CORRECTED TRANSCRIPT OF ORAL EVIDENCE To be published as HC 705-vi

HOUSE OF COMMONS

HOUSE OF LORDS

ORAL EVIDENCE

TAKEN BEFORE THE

PARLIAMENTARY COMMISSION ON BANKING STANDARDS

(SUB-COMMITTEE B)

PANEL ON HBOS

FRIDAY 23 NOVEMBER 2012

MICHAEL FOOT

CLIVE BRIAULT and DAVID STRACHAN

USE OF THE TRANSCRIPT

Oral Evidence

Taken before the Parliamentary Commission on Banking Standards

Sub-Committee B-Panel on HBOS

on Friday 23 November 2012

Members present:

Lord Turnbull KCB CVO (Chair)

Counsel: David Quest

Examination of Witness

Witness: Michael Foot, Managing Director, Retail Markets, Financial Services Authority, 1998 to April 2004, examined.

Chair: May I welcome you, Mr Foot? My apologies for bringing you in when the House is not sitting-the building has a certain Gormenghast quality to it at this time of day.

Let me give you a bit of background on the project as a whole. The Commission is looking at what went wrong and why-almost why things were allowed to go wrong-as well as at warnings that were not given and warnings that were there but not acted on, to try to find out whether there are generic lessons of a more cultural, behavioural kind to supplement the other side of the Commission’s work, which is the pre-legislative scrutiny of structural changes.

A number of panels are looking at various aspects of this whole affair, but why are we doing a case study on HBOS? Principally because it has not really been looked at in the same detail as RBS; there is a 500-page report about RBS by the FSA, so we do not need to go over that ground again. On the other hand, the HBOS story is pretty remarkable, in the sense that two well-known brands-BOS and Halifax-came together in 2001 with a market capitalisation of about £30 billion. HBOS is claimed to have a market capitalisation of about £40 billion by 2007, and, a year later, it has gone-vanished. By any standards, this is a really remarkable collapse, and we need to try to find out why it happened. Are there any lessons that we need to feed in to the Commission as a whole to put into their report?

There is an innovation in the way we are going about our work. For the first time, we are employing a counsel to help with the questioning. This is, I assure you, not because we are trying to turn this into a court, a tribunal or anything of that kind; it is simply that these guys are better at questioning than parliamentarians. It also allows the Chairman to listen to the answer, rather than thinking about the next question.

We are assembling pieces of information. It is not for me, on my own, to try to draw conclusions from this; that will be put back to the Commission as a whole, and they will discuss these issues. We are quite a long way through this process, and that will lead up to us, on 3 and 4 December, seeing the three main protagonists-the two chief executives and the chair.

We are also interested in the FSA’s perception of HBOS, and in whether a consistent message was given to them all the way through. In the decision notice, one of the mitigations Cummings came up with was, "You didn’t tell me that things were this bad." One of the people we interviewed earlier in the week-the senior independent director-said, "Had I known that the FSA thought so badly of this organisation, we would surely have reacted more strongly." We are trying to get a consistent message on the supervisory record on this. The FSA is going to do its own study on this, but it is going to take about nine months to do it, whereas we have to finish in about seven or eight weeks.

Let us start with David Quest, who will try to piece together some of the narrative of your position, recognising, of course, that you left in the middle of ’04. Your colleagues will try to pick up the story when they come to the table.

Q1027 David Quest: Good morning, Mr Foot. You were managing director of the Retail Markets group from 1998-is that right?

Michael Foot: The title changed between my two terms of office, but from 2001 to 2004 it was Deposit Takers and Markets, not Retail Markets.

Q1028 David Quest: And you left that position in June 2004.

Michael Foot: My term ran until the end of May. Because of the structural changes that were going on and the new chief executive and so on, I phased out weeks earlier than that. I then stayed, providing very specific advice to the new chairman and CEO until September 2004, whereupon I left the country.

Q1029 David Quest: And HBOS was supervised within what I think was called the major groups division, which was one of the divisions under your job.

Michael Foot: You have to bear in mind that when we started the FSA in 1998, we were a conglomeration of eight separate, self-regulatory and statutory bodies, which did not have the powers to act in its own right until the Financial Services and Markets Act at the end of 2001. There was that and then the learning process, so names and structures changed from time to time. What we are talking about now is particularly the structure from 2001-02 onwards.

Q1030 David Quest: In that period, the supervision of HBOS fell under your ultimate jurisdiction.

Michael Foot: Oh yes, and it had done right the way through from when I was at the Bank of England, and brought the banking supervisors over to the FSA on 1 June 1998. I had been executive director in charge of banking supervision at the Bank. I had responsibility for Halifax at that point as well.

Q1031 David Quest: I think you say in your statement that you did not have any direct contact with HBOS executives in relation to supervision.

Michael Foot: The structure of how a managing director typically works was different between my two terms; the detailed structure was different. In my first term, I had 11,000 firms and roughly 1,000 staff. In my second term, I had significantly fewer firms, but obviously a number with issues, and about 450 staff. It was just physically impossible, and probably very unwise for two reasons, for the MD to get terribly involved with individual cases.

First, suppose I had agreed to go to address a board of one of the major banks-all the others would have insisted on the same treatment. Secondly, and more importantly, in terms of undercutting the authority of the people who report to you, I cannot think of a worse way of doing it. If the banks conclude that by going to the top, they will get a different answer, for example, they will always try and go to the top. I operated on that model, as did my colleagues in other areas. In so far as I am aware, that is the broad model that continued. You can ask Mr Briault about that later on.

Q1032 David Quest: In terms of the people who did have a direct contact with HBOS, how many levels below you were they?

Michael Foot: My direct report in that area signed a number of letters and oversaw the detail of the arrangements. There was then a head, or a director, of department-again, the titles changed over time-who had a smaller number of firms, one of which would have been Halifax. Then there would be a relationship manager who dealt specifically with Halifax and who ran the detailed day-to-day relationship with it-for example, organising the area visits, but under the guidance of the people above him. Then they would have called in, as necessary, the specialist teams-the credit risk team, the traded risk team and, later on, the operational risk team-for expertise. So, one person, the relationship manager, had immediate responsibility. I do not suppose that he had any authorised firm other than the HBOS group; I can’t remember, although he may have done.

Q1033 Chair: Could you just clarify something? The letter that raised the ICR and then the letter later on that took off the surcharge, was that one or two down from you?

Michael Foot: I can only speak for the first one, because I had gone well before the second one occurred. That was signed by my direct report.

Chair: Sadly, he is no longer with us.

Michael Foot: Sadly, yes, he cannot speak for himself. But that is not the kind of thing that would have occurred without my active involvement.

Q1034 David Quest: In the supervisory process, focusing on the period that you were involved, which is 2001 to 2004, were you aware of anything that, in your mind, set HBOS apart from all the other banks?

Michael Foot: Not specifically. Obviously, the main thought, early on, was the consequences of the merger: whenever two organisations merge there are always things that the regulator worries about. I do not think there is anything particularly unusual about that. There would have been the same general areas of concern for a bank like this, assuming that capital and liquidity were adequate, which would have been part of the vetting process.

We had a rather standard vetting process; there had been a number of major mergers or attempted mergers just before this, so we were quite used to reviewing and dealing with these things. Once the merger had taken place, the obvious concerns would be areas like the IT platform on which the retail services were to be provided, because Halifax and Bank of Scotland clearly had very different approaches and product mixes. Also, bringing two medium-sized organisations together-or rather, one quite large one and one smaller one-makes a very large organisation, which inevitably raises questions about management, in particular, of risk and of internal audit compliance in the areas that the FSA is primarily concerned with.

Then there would have been the culture change-in any merger you worry either that there is not a common culture in the new organisation, or that it is the wrong one. But they were standard concerns, of the sort that I would have had about any other merger of a similar kind.

Q1035 David Quest: What was your perception about what differences in culture there were, specifically, between Halifax and Bank of Scotland?

Michael Foot: They were both organisations that were very proud of their long history, and, having dealt with firms like Barings and the Equitable, I have concluded that there lots of downsides to having a long and honourable history. The Bank of Scotland liked to think of itself as-and it probably was-a more collegiate entity. It was probably run in a slightly more federal and relaxed way, partly because of its size: a thing would be big or small enough that Peter Burt would be able to keep an eye on it, as CEO, but without having to have too much in the way of formality.

Halifax was considerably bigger. It had long since undergone the change from building society to bank. That, again, involved changing the culture and many of the things it did, but it had done that. So it was basically bigger and obviously much more concentrated and focused, particularly on mortgage finance.

Q1036 David Quest: What about the business model in relation to corporate banking, which obviously proved to be problematic later on? One of the things that seems to be apparent from 2001 or before is that the business model in corporate in Bank of Scotland was rather different from other banks-for example, its focus on commercial property, equity participations and so on. Is that something that struck you?

Michael Foot: You have to bear in mind that the whole market in that area was changing quite rapidly at that time. Once the new entity had decided it wanted to grow reasonably fast, for example, that inevitably would have had consequences for its business model, because most FTSE 100 companies at that stage did not need to borrow from banks, so automatically you were looking at a somewhat different group of people.

Bank of Scotland in particular felt that they had done extremely well in the 1990s downturn. They had handled their commercial property exposure; they thought they were experts in it and they were fairly comfortable that, if there was another downturn, they would be able to do the same. In the Halifax case, I think they were pretty comfortable with the way they had handled the tensions in the retail mortgage market in the 1990s. So those had to be brought together. That is an example of the kind of thing that I was talking about-the need for a large, new organisation to get a control framework in so people know where they are going.

Q1037 David Quest: There was obviously a focus on a control framework, but to what extent did you and the FSA think at the time that the supervisory process extended to looking at the quality of that book?

