Parliamentary Commission on Banking StandardsMEETING OF THE DIRECTORS held at The Mound, Edinburgh at 10.30 am on 18TH MAY 2004

MINUTES
Present
Lord Stevenson (Chairman)	Coline McConviile
James Crosby	John Maclean
Charles Dunstone	Colin Matthew
Mike Ellis	George Mitchell
Sir Ronald Garrick	Kate Nealon
Tony Hobson	David Shearer
Phil Hodkinson	Mark Tucker
Andy Hornby	Philip Yea
Brian Ivory
IN ATTENDANCE
***	Lindsay Mackay (item 8)
***	***
***
APOLOGIES FOR ABSENCE
There were no apologies for absence. The Chairman welcomed Mark Tucker to his first meeting of the Board.

1. Minutes and Matters Arising

1.1 Minutes

The Minutes of the Meeting of Directors held on 27 April 2004 were approved, subject to minor amendments.

The following Minutes were noted:

Written Resolution of the Special Committee re appointment of New Executive Director dated 24th March;

HBOS Annual General Meeting dated 27 April 2004.

2. Chief Executive’s Report and Management Information Pack

James Crosby reported that performance during April had broadly been around Plan. Retail continued to struggle, due to rate structures, in particular. It had been a relatively strong month for both Corporate and Strategy & International. But Contingencies were being utilized at an early stage of the year, and the Q2F process was likely to be particularly tough. There had been recent instability in world stock markets, due to a combination of concerns “about Iraq”, commodity prices (in particular oil) and interest rate rises. But overall trading conditions remained relatively benign. UK house prices showed no signs of weakening: rate rises thus far had not had any material effect.

IAS preparations continued, although timing was tight in terms of finalising standards, and arriving at common views of interpretation and application. This issue would be considered in more detail later in the Agenda.

The FSA was continuing to devote significant attention to the issue of endowment complaints. The initial regulatory focus had been on clearing backlogs. In due course the focus was likely to shift to the process of complaint handling. The Group’s relationship with the FSA was improving gradually, largely due to the progress that had been made in dealing with complaint backlogs. The Group was pursuing a pilot initiative (with Aviva) focused on resolving the underlying problems for customers which, in due course, could become a model for the industry.

Discussions in relation to dormant accounts were continuing with the BBA and HMT. The HBOS “straw man” was now the basis of discussions in relation to the possible creation of a voluntary dormant accounts scheme.

The final stages of the savings migration in Scotland had now taken place. Clearly, issues had arisen. The priority was to deal with resulting customer complaints quickly and clearly. Service quality should begin to improve significantly now that merger related disruption was virtually complete.

The intermediary market was beginning to re-focus on strategic relationships, ahead of de-polarisation and mortgage regulation. Discussions were taking place with key intermediaries, to develop relationships across all relevant product areas.

In relation to the individual Divisional results:

Colin Matthew reported that Strategy & International were slightly ahead of Plan in the month, and remained ahead of Plan ytd. Due to timing issues, out-performance to date would not be maintained for the full year, however. Some people changes had been made in Australia, to help improve capabilities in key business areas. There was a strong short list of candidates for the “HBOS CEO Australia” role. The appointment was likely to be concluded shortly. *** had now left the organisation. Discussions with APRA were proceeding positively. Strategic Reviews were due to be submitted to the Board in June in relation to the Irish and Australian operations.

Performance in Ireland remained broadly in line with its tough Plan. A high level announcement had been made in relation to the proposed move into Retail products. The underlying “business as usual” continued to grow strongly.

George Mitchell reported that Corporate was slightly ahead of Plan in the month and for the first four months of the year—due to a strong performance in relation to non-interest income, in particular. Progress was also being made in relation to exits from equity positions, the initial transaction being a sale of the Group’s stake in ***. Other disposals were being considered—in part, to contribute to delivery of the Division’s stretch target: and in part ahead of changes in the accounting treatment of such disposals that would follow the introduction of International Accounting Standards.

