Parliamentary Commission on Banking StandardsMEETING OF THE DIRECTORS held at 33 Old Broad Street, London at 10.30 am on 25 July 2006

MINUTES
Present
Lord Stevenson (Chairman)	Tony Hobson
Peter Cummings	Andy Hornby
Jo Dawson	Karen Jones
Charles Dunstone	Coline McConville
Sir Ronald Garrick	Colin Matthew
Benny Higgins	Kate Nealon
Phil Hodkinson	David Shearer
IN ATTENDANCE
***	***
Peter Hickman (Item 3,4,5 + 6)	***
***	***
APOLOGIES FOR ABSENCE
Apologies for absence were received from Sir James Crosby. The Board noted that Sir James would shortly stand down from the Board, and thanked him for his extraordinary contribution to the creation of HBOS, through the merger between Halifax and Bank of Scotland, and to the subsequent growth and success of the Group.

1. Minutes and Matters Arising

1.1 Minutes

The Minutes of the Meeting of Directors held on 27 June, 2006 were approved, subject to minor amendments.

The following Minutes were noted:

Written Resolution of the Capital and Structured Transactions Approval Committee, re Funded CDS Covered Liquidity Assets, of 20 June 2006;

Written Resolution of the SpecialCommittee, re LINK Network Members Agreement, of 30 June 2006;

Written Resolution of the Committee of the Board of HBOS pic re Potential Disposal of interest in Drive Financial Services LP, of 30 June 2006;

Written Resolution of the Committee of the Board of HBOS plc re Sale of Credit Card Portfolio (Project Spring), of 30 June 2006;

Written Resolution of the Capitaland Structured Transactions Approval Committee, re Covered Bond Series 17 Issue under the €25 billion Covered Bond Programme, of 3 July 2006.

Sir Ron Garrick commented that, at its meeting on 25 July at 8.15am, the Nomination Committee had considered a series of issues including:

appointments to Risk Control Committees. *** had already joined the Treasury and Asset Management RCC. Offers would shortly be made to Oliver Page and *** to join other RCC’s. With them on board, the task of adding non-main Board external specialists to RCC’s was complete, for now;

potential appointments of non-executive directors to the HBOS main Board. A range of potential candidates were under discussion, but the Committee was not at the stage of being able to make recommendations for specific appointments at this stage; and

senior management succession issues generally.

Tony Hobson commented that at its meeting on 21 July, the Audit Committee had considered:

the interims process, where progress had been made in many areas, including in the Financial Services business;

the quality of underlying earnings; KPMG were satisfied that the quality of earnings was consistent with (or better than) prior periods;

the position in relation to endowment complaints, where no additional provision would be taken at the Interims stage, given continuing uncertainty, but the position would be reviewed fully at the end of the year;

the ELAS Initial Premium issue (to be discussed later);

audit differences, which did not jeopardize the integrity of the Interim Results; and

the draft Interim Results Announcement, where comments made by the Committee had been reflected in revised versions of the draft.

The Committee had also considered the fees to be paid to the Group’s external auditors. The Committee recommended to the Board, and the Board agreed and resolved, that the Audit Fee be fixed at £6.248 million for 2006. The increase (over 2005) primarily reflected scope changes, as the tender process had confirmed that there would be no changes to rate levefs in 2006.

2. Chief Executive Designated Report, Management Information Pack and Oral Business Update

Andy Hornby commented that June had been adversely affected by two “one-off” issues—the Grampian write down and the impact of the Umpire’s draft determination relating to the Initial Premium payable by ELAS in respect of the book of non-profit business reinsured from ELAS.

Jo Dawson reported that underlying performance across l&l was well ahead of 2005. Insurance sales were still struggling, although profits were fine. Investment sales continued strongly, but profit performance was affected by a number of “one-offs”, including resolution of the Box Management issue, and a cautious view in relation to the ELAS initial premium issue, given the Umpire’s unfavourable draft opinion. It was noted that the grounds upon which the Group could challenge the final decision by the Umpire Were tightly circumscribed. In General Insurance, the motor insurance business continued to struggle; PPI take up rates were a priority foraction.