Michael Foot: As for the typical ARROW visit, you have to bear in mind that this is relatively early days of ARROW. We had something at the Bank of England that we took over to the FSA and was redesigned to include conduct of business as well as prudential issues. That became what was then known as ARROW. We were the first regulator in the world to introduce something of that complexity. It evolved quite considerably between about 2000 and 2004. By about 2004, if you looked at a series of ARROW letters, the whole process from the planning stage through to the final letters of the firm would have been much more standard.

That was the ARROW process by which it went. It would have involved talking to the senior management in any of the firms that provided a significant contribution to profits or to risk as seen by the regulator. It would certainly have involved talking to the risk function, to the compliance function and to internal audit. It would not typically have involved a team disappearing off to Halifax to look at detailed retail mortgage files, for example.

When the specialist credit risk team went in, a lot would have depended on what its concerns were. I cannot speak to that in the Halifax case. I don’t know what the credit risk team did. I believe it spent some time with HBOS in 2003.

Q1038 David Quest: The point I am trying to raise is: would it have been part of the FSA’s consideration-let us say, for example, exposure to commercial property and the size of that exposure. Would it have been part of the supervisory considerations to ask the question whether it was appropriate to take that level of exposure?

Michael Foot: Yes, it would, but not from the point of view of trying to become shadow directors of the firm. If you have something like that, the question then is-because risk is fine; it is a question of how it is managed and priced-was the pricing adequate and was the control structure adequate? As a general statement, not just for HBOS, you would expect that a firm that has significant speculative property development exposure to have very particular expertise and controls in that area.

Q1039 David Quest: And that, more or less, was the Bank of Scotland’s position; it did have quite extensive speculative property exposure.

Michael Foot: The Bank of Scotland, which brought that over, certainly felt that it had had. As far as I can recall, although I have not seen the papers since 2004 or before, the regulators were comfortable with that in the Bank of Scotland.

Q1040 David Quest: I ask these questions because one of the things that Lord Turner said at the Treasury Committee inquiry was that, in relation to HBOS, the FSA had a philosophy of how it did regulation that focused on organisation structures, processes, systems and reporting lines. He said that it was fairly overtly said that it was not the function of the regulator to cast questions over the overall business strategy of the institution. I wonder whether you agree with that.

Michael Foot: Not in the way that is put. Right from my time at the Bank of England onwards-and it happened there before I took over-we certainly asked questions about where growth was coming from, where profits were coming from, what the concerns were, as seen by the firm, and then matching that against our concerns.

Nowadays, the FSA does a very formalised business model review as part of its supervisory process. That is five generations on, as it were. At the time I am talking about when I was there, that kind of question would have been asked by the individual supervisors to the firms, and there would have been a dialogue about that. It wouldn’t have been any where near as formalised as it is now. As I say, we certainly told our staff very clearly that they would never get in the position of being shadow directors. Challenge was what the job was about.

Q1041 David Quest: May we look at a couple of things that were challenged in the ARROW process? You should have a file there, which has some relevant documents in it. If you turn to tab C4, you will find the 2002 risk assessment letter, which is the first one that was done.

Chair: I am pleased to see that the FSA is working and writing letters like this on Christmas eve.

Q1042 David Quest: If only they had a reply the next day. I’m afraid the pages are not numbered, but if you turn to the third page, you will see under the heading, "Key findings," the first two sentences are, "Following the merger…HBOS is both more complex and better diversified than its predecessors. You have aggressive plans for the Group across all sectors of its business and HBOS is growing rapidly". That was certainly the perception in 2001 as a result of the merger, was it not? Part of the strategy of the merger was to enable fairly rapid growth in all business areas.

Michael Foot: No merger takes place on the basis that nothing is going to change. You take advantage of the strengths you have. What they thought they now had was a significant brand presence in two large areas, rather than one, and a bigger balance sheet off which to gear. You would expect that. I have not read recently what they said at the time of the M and A, but I am sure that that was a formal, open part of what they intended to do with the new entity.

Q1043 David Quest: Yes. Everyone has told us that one of the objectives of the merger was to use a larger balance sheet to, for example, enlarge the corporate banking function that came from Bank of Scotland.

Now, one particular risk that has been identified, which you will see if you turn over the page, is in relation to group capital and funding. That is the second heading. It says, "The Group’s strong asset growth, particularly in the mortgage book and in Corporate Banking, has exceeded growth in customer deposits, leading to the Group being increasingly reliant on wholesale funding." Of the large banks, HBOS was an outlier in the sense that it was the most dependent on wholesale funding.

Michael Foot: I will take your word for that. That is probably correct, but I could not say for sure.

Q1044 David Quest: Do you recall its dependence on wholesale funding being a consideration at the time?

Michael Foot: I certainly recall that one of the issues we always looked at was peer position.

Q1045 David Quest: It seems from this letter that the issue of increasing reliance on wholesale funding was a concern that was identified more or less from the start of the life of HBOS.

Michael Foot: I haven’t seen the papers, but with RBS, and possibly one or two of the others, the same trend would have been evident. It was a function of the time-retail deposits were hard to come by-that to finance growth, banks typically looked to expand their wholesale financing. As you say, HBOS did it at least as much as others.

Q1046 David Quest: It goes on to say in this letter, "As the Group acknowledges, this creates liquidity risk and a need for a robust plan that will ensure adequate access to wholesale funding." It seems to us, from having spoken to other witnesses and having seen how things develop, that while that concern continued to be recognised throughout the life of HBOS, it was addressed by trying to find additional sources of wholesale funding, to extend maturities and so on. But there never seems to be any suggestion that there ought to be a reduction of the reliance on wholesale funding. How did the FSA see HBOS’s approach to that?

Michael Foot: I think you have to understand it in the much wider context of liquidity issues in general. My first involvement in any liquidity debate was in a paper that the Bank of England published in 1980 on liquidity in sterling markets. Both in sterling and in terms of international exposure, there was then a periodic, serious debate in the UK, the Basel committee and elsewhere about what standards of liquidity were appropriate and where they should be held. As each of the major banking groups around the world consolidated-so, instead of having six treasuries, they would have one as their access to markets got better-they were constantly pressurising regulators around the world to reduce liquidity requirements.

When I started at the Bank of England, the liquidity requirement was simple: 30% of assets were to be held in liquid form. By about 2007, I believe, on the same basis of calculation, that number would have been down to about 4%-do not hold me to that figure, but I have seen something like that number in a public article. That was part of a worldwide trend and HBOS were, just the same as other people, looking to make more money, and they were confident that their treasury controls and their ability to access markets was their first and major line of defence. I think that it would have been very difficult for the FSA-then or subsequently-to say, "Actually, we take a different view of that. You must now reduce it" because by saying that, essentially, we would have been directing a key feature of their business.

Q1047 David Quest: In relation to funding, which is what this is discussing as well as liquidity, did the FSA take a different view as to whether it was appropriate for HBOS to be increasing its reliance for wholesale funding?

Michael Foot: I would have thought that the line would have been, much more, "If you are going to do this, you have to demonstrate to us that you have adequate liquidity and adequate reaction points." What, in modern terms, would be regarded as the trigger actions in the new living wills that are now being negotiated between banks and regulators around the world-this is an early, informal example of that-set out for us how you would deal with a problem and convince us that you are able to pick the problem up quickly and do something about it. That is the kind of dialogue that would have gone on between the FSA and treasury function in particular. As far as I know-there is no reason to doubt it-it would have gone on long after I left.

Q1048 David Quest: The sense that one seems to get from this letter-you are right that the letter goes on to say that they will need to demonstrate that they have a robust funding plan in the same paragraph-is that the FSA’s message seems to be that there is nothing wrong with increasing your reliance to wholesale funding in principle; you just have to persuade us that you have a sufficiently robust plan to deal with it.

Michael Foot: I would put it slightly differently: the FSA would not have felt that it was in its remit to bar arbitrarily or force a reduction unless there were specific, worrying circumstances that indicated that that was the only way of protecting depositors.

Q1049 David Quest: Not just an arbitrary bar or reduction, but it seems that the FSA did not feel that it was its role to say, "Well, perhaps you should think about reducing your reliance on wholesale funding rather than going out and getting more."

Michael Foot: I have not seen the detail of the meetings and the debates that would have occurred during the ARROW process. The underlying theme from the FSA side would have always been, "Are you sure that this is appropriate?" and, "What will you do if difficulties arise?"

Q1050 Chair: There is, at some later point, a group funding plan where it is almost as if the treasurer is trying to get the attention of his colleagues. He says, "You realise that our wholesale funding requirement is bigger than all the other banks put together?" The irony of all this is that the FSA, this early, put its finger right on this key problem and yet the combination of the bank and the FSA never grasped it, even though they had correctly identified it. If you were doing a SWOT analysis, this would have been in the "W" box.

Michael Foot: Again, I can only speak for my time there. During that period, the scale of this problem was never such that, if you like, alarm bells were going off.

Q1051 David Quest: On one of the other features of the way that it was dealt with, in the FSA letter you see again reference to the plan to extend the maturity profile of funding. As time went on that was done and, therefore, the percentage of short-term funding gradually reduced as the years passed. But because the total amount of wholesale funding was increasing, the position seems to be that the amount of short-term funding remained more or less constant throughout the life of HBOS.

Michael Foot: If you say so, that may well be. As I say, I can only talk up to the second quarter of 2004. That is exactly the kind of debate that what is now called close and continuous supervision would have involved. There would have been people in the FSA following up on this both in the interim assessment, which I think took place at the end of 2003, and the full next assessment, which took place-after my departure-in late 2004. Those are exactly the kind of debates that would have occurred both with top management and with the treasury function.

Q1052 David Quest: May we move on to the next ARROW letter, which you will find at C7?

Michael Foot: You mean the ICR increase?

Q1053 David Quest: Yes. Unfortunately, there is a page missing. This should contain the ICR letter and, behind it, the group ARROW letter, but it looks as if the first page of the group ARROW letter is missing.