Competitive pressures were increasing—lending growth (14%) was ahead of. last year, but still behind Plan. Credit conditions remained relatively favourable. The result for the full year in terms of provisions should be better than Plan.

George reported that Treasury had had a more difficult month, however. The overall result was around Plan, and the Division was ahead of Plan for the first four months—but the result in April had been flattered by adjustments made as proprietary trading positions were closed down.

Andy Hornby reported that Retail were £10 million down against Plan. In common with the picture in recent months, about £6.5 million of this shortfall was due to funding costs, with the remainder due to a shortfall in capital credit. May was likely to be a further difficult month. Although base rates had now moved, pricing changes would not take place until June, and three month LIBOR had not moved significantly (in anticipation of further rate moves). There should be some recovery in June, in part due to the ATM sale referred to in the Project Pizza paper later in the Agenda, and in part as the result of pricing changes fed through.

These product pricing changes were likely to attract adverse comment. The savings rate changes would not be well received by the press. Year to date performance in savings had been strong. Savings inflows for the full year should remain at an acceptable level. Affordability issues would toughen is base rates continued to rise. Overall sales volumes continued to be strong.

The first-phase (“rural”) savings migration had taken place earlier in the month. This had now been followed by the “Glasgow and Edinburgh” migration. Migration involved significant disruption for customers. The next four weeks would be crucial in terms of dealing with customer issues. Thereafter, service should improve steadily as merger related disruption came to an end.

There had been no further threats of enforcement action in relation to endowment complaints. Significant progress had been made in reducing backlogs. The threat was not removed totally, however, and efforts would continue to be directed at managing the issue. The Group needed to be in the forefront of driving an industry solution—and this was the aim. The FOS view of complaints had changed over time: the Group might offer proactively to review complaints which had been declined in the past in line with prevailing FOS views that had subsequently changed.

Phil Hodkinson reported that profits in HD were ahead of Plan in the month. General Insurance had seen some tailing off of creditor insurance sales, in line with pressure on unsecured lending volumes. This issue was being addressed by Retail and IID.

The comparison of investment sales with the prior year was distorted by the lack of a “Guaranteed Bond” issue in the month: underlying performance was stronger than a straightforward comparison with 2003 suggested.

Discussions were taking place with key intermediary groups, where the HBOS total Group offering was being positioned with major IFA’s. There was significant pressure on commissions in the intermediary market, and the market remained challenging due to the distraction of impending depolarisation and mortgage regulation.

The IID analysts presentation in April had been well received.

3. Project Pizza

A proposal to dispose of part of the Group’s remote ATM estate (the “Estate”) was considered. The Estate was currently branded approximately equally as “Halifax” and “Bank of Scotland”—but the machines were located away from branches, in petrol stations, convenience stores and other locations. Indicative terms had been agreed with a selected purchaser, Cardpoint, that included the sum of £40 million payable in cash on completion together with a further conditional payment of up to £35 million, depending on the number of sites assigned to the purchaser.

It was accordingly agreed and resolved that:

the proposed transaction, details of which were set out in the paper considered by the Board, be and hereby is approved;

authority be delegated to any one director to agree the final terms of the transaction, including the final terms of the proposed agreement(s) with the purchaser of the Estate (including, for the avoidance of doubt, the process for contacting site owners and/or the terms of the loan note) and to execute and/or to authorise the execution on behalf of the Group of any necessary documents in connection with or ancillary to this transaction.