Colin Matthew reported that the International businesses had had a good first half, with strong volumes, good credit quality and robust margins. Overall, the costincome ratio was well below Plan even after the investments being made. Following the Board’s discussion in June, progress would now be made in establishing an East Coast branch presence in Australia. The PCA product needed to be delivered in early 2007 in Ireland. Branch openings continued on track. Delivery of EFS sales in ENA, where the sales Plan was back-end loaded, was challenging. The proposed sale of the Drive business was progressing with two potential buyers. Early indications were that the gain on disposal should be in excess of £200 million.

Phil Hodkinson confirmed that the Treasury and Asset Management businesses had both made strong starts to the year—with higher than expected income in both businesses. The IFRS impact on the Treasury businesses had reduced compared with 2005. Retention of key individuals was proving challenging, in both areas, but particularly in the Treasury business. A brief note was circulated in relation to Project Chip. The initial structure of the proposed transaction had been refused clearance by HMRC—and an appeal to the Special Commissioners had failed. The alternative structure now being considered did not require tax clearance, but locked the Group into maintaining at least a 50% stake for six years, to preserve the tax grouping. This was an acceptable restriction. In practice it had always been assumed that the Group would remain “locked in” to the IPO company for five years, the duration of the initial asset management agreement between the Group and Invista. Confirmation would be secured from Leading Counsel that the proposed new structure would not crystalise the tax risk that would otherwise significantly diminish the value of the transaction. Some “follow on” deals, if the business grew and/or became involved in consolidation in the sector, were likely, and were built into initial business plans. It could be difficult in practice for the Group to fail to support those follow-on deals. It was not believed that the revised structure would adversely impact the value of the IPO business. No decision was required at this time—a meeting of the Special Committee to consider the final details of the proposed transaction would be convened for late August.

Peter Cummings reported that the Corporate business had made a good start to the year. In general, credit quality remained good and was improving, although a write down had been taken in respect of a specific issue in the Grampian business. The key issue for Grampian was the commoditised approach to chicken production. At this time, there were believed to be sufficient provisions in respect of Grampian, but the business was undoubtedly suffering as a result of industry trends, and this might not be the end of the “bad news”. A disciplined approach was being taken in respect of asset growth. Underlying asset growth was in the 5%-6% range in the first half, as anticipated. Basel II remained a significant focus of attention. Project Pace and the integration of the *** business were proceeding.

Benny Higgins reported that Retail was behind Plan in the month, with unsecured provisions a continuing challenge. The overall book was improving in quality—but the general credit environment was deteriorating. Insolvencies were a significant issue, with further significant growth likely. The BBA was spearheading industry efforts to raise awareness of the unintended consequences of recent changes to insolvency laws. The issue had also been raised with the FSA and with Ed Balls, Increased regulation of the pro-insolvency marketeers was critical. The new intermediary Mortgage proposition had been launched and had initially been well received. Branch-based business remained around Plan levels. Service measures had slipped slightly in England and Wales. In the second half of the year there would be significant emphasis on service issues generally. The FSA had agreed that there needed to be no retrospective review of endowment complaints handling.

3. Q2F

Peter Hickman confirmed that Q2F forecast showed that the progress made in the first half of the year would be maintained through to the end of the year. Key highlights of Q2F were for:

annual year-on-year growth in eps of 15% to 99p (compared with 91.5p in the Plan);

SVA and UPBT ahead of Plan, with both UPBT and eps ahead of consensus brokers’ forecasts;

underlying costs growth under control, and below Plan and external targets;

a continuing strong capital position, with all capital ratios well within their target ranges. The buyback programme would be increased for the full year 2006 from £750 million to £1 billion, which would be in line with the market’s expectations;

RWA growth higher than Plan, reflecting the growth opportunities in International and Retail (mortgages) in particular;

finalising the position in relation to endowments, which had not yet been agreed, but would become clearer as further information emerged in the second half of the year; and

goodwill on *** and in respect of ELAS, where an impairment charge might be required, depending upon developments later in the year.

