Parliamentary Commission on Banking StandardsMEETING OF THE DIRECTORS held on 22 May 2007 at 10.30 am at The Mound, Edinburgh

MINUTES
Present
Dennis Stevenson (Chairman)	Phil Hodkinson
Richard Counsins	Andy Hornby
Peter Cummings	Karen Jones
Jo Dawson	Coline McConvilie
Sir Ronald Garrick	John Mack
Benny Higgins	Colin Matthew
Tony Hobson	Kate Nealon
Apologies for Absence
Charles Dunstone
In Attendance
***	***
***	***
***	***
***	***
***
APOLOGIES FOR ABSENCE
Apologies for absence were received from Charles Dunstone. The Chairman welcomed John Mack to his first Board meeting.

1. Minutes and Matters Arising

1.1 Minutes

The Minutes of the Meeting of Directors held on 25 April 2007 were approved.

The following Minutes were noted:

HBOS plc—25 April 2007;

Halifax plc—25 April 2007;

Bank of Scotland—25 April 2007;

Annual General Meeting of HBOS plc dated 25 April 2007;

Annual General Meeting of Halifax plc dated 25 April 2007;

Annual General Meeting of the Governor and Company of the Bank of Scotland dated 25 April 2007;

Written Resolution (Increase in Covered Bond Programme) of the Capital and Structured Transaction Approval Committee of the Board of Directors of HBOS plc dated 27 April 2007;

Written Resolution (Increase in Covered Bond Programme) of the Capital and Structured Transaction Approval Committee of the Board of Directors of Halifax plc dated 27 April 2007;

Written Resolution (Increase in Covered Bond Programme) of the Capital and Structured Transaction Approval Committee of the Board of Directors of the Governor and Company of the Bank of Scotland dated 27 April 2007;

Written Resolution (Medium Term Note Update) of the Capital and Structured Transaction Approval Committee of the Board of Directors of HBOS plc dated 27 April 2007;

Written Resolution (Medium Term Note Update) of the Capital and Structured Transaction Approval Committee of the Board of Directors of the Governor and Company of the Bank of Scotland dated 27 April 2007;

Written Resolution (Non-lnnovative Tier 1 Issuance) of the Capital and Structured Transaction Approval Committee of the Board of Directors of HBOS plc dated 3 May 2007;

Written Resolution (LPBS Provident Trust Change of Rules & Trustees) of the Special Committee of the Board of Directors of Halifax plc dated 10 May 2007.

1.2 Oral Report of Nomination Committee held on 22 May 2007

Sir Ron Garrick reported that, at its meeting earlier in the day, the Nomination Committee had considered a range of issues in relation to main Board (non-executive director) succession planning; Committee memberships (including the implications of the retirements of Brian Ivory and David Shearer); and an adjustment to the Terms of Reference of the RCCs, intended to increase flexibility.

2. Chief Executive’s Report and Management Information Pack

Andy Hornby confirmed that at first sight, short term profit trends looked robust. There were significant sales issues in relation to both mortgages and bancassurance, however, that were not helpful to overall earnings growth. Topline momentum needed to build more strongly, through 2007 and 2008.

The banking fees debate continued, although the precise next steps were still being debated amongst the major banks and the various regulatory agencies involved. The possible instigation of Declaratory Proceedings before the Courts was being investigated. The future pricing strategy in relation to current accounts generally was also receiving detailed scrutiny, to consider how best to position the Group for the future, taking advantage of what would inevitably be a period of instability and discontinuity.

A series of discussions had taken place with *** in relation to***.

There had been a control weakness within Corporate that was likely to lead to the need for a significant unexpected provision during the year. Peter Cummings would comment further. The underlying issue was being addressed as part of a series of projects directed at control issues across the Group. It was essential to ensure that the FSA remained on track with the progress being made by the Group in relation to control issues generally.

Colin Matthew confirmed that the International businesses were on track to deliver c15% profit growth, notwithstanding the significant investments being made. There was strong growth in both assets and liabilities.