4. Quarterly Credit Trends

The report followed on from earlier Board discussions in relation to risk appetite. The intention was to present credit trends to the Board at regular intervals, as part of the process of enabling the Board to monitor performance compared with the agreed appetite. This report demonstrated, for example:

the difference between the growth of the Corporate book and trends in NPA’s. Property related concentration within the Property book remained—but within agreed sector limits. However, a disproportionate percentage (31%) of NPA’s related to the manufacturing sector (which accounted for only 5% of the book);

in Retail, base rate levels of 6% would put similar pressure on affordability as that experienced in previous periods of significant stress. In contrast to experience in earlier years, however, there were no current signs of high unemployment—which was the real issue that could drive higher default levels. A further note would be provided for the Board in due course as background information in relation to the unemployment position by sector, and how this differed from experience in previous cycles;

quarterly credit trends were all within the limits of the Board’s agreed appetite for risk—although it was clear that growth in parts of the Group’s portfolio were different to the peer group (for example, in relation to Manufacturing, where the Group’s exposure was still increasing); and

although there was only limited benchmarking data available, MGGB data suggested that:

overall lending growth was broadly in line with the peer group; and

by sector, however, there was greater growth disparity, for example in mortgages, commercial real estate, unsecured personal lending, and the manufacturing sector. These four sectors accounted for 74% of the Group’s total portfolio as at February 2004.

Further reports would be submitted to the Board in due course.

5. Schedule of Advances—International Operations and Corporate Banking

Schedules of the principal advances agreed by the Corporate Banking and International Operations Divisions during April 2004 were noted. Philip Yea declared an interest in the transaction with ***.

6. Regulatory Change

Mike Ellis introduced the trilogy of papers focused on the substantial programme of regulatory change (International Accounting Standards—“IAS”—and the Integrated Prudential Sourcebook—“PSB”) that was underway. Introduction of IAS and PSB capabilities were now under common project management, with a shared IT workstream, given the imperative that these capabilities were delivered on time, first time. Significant emphasis was placed on personal accountability and prompt decision-making. The approach was deliberately autocratic—mitigated by the use of rapid escalation procedures if disagreements arose, with the Group Finance Director being ultimately responsible for making decisions. Assurance was delivered through a number of channels, with the Regulatory Development Steering Committee providing strategic oversight and advice—but not making decisions, which remained the responsibility of individuals.

Overall there was a significant feeling that introduction of IAS was being rushed by the standards setters. Although there were still some uncertainties, (in particular in relation to EU endorsement) the Group was planning on the basis that IAS would be introduced with effect from 1 January 2005, without the need to provide (audited) comparatives for 2004. For so long as uncertainty as to the final shape and interpretation of the new standards remained, however, it was essential that the Group adopted a flexible, rather than a “hard-wired”, approach to implementation—so that any future modifications or revised interpretations could be accommodated.

The Group had 26 regulated entities, and regulation by regulated entities—along with a separate Treasury bank—increased the complexity of implementation considerably. The costs of regulatory change were significant: with total incremental spend likely to be in the region of £145 million.

Preparations in relation to IAS had caught up with the peer group—and the Group was broadly now in line with peers. The Group was now also broadly in line with peers in relation to PSB preparation, particularly in relation to the insurance businesses—with more progress necessary in relation to credit risk.

International Accounting Standards

*** confirmed that, although IAS did not change the fundamentals of the Group’s business, it would change significantly the way in which businesses and their finances were presented. But there were, as yet, no common views of the likely impacts of IAS on regulatory capital (where the FSA had not yet made its views public); on tax (where Inland Revenue had also been slow to provide guidance); on reported profit; or equity. The figures set out in the report in relation to the possible impacts on profit were highly provisional. For HBOS, the adverse impacts arising under IAS 39 in relation to the insurance businesses (whilst not scheduled for introduction until 2007) were reasonably widely understood. The potential positive impacts of the move to Effective Interest Rates were less well known, however. There would also be impacts on share schemes (which needed to be expensed) pensions; provisioning; leasing transactions; and hedging.

Markets had a broad but imperfect understanding of the likely impacts of IAS on HBOS and its peers. In general, the market’s view of HBOS was likely to be over pessimistic—as the market was focused on the negative impacts for insurance business, but not on the potential positives in other areas. Given the uncertainties and state of flux in relation to standards and their interpretation, it was important not to provide categorical explanations of the likely impacts of IAS, which might subsequently change, until there was greater clarity. There was already some external pressure to increase the level of comment and disclosure, however.

