Parliamentary Commission on Banking StandardsMEETING OF THE DIRECTORS held in The Board Room, The Mound, Edinburgh at 10.30 am on Tuesday, 30 October 2007

MINUTES
Present
Dennis Stevenson (Chairman)	Phil Hodkinson
Peter Cummings	Andy Hornby
Jo Dawson	Karen Jones
Charles Dunstone (by conference call)	John Mack
Mike Ellis	Coline McConville
Sir Ronald Garrick	Colin Matthew
Philip Gore-Randall	Kate Nealon
Tony Hobson	Dan Watkins
Apologies
Richard Cousins
In Attendance
***	***
***	***

1. Minutes and Matters Arising

1.1 Minutes

The Minutes of the Meeting of Directors held on 25 September 2007 were

approved. The minutes of the following Committees were noted:

Written Resolution of the Capital and Structured Transactions Approval Committee on behalf of the Board Directors of the Governor and Company of the Bank of Scotland dated 13 September 2007 (BLC Update);

Written Resolution of the Capital and Structured Transactions Approval Committee on behalf of the Board Directors of the Governor and Company of the Bank of Scotland dated 13 September 2007 (Issuance under Master Issuer Programme);

Written Resolution of the Capital and Structured Transactions Approval Committee on behalf of the Board Directors of Halifax plc dated 13 September 2007 (Issuance under Master Issuer Programme);

Written Resolution of the Share Schemes Committee on behalf of the Board of Directors of HBOS plc dated 17 September 2007 (Sharebuy);

Minutes of the Audit Committee dated 2 October 2007;

Written Resolution of the Special Committee on behalf of the Board of Directors of Bank of Scotland plc dated 3 October 2007 (Increase to Yankee Certificate of Deposit Programme Limit);

Written Resolution of the Capital and Structured Transactions Approval Committee on behalf of the Board of Directors of HBOS plc dated 5 October 2007 (Social Housing Covered Bond Programme);

Written Resolution of the Capital and Structured Transactions Approval Committee on behalf of the Board of Directors of Bank of Scotland plc dated 5 October 2007 (Social Housing Covered Bond Programme).

Tony Hobson commented that, at its meeting on 2 October, the Audit Committee had considered the issue of the Group’s controls environment. This would be an area of particular focus over the next several months (with reference to IT issues and process controls). It had been confirmed to the Committee that work was underway to improve IT and systems resilience. This issue was high up the FSA’s agenda, and would be covered in the forthcoming Arrow review process.

2. Chief Executive’s Report and Management Information Pack

2.1 Management Information Pack

Andy Hornby commented that, as Phil Hodkinson would explain in more detail, the Group’s short term funding and liquidity position was ahead of the assumed position discussed at the Board’s September meeting. The broader macro-economic environment was getting tougher, however, on both sides of the Atlantic. The speed of-house price deterioration/depreciation in the US was increasing. There were increasing levels of write-downs, in relation to asset backed securities, by more significant amounts than previously assumed. Group would emerge from this period having still produced growth. It would be necessary to be even more selective in the future about prioritizing growth and investment decisions. The principal credit indicators in the UK remained positive. There were no signs of significant credit deterioration in core UK markets. But the Group’s current expectation was now that securitization markets would not reopen quickly.

Mike Ellis commented that underlying eps for the full year was currently in the region of c. 107.6 per share, which was slightly ahead of the emerging consensus. Underlying pbt, at c.£5.8 billion, would be 4%–5% ahead year on year. At this stage there was still a £50 million contingency in view of a number of uncertainties. Q3F was in the process of being finalised, but would be lower than Q2F, due to a number of factors, including increased LIBOR costs in Retail; enhanced Retail deposit gathering; and the Treasury “mark-to-market” loss in the trading book although this recorded “loss” should reverse during 2008 and 2009—as currently credit quality was not an issue. The Group’s capital ratios would end the year lower than originally expected due to higher than Plan risk weighted asset growth. The Group would take advantage of any opportunities prior to the end of the year to issue new capital, if conditions proved favourable.

The Plan that was being created for 2008–12 would continue to demonstrate real growth, although growth would be restricted in accordance with the Funding Plan. UPBT may be ahead of current consensus in 2008, with strengthening capital ratios. Cost growth could be an issue and required careful management. Costs would be managed, to produce positive cost: income jaws,

Peter Cummings explained that Corporate syndication markets were virtually closed, particularly in the private equity and commercial property markets. There was no major overhang of assets awaiting selldowns or securitizations within HBOS, and asset quality remained strong. The commercial property market was driven by the health of the general economy, which remained good. There was only limited tenant default—although the retail sector could have a tough run up to Christmas. There was limited execution of new transactions. The US investment banks and RBS were no longer active, and Barclays had also withdrawn from the market (for reasons that were unclear). The Division was now focused on existing clients.