The Irish current account had been launched on the previous day. *** would provide a more detailed update later in the Agenda.

In ENA, picking up the pace on asset growth was a key focus—in North America, in particular, where the pipeline was now beginning to fill up.

Treasury had had a second difficult month, in part reflecting the lack of recent large Corporate deals, in part reflecting a mark to market “loss” in relation to a bond position in ***. There would be a shortfall against Q1F at the half year—but the aim would be to make this good in H2 2007.

Peter Cummings reported that Corporate profitability was robust and would be in line with Q1F. Closing major transactions was proving very challenging. Small deals were taking place, and the pipeline was strong, but there had been no “mega deals” since *** The appointments of *** and *** to key roles in the Relationship bank had now been announced. Credit quality overall remained robust. But, as mentioned by Andy, there had been a weakness in controls in the high risk area within Corporate, details of which were discussed. An additional provision would be required in the full year, the full scale of which was still being verified, Peter and Dan Watkins would lead a thorough review of controls in this area, it was essential to demonstrate clear commitment in dealing with this issue, consistent with the FSA’s view that the Group was clearly the “best” major bank with respect to transparency and openness.

Benny Higgins reported that year to date Retail pbl was behind Plan, largely due to the ongoing shortfall in the mortgage business. Overall Retail-performance was now ahead of Q1F — although income remained under significant pressure. At a gross lending level, the Group was now hitting the necessary volumes, well in excess of 20%. The PR position was also better understood, but challenges continued. First half net lending would be c8.5%, following a very slow start to the year, when the Group was effectively out of the remortgage market, but net lending of c16% had been achieved in Q2. A thorough review of the mortgages position would be brought to the Board in July. A material shortfall in bancassurance (PFA) headcount was being addressed. Other businesses were performing well, including the savings, business banking and banking businesses. Credit conditions were more encouraging, with the flow into collections slowing.

Jo Dawson reported that, whilst profit would be in line with Q1F, underlying sales trends in Insurance & Investment remained stubbornly in line with earlier experience.

Business in SJP continued very strongly—producing over 30% year on year growth. However, bancassurance sales as a whole were flat year on year, in large part due to below Plan levels of PFA headcount. Transfers of colleagues into PFA roles, from the branch network, were being accelerated. The GGB would help overall bancassurance sales, resulting in c5% year on year growth at half and full-year—but challenges to underlying performance needed to be addressed, including ensuring PFAs had a competitive product set available which addressed customer needs in a higher interest rate environment. Intermediary investment sales were struggling, in part due to service issues. A more robust recovery plan was being developed across the Products, Marketing & Sales areas.

General Insurance sales were proving challenging, in a very competitive market. Overall Household sales should be 9% ahead year on year which would be a very strong result. The CC’s investigation in relation to PPI continued: a successful Site Visit had taken place. Jo and Benny would appear before the CC in July. Motor sales were now improving, and GWP would be 8%-9% ahead year on year. Overall sales, taking into account the challenges in relation to PPI, were flat, year on year.

Phil Hodkinson reported that the market’s reaction to the AGM Trading Statement had been positive, reassured by confirmation that other businesses would make good the challenges being experienced by Retail. Investors were clearly interested in the implications of the ABN transaction on HBOS (which was not seen as a threat to the Group’s Retail, Corporate or Insurance & Investment businesses). Size could, however, be important ultimately, if it created the flexibility to do further inorganic activity, paid for in cash. The Group needed to be alive to underlying trends, and the opportunities to take advantage of structural change. Investors probably did not understand the likely scale of the banking fees reversals issue. Some investors had begun to appreciate the strength of future capital generation by HBOS -although there was as yet no irresistible pressure to disclose the “uses” to which “surplus” capital would be part.