You are aware, of course, that at the end of 2003, there was an interim ARROW review of various divisions.

Michael Foot: Which we had said we would do at the end of 2002.

Q1054 David Quest: Yes. A group ARROW letter was written at the beginning of January, which resulted, as you see, in an increase in the group’s individual capital requirement. One of the points you will see, in fact, if you just turn over that page-

Michael Foot: There is nothing on the back of mine.

David Quest: I am sorry; I have been given a different set of documents.

Michael Foot: I just have the one page, which is the letter, with nothing else on it.

Chair: I will lend this to you.

Michael Foot: Thank you.

Q1055 David Quest: You will see, under the heading, "Key findings", a reference to HBOS continuing "to target and deliver ambitious growth across all areas of the business, putting the Group out of line with its peers. As noted in my letter to you following last year’s risk assessment, it is important that delivery of such growth is achieved in a compliant manner and the control infrastructure of the Group must keep pace". In particular, you may recall that particular criticisms were made in relation to controls and the growth of corporate banking. Do you remember that?

Michael Foot: Yes.

Q1056 David Quest: I suggest that it looks as though these are quite serious concerns that are being raised at this stage, not least because, as it says on the first page-dealing with the ICR-that increasing the ICR by 0.5% is a fairly "significant action…to take".

Michael Foot: We did that after very serious reflection and after considerable investigation of what was going on.

Q1057 David Quest: And that was presumably because, in relation to the matters which were raised in the ARROW, there were unusually serious concerns at that stage?

Michael Foot: Well, unusually serious; there was a failure to address all the things we had raised in 2002. Other things, such as the dynamic of the growth-none of these things are static; the organisation grows-meant that what would have happened, guessing at the dates, is that we would have had some form of interim panel review of HBOS, probably in December 2003. There were also other things. In particular, I think that there was a debate going on between the FSA manager and HBOS about some of the corporate privilege issues. In the light of all that, we took the decision to raise their minimal capital requirements, which, as you say, is not a trivial matter and did not occur very frequently. Yes, we did that.

Q1058 David Quest: The response you got from HBOS was fairly robust. If you turn back to C2 in that same file-let’s hope you have that one, too.

Michael Foot: C2 is the risk review visit of October 2003.

Q1059 David Quest: C2 should be a letter to the FSA manager. This is the response of corporate division to its ARROW letter, which was probably the most critical of all the ones that were sent. It was sent by George Mitchell. In the second paragraph, he says: "You will be more than aware from our earlier meeting on this subject that I am extremely disappointed by the overall tone of your letter and indeed find many of the comments and findings to be very unfair." So the response you are getting from HBOS is essentially, to some extent, a rejection of the criticisms that are made.

Michael Foot: I cannot remember ever having had a letter from a chief executive or a senior person that says, "We agree with everything you have just said." This is reasonably measured compared with some of the things that would have been said by other banks at the time.

Q1060 David Quest: So you do not find anything surprising in the tone that is taken?

Michael Foot: It is just a fact of life that bank executives do not like to be shown in a bad light. They always think that the regulator has misunderstood, and they always argue. That is a common factor. It was a common factor in the 1990s, in my time, and no doubt still is today. Maybe now, possibly, there is a bit more humility. But I am not at all surprised by the tone of this. Compared with some of the things that happened to me, this is pretty measured.

Q1061 David Quest: More generally, how did you find the relationship with HBOS?

Michael Foot: I dealt overwhelmingly with James Crosby. I typically dealt at chief executive level, usually in the context of specific things. For example, I recall dealing extensively with him-probably in 2001 or 2002-when Halifax bought part of Equitable’s administration system. That was a negotiation we were representing. We had to be convinced as regulator that the sale was appropriate, so I met him quite extensively. I had detailed negotiations with him over that. I knew him and met him regularly at industry and other functions. I do not think he joined the board of the FSA before I left that board, but I think he may have been on the practitioner panel. He was somebody I would see at least once every two months. I always found him very blunt. He is a straight-talking Yorkshireman, but I find that preferable to some of the other things I used to get.

Q1062 David Quest: What about the relationship at the supervisory level? In other words, the relationship between the people who were supervising the people who were being supervised?

Michael Foot: I think what you see in this-you see it in Oliver’s letter later-is a pretty robust stance by the regulator. They are used to getting dismissed as having not understood. It is the regulator’s job to warn, and we were used to having a good deal of the argument thrown back at us, so I think this is evidence of a pretty robust relationship between the people who were commenting from the FSA and Halifax. As I say, I do not find the tone unusual. The most extreme example I ever had was a complaint by a firm to the Prime Minister of the day over something that we had done. That is the more extreme end. I think this is absolutely within the norm.

Q1063 David Quest: So, as far as you are concerned, there was nothing unusual about the relationship between the FSA and HBOS?

Michael Foot: As far as I was concerned, it was fine. I had had a good relationship with Peter Burt at the Bank of Scotland. He was another very open, practical person. I would have continued to see him certainly in the period when I think he was there in 2002 while the merger was bedding in.

Q1064 David Quest: Increasing the ICR, as you say, was a significant step in January 2004. You obviously ceased to be involved relatively soon after, but I think you were aware that there was then a section 166 skilled persons report. Then, by the time the final ARROW is completed, at the end of 2004, despite the concerns that have been expressed at this stage, the ICR increase is reversed. Obviously, that is something that you were not particularly party to, but, looking at it, does it surprise you that it was taken off so soon after it was put on?

Michael Foot: I really couldn’t comment without having been involved in the detail of what was done. The purpose of the sort of letters that we sent out-this was something I believed in very strongly-was that when you set or increase a ratio, you told the firm in detail what had made you do so, in order that it could then work out, if it wished to, the areas it should concentrate on and the money it should spend to remedy those things to get the ICR down again.

So I take the 2002 and 2003 letters, which I was involved with, as, basically, setting out the signposts, saying, "This is why we are increasing your ratio in early 2004." I just do not know what happened, but undoubtedly the FSA would have had detailed discussion on those key issues during 2004. Obviously, by the end of 2004, the people there had concluded that it was appropriate to reverse. But that process is what would have been followed, and that was the normal process.

Q1065 David Quest: And you are not surprised that problems of the kind that were being identified at the end of 2003 could effectively have been regarded as solved or mitigated by the end of 2004?

Michael Foot: A year is a reasonably long time, particularly when you bear in mind that many of the problems with a merger would have been resolved during 2002-03. One of the great problems with the merger is always, for example, management of information, data on things like loan exposure and so on. So it is not at all improbable, although I have no idea what is probable, that, between December 2003 and December 2004, HBOS was able to do a lot in areas like that, which the FSA had criticised before.

Q1066 David Quest: You were not involved post-June 2004, but obviously you know how things developed.

Michael Foot: I worked in the Caribbean for three years, and, frankly, I forgot about the UK.

Q1067 David Quest: Presumably, you have read the final notice to Bank of Scotland?

Michael Foot: Yes.

Q1068 David Quest: Looking back on it, and obviously you can apply hindsight, so far as is relevant do you think that the FSA was looking at the right things in relation to HBOS?

Michael Foot: I find that impossible to answer, frankly, because I was not here during that whole period. I mean, clearly there was a kind of collective insanity. I have done a lot of work in Ireland as well. A kind of collective insanity descended on some of the economies in western Europe, such that they concluded that there was never going to be a bust again. The markets were full of financial innovation and banks such as this and the Irish banks, and many others, were finding new ways of expanding their balance sheets. I was out of the country dealing with very different problems a long way away. I cannot comment, looking back. With hindsight, of course, a lot was wrong, but that is hindsight.

Q1069 David Quest: But, for example, there seemed to be a particular focus by the FSA on topics such as capital adequacy and treating customers fairly. In the end, the problems came from other areas. Do you think that there was too much focus on those topics?

Michael Foot: I am not sure I quite agree with that. The problem, as I see it-again, purely from what I have seen in the public domain-was that HBOS got into liquidity problems, which were in significant part caused by doubts about the quality of its asset book. Liquidity does not dry out for no reason-it dries up in some places more than others.

At the end of 2008, the whole market was in great difficulty. Yes, it is absolutely right that Halifax could still have had problems, but my take on what I have seen since then-the sort of provisions that I believe Lloyds have had to make, and so on-is that, even had those been surmounted, the credit problems for HBOS would have caused a serious problem, if not failure, quite separate from liquidity. So they are linked in that way. Of course, you are right that liquidity was what got to them first.

Q1070 David Quest: Okay. Just expanding on that last point, the figures we have seen in relation to the outcome of the loan book show, I think, that in 2008 there was an impairment of something like £7 billion in the corporate book alone. I think there were even larger impairments against that loan book in subsequent years, and the figure of total impairments is something like £49 billion. It is the point you are making: those are losses that the bank simply could never have sustained.

Michael Foot: I have not done a detailed study, but I would be amazed if they could have sustained it. If the liquidity problems had not occurred earlier because of doubts about this position, I suspect that at some point, subsequent to 2008, Halifax would have run into the same problem as the losses became apparent. But I have not looked at the detailed figures, and I have no idea.

Q1071 Chair: Consistently, from the time when the leaders of HBOS came before the Treasury Select Committee, we heard what one might call the innocent victim thesis-"We were a great bank doing very well for our shareholders, and then we were engulfed." In talking to various people from the firm, that view is still maintained. What we are trying to test is the proposition that this is not really the true story.

In the loss of that £49 billion, the biggest was in corporate, but there were some big losses in the international businesses, particularly in Ireland and Australia. There were some losses, probably quite moderate, on the retail side, and there were some impairments on the treasury side. When you add it all up, it looks to us as though it was heading for a solvency problem.