Impairments were now forecast to be c. £1.8 billion for the full year, compared with external expectations closer to £1.9 billion. For the full year, it was likely that the full “target” of £1.9 billion would be required, however. ROE was now in excess of the stated target range of 19%-20% (at c. 20.5%), in part as a result of the share buyback programme, it was not thought appropriate that ROE should continue to grow.

Downside risks included the Umpire’s decision in relation to the ELAS. Initial Premium, as well as the need to complete Projects Chip and Grant successfully. The Plan remained stretched—with a reduced central contingency of £50 million. Regulatory scrutiny continued, with serious challenges that could adversely impact income and profit.

4. Interim Results Announcement (2006)

Drafts of the proposed interim Results Announcement had been considered in detail by the Audit Committee and the executive interim Results Committee. Additional comments should be passed to the Group Finance Director and/or the Investor Relations team prior to 31 July. Key features of the draft, subject to finalisation, included:

PBT up 17% to £2.654 billion and UPBT up 13% to £2.612 billion;

Basic eps up 15% to 45.3p and underlying eps up 15% to 47p;

post tax ROE at 20.5%;

broadly stable Group net interest margin at 179 bps;

cost:income ratio at 40.9%; and

Tier 1 capital ratio at 8.1% and total capital at 12.2% (after buybacks of £502 million in H1).

These were undoubtedly strong resuits—with annualised asset growth of 10% and annualized deposit growth of 7%, coupled with strong cost control and capital discipline.

The interim Results would be considered further at the adjourned meeting of the Board at 4.30pm on 31 July.

5. Interim Dividend (2006)

Peter Hickman confirmed that no decisions were required at this stage. The final decision would be made at the Board’s meeting on 31 July. In general terms, the intention was to increase dividends more closely in line with the growth in earnings, whilst restoring dividend cover to 2.5 times. As in previous years, the Interim Dividend would be around one third of the anticipated full year’s dividend—and a recommendation was likely to be made that the interim Dividend should increase by c. 14.9% to 13.5p per share (and an anticipated/likely dividend for the full year of 40.8p -which would be ahead of current brokers’ expectations).

6. Planning Framework 2007–11

Peter Hickman explained that the Planning Framework sought to establish the assumed economic background against which business plans should be prepared; the key issues that needed to be addressed during the 2007–11 Plan period; and the financial targets that all Divisions and the Group should aim for, so that the Plan would provide clarity on the Group’s delivery of further value to shareholders. Costs management remained key: and capital discipline would continue; but growth would be pursued in different markets and segments, as opportunities arose. There were also a number of outstanding key challenges for the Group that needed to be resolved during this next Plan period, including:

service quality, where service levels remained unsatisfactory;

overdependence on wholesale funding markets, where the Group’s deposit raising capabilities needed to be maximized, and sources of funding diversified;

delivery of Basel II, whilst also rising to the challenges posed by the various regulatory interventions pending and threatened;

extending the Group’s cost management credentials, to create capacity for further investment in growth; and

making further progress in implementing the Leadership Commitment and increasing the strength and depth of the Group’s talent pool.

Financial targets would aim for 11% growth in UPBT in 2007, with steady double digit growth thereafter; UK cost growth of no more than 3%–4% p.a., and overall costs growth less than 6% p.a. in the Planning period; all initiatives being SVA enhancing within the Planning period; and continuing strong capital ratios.

At this stage the full targeted income and profit had not been identified, but should be achievable with reasonable stretch.

The Group Business Plan would be submitted to the Board for approval in November 2006, along with Q3F, the forecast outturn for the full year 2006.