3. Securitisation

Colin Matthew explained that the aim of this item was to clarify the position in relation to existing internal limits concerning securitization and capital issuance by the Group, and to increase the aggregate internal limit for securitizations and covered bonds from £45 biliion to £60 billion. It was therefore agreed and resolved that, with immediate effect, the internal limits for covered bonds and securitization transactions completed or to be completed in calendar year 2007, be as follows (in any currency or mix of currencies, equivalent to):

covered bonds—£10,000 million;

securitizations (of any type, including whether “traditional” or “synthetic”)—£50,000 million (based on the nominal value of the underlying assets);

subject to an overall aggregate limit of £60,000 million.

4. Schedule of Advances

Schedules of the principal advances agreed by Corporate Banking and the International businesses during April 2007 were noted.

5. Platform for Growth

*** paper provided an update in relation to the progress of “Platform for Growth”. In summary, the Programme was on track to deliver the promised levels of benefits at lower cost than originally proposed—with the potential, therefore, to “outperform” external expectations. The precise phasing of both costs and benefits was subject to change—most probably as part of Q2F. This would have a beneficial P & L impact in 2007. But there could be some corresponding delays to the realization of benefits, in 2008.

Some of the initial initiatives had been stripped out since the original proposal was considered by the Board, but good progress was being made. There was increasing focus on continuous improvement, as well as on the means of delivering change. The costs involved in PFG were not being treated as an “exceptional” item. For external audiences, progress in relation to the cost/income ratio was key, particularly whilst major investments were still being made.

*** commented that there were still some significant challenges to be faced, including:

the procurement workstreams, which had now been rephased, and which remained subject to close scrutiny, under Benny’s leadership;

the slower than expected start to IT mobilization, and IT spend—although no delays to benefits realisation were yet forecast; and

visibility of PFG delivery, and identification of PFG savings.

There had been a reduction in the likely number of affected FTEs. Ail potentially affected colleagues were now fully briefed, and constructive consultations were taking place with Unions, although there needed to be greater emphasis in those consultations on growth opportunities and initiatives, not merely on the savings that were to be made.

Over the next few months it was critical to ensure that the focus on mobilization post business case, and on the delivery of benefits, was maintained. Progress to date was noted: further updates would be provided as the Programme progressed.

6. Basel Implementation Update

*** reported that significant progress had been made with respect to the Waiver Application, where:

accreditation in respect of Operational Risk had been forthcoming, with unconditional approval having just been granted;

meetings between the FSA and senior management had gone well;

both the FSA and the Financial Regulator (in Ireland) were satisfied with the rollout plan for BOSI; and

discussions continued with APRA, but the Australian issue should not adversely impact the UK Advanced Application.

It was believed that both the Treasury and Retail models would be recommended for approval.

The FSA now supported the Property Investment Models, where they believed that the models rank ordered risks. The major challenge was now the General Corporate Models and, in particular, the General Corporate Model PD model 4. Discussions were continuing with the FSA, but time was running out. The Group continued to believe that the GCMs were good enough, although the relative lack of detailed inputs to the models was a real issue. The Group had offered to override the model 5 in capital terms, for an initial period -although there was in fact no risk of capital leakage from the system. Andy would shortly see Simon Green, to stress the importance of this issue—which affected only a small part of the Corporate book, in any event, should not be seen as “material” in Group terms, and should not jeopardise the Group’s Application.

7. Quarterly Key Credit Trends

*** reported that key credit trends remained broadly stable, in line with recent experience, with:

improving new business quality in relation to Retail unsecured, albeit with ongoing losses driven by the back book;

credit quality improvements in Retail Secured, where potential moves up the risk curve, to drive returns, would be monitored closely;

early indications that the Corporate credit cycle might be about to turn. A market correction was expected at some point, but there was as yet no sign of stress in the Corporate leveraged portfolio. However, the Corporate credit cycle was being impacted by shifting views towards “infrastructure” assets, as well as inflows of foreign money. Commercial property broadly tracked the general health of the UK economy—outside London. In London, there were ample signs of irrationality in pricing. These factors, alongside major M & A activity, masked developments in relation to the credit cycle, which was therefore proving extremely difficult to read; and

a generally upward trend in arrears and impairment levels in Australia and Spain.