Partly the people sniffed that, and that triggered the liquidity problem, which then triggered the write-down in the values. It got itself to a point where its demise was inevitable. Even with a big injection of liquidity, which in a way it got through joining Lloyds bank and then getting the Government’s liquidity injection, these losses were permanent and were never going to be recovered by simply pouring more liquidity in.

Michael Foot: You have just said more eloquently what I was trying to say before. I agree with that.

Q1072 David Quest: If one is trying to look at why things went wrong, that must suggest at least some criticism of the way in which the loan book was put together and the quality of the loans, as well as the issues that arose in relation to the funding strategy.

Michael Foot: You couldn’t possibly have that scale of loan without-if you had a chance to do it again-doing things differently. I have explored banks in other countries ex post. This story is by no means unique. Certainly, in the case of Ireland, the scale of the problems and losses were probably even greater.

Q1073 Chair: There is an interesting question here about the balance of the FSA’s effort. By the time you get to 2006-we will talk about that in the next part of the session-there were criticisms made. But by then, concerns seemed to be more about, "You are behind in your preparations for the Basel II model." So you have a lot of effort going into the Basel II model and into conduct issues. The two risks that really killed the company-heavy reliance on wholesale funding and the quality of the loan book-did not get the same attention.

You left the FSA in the middle of 2004, but I would be interested in your reflections on the effort that we put into the Basel II model and whether that turned out to be a waste of time and did not produce the benefits commensurate with the importance attached to it. Is this the classic illustration of Andy Haldane’s dog and the frisbee, where people are looking at issues such as the particular structure inside the model, forgetting that there is a wolf at the door?

Michael Foot: My views on Basel II, and indeed on Basel III, were not normal for a regulator.

Q1074 Chair: But they have become fashionably right.

Michael Foot: Well, I did say these things on a number of occasions from, I think, the end of 2003 and beyond. I accept fully that I was part of the management structure which eventually approved the UK’s contribution to this, but there was an irresistible worldwide pressure. The way I put it-in the middle of a conference, I think-was, "If Basel II is the answer, you’re asking the wrong question." I firmly believe the same is true of Basel III, but not so quite so badly.

There are two dangers I see, and I think you have picked this up. From the regulator’s point of view, Basel II was meant to do two, or maybe three, really important things. One is that it was meant to reduce the ability of banks to game the system, so that they could not present assets that looked like a duck to the regulator and like an elephant to somebody else-that earned the profit of an elephant, but attracted the risk weighting of a duck. Going from the original, simple seven buckets, or whatever it was, to multiple buckets was a way of stopping gaming, and the regulator quite understandably wanted to do that.

The second thing was about data and controls. The Basel II models did at least have the merit of forcing firms to bring together past data, put it together-in this case, it must have been very interesting and difficult to do, with the Bank of Scotland and Halifax elements to it-and then, basically, ensure that that helped to improve the monitoring and controls, and also became an integral part of the thinking of senior management as to how they went forward.

I am trying to be sympathetic to the regulators-I understand the problems, and there was huge international pressure to do these things-and they thought of things like Basel II, as they now think of Solvency II, as a way of trying to sort out some of the past problems and ensure that, going forward, things are much better. That was the reason for the focus on Basel II. It was immensely complex and immensely resource demanding, and I personally think it was a complete waste of time, but that is just me.

Q1075 Chair: Meanwhile a lot of concern was expressed about the fact that liquidity was not getting addressed in these fora.

Michael Foot: Again, I draw your attention back to my earlier answer: this debate about what constituted an adequate level of liquidity was a global one and had been going on for 30 years. What every bank-whether it was J. P. Morgan, Deutsche, Barclays or whoever-was saying to their home regulators was, "We now have vastly improved systems for monitoring and reacting to financial pressures, and vastly new and improved ways of tapping money when we need it, but"-this was the key part-"if you don’t give us further concessions, the shadow banking sector will take even more of our business than it is already doing. You wouldn’t want that, would you?"

That is not an HBOS-specific point; that was a point made by virtually every major bank that I can think of all the way through this period. If you want to find a reason why we went from 30% down to something like 4%, that is the biggest single one I would cite.

Q1076 Chair: I am interested that you almost certainly read the same textbooks at university that I did. I remember this figure of 30%; it is probably from Sayers’s "Money and Banking".

Michael Foot: Yes, it is. I worked for Sayers for a time.

Q1077 Chair: I have two more general questions. What people have observed about when the executive team was put together is that two key players from BOS-George Mitchell and Colin Matthew-came on to the board to look after business lending, but most of the head office functions went to HBOS people. Was there really anyone in head office who could challenge these two businesses?

People have told us that if you wanted a view on corporate lending, you asked Colin Matthew, and if you wanted a view on international, you asked George Mitchell, because they were the people who understood it best. But at the centre, in terms of the chief executive, the CFO or group risk director, the ability to challenge effectively what these business lending people were doing seemed to be weak.

Michael Foot: I have two observations on that. One is that when a merger occurs, usually one side or the other comes out on top. If you think, for example, of the Lloyds-TSB merger some years earlier than that, the TSB people came out on top subsequently. It is not at all surprising. It is to do with not wanting to change your ways of working and regretting that you have lost your status as quite a large fish in a small pond. The fact that one side moved out over time is not surprising.

The second point that you make is an entirely reasonable one. In recent years, I have come to the conclusion that the three most important people in any company, particularly a large company, are-not necessarily in this order-the chairman of the board audit committee, the chairman of the board risk committee and the CEO. If they, particularly the first two, support the second and third lines of defence properly-

Q1078 Chair: Just go through those again quickly. The chairman of the audit committee-

Michael Foot: The chairman of the board audit committee, the chairman of the board risk committee and the CEO. What you will typically find is cases where the executive is too dominant or where the individual silos are too strong. A common feature I saw in a number of problem banks over this period is that the local area had more say relative to the group function.

Q1079 Chair: In this case-this is all pre-David Walker days-there was no board risk committee.

Michael Foot: Indeed there was not. It is hard to be critical, however; many insurance companies, as you probably know, have only introduced them in the past couple of years. The risk committee is a relatively recent introduction. Whether you have it as a formal committee or not, it is important that there is somebody there to protect the chief risk officer, who I think has one of the most difficult jobs in any large organisation.

Q1080 Chair: What we observe in this case is that the function of chief risk officer was created only in about 2004. The group risk officer did not, in those days, have a chairman of the risk committee to go and take their concerns to. They were someone in authority miles junior to the two guys running corporate, who had been doing it for 30 years and were on the board, so the CRO, it seems to us, was in a pretty weak position. She acknowledged this and talked about having an advisory role but not much authority.

Michael Foot: Which is why the CEO’s role is so important. I will give you an example of another bank where the CEO, between about 2008 and 2010 when he saw the FSA for a close and continuous meeting, took only one person who was the head of risk. That gave a signal to the rest of the people in the organisation that the CEO took risk seriously and that the individual, whatever their formal standing, was someone who counted. That is the kind of thing you need to do.

Many risk officers I have come across, not just in the UK, are, or have been until recently, quite junior people. It has been very difficult until recently to find a significant number of people who have the right kind of CV, because you are asking people to have expertise in operational risk, credit risk, market risk and macro-economics. You are asking a huge take.

You always have the problem-I suspect from the papers I have read that this may have been an issue here-of having an awkward choice, because if you have somebody who is reasonably expert but separate from the business, they do not cut the mustard because they do not talk the language that the first line understand. If you have somebody who does cut the mustard with the first line, the thing is: do they really understand the risks that they are now representing on the other side? That is a dilemma I have seen played out over and over again.

Q1081 Chair: I have one final question that can be answered very quickly. I would just like you to confirm this. The phrase "regulatory dividend" has appeared and, in a sense, the removal of the 0.5 was an acknowledgment that the firm had done various things that you wanted it to do, but there was nothing as explicit as a regulatory dividend in this case.

Michael Foot: This language long post-dates my involvement. I do not think that anyone, while we were at the Bank of England or in the early years of the FSA, talked about that. They certainly talked about the importance of business-friendly regulation, in terms of speed, focus and the rest of it.

One of the things that drove the early structure of the FSA for a firm like HBOS was bringing together all the regulators into a consolidated framework so, instead of having to deal with five or six regulators in the UK, it dealt with one team led by one relationship manager. Those were the kinds of changes. The idea that we went soft, or rewards for good conduct-as I said, I think the half per cent. increase is eloquent testimony that that was not the case here, certainly for the period I was there. I cannot speak for afterwards.

Chair: Thank you very much. It is good to have your appreciation of what happened at the time, but also there is the wider wisdom on what has happened over the past 10 years. We are very grateful to you.

Examination of Witnesses

Witnesses: David Strachan, Director, Major Retail Groups, Financial Services Authority, June 2006 to April 2008, and Clive Briault, Managing Director, Retail Markets, Financial Services Authority, May 2004 to April 2008, examined.

Q1082 Chair: Hopefully you heard the exchanges so I do not need to repeat the introduction. You see how we have developed the story up to about the middle of 2004, almost to the point, I think, when one of you would have been responsible for the December ’04 letter rescinding the ICR increase. That letter has various references to "made good progress", "fit for purpose", "good start", "modernising technique", etc. By that stage, you had seen that your relationship with the firm had in a sense been normalised-the rather harsh exchanges that had gone on around the turn of the year have disappeared. You still left them with a to-do list, but then that was normal. My impression is that-as I would describe it-they were no longer in special measures, there was just a programme of a kind that many other banks had to do. Would you say that that was an accurate characterisation of the position as of the end of 2004?

Clive Briault: Perhaps I should answer that question because David did not become director the Major Retail Groups division until some time in 2006-

David Strachan: April 2006.