Jo Dawson commented that l&I profits would grow by c.11% year on year, even after the extraordinary flood costs. Current levels of investment Sales across the sector were being impacted by IHT changes, and other changes that were affecting the IFA market—but the Group’s investment sales would look relatively strong, compared with the peer Group. The Group was in strong position in terms of household insurance sales, although the Repayment market was proving tough, and was subject to increasing regulatory challenge. PPI complaint volumes were increasing.

The FSA’s Arrow process was about to be launched. It would be important to provide robust examples of good performance and behaviour to counter negative perceptions.

*** commented that Retail trading in Q3 had been strong, particularly in Banking, Savings and Mortgages. Savings should deliver a very strong inflow in the year as a whole. There would be some deliberate slowdown of mortgage share, leading to a net share for the full year of c.11 %.

Colin Matthew commented that all three International businesses were trading broadly in line with Q3F. The Australian business was facing a severe reaction by competitors. ENA still had challenges in relation to EFS sales, and asset realization in the US. Treasury had a good underlying sales performance, but the P&L was dominated by mark-to-market/model losses in the trading book.

Philip Gore-Randall was focused in particular on IT and Group IT, where there had been some reorganization, to help drive greater focus. Investment spend in 2008 would include focus on helping to deliver improved resilience. The Faster Payments project was making progress, with a stronger team now involved. Some difficult support issues had been resolved. The Procurement elements of Platform for Growth was receiving attention. Good progress was now being made.

2.1 Liquidity and Capital Update

Phil Hodkinson’s update confirmed that the Group’s current liquidity position was ahead of the “central” scenario discussed at the Board’s meeting in September, even through the market generally had not improved as quickly as expected. The position would continue to be monitored closely. The agreed “Phase 1” contingency actions had been implemented:

in Retail there had been a reduction in mortgage applications, and an increase in product cessations, which would result in reduced mortgage asset growth by year end. Customer deposits had also been better than expected. Some (weaker) competitors were still pursuing strong growth with overly aggressive pricing and criteria; the position was being considered by the FSA;

the current funding position in Corporate was running in line with forecast, but the Division was facing exceptionally strong demand from customers which could challenge the forecast net funding requirement; and

the forecast outturn for the full year was likely to be 13% higher than 2006 in terms of asset growth (compared with a Plan of 10%) and 11% ahead in terms of deposit growth (compared with a Plan of 9% ahead). Overall, the net funding requirement (pre securitization) would finish the year 18% ahead year-on-year, and c.£7 billion ahead of Plan.

Average daily wholesale funding continued to exceed the targets, discussed at the September Board Meeting, and the term of this funding was now steadily being lengthened. The cost of funds had also fallen (although was still ahead of pre-liquidity crunch levels). The Grampian conduit was being funded fully through the commercial paper market. And the Group was now a net depositor in the overnight markets. This was a strong position. But the risk to the Group’s liquidity position was not yet fully over—not least as the prospects of securitization and term markets re-opening in the near future was now considered less likely. But the already remote risk of a HBOS—specific event appeared to have receded further.

The Group’s position at the end of the year would be ahead of Plan in terms of RWA growth, which meant that the Group’s capital ratios would be at the lower end of the target range by year end. A clear explanation would be given to the market. And the Group’s relative position may still appear strong. If current market conditions permitted, capital issuance would be pursued in the balance of the year, to strengthen ratios further before the end of the year. Critically, however, “excess” asset growth in 2007 would limit the Group’s capacity to support asset growth in 2008. And this limitation or constraint was informing creation of the Group Business Plan 2008–12 (as would be discussed at the Board’s Meeting in November). The external view (including at the FSA) was that the Group had managed its position through the liquidity crunch extremely well.

3. Bi-Lateral Mortgage Collateralised Loan

It was proposed and the Board (of Bank of Scotland pic) agreed and resolved to:

establish the Transaction (as referred to in the paper considered by the Board) in an amount up to a maximum of £2 billion; and

that the Capital and Structured Transaction Approval Committee be and hereby is authorised (with power to sub-delegate) to approve and execute or authorize the execution of all relevant documentation and otherwise to take all stages necessary or desirable in connection with the transactions and any matters ancillary thereto.