The key concern remained the impact of affordability and insolvencies on the Retail unsecured book, although there had been some leveling off of the recent IVA and insolvency experience. Base rate increases and threats to affordability generally could present further challenges, however.

The Group had not yet participated in a “Covenant-Lite” transaction, but it would consider doing so, depending upon its belief in the strength of the underlying business.

8. Group Credit Risk Strategic Capability

*** commented that this Review focused on the effectiveness of the Group’s credit risk management process (“CRM”)—in the context of a changing internal and external environment. There was no doubt that the. Group’s CRM process remained effective and fit for purpose. The Group had some real strengths—in Treasury, Corporate, Retail and Australia, in particular. But, overall, the Group’s CRM capabilities did not provide a competitive advantage. The next aim therefore would be to move beyond a primary focus on controlling absolute levels of loss, to one that was concerned about improving overall risk/reward assessments across multiple asset classes, multiple divisions and multiple jurisdictions. The quality of the Group’s future performance depended largely on the CRM decisions taken today. In an environment where there was:

an increasingly competitive market for both the products sold by the Group and the capital to support the business (including increased opportunities for arbitrage between different banks, having different profiles, for the same assets);

an increasing commoditisation of credit risk. The growth of credit structures would ultimately give HBOS and its peers more flexibility and choice as to the balance between origination and hold appetites;

a growing impact from regulators and other stakeholders; and

an increasing need to turn data efficiently into information to support decision making.

It was essential to develop the Group’s CRM processes—not least so as to ensure that risk “numbers” were produced to the same standards as the Group’s reporting and public disclosure obligations; and to build a framework that would better enable the HBOS portfolio in aggregate to be assessed. Aggregating across HBOS would provide a forward looking view of the future risks that Business Plans would embed in the balance sheet, and the capital required to support those risks.

The Group’s major exposure in relation to credit was.the scarcity of appropriately skilled credit risk resource, which was an increasingly difficult issue across the Group.

9. Group Funding & Liquidity Strategic Review

*** reported that Q1F confirmed that the Group had sufficient funding capacity to support the asset growth shown in the Business Plan—and maintain its targeted wholesale funding maturity profile, and strong prudential liquidity position. Good progress had been made in increasing wholesale funding capacity: the current view of likely funding requirements in 2007 had also shifted downwards. In combination, these factors meant that the estimated unused wholesale funding capacity (or “buffer”) had increased—from about £5 billion to about £30billion. But there was no room for complacency. HBOS continued to be highly dependent on wholesale markets—and more so than the peer group. Q1F indicated that the wholesale funding need would continue to increase—from £208 billion to £356 billion over the Plan period. Customer deposits thus remained a priority. The additional deposit raising initiatives outlined to the Board at its meeting on 25 April were now being reviewed by the Group Funding and Liquidity Committee, for possible inclusion in future Business Plans, There also heeded to be greater asset diversification in the Group’s securitization strategy.

Material progress had been made in improving the Group’s prudential liquidity position in the past four years—through increased use of securitisation and covered bonds, as well as by limiting short term (under one month) residual maturity exposures. The position had been transformed, and the extent of one month mis-match had reduced significantly. The Group now anticipated stabilising the mis-match to current limits—with no need to further tighten current metrics.

Phil Hodkinson commented that, given its capital position, the Group could in theory grow assets at a faster rate—but funding challenges meant that the Group did not have the capacity to retain these additional assets on its balance sheet. This whole issue, and the “tension” or balance between asset growth and funding capacity, would be looked at further, later in the year, in the context of the Group’s capital position, and the Planning process.

