Parliamentary Commission on Banking StandardsMEETING OF THE DIRECTORS held in The Board Room, The Mound, Edinburgh at 10.30 am on Wednesday, 28 May 2008

MINUTES
Present
Dennis Stevenson (Chairman)	Andy Hornby
Richard Cousins	Karen Jones
Peter Cummings	John Mack
Jo Dawson	Coline McConville
Mike Ellis	Colin Matthew
Sir Ronald Garrick	Kate Nealon
Philip Gore-Randall	Dan Watkins
Tony Hobson
In Attendance
***	***
Peter Hickman (Items 1, 5 & 8)	***
***	***
***	***
***	***
***	***

1. Arrow II and RMP

*** commented on the FSA’s recent “ARROW” risk assessment with respect to HBOS, including the ARROW letter and RMP, (both of which had now been approved formally by the Board).

The context for this ARROW review had been the FSA’s assessment that the UK as a whole was heading for a less benign economic outlook—which affected the “real” economy, and not merely financial services companies. These tighter economic conditions were already leading to a more difficult environment for consumers, and there were clear consequent risks for firms, in some cases (albeit not HBOS), firms’ business models were under threat. The need for firms to deal with these emerging challenges meant there was a risk that efforts could be shifted away from processes and controls. In these tougher conditions, market participants and consumers could also lose confidence in financial institutions, and regulators. A significant number of consumers could experience financial problems because of high levels of borrowing. There was probably also a risk of higher levels of financial crime.

The ARROW assessment had been carried out in late 2007 and was a snapshot—although underlying trends and issues were still valid. The regulator enjoyed an open relationship with HBOS, which had helped inform the review. But the nature of the ARROW process was to focus on downsides and risks—and not to comment on “positives”, or things that were going well.

The last ARROW assessment had been carried out in 2004. Since then, much had changed—both in the wider economic environment, as well as with specific respect to HBOS, in this review, the FSA had focused on both sector wide issues as well as HBOS specific issues including:

HBOS Specific Issues:

operating controls; and

treating customers fairly.

Sector Wide Issues:

balance sheet management; and

credit risks.

The risk assessment considered risks relating to the overall environment; the business model; controls; oversight and governance, and considered the mitigating impact of the quality of risk management—leading to an overall account of the probability of problems occurring. HBOS was regarded as “Medium High” for business risks and controls; “Medium Low” due to the quality of oversight and governance; with an overall High score, due largely to “environmental” factors, capital, and the scale of the business. HBOS was not an outlier in terms of the quality of its internal control environment, but the Group was regarded as presenting a high systemic risk, because of its reach and relative “importance”. The Group had the potential for creating a high impact on the UK financial system if anything significant were to go wrong.

Specific issues identified with respect to HBOS included:

balance sheet management issues (including funding and liquidity, as well as possible pressures on capital). The FSA was aware of the Group’s successful management of its position through recent turbulence, but still regarded HBOS as a relative outlier in terms of the size of the wholesale funding requirement. The target outcome was for HBOS to arrive at a more resilient-funding and liquidity position. This would remain a key area of focus for the FSA, as market conditions were expected to remain tight for some time to come. Capital had not been an area of key concern for the regulator. The FSA welcomed the Rights Issue, and thought it the “right thing to do” against the backdrop of a worsening economic environment, but had not been putting any pressure on HBOS in this;

credit risks, which included vulnerability to the risks of a significant UK downturn, given the Group’s exposures to residential and commercial property assets. Even though the quality of residential collateral was good, there were pockets of potential strain within an overall sound portfolio. Thematic visits would explore this issue in further detail later in the year. At present there appeared to be increasing stress with respect to isolated pockets within the secured book; unsecured lending quality seemed stable;

treating customers fairly remained an important area of focus for the FSA, with a requirement for greater embedding and greater Ml supporting TCF outcomes for consumers. Within HBOS, considerable efforts had been devoted to producing valuable Ml about how the Group’s actions were affecting customers. HBOS compared well to its peer group in this respect. But the FSA was keen to ensure that appropriate efforts continued to be directed at TCF, and that internal processes did not get in the way of treating customers fairly. Again, further themed work would be carried out later in the year; and

operating controls and IT systems, where the aim was to achieve greater resilience, reduced manual intervention, and promote proactive plans to address future needs. Governance was strong. There were no concerns around costs leadership, but resource allocation was a cause of potential concern.