Clive Briault: April 2006-whereas I did succeed Michael Foot as managing director, as he explained. At that point, the structure of the FSA was also changed, to divide it in a slightly different way from how it had been divided up previously, so that I became responsible for something called the Retail Markets business unit, and what that reflected was a decision to structure the FSA-in terms of supervision-between those firms that were predominantly retail-focused, which included HBOS along with the other major UK retail banks, life insurers, household-facing general insurers and so on, and a Wholesale Markets business unit, which focused on firms that were of a primarily wholesale market nature.

Also in my area at the time, reflecting to some extent the divide between retail and wholesale, Retail Markets had responsibility for conduct of business policy, whereas prudential standards policy was located in the Wholesale Markets division. Retail Markets also had responsibility for the FSA’s contact with consumers, with its consumer thematic work and its financial capability work. I just mention that by way of background, in terms of the switch-

Q1083 Chair: This structure various people have criticised, in the sense that if there is business lending in a firm that is 75% retail, does that mean that the business lending gets the attention that it should do?

Clive Briault: Yes, it does, because the structure also had a number of cross-FSA overlays, which were absolutely consistent across both the retail and the wholesale business units, which between them supervised all the firms.

One of those was something that was mentioned in the earlier session, in terms of the ARROW approach-the risk-based supervision approach. That was absolutely consistent. Irrespective of where the firm was located, as Michael Foot explained earlier, the focus was then on each of the major business units within the firm, and judgments were taken on what the inherent risks were and how good the mitigants were in terms of capital, liquidity, corporate governance, systems controls and so on. From that you could therefore tell what the overall risk profile of the firm was and which particular areas were reasonably high risk.

Another overlay, which I think was also mentioned earlier this morning, was the use of some of the specialist teams for credit risk, market risk, operational risk and insurance risk as well, if I recall correctly, which were available across the FSA to take that consistent view. Within each of the business units, where you had firms that spanned different types of business-in some cases, there were firms that had both retail-focused businesses and investment banking businesses within the same group-the approach was that they should be supervised as a single group. As a result of that, the supervisory team supervising them should have sufficient expertise across all those areas to do that.

Q1084 Chair: So the balance of wholesale and retail determines who, in a sense, is in the lead-

Clive Briault: Yes.

Q1085 Chair: But it did not determine who was supervising, because that was dealt with by co-opting people from the other side of the house.

Clive Briault: Well, not so much co-opting from the other side of the house, more a question of having sufficient expertise within the team responsible for the supervision of each group. As part of that, there was regular contact between the Retail Markets business unit and the Wholesale Markets business unit, but if anybody sitting in either of those two main business units felt that they needed more assistance for a specialist type of business that happened to fall within the group they supervised, there were central specialist experts available.

They also had the ability to ask colleagues elsewhere in the FSA questions, saying, "Look, I am trying to focus on this part of the group as part of my risk assessment, can you please help me by telling me what view you have taken of similar businesses in your business unit?" The units were not entirely separate. Indeed, they worked in a co-operative spirit. The central premise was that, by and large, within the supervision team responsible for a group, there should be sufficient expertise to be able to supervise that group effectively.

Chair: Okay, I think we-

Clive Briault: Sorry, you asked a rather different opening question, which I am sorry I did not respond to. Perhaps I should. The question was about the view taken by the end of 2004 about the individual capital requirement add-on.

Q1086 Chair: Had in a sense relations been normalised, having gone through this period of imposing an ICR surcharge?

Clive Briault: I would not describe the late- 2003, early-2004 period as abnormal. The supervisors took the view, very much as part of the ARROW system of risk-based supervision, that there were particular issues that reflected serious risks in, in this case, a high-impact firm. Indeed, it reflected serious risks in all the firms supervised in the Major Retail Groups division, as it was called by David’s time, and we should perhaps stick to that wording. They were all high-impact firms, be they banks, insurers asset managers or whatever. If you have a serious risk in a high-impact firm, there is a range of tools available to the supervisor in responding to that perception.

Clearly, at one end of the spectrum-this was used on some occasions and, indeed, in some areas but not in terms of some of the main issues raised in 2004-that might result in enforcement action against a firm, as a supervisory tool in referring a matter to enforcement for further investigation, if the risk or perceived failing was sufficiently serious. Other tools included some that you see being used in this particular case, which was amending the individual capital ratio to give a very clear signal to the firm as to how seriously the FSA regarded the matters which would have been explained and also the use, as we see in this case, of a section 166 commissioned report from a skilled person.

Q1087 Chair: That is why I characterise this 03-04 period as, in a sense, abnormal. Presumably, if you did not have particular concerns, you would not have demanded a 166 and you would not have imposed the extra surcharge. All I am saying is that, by the time we get to 2004, the 166 has happened and there is agreement about what needs to be done and the surcharge is removed.

It looks to me as though you went through a period of heightened concern and, by the end of 2004, had got back really to where you were, and those two measures-the 166 was finished and the calibrator was reversed. That is why I characterised it as normalisation. You did not have the same degree of heightened concern as you had before, because you had frankly dealt with it.

Clive Briault: Certainly, not the same degree of heightened concern. I was just trying to make that point that it was not abnormal to use those tools.

Chair: No. I agree with that.

Clive Briault: The circumstances for the use of the tools were the circumstances appertaining to the supervision of HBOS at the time. In terms of the decision to reduce the individual capital requirement back to where it had been-it went up, or so I understand it, from 9% to 9.5% and back to 9% at the end of 2004-and as set out in the letter sent to the firm at the time, it reflected primarily two things.

One was the report commissioned under section 166 of the Financial Services and Markets Act from skilled persons to take an independent view of the controls-I shan’t read out the entire terms of reference-but basically the control structure within HBOS. The second would have been the pretty much continuous contact between the supervisory team and the bank itself-HBOS-about the progress which HBOS had made about a range of other issues which were set out in the earlier ARROW letters.

The supervisory judgment at the end of 2004, as was communicated to the firm, was that sufficient comfort was taken by the supervisors from the conclusions of the skilled persons report, which I believe was sent to the FSA in the summer of 2004, and by the progress evidenced through their contact with HBOS during the year on a range of other issues and also, perhaps I should just add in the context of the skilled persons report, the acceptance by HBOS that it would carry forward the recommendations contained in the skilled persons report.

All those things led to a supervisory judgment that the reasons for imposing the addition to the individual capital requirement had been addressed, either because the controls and systems were regarded in the PWC report as being better than the supervisors might have feared, on the basis of the evidence which was available to them at the end of 2003-that was an independent view in detail undertaken by the skilled persons of those system and controls-and although, inevitably, as would have been the case with any institution, some issues did indeed remain, they were in the process of being addressed adequately by HBOS.

Chair: Okay, David, pick up the story from that point.

1088 David Quest: In terms of the story it might just help if we look at the documents at the end of 2004. If you have that file there, you can turn to C10. That is the minutes of the ARROW panel. The final ARROW assessment was sent out at the end of 2004.

Clive Briault: Yes, that is correct.

1089 David Quest: This would have been the meeting before then.

Clive Briault: Yes.

1090 David Quest: Just to pick up a couple of items which had featured quite significantly at the end of 2003, if you turn to item 3, which is "Risk Appetite in Corporate Banking".

Clive Briault: Yes.

1091 David Quest: You see a question was raised from the panel as to whether the FSA is comfortable with the risk appetite of HBOS, especially in the area of specialised lending and commercial property; both HBOS and RBS appear to be the leading firms.

Clive Briault: Yes.

Q1092 David Quest: Some information is given, and the conclusion is that no action needs to be taken on that.

Clive Briault: The conclusion, as I understand it, is that there were issues that still needed addressing. As it says at the end of that paragraph: "Further work on the delivery and embedding into the business of the credit sanctioning unit and stress tests are noted in the HBOS corporate banking RMP."

David Quest: Right, but under the "Action" column it says "No action".

Q1093 Chair: What does "No action" mean?

Clive Briault: I think that "No action" means no action in terms of changing the draft letter that would have been under discussion at this time, which then became the final letter that was then sent to the firm on 21 December 2004.

Q1094 David Quest: We will look at the letter in a moment, because it is behind this. You will see that there is also an item 5 about the growth target and strategy. Again, the question raised is how confident the FSA is that HBOS has a controlled growth target. In the third paragraph of that section, you will see that it concludes: "In terms of strategy, no immediate issues with strategy exist from the FSA’s perspective. Nonetheless, there is a more medium to long term question" that is one for the management "to address in due course." The letter itself is at C11, and you will see that the "Key findings" are on the third page.

The second paragraph makes reference to the "skilled person’s review" and the fact that the FSA has concluded, on the basis of that review, that the risk management framework was fit for purpose. The third paragraph states that the "Corporate Division has made a good start in modernising its techniques for…monitoring credit risk". HBOS remained under what is called close and continuous supervision after this letter.

Clive Briault: Every major impact firm was subject to close and continuous supervision as part of the ARROW process. That approach, in terms of keeping in close and continuous touch with the senior management of the firm, applied to all high-impact firms irrespective of the specific risks.

The question is that the intensity and the subject matter of that close and continuous relationship would have reflected the particular risks and actions set out in the ARROW letters. One could conclude that, if one says that there is a good start made, but further work to be done in any particular area, then absolutely the purpose of the close and continuous contact is to ensure that that work is continuing, and that the improvements are continuing to be put in place.

Q1095 David Quest: The message that the letter seems to be giving to HBOS is that they will remain under supervision, but the relatively serious concerns defined a year earlier have been significantly mitigated.

Clive Briault: Yes.

Q1096 David Quest: As a result of which, there was then a reduction of the capital.

Clive Briault: Yes, and I think those two are entirely consistent with each other.

Q1097 David Quest: Mr Strachan made reference in his statement to part of the RBS report, which deals with deficiencies in the FSA’s approach to supervision generally. I just wanted to pick up on one of the points that were made in the FSA’s RBS report as being an acknowledged deficiency, which is that a "much greater focus should have been applied to understanding and assessing liquidity.