10. Meeting the EU Policy Challenge

*** commented that active but targeted engagement with EU institutions in Brussels was critical—as the EU was now, and had been for some time, the key regulator on both domestic and cross border business. Policy originated in Brussels—with national Governments increasingly involved in implementation only. Against this background, engagement could help hasten welcome change; block or delay unwelcome change; result in change that had more significant relative impacts on competitors; redirect regulatory attention; or focus on non-regulatory “remedies”. It was not credible to rely on HMT or HMG to lobby on behalf of the sector, or individual firms. The good news was that timely and constructive input was welcomed in Brussels—and Brussels institutions had clear and (mostly) transparent processes. But affective lobbying activity needed to be committed and consistent, as well as constructive. There had been some early HBOS successes—but there was clearly scope to increase the scale of engagement, as well as a need to ensure that HBOS developed clear and coherent “positions” in relation to key policy issues. In brief, it was agreed that:

not engaging in EU activities was not a realistic option;

awareness needed to increase; and

credible positions needed to be developed.

PPU would take the lead in identifying opportunities and targets, highlighting to business areas these topics in respect of which effective lobbying by HBOS should be a priority. And businesses would endeavour to make available the necessary senior, skilled, (and finite) resource. There would be an increasingly top-down endorsement of involvement—supporting the principle of getting involved, and getting involved sooner. Solvency 2 was an example of where the Group had got its act together, and had made a real impact.

11. Reputation Management Strategy

*** reported that reputation management was a minefield for banks given Press, City, political, customer and consumer scrutiny, and a relentless external focus on the sector’s perceived “failings”. The financial services sector was the most closely watched sector in the UK—subject to aggressive press coverage and strong consumer lobbying. Against this background, HBOS had developed a strong reputation management programme—being distinctive, pro-active, and practical. There was active engagement with key politicians and the media—not only in relation to HBOS specifically, but also in respect of broader industry concerns. Within HBOS there were clearly defined responsibilities for media management across the Group, within strong governance arrangements, led by the HBOS Communications Group. And the approach was heavily focused on products and business strategy (avoiding a more “personality-led” approach). Most crucially, reputational considerations were an integral part of the business decision making process, and not an afterthought.

Notwithstanding the strengths of the Group’s approach, there were a number of real and emerging challenges, including:

increasing references to the “Big Five”, associating HBOS increasingly with the four large traditional clearing banks. HBOS needed to reaffirm its distinctiveness;

theaftermath of the Farepak affair, where there had been a major negative impact, amongst MP’s, in particular, and

the need for more successful co-ordination of message management across Divisional boundaries, and across the Group as a whole.

The Group also needed to make more of the Group’s positioning in terms of Long Term Savings and, increasingly, Climate Change.

12. Bank of Scotland (Ireland) Strategic Update

*** reported that the focus in BOSI in 2007 was on delivery. Performance in 2006 had been exceptional, but had been flattered by very strong economic conditions in Ireland, and other one-offs. Conditions in 2007 were likely to be tougher. Nonetheless, BOSI was well placed to achieve its planned future growth. The current five year Plan would see UPBT grow to in excess of €500 million, with over €50 billion of assets, and a cost:income ratio of c36% by the end of the Plan period.

The Retail rollout was not yet complete—but there was huge competition in the marketplace as competitors had reacted aggressively. The PCA had been launched on the previous day: it was obviously still very early, but there had been an excellent start. BOSI had already captured c8% share of the outstanding mortgage debt, from a standing start, and would aim to grow share by 1% p.a. in future. The target was to grow total Retail market share to 13% by 2011, with products designed to capture customers, led by the PCA/HCA—offering a market leading rate of credit interest—and a relentless focus on the back books of the established competitors.

The commercial banking business was already successful: the next aim would be to refocus efforts, taking advantage also of the “halo effect” spreading across from the Retail launch. Organic growth of the business bank would be accelerated—continuing to penetrate the Irish commercial market—and would be supplemented by development of an enhanced Corporate proposition in Ireland. There was a clear appetite in Ireland for integrated and JV propositions for Corporate customers, and significant potential for growth.

The level of advocacy amongst the BOSI customer basis was healthy—as was colleague advocacy notwithstanding the huge changes and demands made of colleagues.

This was only the start of a journey towards the overall strategic goal of becoming the fourth largest full service Irish bank by 2009.

13. Next Meeting

The next meeting of the Board would be held at 10.30am on Tuesday, 26 June 2007, at The Mound, Edinburgh.