The agreed RMP would continue to be monitored as the Group pursued implementation of the target actions. The close and continuous relationship would allow the parties to work closely together; and ongoing risk assessment would continue to inform the FSA’s view of the risks posed by the Group.

*** also commented that the Group’s current position left the Group potentially exposed to the risks of the market “closing” against HBOS, but accepted that it was over simplistic to focus on the split between wholesale and retail funds, not least because some retail deposits were not necessarily truly “sticky”. There were some difficult sector-wide strategic issues relating to the current UK banking model, which needed further consideration by firms and regulators. Simply increasing dependency on retail deposits, particularly against a background where UK consumer disposable income would be under pressure, could not be the whole solution—although it could be part of an overall solution.

The Group’s TCF MI position was improving. There was a very real desire within HBOS to treat customers fairly—but all firms had process-driven systems that were not necessarily designed to deliver customer-specific outcomes. Appropriate resources needed to be directed at considering and delivering desired outcomes. Although this was extraordinarily difficult to measure and assess. It was noted that the recent formal FSA letter on TCF for HBOS had not provided actionable feedback and this was perhaps a missed opportunity to help our progress.

The FSA’s view of funding was shaped by concerns about the risks faced by others, particularly as wholesale markets were more likely to be increasingly discriminating. It was crucial to focus on the quality of the Group’s funding, as well as the terms of funding. The FSA’s concerns about HBOS would continue for so long as HBOS, in the FSA’s view, remained an outlier. It was inevitable that the Group would need to shift its retail wholesale balance/mix. Ultimately the core issue, was to avoid becoming a name-specific risk. Being higher risk than the sector involved increased name-specific risks.

The Chairman commented that this had been a smoother process than on some previous occasions. It had been conducted through a helpful dialogue, during which perceptions had changed. The risks identified by the FSA were consistent with the Group’s view of its own risks, and the actions that were required to manage and mitigate these, (although the emphasis in some areas was not necessarily wholly agreed).

2. Minutes and Matters Arising

2.1 Minutes

The Minutes of the Meeting of Directors held on 1 and 27 April 2008 were approved.

The Written Resolutions of the following Committees were noted:

Written Resolution of the Capital and Structured Transactions Approval Committee on behalf of the Board of Directors of Bank of Scotland plc dated 11 April 2008 (Candide 2008);

Written Resolution of the Capital and Structured Transactions Approval Committee on behalf of the Board of Directors of Bank of Scotland plc dated 22 April 2008 (Issuance Under Master Issuer Programme);

Written Resolution of the Special Committee on behalf of the Board of Directors of Bank of Scotland plc held on 25 April 2008 (Bank of England Special Liquidity Scheme);

Minutes of the Committee of the Board of Directors of HBOS plc held on 29 April 2008 (Project Blue);

Written Resolution of the Special Committee on behalf of the Board of Directors of HBOS plc held on 6 May 2008 (Bank of Scotland plc Euro Commercial Paper and Certificate of Deposit Programme);

Written Resolution of the Special Committee on behalf of the Board of Directors of Bank of Scotland plc held on 6 May 2008 (Bank of Scotland plc Euro Commercial Paper and Certificate of Deposit Programme);

Written Resolution of the Capital and Structured Transactions Approval Committee of the Board of HBOS plc dated 8 May 2008 (Annual Update of the Euro Medium Term Note Programme);

Written Resolution of the Capital and Structured Transactions Approval Committee of the Board of Bank of Scotland plc dated 8 May 2008 (Annual Update of Euro Medium Term Note Programme);

Written Resolution of the Capital and Structured Transactions Approval Committee of the Board of HBOS plc dated 8 May 2008 (Annual Update of the US Medium Term Note Program);