7. Guarantee Covering Transactions with Bank of England in Respect of the Management of the Exchange Equalisation Account

In connection with the Bank of England’s reforms of the sterling money markets it was agreed that a specific guarantee in the form of the draft considered at the meeting (“the BoE Guarantee”) should be provided in favour of the Bank of England and that any two directors or one director and the secretary be and hereby are authorized to execute the BoE Guarantee on behalf of the Company.

8. Schedule of Advances

Schedules of the principal advances agreed by Corporate Banking and International Operations during June 2006 were noted. The position in relation to the Group’s investment in 33 Old Broad Street was noted.

9. Climate Change

Phil Hodkinson explained that climate change was a significant and pressing issue -the cost of dealing with which was likely to fall predominantly on industry. It was sensible to develop a coherent policy in respect of climate change—to make sure that decision makers in the Group’s businesses took appropriate account of the impact of climate change in their decisions. It was thus agreed that a small Group, led by Phil Hodkinson, would be established to develop an HBOS approach to climate change issues—reporting back to the Board with specific proposals later in the year, alongside consideration of the Group’s broader Environmental Strategy.

10. Basel II Implementation—Update

*** confirmed that, since the last Report to the Board:

concerted efforts had been made to increase the quantity and quality of communications with the FSA, to help build FSA confidence in the Group’s capabilities to deliver the Basel II agenda;

good progress had been made with key models, following improvements to enhance the predictive capabilities of models in some cases;

the planned FSA review meeting,with the Property Investment Model had been deferred, but the meeting had been rescheduled for August, and a positive outcome was anticipated. The model would continue to be relatively weak, given the paucity of data that would help predict problems—but this was an issue that would apply across the sector; and

there was now clear line of sight to the Q4 Waiver Application—albeit with some “gaps” in respect of which there would need to be a credible delivery plan.

The challenge in Corporate, and across the Group was now to move to embed Basel in the day to day operations of the Divisions. The FSA’s interim ARROW assessment had made specific reference to the Basel II implementation programme as high risk—and this issue would remain an issue of focus for the FSA in 2006 and into 2007. Future Reports in relation to Basel would begin to focus increasingly on the capital Implications of Basel once the regime was operational and applied to HBOS, and not simply implementation issues.

11. FSA Interim Arrow Letter and Risk Mitigation Programme (RMP)

*** confirmed that the FSA’s interim (desk based) risk assessment of the Group contained no surprises—and generally highlighted issues of which the Group was already aware. The FSA acknowledged the significant progress that had been made with respect to the Group’s control environment, although there was still more “to be done”. The two biggest risks to the Group, according to the FSA, were:

the controls environment within HBOSFS, which was still inadequate; and

implementation of Basel II. Significant progress was required on credit risk modeling and demonstrating compliance with the “use test”. A contingency plan would also need to be developed in case the Q4 2006 deadline was missed.

Other issues raised by the FSA included the Customer Contract; Business Continuity Planning; the implications of the Group’s overseas growth strategy; HBOSFS PPFM; and the ongoing monitoring of the Retail Sales Culture.

The letter was balanced and fair. It was a generally positive assessment, and in line with expectations. The majority of issues would be dealt with through the regular programme of close and continuous meetings. The FSA was comfortable to place increasing emphasis on senior management to ensure that business and control risks were properly identified and mitigated. Specific “largely operational” RMP’s and deadlines were proposed in respect of eight issues. Delivery of these requirements would be monitored by Group Risk and reported through the relevant Risk Control Committees. In keeping with the trust demonstrated by the FSA’s approach, it was critical that the Group deal fully and effectively with all issues identified by the FSA.

12. The Way we do Business Annual Review

*** explained that the Group’s CR strategy was distinctive. Unlike other banks, the Group’s strategy was firmly focused on the Group’s products. Transparency, responsible lending, value for money, and inclusion were major drivers of the CR programme. External appreciation of the Group’s track record was improving: but there was scope to improve performance in a number of Key respects. HBOS was also unique in publishing KPI’s, measuring and tracking performance, although fewer and more focused KPI’s could assist—as could clearer and simpler disclosure of the Group’s performance in relation to key initiatives. The Group’s Environmental performance also needed to improve: and this would be covered in the Environmental Review to be considered by the Board later in the year. Steps were also underway to adopt a more holistic approach to Financial Inclusion issues, through the Financial inclusion Committee chaired by Benny Higgins.