4. Bank of Scotland Capital Requirements 2007

There was a need to inject up to £1.5 billion of Tier 1 and up to £500 million of dated Tier 2 capital into Bank of Scotland plc (“BoS”) to ensure that the capital ratios of BoS were maintained above target levels. It was accordingly agreed and resolved that:

BoS would issue 166, 700, 000 ordinary shares at £9 each (equivalent to £1.5 billion of Tier 1 capital) to the Company; and that

the Company would subscribe for the £1.5 billion of ordinary share capital to be issued by BoS, as referred to above; and that

BoS would issue £500 million of Tier 2 subordinated debt with a maturity date of five years after the Company gives notice requiring repayment, at a coupon of three month LIBOR plus 76 bps; and that

the Company would subscribe for the £500 million lower Tier 2 subordinated debt to be issued by BoS, as referred to above.

5. Amendment to Trading Book Stop Loss Limit

Further to earlier decisions by the Board, to increase and then suspend the quarterly stop loss limit for the trading book, it was noted that there had been a further deterioration in Credit Default Swap (“CDS”) spreads in relation to banks generally (and US investment banks in particular). The mark-to-market loss in Treasury now stood at c.£70 million, following a further mark-down—but Treasury and Group Risk continued to believe that credit fundamentals in relation to the Treasury trading book remained strong, and “selling into distress” would be a mistake.

Given that markets continued to be fragile, it was quite likely that the level of the “loss” could increase further—and could exceed £80 million (in the case of the Treasury trading book) by the end of the year.

In these circumstances, to provide sufficient discretion and flexibility, GMRC recommended, and the Board agreed and resolved that the annual stop loss limit be increased to £130 million, for the remainder of 2007.

6. CIFAS Staff Fraud Database

ClFAS had developed an industry-wide data sharing facility, to help combat staff fraud—in part, though using the CIFAS database as part of recruitment, selection and disciplinary processes. Part of the CIFAS requirements were for system users to provide CIFAS with an indemnity that was widely structured and, legally, “unlimited”. In the circumstances it was agreed and resolved that such an indemnity be provided, in a form agreed by Group Legal, to enable HBOS to benefit from the CIFAS system.

7. Crime, PI and D&O Insurance 2007 Renewal

Details of the recent renewals of the Group’s Crime, Professional Indemnity and D&O Strategic Insurances were noted. The approach to external cover remained to purchase appropriate high-level limits, to mitigate unexpected and non-trading risk losses of a “catastrophic nature”—with lower level risks and losses being carried by the Group, supported by a strong risk management approach. The key activities of the Insurance Mitigation team over the next 12 months were noted.

A review would be carried out in relation to the nature and extent of the Group’s D&O coverage, in advance of the 2008 renewal.

8. Schedule of Advances

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

9. Tax

The Board noted the Tax Policy document, created following review by the Board earlier in the year. The Policy would be shared with HMRC—as part of the agreed process of attempting to build stronger relationships with HMRC at senior levels (for example, as in the recent discussions with ***, HMRC’s Director of Large Business Service).

10. The Way we do Business

*** commented that significant progress had been made over the past 12 months in relation to the Group’s CR programme. The Group’s approach remained driven by the products agenda—focused on transparency; financial inclusion; and responsible lending. In addition, more emphasis was now being placed on the Group’s environmental programme, and its Climate Change agenda. HBOS was the first carbon neutral bank in the UK, and had launchedthe banking sector’s first Climate Change Report.

The Group’s CR credentials had, however, been damaged in 2006 by the Farepak issue—particularly amongst. MPs. Steps had been taken to rebuild the Group’s reputation—in part through the launch of its own Christmas saving product.

Key challenges in the next 12 months would include:

Climate Change, where the Group needed to improve its paper usage and paper waste generation, as well as increase usage of recycled paper. Significant efforts were being devoted to improving the environmental aspects of the Group’s shareholder communications;

Favorability among MP’s, where further efforts needed to be devoted to improving favorability ratings;

Financial inclusion, where further efforts would be devoted to filling in “gaps” in relation to the Group’s financial inclusion agenda, including in relation to Credit Unions.

The Group was leading the public debate in relation to affordable housing, given the strong relationship between housing and the HBOS brand, although there needed to be new ways of promoting the Group’s credentials.

Phil Hodkinson commented that a much broader range of colleagues across the Group were now choosing to be actively involved in CR activity. The engagement of the International businesses was building strongly. Colleagues were keenly interested in the Group’s CR credentials, with particular reference to Climate Change. Colleagues were proud of the Group’s track record—but were keen to see more action and progress.

11. Retail Strategy Review

*** summarised key external challenges facing the Retail business, including:

declining mortgage profitability;

regulatory threats to key sources of income;

unsustainable pricing in some markets;

and some “revitalisation” or re-invigoration amongst competitors.

Against this background, the Group had delivered significant service improvements in recent years; continued to have high levels of sales productivity; and was supported by strong colleague advocacy. Retail would, however, deliver a year on year profit reduction in 2007 as a whole.