Written Resolution of the Capital and Structured Transactions Approval Committee of the Board of the Bank of Scotland plc dated 8 May 2008 (Annual Update of the US Medium Term Note Program);

Written Resolution of the Capital and Structured Transactions Approval Committee of the Board of Directors of HBOS plc dated 15 May 2008 (Project Ratho);

Written Resolution of the Capital and Structured Transactions Approval Committee of the Board of Directors of Bank of Scotland plc dated 15 May 2008 (Project Ratho);

Written Resolution of the Capital and Structured Transactions Approval Committee on of the Board of Directors of Bank of Scotland plc dated 16 May 2008 (Issuance Under Master Issuer.

3. Chief Executive’s Report and Management Information Pack

3.1 Management Information Pack

Andy Hornby commented on developments since the Rights Issue had been announced on 29 April.

Discussions at the planned July Board Strategy Session would focus on:

a detailed examination of the Group’s current funding position, including a comparison of the Group’s absolute and relative funding strengths and weaknesses;

the appropriate funding and liquidity strategy for the next few years;

measures to improve costs and productivity;

divisional presentations about the future shape of the Group’s core businesses; and

a review of potential longer term inorganic options, with particular reference to those that could positively influence the Group’s funding requirements.

4. Funding & Liquidity Update

***

Money market funding, excluding repo, continued to be predominantly short dated, but of good size. There had been some improvement since the March Board meeting, and CDS levels had improved in both absolute and relative terms. Since 12 May the Group had successfully completed a five year MTN issue of Euro 1,5 billion; a Lower Tier 2 issue of £2 billion; and a residential mortgage securitisation of £500 million, All of these issues had been well received and oversubscribed, and had continued to trade well since their respective issue. Grampian had funded reasonably well, with about half the facility now funded through ABCP.

It had previously been reported that asset growth targets had been reduced to £6 billion below Plan level and deposit growth targets increased to £13billion above Plan—but it was now clear that the deposit targets, in particular, were increasingly challenging, not least as a result of intense competition. A contingency of £8 billion had thus been established. Delivery of the reduced asset target also remained challenging; success was dependent upon experience with respect to principal repaid and, potentially, sell downs.

Although there were some early signs of stabilisation in wholesale markets, the market generally remained vulnerable to further shocks. The Group therefore continued to take wide ranging action to constrain asset growth and increase deposits. At this stage no further asset reductions were proposed beyond those already discussed, but the position was being monitored closely.

5. Treasury VaR Limits

Peter Hickman commented that, as previously advised, both Treasury and Group Risk now regarded VaR as an inappropriate measure of the credit risk spread for both the ABS and FRN portfolios. Accordingly, it was agreed and resolved that:

the ABS VaR limit of £25 million be removed;

the credit risk spread on the FRN portfolio be removed from the VaR calculation; and

all other positions would be subject to a £25 million VaR limit.

Treasury would report monthly to GMRC the total amount of VaR utilisation and would identify the proportion being used to support normal trading activities.

6. Project Blue—Update

Philip Gore-Randall and *** commented on Project Blue, with particular reference to:

the proposed timetable;

the key Rights Issue documents—including the Circular and the Prospectus—as well as the required update on current trading that would be included in the Prospectus, and other steps necessary to effect the Rights Issue;

the proposed Capitalisation Issue;

the options that would be available to shareholders and colleagues, and

the associated communications strategy; and

the likely costs of the Issue.

Significant progress had been made since 29 April with respect to preparing the legal documentation; in resolving the complex legal and logistical issues that followed from the size of the HBOS share register; in agreeing the range of options that would be made available to retail shareholders; in identifying the various adjustments necessary with respect to the Group’s colleague share schemes; in organising the logistics surrounding the various print and mail exercises; and in formulating a communications strategy that would guide the Group’s small shareholders through the process. IR activity since 29 April had targeted a broad spectrum of Institutional Investors, to explain the Company’s rationale, and seek support for the Rights Issue.

