Parliamentary Commission on Banking StandardsMEETING OF THE DIRECTORS Held at Old Broad Street, London at 10.30 am on 1 MARCH 2005

MINUTES
Present
Lord Stevenson (Chairman)	John Maclean
James Crosby	Brian Ivory
Charles Dunstone	Colin Matthew
Sir Ronald Garrick	George Mitchell
Tony Hobson	Kate Nealon
Phil Hodkinson	David Shearer
Andy Hornby	Mark Tucker
Apologies
Coline McConville
IN ATTENDANCE
***	Lindsay Mackay (Items 9+10)
***	***
Jo Dawson (Items 8,9+10)
APOLOGIES FOR ABSENCE
Apologies for absence were received from Coline McConville.

1. Minutes and Matters Arising

1.1 Minutes

The Minutes of the Meeting of Directors held on 25 January were approved.

The following Minutes were noted:

Minutes of the Board of Directors of Halifax plc (Halifax plc preference shares) dated 14 January 2005;

Written Resolution of Share Schemes Committee (SJPC Partners Share Option) dated 9 February 2005;

Minutes of the Audit Committee dated 8 February 2004.

1.2 Report from Audit Committee 25 February 2005

A note had been circulated to all directors confirming the key outcomes of the Audit Committee’s meeting on 25 February. Tony Hobson commented in particular on:

the quality of earnings, which were consistent with those in prior periods;

the extent of the challenge for the Finance teams, in particular in IID, where a huge amount had been achieved in very challenging circumstances;

underlying credit quality, which showed some deterioration in Retail, but with improvements elsewhere. In overall terms, the Group’s provisioning was at acceptable levels, and in line with the peer group;

endowment provisions, where it was clear that this was not a “kitchen sink” approach, but an attempt to take a realistic view of the likely costs that would be involved; and

the draft Stock Exchange release, where a key issue would be credit quality and movement of experience in relation to NPA’s.

The Committee had considered the draft year-end documentation in detail: a number of comments had been submitted, and were reflected in the documents tabled at this Board meeting, that would be considered in detail later in the day.

HBOS had complied with the Turnbull requirements during 2004. Jo Dawson had submitted a paper to this meeting in relation to Basle II implementation which gave a useful summary of progress in relation to this key issue.

KPMG’s investigation in relation to Project Garrett was nearing its conclusion. An oral report in relation to progress to date would be submitted to the Committee on 8 March.

2. Chief Executive’s Report and Oral Business Update

James confirmed that, as referred to by Tony Hobson, the Preliminary Results demonstrated equivalent quality of earnings to those in prior periods. The Results were likely to be slightly ahead of expectations. In terms of costs, volumes and margin the Group’s performance should look good compared with the peer group. The Group’s cost credentials were particularly strong. There was no evidence of serious costs discipline amongst the peer group, where competitors were justifying costs growth at what could prove to be a very difficult stage in the cycle. Retail’s credit experience (particularly in relation to unsecured lending) was likely to be the key issue for analysts and investors.

The draft IFRS Plan that the Board would consider later in the Agenda now presented a sensible picture: which underlined the scale of the challenge in relation to Basle 11. The relationship with the FSA and FOS in relation to endowments was improving, but there were emerging challenges in relation to dealing with ***.

Phil Hodkinson confirmed that overall HD volumes ytd were behind Plan. In relation to investment products, the “Direct Offer” approach had ceased. In the short term, this was having an adverse effect on PFA efficiency—but this would be addressed. The ISA/PEP/Pensions season would help illustrate whether overall investor confidence was improving. The slowdown in the housing market was adversely affecting sales of General Insurance products. January storms would have limited financial implications for the Group, but the need to maintain service levels may have had some impact on volumes. Creditor insurance profitability had historically subsidised the pricing of unsecured lending products. The overall pricing of the unsecured loan/insurance package was being reviewed, and would be reported to the Board later in the year.

Depolarisation was likely to be a significant news item as the year progressed. The Group’s businesses were well placed in terms of costs and distribution to deal with the new market conditions. Once understanding of the new accounting regime increased, investor interest was likely to turn to the performance, returns and value creation of investment businesses. The achievements of the business in 2004 would provide a good platform for what was likely to be a further challenging year for IID in 2005.

George Mitchell confirmed that Corporate was planning for a 10% net growth in profitability, which was likely to be a significant challenge, given increasing levels of churn. Corporate Finance activity generally, and amongst the Group’s key contacts in particular, needed to remain buoyant. Commercial property also needed io remain an attractive asset class. Deals in both areas were being concluded by some competitors on unattractive terms. The Group would continue to turn away pricing or structures that were too aggressive.