Jo Dawson commented that preparation of the Retail Business Plan 2008–12 had been informed by these challenges, and would seek to address:

restoring profit momentum;

building the franchise, including through stronger cross sales;

developing future sources of income; whilst also

re-energising leadership and colleague engagement across the Division.

*** explained the importance of building quality relationships with customers. Full service primary current account holders, for example, were generally of higher quality, and generated more value for the Group. This required investment in “great service”; as well as in selling more—at the right level of costs (including through investment in efficiency, controls and credit quality). More satisfied customers had a greater propensity to buy more products, and the Group’s differentiation from the peer group in this respect needed to be maintained.

Competitors could and did respond to marketing initiatives and product design—but colleague advocacy, and the quality of colleagues, were the competitive advantages that were most difficult to replicate.

*** commented that Branch Managers were key in delivering colleague engagement—leading to product and employer advocacy. Branches remained critically important. There was a strong cadre of experienced and positive Branch Managers, but these had probably not been supported sufficiently in recent years. To help address this situation, there would be great emphasis on providing the right level of resources; processes, would be streamlined, to help free up management time; Managers’ independence and autonomy would be increased—and their contribution recognized properly. Freeing up Branch manager, and colleague time, to enable focus in turn on customers, was a key priority.

Profits in 2007 would be behind 2006—but would begin to bounce back in 2009. There needed to be investment in new sources of revenue—recycling costs away from less value-generating activities. The Division was working towards being self-funding by 2009—and there would be huge focus on liability growth. Delivery of these financials -in a world that was changing dramatically—and where the business needed to be reshaped for the longer term—would be hugely challenging, and would require some tough decisions, and the risk of more adverse external comments—but Retail growth was important to investors, and to the wider Group. Future costs investment would be selective, prioritising in favour of higher value—adding areas, and areas of future income streams—and away from lower value—adding activities.

The impairments position would improve in 2008 compared with 2007—as the current year included an element of “catch-up”. Over the Plan period (2008–12) there was likely to be some deterioration in the experience relating to secured lending, reflecting the increase in the size of the book.

The market for primary current accounts was becoming increasingly competitive. Recent PCA advertising had been very successful—but there would be increased efforts on converting existing “secondary” customers into “primary” customers, through transferring their key relationships. A joined up proposition, with strong service delivery, was critical to delivering real “relationships”. Simplifying the current account range was important—but the transition to a desired position involved significant risks.

The peer group shared the Group’s experience in relation to the increasing competitiveness of various product sectors—although this impact would vary from competitor to competitor. The Group’s relative performance in the Plan period overall would look good compared to peers Group. Abandoning external net lending targets had given the Group additional flexibility to select the most attractive segments of business, in light of market and competitor developments—although this increased the scale of expectations of the Retail leadership team.

Over the Plan period, the unsecured loans business would not grow, not least as pricing was unsustainable or illogical, although the Group’s profitability was probably ahead of the “norm”. In the longer term, these structural issues needed to be addressed.

Our challenge is to deliver short-term profit and cost targets whilst rebuilding the business in the right shape for the long term interests of HBOS.

12. E-COMMERCE STRATEGY

*** confirmed the outcome of this review of the Group’s current e-commerce capabilities, in essence, it was clear that e-commerce could contribute even more to the achievement of the Group’s strategic objectives.

Hitherto the Group had adopted a purely incremental approach to e-commerce—in part due to the lack of a clearly articulated “road map” of the ways in which the Group expected to use e-commerce—best effect. It was therefore recommended, and agreed that:

a clear strategy for e-commerce should be established, to define the products and servicing functionality that would be offered online to customers over the next five to 10 years. Dan would lead this work, aiming to report back to the Executive Committee in January 2008;

once this strategy was developed, Group IT and Divisional IT colleagues would determine the most appropriate IT solutions to deliver the agreed business requirements—including consideration of cost advantages; speed to market; and online security. Philip Gore-Randall would lead this phase, aiming to report back in good time to inform creation of the 2009–13 Business Plan.

In these ways it was intended that establishing a clear business strategy for e-commerce, would provide the direction for the development of the right IT solutions to improve the Group’s ability to expand this channel to distribute products and services -and to transform the cost case.

13. Any Other Business

The Chairman confirmed that a dinner would be arranged for non-executive directors with the Chairman and the Chief Executive on the evening before the November Board.

Given the scale of recent macro-economic and other changes to the broader business environment, a broad—ranging strategic review would be organized for the first half of 2008, on a date or dates that would be confirmed to directors in due course.

14. Next Meeting

The next meeting of the Board would be held at 10.30am on Tuesday 27 November 2007, at The Mound, Edinburgh.