Significant work remained outstanding—to finalise and secure regulatory approval to the Circular and Prospectus; to satisfy the due diligence and verification requirements essential to enable the Issue to proceed; and to agree the dealing strategy that would ensure that “nil paid rights” not taken up, or to be sold, were managed into the market in an efficient way.

Nonetheless, the Project currently remained on track to hit the key deadline of a General Meeting on 26 June, with the Issue being complete on or about 21 July.

Having considered the update, including the draft versions of the Circular and Prospectus that had been circulated (and, in particular, the Risk Factors included within the draft Prospectus), together with advice provided to the Board in the form of various Legal Memoranda, the Board agreed and resolved as follows:

to confirm that, in the Board’s view, the Rights Issue and the Capitalisation Issue are in the best interests of shareholders as a whole;

to note the proposed timetable with respect to the Rights Issue;

to note the contents of the draft Circular and to approve in principle the issue of the Circular;

to note the contents of the draft Prospectus and to approve in principle the issue of the Prospectus;

to note the proposed arrangements with respect to the various options that would be made available to shareholders, and to approve the arrangements that would be made with respect to the Group’s various colleague share schemes;

to agree the proposed arrangements with respect to the Capitalisation Issue;

to note the estimated costs of the Rights Issue;

to appoint a Committee of the Board comprising any two directors (at least one of whom to be the Chief Executive and/or the Group Finance Director) with full authority on behalf of the Board (including the power to sub-delegate) to progress and agree all arrangements, agreements, or other documents on behalf of the Board and to take any and all other actions, decisions or steps necessary or expedient to effect the Rights Issues and/or the Capitalisation Issue, or reasonably ancillary thereto, including preparation, finalisation and issue of the Circular on behalf of the Board, and any and all other documents relating to ancillary to the issue of the Circular.

It was further noted that an additional meeting of the Board would be convened in due course (most likely on or around 17 June) to consider and, if thought fit, approve the Prospectus.

7. Schedule of Advances for March and April 2008

Schedules of the principal advances agreed by Corporate Banking and the International businesses during March and April 2008 were noted.

8. Quarterly Key Credit Trends

Peter Hickman commented on early signs of increases in stress that were likely to feed through into increased impairments in due course. Impairments with respect to UK Retailed secured loans were continuing to increase; repossessions were also likely to increase as customers under stress found it more difficult to refinance. Credit quality with respect to the unsecured book remained stable, as did average credit quality across the Corporate UK book. The Treasury portfolio continued to hold up well in a difficult climate. There were some emerging concerns in some of the International businesses, although relatively minor at this stage.

Overall, the slowdown of the wider economy was now having a clearer impact on HBOS. It was likely that the UK Retail and Corporate portfolios would see a continuation of this trend, and increased impairment losses, in 2008—and into 2009.

9. Project Voyager

*** commented on Project Voyager, which was the proposed strategic response to the challenges facing the Group’s Asset Solution (“AS”) businesses. The review of this business had originally been triggered by the Asset Class Management approach, but had recently been accelerated.

In brief, the review of the AS businesses had confirmed that these businesses were not complementary to the Division’s core goals, with minimal cross sale or development potential. The dealer business model was being superseded, and was not a model that should be extended (except, perhaps, as part of a consolidation play). The lack of strategic fit and tactical advantage was exacerbated by the fact that the income potential was not compelling compared with the costs involved. Returns were relatively unattractive, and there was a high consumer regulatory burden.

Given the lack of strategic “fit”, a full review of options had been undertaken. Keeping these businesses “as is”, or possible expansion of these businesses, were not realistic options. In current market conditions a sale of most parts of this business looked unlikely. A sale of the “dealer” business would also present significant disengagement challenges. A possible sale of the *** business (possibly to the management team) looked more promising, however. With respect to the majority of the AS business, therefore, the best and most predictable route to releasing value was via a controlled wind down, with an increased focus on collection and recoveries; strong costs discipline; alongside planned (and immediate) FTE reductions. This approach would give rise to internal and external challenges: particularly in some locations where there could be significant colleague impacts. There could be some small “knock on” effects in Ireland.