The Plan also assumed stable margins—which, given aggressive pricing by at least some competitors, would also be a major challenge. The integrated approach, and the Group’s extended family of entrepreneurs, continued to give competitive advantage. Systems and processes rationalization should drive out costs and give rise to greater revenue opportunities. Good inroads needed to be made in relation to the England and Wales rebanking market (re-banking largely remained event driven).

Non-interest income in 2004 had been strong—and this performance needed to be repeated. Costs pressures were increasing. Credit quality was, however, improving: NPA’s and all leading indicators were moving in the right direction. Earnings and net lending ytd were ahead of Plan—an encouraging start to the year, but there were significant challenges—but also attractive opportunities—ahead in 2005.

Treasury was planning for only 5% earnings growth- but this reflected the dilutive effect of the Group’s continuing lengthening of the maturity profile of wholesale funds. This effect should come to an end in 2005. The full benefit of increased sales and trading activity should feed through to Treasury’s results in future years. There would be significant investments in Treasury front office and product capabilities (and in Australia) during the year, but this impact should be larqely confined to 2005.

Andy Hornby confirmed that Retail would report in excess of 20% profit growth in 2004 compared with an average growth rate of c. 2%–3% in competitors. But there had been a tough start to the year, in a number of respects:

net interest income was under strain;

there was continuing unfavourable experience in terms of unsecured provisions;

planning expectations of base rate moves (November 2004 and February 2005) had not happened. The balance of external opinion was that the next likely move in interest rates would be upward. But rates could remain stable for some time. Base rate moves before the likely General Election were unlikely; and

the degree of slowdown in markets. Trading transactions were well down—c.28%—as was consumer credit activity. The mortgage market was likely to be c.20% down, year on year.

Approximately c. £60–70 million of additional cost savings had been identified to help offset the likely profit shortfall. This even tghter approach to costs would further increase the outlying costs credentials of the Group. Other initiatives were being planned to address the margin shortfall, including potential unilateral rate moves. Performance during the year would undoubtedly be back-end loaded, given the slow start to the year, with obvious implications for the scale of the challenge for Retail colleagues.

Basle II was a major challenge for Retail- but it was essential to achieve the right result, and deliver the necessary resource to secure this result.

A tough year for HBOS in 2005 would make the Group’s costs performance even more critical—particularly as slowdown in various markets would make it more difficult for the Group to outperform. Cost reductions were significantly driven by further process changes and improving central costs efficiency. These should have no adverse impacts on customer service in the year, where ringfenced investments were still being made. Weaker consumer markets made increases in interest rates less likely: this was across ail Retail markets, not merely financial products. The worsening credit trend could be being affected by changes in personal bankruptcy rules: but the largest impact was simply default (refusal to pay), in part, due to over-indebtedness. Creditor insurance policies were generally not being triggered—and creditor insurance profitability remained strong.

The cautious approach adopted by the Group to mortgage lending in the past two years—including tightening LTV’s—would continue. The Group was likely to have a c. 20% market share in H1: with a lower share in “H” and LTV’s would continue to tighten.

Mark Tucker confirmed that iFRS remained a significant challenge for 2005, and needed to be embedded in all business and finance processes. An IFRS version of the 2004 results would be delivered to investors in May. The more disciplined approach to Capital Management continued to develop, as illustrated by the update later on the agenda. Basle II was also a major challenge for 2005—and progress would be reported to the Board as progress continued towards submission of the group’s Waiver Application.

A full IR programme was being developed with the new brokers. The scale of the inter-action with investors would be increased. It was essential to illustrate to the market the diversity of the Group’s businesses, with greater involvement by all members of the Executive team.

Various initiatives were being pursued across Group Technology—to review all operations, and identify cost-saving and value-adding opportunities. Simplifying the IT landscape across the Group remained a major priority for 2005.

in Colin’s absence, James confirmed that the international businesses had made a strong start to the year. The “A+O” exercise would be launched fully shortly. The Chairman of the Group’s Irish businesses had resigned: Sir Ron Garrick had been appointed as an (interim) Chairman of the Irish businesses. A permanent, local, Chairman would be sought in due course.

3. Annual Results: 31 December

Drafts of the proposed Announcements, Annual Report and Accounts and Summary Financial Statements for both the Company and Halifax plc had been circulated: revised drafts were available showing changes made since these drafts were circulated, including those arising following the meeting of the Audit Committee on 25 February. These documents were noted: final versions would be presented for approval when the Board reconvened later in the day.