Thus far 120 Recommended Policy Guidelines had been prepared; 200 current state: future state analyses had been concluded; with some associated systems development and process changes still open. Overall, the IAS Project was “Amber”. Work was in hand to ensure the Project was delivered on time—but as not all of the issues were under the control of HBOS, the Project might not be “Green” until 1 January 2005, when it became operational.

Prudential Sourcebook

*** explained that the FSA Prudential Sourcebook comprised a new risk-based regime intended to integrate and cover all financial business—both banking and insurance activities—across all regulated firms. The regime was focused on regulated entities: even though the Group was managed on a Divisional basis. The new regime sought to ensure prudential management of firms via:

appropriate risk management systems and controls.

Standards would be set on a risk-by-risk basis, rather than the sector approach followed under the interim prudential sourcebooks. PSB would also introduce monitoring of an additional risk—“Group” or “contagion” risk ie the risk to an authorised firm that arose from being part of a wider group. Firms that qualified as “financial conglomerates” would be subject to additional regulatory requirements directed at this contagion risk. It was a working assumption that HBOS would be regarded as a “financial conglomerate”, although this was yet to be confirmed.

Under PSB, there would be a more explicit link between how firms managed risk and the amount of capital they were required to hold. PSB would be the mechanism through which the Basel II capital requirements, and the Risk Based Capital Directive, would be implemented within the UK. It now looked likely that the “advanced” requirements under Basel would be delayed by one year, but this suited the Group’s likely state of readiness.

Introduction of PSB required wholesale review and revision of risk policies; governance and risk management structures; management information; record keeping; and regulatory reporting procedures. Significant training would be necessary, as procedures and systems changed. In addition, preparations for mortgage and general insurance regulation were included within the scope of the PSB project. These products would be regulated from 31 October 2004 and 14 January 2005 respectively. Documentation, sales process, disclosure and other requirements in relation to mortgage and general insurance products would be co-ordinated with PSB requirements.

Implementing the requirements of PSB demanded significant commitment and support—but the potential financial benefits for the Group and operational improvements, were also significant.

Mike Ellis commented in relation to both IAS and PSB that major implementation risks were being taken by the regulators: IAS, for example, had originally been driven by a desire to improve the credibility of financial statements. But rushed implementation, with the consequent risk of restatements and reinterpretations, could produce the opposite result.

Further updates would be provided to the Board later in the year.

7. Corporate Responsibility Annual Review

Corporate Responsibility was aimed at integrating a range of business activities, so that HBOS was seen as a “good corporate citizen” in the eyes of key stakeholders. The primary focus was on:

increasing colleague advocacy, although other stakeholders were increasingly vocal, and keen to engage in dialogue with the Company on CR issues; and

differentiating HBOS from its peer group. Traditionally, banks had performed well in CR indices—but many stakeholders, and MP’s in particular, regarded banks amongst the least favourable sectors.

The “Way We Do Business” statement, recently published, represented a significant step forward—a public record of the values, and behaviours to which the organisation aspired. Together with the metrics supporting the statements, this was an important tool in helping to increase advocacy internally and favourability externally.

Leading edge products were at the core of the strategy, contributing both to colleague advocacy and differentiation. Measurement—as well as engagement—was also important. The Group had put in place a comprehensive range of indicators, against which progress could be judged and reported.

The focus on products was supported by aggressive PR, which had helped drive up external perceptions in recent years. Given this focus, there was a clear risk that perceptions and favourability could slip if “momentum”—in terms of new and innovative, value for money, products and services—was not maintained.

Good progress had been made during the previous year. There was a growing understanding of the role played by CR in the Group’s overall business. But there was more to do. Immediate next steps included continuing and developing dialogue with colleagues; improving the Group’s “scores” in the key CR indices; and moving further towards the goal of being the best bank for CR in the 2005 MORI MP’s survey.