With the benefit of hindsight there should also have been a greater focus on capital and asset quality". To either one of you or both of you, to what extent at this stage did the FSA concern itself with asset quality, particularly, having regard to what happened later, the asset quality in the corporate loan book?

Clive Briault: Perhaps I should answer at this stage and let David answer in addition, given that you mentioned his particular reference to start with.

Q1098 David Quest: Before you continue, Mr Strachan mentioned that as being something in the FSA’s report.

Clive Briault: It was.

Q1099 David Quest: Do you accept that as being a deficiency of supervision?

Clive Briault: Let me explain. In terms of asset quality, the approach-and I think you see this approach here in HBOS, and you would have seen it if you looked at other banks at that time-was that the main focus of the FSA was to try to ensure that the loan book was properly managed and controlled. The focus, therefore, was on: the systems and controls for granting loans and monitoring whether those loans were becoming impaired; the quality of that loan book over time; whether the credit committee procedures had been properly followed; whether those procedures themselves were good procedures in line with good practice at the time; and so on. That was the main focus.

There was, as I said earlier, a specialist credit risk team available across the FSA, and that was used by supervisors to assess two things. One was a more in-depth view of the systems and controls all the way down through the organisation to check that the procedures set out in the credit committee were indeed the procedures that had been followed on a loan-by-loan basis by looking at a sample of loans and following them through.

Secondly, if the supervisors were particularly concerned about asset quality, in terms of the individual loans in the loan book, the credit risk team was used in some cases to go in and look at individual loans to take a view of the quality of those loans and to compare them to see whether there was perceived quality in the way in which the bank perceived the quality of those loans. That specialist team was available.

Q1100 David Quest: Was it used in relation to HBOS?

Clive Briault: As I recall, I think there was a credit risk specialist team visit to HBOS in 2002 or 2003, but that was before the time that I took over as managing director of the Retail Markets business unit. I cannot recall the credit risk team being used in that particular way during my period. It did then become a team that also supported the Basel II model approval process, which we may want either to address here or leave until a bit later in the narrative.

Q1101 Chair: In December 2003, one of the components of this interim review was a look at the credit approval process of corporate.

Clive Briault: Yes.

Q1102 Chair: A particular phrase that came out of that was "atypical." A number of suggestions were made, as I understand it, to change that and to have less reliance on single credit approvals in the sense of loan-by-loan, entrepreneur-by-entrepreneur.

Clive Briault: Yes. There were clearly issues around that, but, as you say, the focus was primarily on how the loan book was controlled, as opposed to, "What is our view of the asset quality of this specific loan?" Typically, at the time, the FSA did not focus on the quality of individual loans on the loan book; it focused much more on the systems and controls. I think that is the shift of emphasis that is referred to in the FSA’s report on RBS in the context of the focus on asset quality.

Q1103 David Quest: You say that it did not focus on individual loans. Did it focus at all on the overall shape of the loan book? For example, what we have in mind in relation to HBOS is the particular exposure to commercial property.

Clive Briault: Yes, it did, because you absolutely have to understand the shape of the loan book to be able to form a view as to whether the systems and controls around that are adequate. The sorts of systems and controls that banks typically have in place with respect to retail loan books, where you are basically looking at a very large number of small loans, is different from the sorts of systems and controls you have in place for the corporate loan book, where you are typically looking at a rather small number of quite large individual loans.

Clearly, you need to understand the bank’s strategy and business model in order to understand where you need to devote your resources to ensure that the appropriate systems and controls are in place. You have to know what the bank is doing, which in itself is very much part of the ARROW risk assessment process. That is stage 1, if you like, which is, "What are the business activities of this group?"

Q1104 David Quest: What the bank was doing, particularly in relation to corporate, was-to some extent at least-different from what its competitors were doing. It had, for example, a significantly larger exposure to commercial property. It also had a different kind of borrower base; I think one of the witnesses referred to it as being targeted at entrepreneurs. Was it the FSA’s view that, in principle, there is nothing wrong with that kind of strategy, provided that there are adequate controls?

Clive Briault: Broadly speaking, yes.

Q1105 David Quest: So the focus was on making sure that the controls were right rather than on saying the strategy was wrong?

Clive Briault: Yes. I would say that, at the time, it was understood in the FSA what types of business HBOS was doing. It was understood that it was specialising in commercial property lending; it was understood that, for some of its commercial lending, HBOS was also taking an equity stake in the business as well as lending to the business; and it was understood, broadly speaking, what its strategy was in the retail mortgages market.

However, as I say, having understood that, the question then was, "If the strategy is to develop and build particular parts of this loan book, and to the extent to which those parts of the loan book are already becoming significant in terms of their contribution to the risk and profitability of HBOS, clearly those are the areas on which supervision should be focusing, in terms of: are the proper systems controls in place to support that strategy?" So you have to understand the strategy to understand where you need to look in terms of the systems controls.

Q1106 Chair: Can we move on to 2006?

Q1107 David Quest: We were just looking at the final ARROW for 2004. There is then an interim risk assessment. If you turn to page C12, you will see there is the letter with the group risk assessment-29 June 2006. Do you have that?

Clive Briault: Yes.

Q1108 David Quest: Let us look first at what is said about corporate. In the body of the letter, I think that corporate is mentioned on page 4. You will see, under the heading "Corporate issues", that it says: "Credit control - Corporate has made good progress in developing credit grading systems and enhancing its credit decisioning process and as such we no longer consider specific actions on these points are required in the RMP." That is the risk management plan. Then it says: "We expect…we will be able to test the degree to which the Division has embedded the credit grading". Again, the message to HBOS seems to be that the risks and the concerns previously identified in 2003 are being addressed to the FSA’s satisfaction, subject to the continuing supervision.

Clive Briault: I think the message is that, first of all, through the close and continuous contact with the firm, the interim ARROW was primarily a desktop-based exercise, which would have looked at all of the previous contact with the firm and taken a judgment on whether we were seeing progress in the areas that we were particularly focused on. The point about a desktop interim ARROW is that you do not then actually do your own formal visits to the firm as part of the assessment. That is the key difference between a full ARROW and an interim assessment.

However, I think that what this is saying here is clearly, first of all, that close and continuous work was judged by the supervisors as providing evidence that improvements were indeed continuing to be made. But secondly, and as is also clear from the risk mitigation programme attached at the back of this letter, there were still some remaining issues on the corporate lending book. The view of the supervisors at the time was that a good way of addressing those issues would be to do so in parallel with the Basel II model approval process, so particularly the issues at the back about stress- testing and indeed the issues on page 3 of the letter, where the Basel II work is picked out as a particularly important aspect.

Q1109 Chair: What I get from this letter is that corporate is no longer considered for specific action. So you are not prioritising it-there is continuous work to be done. Three other areas are referred to as being of particular concern. One was the insurance and investment division. The second was international, which is a different business from corporate, although lending in a very similar way with the same tragic results. Thirdly, "As indicated above we consider the Group’s Basel II programme remains high risk." The December ’04 letter is the beginning of references to Basel II.

It seems to me that the FSA absolutely identified correctly what brought this company down, which was liquidity and corporate lending. It identifies those early on, but by 2006 it has shifted its focus elsewhere and has decided that the highest priority is work on Basel II. We heard from Michael Foot that a great deal of work had gone into what turned out to be a very flawed system. So in a sense, you took the pressure off the things that were really, in the end, going to prove the killers for the company, and were then looking at other things, which didn’t kill the company.

Clive Briault: Can I make two comments in response to that, and then perhaps ask David as well, because we have now entered his period, if you like, as director of major retail groups division. Just picking up on those two main areas-first of all, corporate lending: I think it is important to recognise that the Basel II model recognition procedure involved the bank making an application to the FSA, essentially for a waiver, so that you are no longer subject to the standard risk weightings and you can now use your own internal model to calculate your capital requirements. That was the essence of it.

There were, as set out not just in Basel II itself and the way that was copied into the EU Capital Requirements Directive, but also the way that was translated into the FSA’s own rule book, a set of quite onerous conditions that a bank would have to meet before the FSA would be prepared to grant that waiver; and I do think it is important to recognise that those conditions included a number of areas, which were still absolutely central to the way in which the FSA was thinking about the risks around the corporate loan book. They included risk management; they included data management information systems; they included the way in which the bank itself monitored and assessed its loan quality within its different asset exposures. It included, as you will see in this particular ARROW letter, also the way in which the bank stress-tested its positions against macro-economic and other scenarios.

I think it is important to recognise that the Basel II model recognition work was not actually something completely separate from the sorts of concerns which the FSA had had throughout this period and the previous period that you discussed with Michael Foot earlier, in terms of what were the system’s controls, what was the risk management and what was the asset quality in the corporate loan book.

Q1110 Chair: You could have got to what was really wrong in corporate by a much shorter route, because you go straight to the fact that by this stage commercial is probably dealing with only half the total; the concentration of single loans had grown very substantially; there was the placing of very big bets; loan quality of individual borrowers was falling; and there was a lot of innovative but very risky funding. By taking the debate into the Basel II discussion, I think what happened is you took the focus away from looking at very simple things that you could look at, into a realm where model experts and specialists take over, and good common-sense judgments get lost.

Clive Briault: I would not accept all of that, because I think that this was not just a question of model specialists. That was part of it, undoubtedly, because part of the considerations in terms of granting a waiver were about some quite technical details of the model. But as I say, other aspects of it, which were important and we see later in the story, resulted in the FSA taking a tough line on whether or not the corporate lending book of HBOS should be included within the model process, and were more about issues relating to risk management, loan quality, and the like. So yes, a series of issues was looked at.

Q1111 Chair: There was much less emphasis on quite straightforward things, such as does this business model make sense? Taking it into a world of internal models and stress tests turns it into a technical exercise, rather than an exercise of judgment. Can it make sense for you to have increased your commercial property lending from 30% of the total to 50% of the total? I think the history tells us that this whole Basel II exercise was a distraction from the exercise of common-sense judgment-an exercise which, I have to say, coming from the insurance industry, is going on to this day in the insurance industry. Fortunately, it is going to run into the sand, but that is another question.