As previously discussed, the Announcement would confirm c. 22% year-on-year increase in PBT, with underlying eps growing by 23%, and ROE of 19.8% (allowing for the household insurance impact). The ratio of NPA’s as a percentage of customer advances had grown—and this was likely to be a significant focus of attention for investors.

4. Final (2004 Dividend)

At the meeting later in the day, the Board would consider a revised recommendation in respect of the 2004 final dividend namely an increase of 7.5%—being an initial move beyond the previous (5%) rate of increases, reflecting achievement of the 2.5 dividend cover target. This would be in line with market expectations.

5. UK-UK Transfer Pricing Project—Transfer of Employment

To reduce the Group’s exposure in respect of the latest UK-UK Transfer Pricing Rules, it was agreed that the majority of the Group’s UK colleagues would be transferred (from HBOS UK pic, including the majority of the employees of ***) to the employment of HBOS pic, with effect from 22 March 2005 (“the Transfer Pricing Project”).

It was further agreed that any two directors or any one director with the Company Secretary be authorised to do all things appropriate and to sign/complete all documents in connection with or ancillary to theTransfer Pricing Project including, without limitation:

the Business Transfer Agreements, transferring employees to HBOS plc;

the Employee Services Agreement, in relation to the provision of services of employees of HBOS pic to other members of the HBOS Group; and

the undertakings to be entered into by various members of HBOS Group dealing, among other things, with the acknowledgement of the respective financial services regulatory responsibilities of these companies arising in consequence of the Single Employer Project.

6. Schedule of Advances

Schedules of the principal advances agreed by Corporate Banking and international Operations during January 2005 were noted.

7. Capital Management Update

Mark Tucker presented an update in relation to progress following establishment of the Capital Management Steering Group, including in relation to:

monitoring RWA’s, through a more robust process;

the timing and extent of share buybacks;

Project Figaro, where the likely approach would be to “flip” the Preference Shares to HBOS pic, at an enhanced coupon; and

the possibility of securing repayment by *** of the £500 million Contingent Loan, probably in conjunction with a tax efficient innovative Tier 1 issuance by ***.

The initial share buy-backs would commence after the announcement of the Preliminary Results, but it was clear that achieving the announced limit of £750 million during the full year would be a significant challenge. But work was in hand across various workstreams to strengthen the Group’s approach to the management of its capital.

8. Group Business Plan—IFRS Version

Mark Tucker presented the IFRS translation of the 2005–09 Group Business Plan financials. Further work was required to finalise the detail—but the current draft was consistent with indications given, to the city in December 2004 concerning the implications of IFRS for HBOS—in terms of earnings and capital. The IFRS Plan targeted year on year profits growth of 9%—which was also consistent with the UK GAAP version of the Plan. The position in relation to the target capital ratios would be monitored, as the year progressed, by the Capital Management Steering Group.

9. Basle II Implemenation—Update

Jo Dawson confirmed that this was the first of a number of updates in relation to Basie II—which had been identified by the FSA, in the 2004 ARROW process, as one of the key issues facing the Group in 2005. The HBOS aim was to achieve “Advanced” status across ail of the key business areas at the earliest possible opportunity—given both the potential for future reductions in regulatory capital—and more imminently, the reputational and investor perceptions (relative to competitors). Actual timing remained uncertain: but the current plan assumed Advanced status for Retail assets from 1 January 2007 and for non-Retail assets from 1 January 2008. To meet this deadline, the appropriate application (the “Waiver Application”) would need to be submitted to the FSA by end October 2005.

Against this background, the Project had been graded “Red” in January:

in part, due to the volume of additional “guidance” recently issued by the FSA, that needed to be assessed. But it was already clear that the extent to which the new models and processes for the measurement and management of risk were embedded within businesses (the “Use Test”) would be key;

in part, given recent FSA Feedback following themed visits; and

in part, given an accelerated timetable by the Australian regulator.

A full review of implementation plans was being carried out, to ensure that the Group had a credible, robust and comprehensive plan to deliver the Waiver Application to the FSA by October 2005. This exercise should be completed within four to six weeks. This would be a key priority for Risk teams: but, it was also necessary for all businesses to commit the right level and quality of resource to this issue, which would be done. Regular updates would be provided to the FSA, as the year progressed—particularly in relation to the “Use Test”. Modeling outputs needed to be credible—but also needed to be used in managing the business. Appropriate MI would need to be created and tracked to demonstrate that Basle methodologies were being used in monitoring and decision making.