8. Treasury Strategy

The Treasury Operating Division had the overriding objective of being the sole provider of all financial products and financial solutions to the Group and its customers, and the preferred supplier to IID. Key priorities were to:

provide wholesale funding and manage liquidity for the Group;

take trading risks, where knowledge of Group and customer flows created market opportunities; and to

develop a strong, growing and diversified income base—building on the Group’s and the Division’s competitive advantages.

Against this background, the presentation by Lindsay Mackay and Cliff Pattenden focused on the strategy towards:

management of the Group’s liquid assets, which was a core element of the Division’s “Funding and Liquidity” mandate. At present, there was an overemphasis on Government bonds, and an overeliance on a correlated asset class ie bank certificates of deposit. Diversification was essential. Alternatives were being developed to build new pockets of liquidity; to develop new products—for example in Credit Derivatives—that would have superior returns and liquidity characteristics; to lower the cost of high quality liquidity assets; and, generally, to leverage expertise to create income—generating businesses based on external flows (following the model of the Structured Investments Portfolio, originally established to manage excess capital);

further develop the sales initiative. Key aims were to widen and deepen the available product range; focus attention on relationship management as well as product expertise; working closer with other Divisions, to ensure appropriate “Treasury” opportunities were identified and referred to the Division; whilst being totally transparent about the derivation of Treasury income—to enable ail Divisions to have a full appreciation of the value of individual customers, and the potential value to the Group of Treasury business;

extracting value from flow trading for the Group. Key objectives of the flow trading businesses were to provide competitively priced products to the sales teams, to enable them to win business, whilst producing profit for Treasury. Sales and flow trading were the engine for growth in Treasury profitability. Initiatives focused on improving the sales function would produce benefits for flow trading. In particular, widening and deepening the product range was key: although this would need to be supported by investment in risk management capabilities.

Treasury was not focused on client acquisition—but could provide additional value for the group from clients acquired by other Divisions. Significant progress had been made since merger in bringing the former Halifax and Bank of Scotland Treasury Operations together. Now that integration was complete, the business could be developed to new levels of service and profitability. Development of the Treasury platform and extension of the product range would require (relatively modest) investment. In the next (2005–06) planning round, the Division would clarify the additional investment required, and the additional income that would result.

The Group’s reliance on wholesale funding had grown significantly since merger, and was projected to grow further: from c£188 billion in 2004 to £265 billion in 2008. Sources of funding had been diversified, but further diversification remained essential, given the scale of the requirement. The maturity profile had been extended—but further extension was required, part of which would be achieved through planned MTN issuance, and further Securitisation and Covered Bonds. Attention needed to be given to the Group’s approach to Transfer Pricing, to avoid the risk of dysfunctional behaviour in relation to Securitisation. Securitisation also had to be extended beyond residential mortgages into other asset classes: and significant volumes of money market funding needed to be shifted down the curve—from less than one month to 3–12 month maturity. The new Capital Markets Initiative was key: the first third party mandate had now been secured. The New York branch would enable a significant extension of the existing Yankee CD programme, and an increase in wholesale deposit taking. Markets in the Far East were also a potentially significant source of funds. At present, the intention was to access these markets remotely, rather than through a local presence—but more could be and would be done to develop these markets for the Group.

Lindsay emphasised that the Division’s strategy was closely aligned to the Group’s overall strategy. Further success could be achieved by leveraging expertise and maximizing the potential from flow trading and sales to customers acquired by other Divisions. The employment market for Treasury professionals was becoming more difficult, as investment banks were hiring again. The Group was now seen as an attractive employer in this field, but the business needed to ensure that its reward structures were right, and focused on rewarding success. The Treasury team were determined to take the business forward, provided this could be built on quality earnings—derived from Group flows, and. sales to other Divisions and the Group’s customers.

9. Any Other Business

Project Safari

James outlined work that had been carried out to date to evaluate this potential opportunity. There was a relatively low probability that this would be pursued, but further work would be carried out to assess the “do-ability” and attractions of a transaction.

10. Date of Next Meeting

The next meeting of the Board would be held at 10.30am on Tuesday 22 June 2004 at The Mound, Edinburgh.