You lost sight of some simple judgmental issues about whether having that many loans over £2 billion or £1 billion-individual borrowers-made sense. So there was a diversion of effort.

Clive Briault: I can see that, clearly, it diverted from those judgments being made. The difficulty, I think-it is a point that Michael Foot made earlier, as did I -is that at the time those were not the sort of supervisory judgments which the FSA was typically taking anywhere across any of the firms that it supervised, wholesale or retail. The view was that, generally speaking, it was for the senior management of the board of the bank to decide the strategy and the key focus of the supervisors was the systems and controls to support that strategy.

Q1112 Chair: I am arguing that the criticisms that were made about the style of supervision in relation to RBS are exactly the same as we see repeated in the HBOS case. Supervision did not sufficiently asses and challenge key business decisions-business model risks.

Clive Briault: I absolutely agree with that, in the sense that I am not claiming that HBOS was different from RBS, in terms of the way it was supervised; I am saying the opposite, which is that it was supervised in exactly the same way as all the other banks-wholesale and retail, and the insurance companies, etc., across the board. This was the FSA’s style and approach to supervision at the time, which was faithfully reflected in the case of HBOS.

Q1113 Chair: You are accepting that, in effect, there was a style of FSA supervision. The RBS report recognises its shortcomings. Those shortcomings apply as much to HBOS as they did to RBS.

Clive Briault: To pick up on your second question, before passing across to David, you also mentioned the liquidity and wholesale funding issue, which I have not yet commented on, so perhaps, if I may do so.

As I point out in my written evidence to the Sub-Committee of the Commission, in a view that probably echoes that mentioned by Michael Foot this morning, the view that supervisors across the FSA-and regulators, in terms of the people writing the rule book, not just the people doing supervision-were taking at the time, which was probably an international phenomenon, was that it had become easier for banks, generally speaking, to raise wholesale funding in the market and to raise liquidity when they needed it, because of the development of a wide range of instruments and techniques for borrowing funds against assets. Ever since the first securitisation in the United States, which I believe was around 1970, those types of markets had been developed.

To come back to the point about HBOS, the focus of the supervisors at the time, because they were not in the mindset of asking themselves whether there should be a fixed limit on the amount of wholesale funding, was, as Michael Foot said and you discussed in the context of the earlier ARROW letters, to focus on the diversity and range of the funding sources of the firm and, I am sure, to take encouragement from the fact that, as was also mentioned earlier today, HBOS had apparently increased the average maturity of its wholesale funding over this review period. That gives you some added protection in terms of your vulnerability to shocks. Again, I think the supervisors were saying a consistent message; they made the point explicitly in 2002 that they were not objecting to HBOS raising wholesale funds. They were saying that there had to be a robust and well-diversified strategy and policy for doing so.

Q1114 Chair: A system where one bank raises money by borrowing from another bank, who then treats that lending as part of its assets.

Clive Briault: Yes, but in this case, what you see with HBOS is that HBOS also relied to a considerable extent on vehicles such as the one called Grampian, which, if I understand it correctly, raised medium-term funding against, in effect, the security of the mortgages issued by HBOS.

This was not borrowing from other banks; this was borrowing from institutional investors who bought medium-term notes issued by Grampian, secured against mortgages transferred from HBOS into Grampian for that purpose. This was a securitisation vehicle being used to secure medium-term funding using the assets of the bank. A lot of banks were doing that at the time. Investment banks were doing something similar, except much more short term, through something called the sale and repurchase market, but it was in essence the same thing.

Q1115 Chair: The irony is that the FSA, by expressing concerns about liquidity and funding, basically got it right, but, in a sense, did not press the point hard enough in the end.

Clive Briault: Yes, and I think the point I am making here is that, equally, the FSA at the time did not press that point with respect to any other bank, wholesale or retail. That was the general approach to liquidity at the time. The line supervisor would have exercised their judgment as a part of each of these ARROW assessments throughout this period, until after August 2007 when clearly liquidity was judged to be a serious problem because it had become a serious problem in practice.

Until then, the line supervisor, in completing the section of the ARROW risk assessment on liquidity, would have taken the view that, actually here is a bank which appears to have a wide and well-diversified set of funding sources-both retail and wholesale, across currencies and different countries- and is operating well, is well controlled and part of an overall strategy. That is as opposed to saying to an individual bank, "Well, you can’t have wholesale funding of more than 20% of your total liabilities, but it is fine for another bank to do so."

That is difficult for an individual supervisor to say, without somebody on the regulatory side saying, "We are now going to change the rules that apply to liquidity" and without some very good reason specific to that first bank as to why you would set such a limit. The context was that the supervisors were not operating those kind of rules.

Q1116 Chair: Again, coming back to the RBS thing, with hindsight the FSA’s approach to the supervision of high-impact firms was deficient. Then it says: "A much greater focus should have been applied to understanding and assessing liquidity." Again, the same story you see happening at RBS is basically repeated at HBOS.

Clive Briault: Yes. With the benefit of hindsight, that same story-conclusion-would have arisen, and it certainly arose, for example, in the case of Northern Rock, where, again, the FSA published a report. The same conclusion would arise if one looked back with the benefit of hindsight at what happened to a range of other banks, retail and wholesale, not only in the UK, but globally. For all of those firms, one might have looked back and said, "Well, we should have paid more attention to liquidity", but I have not given David a chance to answer some questions that were directed-

Q1117 David Quest: We will come to you in a moment. Perhaps Mr Strachan, you could pick up the point that we were just discussing in relation to the message that was being given in the 2006 interim risk assessment. To see it in context, we need to look at another document, which you will see at C16-"Evaluation of progress against issues raised". Who would have been responsible for preparing this document? The second document.

David Strachan: That would have been prepared around the time of preparations for the end-2007 ARROW risk assessment. It would be prepared by the supervisory manager and his or her team. It is looking back, tracking progress and-

Q1118 David Quest: We have seen what the June 2006 interim ARROW said, particularly about corporate. I just wanted to pick up where the FSA sees the position at the end of 2007. If you turn to page 2, you will see four issues identified: stress testing, credit decisioning process, risk-rating system management and provisioning. Take a moment to look through them if you like, but, as I read it, the FSA has by now reached the view that those four issues that had previously been raised, which were the remaining issues, have now all been essentially satisfactorily resolved. You will against each of those issues, "issue closed".

David Strachan: In broad terms, I agree with that assessment, but there is some important detail in there. If I take the first one on stress testing, we have picked this up through the supervisory review and evaluation process work conducted during 2007, so there was a detailed look at the processes around arriving at that individual capital guidance.

As part of that, some gaps in stress testing were identified, so a capital add-on was imposed in respect of that gap. That was picked up through the proper channels and processes. Credit decisioning, I agree, was closed because of the review by Group Risk. And the other two-yes-closed, although in relation to the risk-grading system, the Basel continuous work would pick that up. So, yes, broadly, although there are some important details to be picked up.

Q1119 David Quest: The consistent message that HBOS is getting is that over time, the issues that the FSA had originally raised back in 2003 are gradually being closed.

David Strachan: Yes.

Q1120 Chair: Can you clarify again that this is-referring to the "Interim ARROW" on the first page-being written at some time later than June 2006?

Q1121 David Quest: The date is actually on the bottom. I think that it is 26 October 2007.

David Strachan: So this would be part of the preparation for the start of the ARROW.

Q1122 David Quest: Does it sound about right to you, Mr Strachan, that it would have been about that time?

David Strachan: Yes, because one of the standard practices would be going into a new ARROW to make sure there was an up to date position on the issues that remained.

Q1123 David Quest: One point that seems very striking to us, bearing in mind what is being said this time in relation to points such as credit decisioning and risk rating, is that when the FSA comes to produce its final notice in 2012, some of the issues that come under the greatest criticism are those that are identified here as being closed-for example, credit decisioning and risk rating. Have you a copy of the final notice?

David Strachan: I believe it is in the pack.

Q1124 David Quest: Yes, E13. Just by way of comparison, if you look at paragraph 4.21, which is under the section, "Significant flaws in the control framework of the Corporate Division". At 4.21 (1), you will see one of the points that the FSA makes at that stage is that there are significant issues with the control framework, "such that it was not capable of providing robust oversight and challenge to the business". If you go to 4.24 (1), you will see that there is a criticism that there were "continuing and significant weaknesses in credit skills and processes at all stages of the transaction cycle". It seems surprising, given that these areas seem to have got a pass in 2007. How is it that they are the subject of such serious criticism in 2012?

David Strachan: There are a couple of possible explanations for that. First of all, about the 2006 interim ARROW process, that would have been a desk-based review, as Clive mentioned. It would not have been undertaken on the basis of any detailed discovery work, unlike the 2007-08 ARROW. It is instructive that when you look at the 2007-08 ARROW, which I am sure we will come to in a moment, when it comes to the letter and the associated risk mitigation programme, there are a range of actions raised in relation to corporate credit. Over that period, because of the different approaches used in the interim versus the full ARROW, the full ARROW is clearly bringing out more issues of concern for investigation. That is one point.

On the second point, I am afraid I do not have the information, but my expectation is that the enforcement notice will have been underpinned by a very detailed forensic review undertaken by a team of specialist investigators over a period of weeks, if not months, to put together the evidence that underpins this case. The supervision divisions, even if you took into account the credit risk specialists, would not have been resourced to undertake the sort of review that, as I say, underpins this enforcement notice.

Q1125 David Quest: Can I follow up on those two points, dealing with the latter one-the more detailed analysis-first? There is no suggestion in any of your correspondence with HBOS that we see here that you were not receiving enough information from them to make a judgment. There is no suggestion in the ARROW letters that you needed to do further investigations in order to reach a view. You seemed satisfied that you had enough information from HBOS to form a view about their controls.