Regular updates on progress would also be provided to the Board.

10. Quarterly Credit Trends (Q4 2004)

*** reported that, in most areas, previous trends continued. Retail was the major emerging concern—with higher default rates suggesting some consumer-indebtedness strain. If employment rose, this strain would increase dramatically—and falling property process would reduce the ability of customers to re-finance.

The market was approaching indebtedness levels seen in the 1990’s, but without the additional factors of rates and prices falling. Historic growth rate of unsecured lending had now slowed—and it was essential to get this message across to external audiences.

Shifting scorecards did not deal effectively with credit abuse—and assessing total indebtedness was more difficult to assess than headline ability to pay.

11. Group Funding & Liquidity Management

Jo Dawson explained that this was the first in a series of planned Strategic Reviews of Risk issues that would be presented to the Board during the course of the year.

This particular Review was combined with an Update of the Group Five Year Funding Plan, that reflected the approved Group Business Plan 2005–09. Immediate post merger, funding had been one of the most significant strategic challenges facing the new Group. The issue had been addressed through:

increased focus on customer deposit raising;

diversifying both the sources of funding and the nature of the products offered; and

strengthening the Group’s liquidity position, through extending maturty profiles.

As Lindsay Mackay confirmed, significant progress had been made against each of these requirements. The Funding position was now far more comfortable—in part as a result of the Group’s anticipated future growth profile; in part reflecting the steps that had been taken to transform the Group’s funding capacity—including, for example, development of Covered Bonds; developing US and Asian based funding sources; and the capital markets initiative.

Liquidity, however, remained a significant management challenge. HBOS was structurally illiquid: this needed to be overcome through ensuring sources of funds were appropriately diversified, with identified additional capacity in case of need. There were no global regulatory standards in relation to the holding of liquidity. The FSA’s current regime was weak: There were intentions to improve these requirements, to look at the issue in an international context, but these were unlikely to be effective until 2008.

***

Internally, the Group broadly followed the FSA’s regime in relation to the appropriate levels of prudential liquidity but, applying liquidity across all currencies, with stress testing and behavioural modeling. The outputs were, however, subjective, reflecting management opinions, after appropriate challenge, not objective assessments. The process of building models had helped increase the Group’s understanding of liquidity issues, which would be benchmarked against peers later in the year. A revised liquidity framework would be fed into the 2006–10 planning process, and the subsequent Business Plan.

The Group’s prudential Liquidity position was strong. The liability profile of the Group’s wholesale requirements had successfully been expanded, and the range of liquidity assets held had been strengthened.

The Group still had a significant dependence on wholesale markets, way ahead of the peer group. The pressure to develop deposits needed to be maintained. Securitisation had been extended—but care needed to be taken to avoid swamping any markets with Group paper. Increasing diversification of funding sources had some impact on the average cost of funding. The Group’s modeling/behavioural modelling was more granular than the FSA’s generic approach.

The Group was moving towards a position where it could optimise the type of deposit gathering and instruments issued. Securitisation was a valuable tool in relation to funding, liquidity and capital management.

The retail deposit gathering base was ahead of the competition: but this was not true on the Corporate side, largely as a result of the Group’s history. Corporate deposits growth had been strong, however, and capabilities were being developed further. Significant progress had been made during the past two years—but this remained a significant challenge. The Group was potentially more exposed to market events that affected the availability of longer term funding from markets as a whole. But, as a strong name, a flight to quality of short term requirements should benefit the Group. Increasing the maturity profile provided valuable protection.

Early warning indicators were built in to reflect both general market conditions and HBOS-specific view to enable the Group to manage its funding and liquidity position.

12. Adjournment

At this point the meeting was adjourned, and would reconvene later in the day at 4.30pm.

13 Accounts for the Year End 31 December 2004

As agreed earlier in the day, the meeting reconvened at 4.30pm to consider finalisation of the Preliminary Results and various year end documents.

14 Bank of Scotland

14.1 Post Balance Sheet Events

The Group Finance Director confirmed that, except as already included in the documents, there were at present no further post balance sheet events, commitments or other contingencies requiring disclosure in the Annual Report and Accounts of the Company. It was confirmed that there was no material litigation outstanding which would require disclosure. Having considered those contingencies the Directors agreed that no further disclosures were required at this time.