The *** business was not included within the scope of Project Voyager, as *** had good cross sell and growth potential, and was a very different business to the other AS businesses. Integration of the *** businesses was continuing; the focus on added value services provided a more diverse income mix, that justified the retention and continuing development of that businesses.

10. SME Banking in England and Wales

Philip Gore-Randall commented on the review that had been carried out with a view to assessing the most value added operating model for driving the Group’s position in SME Banking in England and Wales. The SME strategy for England and Wales was focused on delivering sustainable shareholder value, with specific reference to:

reducing costs;

growing deposits; and

growing the franchise through increased focus on the highest value SME sub segments.

*** confirmed that the proposed approach to England and Wales would not be an approach directed at providing all products to all customers, but involved a more focused and selective approach, that would reduce duplication and fragmentation; with integration of back office operations (across both England and Wales and Scotland), functional and managerial support; and benefit from a low cost manufacturing layer, with multi-channel and cross divisional distribution. Costs would thus be re-based; there would be increased concentration on accelerating growth in deposits; whilst growing earnings. Historically, the Group had been driven by market share targets: but the future aim would focus more directly on value, and deposit raising.

This was a development of the ambitions spelled out at time of merger, with deposit growth now being the primary focus. Deposit rich SME’s, as well as SME’s that hold funds for clients, would be targeted—along with the Not for Profit and Public Sectors organisations. Implementing this strategy, including the impact of efficiencies, growth in higher value segments, and shifting the emphasis to deposits from lower value lending, would be significantly SVA enhancing over the Plan period.

11. Corporate Real Estate

*** explained that the Group’s UK Corporate Real Estate proposition was primarily based on senior debt funding packages over the property investment and development sectors—both residential and commercial. The JV business focused predominantly on commercial real estate, hotels and house builders, where a fully integrated funding approach was pursued in partnership with customers. The ability to offer integrated debt and equity packages, as well as the focus on leading real estate entrepreneurs, was a significant differentiator. Historically, the business had maintained a conservative rate risk appetite and approach to risk management. This should continue to produce strong returns even through periods of market turbulence. The business had grown at a conservative rate in 2007, and had sold assets into a bull market. Although there was an admitted exposure to house-builders, the overall portfolio had been built up over time and was well understood and well managed.

*** commented that current conditions were leading to pressure in various segments of the portfolio, most notably in the residential development and house building areas. In all areas under stress the Group was tightening its oversight. With respect to residential developers and house builders, in particular, discussions were taking place to explore opportunities to de-gear and/or assist connections. Across the portfolio, almost all new lending had ceased; existing connections were being re-priced; and costs were being reduced; whilst robust plans for managing exposures to key segments were delivered. Earnings in 2008 would be behind 2007, and appropriate steps were being taken to improve performance in the short term.

In the longer term, the aim would be to re-establish the Group’s credentials as the Real Estate bank for entrepreneurs, with third party capital being allocated to increase leverage from the HBOS balance sheet—which would be critical to enable this business to continue to lend at scale.

12. UK Mortgage Strategy

*** commented that the Mortgage business remained a key driver of Retail profitability, and of the external perception of “value” in HBOS. Since mid 2007, the business had been stabilised; and the understanding of key drivers of value had increased, allowing the business to be steered carefully through current challenging conditions. The key immediate priorities were to limit asset growth, and ensure that pricing adequately compensated for increased funding costs. In this respect, good progress was being made in locking in high margins, that more than offset increases in funding costs.

Over time, the strategic objective was to help more people own houses more easily. But current market turmoil presented an almost unique opportunity to reset key aspects of this business:

with prioritisation of branch sales and other direct channels;

putting the relationship with intermediaries on a firmer footing;

managing risk through adding high quality assets, even though the Group would continue to have a higher specialist mix than the market (provided that risk adjusted returns continued to offer better value); and

improving efficiency, through exploiting scale advantages and pursuing rationalisation.

13. Next Meeting

The next meeting of the Board would be held at 10.30am on the 24 June 2008 in Edinburgh.