions in respect of unsecured lending made in the period immediately after launch. A full Strategic Review of the IF business would be brought to the Board in September, and would outline plans for dealing with these issues, including the introduction of a broader product range in the business.

Mortgage provisions remained strong, but unsecured provisions were creeping upwards. Brand data confirmed that service issues were a challenge; no significant positive strides were being achieved in service quality and there were some signs that cost controls were putting additional pressure on service delivery. Call Center demands were intense. Actions had been taken to add resource, given growth in transactions and customer numbers. Issues of service, the trade-off between costs and service, and the potential attractions of moving processing and other functions offshore, would be brought to a Board meeting later in the year.

George Mitchell reported that May had been a further strong month for Corporate Banking, with income well ahead of Plan, at stable margins. Some additional provisions would be necessary, but at a lower level than H2 2002. All areas of the Division were contributing to this strong performance. Deal flow remained strong: there was increased activity in the “public to private” sector. Provisions remained the most significant challenge, but the full year’s outturn should be no worse than 2002.

Colin Matthew confirmed that Business Banking had been on Plan in May, and a strong June was expected, leading to a half-year result that was slightly ahead of Plan. Fee levels, in particular, had been strong and vehicle residual values were robust. Overall credit quality continued firm. A new process for delivering higher quality leads from Retail would be introduced shortly.

Treasury performance in May had been behind Plan, as reported by Gordon McQueen, largely due to unrealistic planning assumptions in relation to funding and liquidity. The first half in total was likely to be slightly behind Plan, but robust in terms of sales and asset quality. The final Treasury weekend systems migration had been completed successfully, and systems integration was now complete.

Funding and capital raising had continued successfully with $1 billion of US $ Lower Tier 2 and the third Mound Financing mortgage Securitisation completing recently, together with a $500 million equivalent Lower Tier 2 Yen issue. The Covered Bond transaction had been announced: the initial offering would seek to raise Euros 2+3 billion; other institutions were believed to be looking at launching similar instruments.

3. Mortgages

The mortgages business was considered the bellwether of overall Retail performance. The business had three key strategic objectives:

delivering 25% net lending share;

whilst maintaining credit quality; and

and broadly stable margins.

These objectives required a balance between acquisition activity, by sector of the market, and retention. Share ambitions would be fulfilled by increased focus on specialist sectors (which had greater longevity and attractive margins, on a risk adjusted basis, if properly managed) whilst under performing in remortgages, (which typically had the lowest longevity). Remortgaging and churn continued to grow. Improving retention and reducing churn was central to success.

Retention would be attacked through a range of initiatives: the ongoing Mortgage Review; aggressive retention pricing for multi-product customers; changing intermediary remuneration to reward retention; and the introduction of (transparent) lock-ins for part of the range. A 20% reduction in churn—aimed for by 2005—would deliver the equivalent of 3% net lending.

The original aim had been to complete re-pricing of the back book during 2004: this would now be delayed to mid 2005. Earlier repricing was considered unlikely to deliver improved retention. But the likely eventual price would be lower—80 bps. The eventual price had to establish price leadership. If this enabled acquisition pricing to be moderated, and competitors followed, churn would reduce. If competitors did not follow, the Group would then be faced with a straight choice between margin and share. Earlier repricing by competitors could inflict (limited) PR damage on the business—but, given the costs to competitors, was unlikely. If some competitors did reprice early, however, this increased the likelihood that others would follow, particularly once HBOS moved. The risk that competitors did not follow was one of the biggest strategic risks facing the business: together with a reduction in the rate of savings inflow, necessary to fund asset growth, and the challenge of simply keeping all the balls in the air, given the amount of activity taking place in this market.

Growth in the offset sector (which could grow to 20% of the UK market) was a potential threat to margins, which needed careful management. Mainstream offset products would be launched in due course: but the aim would be to maintain differential (15 bps) pricing for offset products.

A number of Government-led initiatives could provide future opportunities, which the business was well positioned to exploit—including moves in relation to longterm fixed rates (where, in the absence of excessive Government intervention, the Group’s size and share should deliver a competitive funding advantage); the implications of Basel II (and the prospect of increased returns, which some competitors were already factoring into their otherwise unrealistic pricing); increased mortgage regulation (which would increase barriers to entry, and could cause some smaller players to leave the market); and reform of the home-buying process (where the Group’s position in estate agency and valuation should provide a competitive advantage and early access to mortgage leads).

4. Savings

The Savings business was a cornerstone of the Retail Division, vital to funding the asset side of the balance sheet, and critical to success. The business had 16 million customers with £90 billion of balances. Key aims were to maintain the position as the No 1 savings franchise; being the major source of retail funding for the Group; and supporting growth of the Bancassurance business. Halifax was the core brand, with £85 billion of balances: retention, steady growth, and margin management were key to Halifax. Other brands were positioned as niche engines for strong growth.

The overall liquid savings market had grown strongly recently, largely as a result of a “flight” from equities, which would at some point reverse. Transferring significant balances into Bancassurance products would help build retention—both against loss to other liquid savings providers, and to equity products in due course.

The Group’s fall in market share from 1995 to 2001 had been halted and now put into reverse, but this was an increasingly competitive market. The Big 4 were currently the most effective competitors, being particularly skilled at linking PCA’s and savings products, and attracting regular savings. Former building societies and mutuals added to pricing pressure, as they competed for retail funds. The threat from supermarkets had temporarily receded: but the new entry by ING Direct needed to be kept under observation.

The multi-brand, multi-channel, approach to this business was fully in tune with the Group’s customer champion credentials. Not ail products appeared in “best-buy” tables: but that was not the aim. The business sought to provide a wide range of competitively priced products that provided choice and reflected customer needs and preferences. Customers’ needs were proactively managed through Savings Reviews, and customers were migrated towards more suitable and/or higher rate products whenever appropriate. Spreads were falling. A major challenge for the future was to encourage more regular saving by more customers, in part through more focused links with PCA’s.