The Group Finance Director tabled drafts of the:

Annual Report and Accounts for the year ended 31 December 2004 for Bank of Scotland; and

the Solo Profit and Loss Account.

It was agreed that each of the documents be approved, subject to any final amendments agreed by either the Chairman, Chief Executive or Group Finance Director, and that the Governor, Chief Executive, Chairman of the Audit Committee, Group Finance Director, and Secretary were authorised to sign the documents.

14.3 Final Dividend

The Directors agreed that, following finalisation of the Annual Report and Accounts of the Company, they would recommend to ordinary shareholders the payment of a total final dividend of £254 million for the year ended 31 December 2004.

14.4 Letter of Representation to KPMG Audit Plc

The Directors authorised the Group Finance Director or, in his absence any other Director, to sign the representation letter to KPMG Audit pic in the form of the draft produced to the meeting, and to release the letter to KPMG Audit pic on finalisation of the Annual Report and Accounts of the Company.

15. Halifax plc

15.1 Post Balance Sheet Events

The Group Finance Director confirmed that, except as already included in the documents, there were at present no further post balance sheet events requiring disclosure in the Annual Report and Accounts of Halifax plc. it was confirmed that there was no material litigation outstanding which would require disclosure. Having considered those contingencies the Directors agreed that no further disclosures were required at this time.

15.2 Preliminary Results Announcement

A copy of the proposed Preliminary Results Announcement for Halifax pic, initialled for identification by the Group Finance Director, was tabled and approved. The Chief Executive was authorised to finalise the Announcement and, when finalised, authorise to release it to the London Stock Exchange.

The Group Finance Director tabled drafts of the:

Annual Report and Accounts for the year ended 31 December 2004.

15.3 Annual Accounts and Related Documents

Summary Financial Statements; and

the Solo Profit and Loss Account.

It was agreed that each of the above documents be approved, subject to any final amendments agreed by either the Chairman, Chief Executive or Group Finance Director, and that the Chairman, Chief Executive, Chairman of the Audit Committee, Group Finance Director, and Secretary were authorised to sign the documents.

15.4 Final Dividend

The Directors agreed that, following finaiisation of the Annual Report and Accounts of the Company and the accompanying Stock Exchange Announcement, a total final dividend payment of £594 million be paid on the ordinary shares of the Company in respect of the year ended 31 December 2004.

15.5 Letter of Representation to KPMG Audit Plc

The Directors authorised the Group Finance Director or, in his absence any other Director, to sign the representation letter to KPMG Audit pic in the form of the draft produced to the meeting, and to release the letter to KPMG Audit pic on finaiisation of the Annual Report and Accounts of the Company.

16. HBOS plc

16.1 Post Balance Sheet Events

The Group Finance Director confirmed that, except as already included in the documents, there were at present no further post balance sheet events requiring disclosure in the Annual Report and Accounts of the Company. It was confirmed that there was no material litigation outstanding which would require disclosure. Having considered those contingencies the Directors agreed that no further disclosures were required at this time.

16.2 Preliminary Results Announcement

A copy of the proposed Preliminary Results Announcement for the Company, initialled for identification by the Group Finance Director, was tabled and approved. The Chief Executive was authorised to finaiise the Announcement and, when finalised, authorised to release it to the London Stock Exchange.

The Group Finance Director tabled drafts of the:

Annual Report and Accounts for the year ended 31 December 2004;

Summary Financial Statements; and

the Solo Profit and Loss Account.

It was agreed that each of the above documents be approved, subject to any final amendments agreed by either the Chairman, Chief Executive or Group Finance Director, and that the Chairman, Chief Executive, Chairman of the Audit Committee, Group Finance Director, Chairman of the Remuneration Committee and Secretary were authorised to sign the documents.

16.4 Final Dividend

The Directors agreed that, following finalisation of the Annual Report and Accounts of the Company and the accompanying Stock Exchange Announcement, they would recommend to shareholders the payment of a final dividend for the year ended 31 December 2004 of 22.15 pence per ordinary share, payable on 13 May 2005 to shareholders on the register of members of 18 March 2005.

16.5 Letter of Representation to KPMG Audit Plc

The Directors authorised the Group Finance Director or, in his absence any other Director, to sign the representation letter to KPMG Audit pic in the form of the draft produced to the meeting, and to release the letter to KPMG Audit pic on finalisation of the Annual Report and Accounts of the Company.

17. Next Meeting

The next meeting of the Board would be held at 10.30am on Tuesday 22 March 2005 at 5 Morrison Street, London.