A sound CR strategy was both defensive and offensive—in part, deflecting or defining external criticism; in part, helping to drive up stakeholder advocacy, amongst media, public officials and colleagues.

The CR programme supported, and needed to be based in, the Group’s business strategy. The Group had the opportunity to differentiate itself from the other major banks by further emphasis on responsible lending and financial inclusion, supported by more transparency, sharper reporting, and improving colleague advocacy.

13. ENA Strategy

*** presentation explained that ENA was a broad-based diverse financial services business that had huge potential—to leverage Group capabilities to build competitive advantages across Europe and North America. ENA operated in expansive, established, affluent and accessible markets whose characteristics suited HBOS products, innovation and risk appetite—and where the Group’s specialist expertise and current low market penetration provided significant growth potential. The Division had a very experienced senior management team, although some strengthening of the talent pool would be valuable below the top team. In total, the Division employed c. 1,600 colleagues—generating PBT of £283 million in 2005 (c. 6% of HBOS Group earnings). Growth in 2006 was likely to be in the region of 17%, Based on the scale of the opportunity for selective and targeted expansion, the aim was to build a business capable of delivering sustainable profitable growth and £1 billion of earnings by 2011.

In the European Corporate Business there was increased focus on the local customer base, whilst also supporting UK and global customers. There was matrix management around Product, Geography and key sectors—with clear emphasis on credit quality and proactive risk management, that recognized the significant differences in terms of security arrangements, and recovery levels in insolvency situations in these markets.

The European investment businesses had entered a period of radical change in 2005, with the strategic objective of creating a multi-brand, multi-channel, multiproduct life and pensions business of scale with a focus on core German and Spanish markets. The strategy had made a major step forwards following the acquisition of *** (now ***). The combined business offered significant growth potential alongside plans to further expand distribution channels. Although c. 90% of EFS sales were generated in Germany, the current market share was less than 2% and there was huge potential to grow. The distribution agreement with *** provided long term access to 2,500 financial advisers, the third largest sales force in Germany. There was an opportunity to expand to other channels, and a strategic partnership capable of extending into wealth management and mortgages.

The European Retail strategy was more challenging, and efforts were directed at considering opportunities to build a more coherent business model—focused on leveraging the Group’s core strengths into receptive and attractive local markets. The fundamental issue was whether the Group’s Retail skills and core competencies (particularly in relation to Housing Finance) were truly exportable. There needed to be an overarching non-UK Retail strategy based on (successful) leverage of UK competitive advantages.

The US Corporate office had been established over 25 years ago and employed c. 140 colleagues with a strong emphasis on risk management and clear focus on specialist sectors. Corporate USA had delivered consistent and sustainable profitable growth and had created real value in Drive, although this had arguably become a major distraction for US senior management. The business had a strong relationship with OCC and had an excellent track record on credit quality. Post the assumed sale of Drive, the aim was to broaden the operating base of the US business through selective but material investment in the office networks, people, and the infrastructure—but with continued emphasis on core specialist areas of expertise, targeting strong growth through doing more of what was currently done well.

Language and cultural issues were critical to success in ENA, and significant progress needed to be made to build the requisite skills, supported by a more internationally focused and tailored HR proposition for non-UK employees. The aim over the Planning Period would be to develop this business further to produce a proven business with a strong track record; low cost income ratio; and positive influence on Group SVA—and the HBOS share price—demonstrating clear returns on the Group’s international investments.

14. Next Meeting

The meeting was then adjourned, to be re-convened at 4.30pm on Monday 31 July 2006 at 33 Old Broad Street, London. The next following meeting of the Board would be held at 10.30am on Tuesday 26 September 2006, at The Mound, Edinburgh.