5. HBOS BIS (II) Programme

***’s paper and presentation considered the strategic implications of the proposed BIS II accord. Implementation was currently targeted for the end of 2006, although this date would put significant pressure on the EU parliamentary process. Recent developments in the US, (which appeared to be “backing off the new accord, restricting its application to the largest banks only), added further uncertainty in relation to implementation of BIS (II). Within the UK early, albeit partial, implementation would occur through the FSA’s Prudential Source Book project.

Regulators were interested in good risk management given their belief that this would resuit in fewer defaults and less systemic problems. BIS il incentivised good risk management, given that it imposed lower capita! requirements on companies good at risk management—a regime far closer to “risk based capital” than the current Basel Accord. “Advanced” status was the oniy credible status for HBOS, it was an essential defence against competitive erosion and a key weapon in driving competitive advantage. “Advanced” banks would have the capacity to undercut competition on chosen tranches of business, with cost of capital being a key strategic weapon.

To secure “Advanced” status it would be necessary to demonstrate understanding of the Group’s risks and how to measure and manage them successfully. The Group was not yet in a position to do this: acquiring the necessary capabilities and demonstrating the necessary risk management expertise was a key priority, although the full details of how this would need to be demonstrated were not yet known. At least some of the necessary risk management capabilities would have been introduced in any event, for the better management of the Group’s businesses: but there was no doubt that in some areas the need to secure Advanced status under the BIS II, (which was clearly in the interests of the Group as a whole), would require additional risk management efforts beyond those that otherwise would have been made. The overall Project aimed at delivering the necessary risk tools was “Amber”—but there was commitment to deliver.

6. Group Credit Overview & Analysis

***’s paper followed on from the paper considered by the Board in March dealing with credit conditions in the Group’s banking businesses. This paper reported on the results of stress testing across the Group, together with the consequences for profitability and capital adequacy.

In recent years the mix of the Group portfolio had been a benefit and had delivered competitive advantage. But it had to be recognised that that position could change under some economic scenarios. The raw results of stress testing suggested that, after some assumed management actions, the “worst case” credit loss assessment would result in the Group having to provide/write off in the region of an additional £1 billion pa for three years. Equivalent, after tax, to about a 5% reduction in Tier 1 capital p.a.

This raw assessment was within acceptable parameters, and would probably also be broadly in line with peers—unless there was also a material deterioration in the employment situation and/or significant asset price deflation—in which case the Group’s exposure to residential and commercial property could result in a worse outcome.

These results did not take account of the ability to mitigate the extent of any losses by using risk management tools and techniques to predict adverse credit conditions, and take early corrective action. In part in anticipation of BIS II, and in part in the ordinary course of business, Divisions were developing appropriate early warning indicators and credit risk measurement systems, that would enable more effective monitoring of conditions, allowing earlier actions to be taken—which, if taken early enough, (and were “right”), could significantly reduce the potential impact of adverse credit conditions.

7. Hbos Insurance (Pcc) Guernsey Limited—Change Of Holding Company

As a precursor to the possible liquidation of HBOS Guernsey Mortgage Limited (“HGML”) and Halifax Guernsey Guarantee Limited (“HGGL”) it was proposed to transfer the shares in HBOS Insurance (PCC) Guernsey Limited (“HIPGL”) currently held by HGML to Halifax plc. Accordingly, the Board agreed and resolved that Halifax plc would purchase 75 million fully paid core shares of £1 each and 3 fully paid cell shares of 1p each in HiPGL from HGML at a consideration equal to their net asset value shown in the book of account of HIPGL and that the effective date of this purchase be no later than 30th September 2003. It was further agreed and resolved that any Director or the Secretary be authorised to sign or arrange the sealing of any agreement or any other document necessary to give effect and/or ancillary to the foregoing resolution.

8. Capital Requirements

It was necessary to maintain solo total capital adequacy ratios for Halifax plc and Bank of Scotland at or above the FSA’s required level of 9% (and, in practice, above an internal target of 9.5%). Additional capital was now required, to ensure that the required minimum ratios were in place as at end June 2003. For this purpose it was proposed that each entity should issue Tier 2 subordinated debt, subscribed for by HBOS. After due consideration, the Board agreed and resolved that:

Bank of Scotland would issue and the Company would subscribe for £300 million Upper Tier 2 perpetual subordinated debt at LIBOR plus 190 bps.

Halifax plc would issue and the Company would subscribe for £300 million Lower Tier 2 subordinated debt, with a maturity date of five years after the Company gives notice requiring repayment, priced at LIBOR plus 100 bps.

9. Dividend Policy

The Group’s clearly stated policy was to “maintain a progressive dividend policy while moving towards underlying dividend cover of 2.5 times”. For 2003, consensus forecasts assumed a total dividend of 30.9p per share, split one third (10.3p) as to the interim dividend and two thirds (20.6p) to the final dividend. No decision was required at this stage, but this general approach was supported in respect of the 2003 interim dividend, when it was also likely that a scrip alternative would be offered. A full recommendation would be submitted to the Board on 30th July 2003. The Company’s dividend would be funded by upstreaming dividends from Halifax plc, Bank of Scotland and HBOS Insurance and Investment Group Limited.

10. Schedule Of Advances—Business and Corporate Banking

Schedules of the principal advances made by the Business Banking and Corporate Banking divisions during May 2003 were noted.

11. Date of Next Meeting

The next meeting of the Board would be held at 10.30am on Tuesday 29th July 2003 at Old Broad Street, London.