David Strachan: We were satisfied that we had the information. My point is more that the discussion and the investigation are quite different in nature. Pursuing an issue through close and continuous would involve asking for the bank to provide management information, reviewing that information and discussing it with management. It would not involve going on to do detailed work on site within the bank to satisfy yourself about some of the underlying issues. I am trying to make a distinction between a supervisory process, particularly the one pursued at the time, and the forensic work that went into the enforcement case.

Q1126 David Quest: I understand the difference, but in relation to the supervisory process, you also had a section 166 review of those very corporate controls. That presumably involved a much more detailed analysis.

David Strachan: Yes.

Q1127 David Quest: I am just trying to work out how it is, if what is said in the final notice about the controls and the serious criticisms made are right, that that was not detected earlier.

Clive Briault: That is a difficult question to answer. The section 166 report that you refer to-the one undertaken during 2004, which clearly had a major role in the decision to reduce the individual capital requirement at the end of 2004, which we discussed earlier-although it contained at the end a long list of recommendations, my reading now of the executive summary to that report is that it was actually a reasonably positive report about the systems and controls in place at the bank at the time.

Q1128 David Quest: I think you described them to HBOS as fit for purpose.

Clive Briault: Which is entirely consistent with the judgment then reached at the end of 2004.

Q1129 Chair: The opposite point really is that in these two decision notices, on BOS and on Mr Cummings personally, the relevant period is described this time of 1 January. By the middle of January, there are words such as "good progress", "fit for purpose" and so on. By 27 October 2007, it is "issue closed", "issue closed", "issue closed".

Mr Cummings commented that it was notable during the relevant period that the FSA had not complained about the systems and controls in corporate. He submitted that, if they were so inadequate as to have been below relevant regulatory standards, the FSA should have expressed that view at the time.

He argued that the fact that the FSA had not complained at the time was strong evidence to suggest, even to an independent observer, that the systems and controls appeared to be suitably robust. Did he not have a point? More than halfway through the relevant period for which the company is being sanctioned and he is being criticised, sanctioned and fined, we find things such as "required actions have been satisfied" and "issue closed".

Then ex post these really swingeing criticisms are made dating from 1 January 2006. Yet halfway through that period you were not making criticisms of anything like that strength. Is he entitled to say, "Why should I have reacted or how could I have reacted when you were not telling me just how badly you thought of our systems at the time?"?

David Strachan: Can I make two or three points on that? Certainly, in one of the notices, the FSA makes it absolutely clear that it is not the FSA’s function to be a substitute for the responsibilities of significant influence function holders.

Q1130 Chair: I think that is an absolute cop-out. This is the famous paragraph 5.56: "The FSA considers that significant influence function holders are responsible for the management of their firms: it is not for the FSA to duplicate…decisions…The FSA considers that all authorised entities…are responsible for their own adherence to regulatory standards."

If you have no role in this, what is the point of conducting all these exercises, and, if something goes wrong, you are just going to wash your hands of it?

David Strachan: I don’t think, having read the Northern Rock and the RBS reports, that the FSA has ever washed its hands of anything.

Q1131 Chair: But in the Cummings case, it is saying, "It is not up to us to express a view." People can take no comfort from the fact that you have said "good progress", "fit for purpose", "issue closed". They have got to make their own decisions.

David Strachan: The FSA has always been clear that it is the prime responsibility of senior management to run their own affairs properly in accordance with the standards set by the FSA.

I do want to answer your question. As I say, one of the reasons for that mismatch and discrepancy is that at the time the FSA was operating on the basis of work that had been done by the firm, reviewed by Group Risk and group internal audit. It was working on the basis of the reports that it had received from management. It was also working on the basis of information that it had obtained during the Basel II recognition process.

Those sources of information were leading to the conclusions that we have just discussed on the ARROW findings. However, look at the ARROW discovery visit that was conducted at the end of 2007, early 2008, and the risk mitigation programme that was put in place afterwards. In that, you will see serious concerns raised about elements of the corporate book. As I say, a series of reviews were put in place, most of them, I think, by FSA specialists-not by the firm itself-to respond to issues that had been identified during that ARROW discovery process.

I acknowledge that that was at the end of 2007, early 2008, but that was when the ARROW work was done. That on-site work, as opposed to the desk-based and meetings-based work, was in my view identifying concerns at that stage.

Q1132 Chair: It tells you something about the weakness of the interim system that you did not spot any of these difficulties. Yet, my contention is that, had you been looking less at process and stress testing, and more at simple questions about whether it made sense to lend this amount of money to this small group of individuals, you would have smelt a rat.

David Strachan: I think I saw an extract from the RBS report in front of you. From memory, that says that the FSA’s approach at the time-with the benefit of hindsight, and in the absence of specific prompts of concerns for action-was less likely to detect some of these underlying issues.

Q1133 Chair: In which case, I would have thought that the FSA should have been a bit more humble about approaching particularly Mr Cummings, when it is clear that its systems did not detect these shortcomings, and then it just dismissed them, saying, "It is all down to you."

Anyway, you are not enforcement, so-

David Strachan: Just to be absolutely clear, I had left the FSA well before that.

Q1134 Chair: I do not want to be shooting the messenger. On the one hand, the losses created by corporate were absolutely horrendous. In my view, as you have seen from the discussion which I think Mike Foot agreed with, that probably went way beyond simply a problem of liquidity. When assigning blame for this, for the FSA to say, "It was nothing to do with us", was a bit harsh-actually, very harsh. The irony is that, in this whole affair, this man is the only person who has been fined. That is what I find extraordinary, but that is another story.

I think we are getting to the point where we are recognising that the highly sophisticated methods of analysis at Basel II, which are bringing in ways of assessing risk, did not achieve what much simpler methods and common-sense judgment might have achieved. I think that is an important lesson-

Clive Briault: Mr Chairman, on your point about whether the supervisors should have asked themselves a question about a loan book that was-not surprisingly, given its nature-quite lumpy, the supervisors might well have asked themselves that question. However, one of the elements against which they would have judged this-not the only one, but certainly an important one-is that the FSA had, as the Bank of England did beforehand, a large exposures regime. That meant that any exposure of more than 10% of capital base, if I remember correctly, had to be reported quarterly to the FSA, and that you were not allowed to lend more than 25% of your capital base to any one individual customer.

That provided a framework within which to ask, at least, the question that I am sure the supervisors did ask themselves, which is, "Is there any risk of these exposures moving up to a point where they are in breach of the prudential rules?" That is part of the backdrop. To go to a bank and say, "Well, those are the rules that apply to all banks, but for you we are going to set the limits at 2% and 4% rather than 10% and 25%," might be justifiable if the FSA had a very particular set of reasons to do so for a specific bank, but would not be justifiable generally, because the prudential rules were supposed to capture that judgment.

Q1135 Chair: What went wrong here is that those rules would be fine if you were asking about how much a bank had lent to British Aerospace or to Tesco, which are big plcs, but these were individual property entrepreneurs, who had virtually no capital and were very highly leveraged. I do not think that you can simply look at these large exposures without asking the question, "Who are you exposed to?"

Clive Briault: That is what I mean when I say there may be specific circumstances where you aim off from the general rules that apply to all banks and say, "In your particular case, you are not what these rules were designed for. These rules were designed for the generality and you have specific circumstances that are different." However, I am sorry, but I do not know what results, under that test, would have come out for some of these exposures. The capital base of HBOS at the time was probably in the region of £30 billion to £35 billion, so 10% of capital would have been £3 billion, and one would have had to compare individual exposures against that.

Chair: We are talking about single people-not plcs, who themselves have capital, but single people with exposures to £1 billion or £2 billion.

Clive Briault: That sounds as if it might have been in the region of about 4% of capital. That would then have been judged against a rule that said, "You have to report if it is more than 10% of capital. You cannot go above 25%." I do not know the extent to which supervisors, at the time, took a view as to whether or not that was reasonable, given the specific circumstances of the bank and the specific nature of the borrowers.

Q1136 Chair: That rather shows the limitations of looking at a rule of that kind without attaching some degree of market intelligence to it.

Clive Briault: In terms of market intelligence, it goes back to my point that the supervisors at the time, and the FSA at the time, generally, were aware of the sorts of business that HBOS was undertaking. The FSA was aware that HBOS was quite heavily reliant on wholesale funding as part of that. Those were well known facts. You could even see that from the face of the HBOS balance sheet.

Q1137 Chair: But that concern is not what the ARROW papers seem to indicate, when you get "issue closed" or "no further action".

Clive Briault: I did not say that that was necessarily therefore a concern in the FSA. I am saying that, again, it comes back to the point that the FSA understood what HBOS, and indeed other banks, were actually doing. Like the one you raised about funding, the question is why that did not trigger the sorts of warning bells that you would certainly trigger today, looking back at what happened with the benefit of hindsight. You would also try to explain why that was, in terms of the view of liquidity at the time across the board, across all developed countries.

Q1138 Chair: If you take a view of the business model for the whole company, you have HBOS expanding corporate lending and taking increasing risk. It was doing the same thing in international; it was doing the same thing in retail, as it was the market leader in specialist, i.e. risk area, mortgages; it was doing the same thing in corporate; and it was combining it with a high-risk funding model.

The different parts of the business were all pushing and were not offsetting one another. This is where your emphasis, now, on the business model seems to me a big advance on the way the supervision process was analysed in the mid-2000s.

David Strachan: I think that is right. The business model analysis introduced from 2008 and 2009 onwards, in terms of its depth and rigour, is very different, as far as I can see from the outside-I think Michael Foot described it as several generations ahead.

Chair: It is a pity that it had not got to that point earlier. I have probably finished my questions to David. Anything further?

Q1139 David Quest: I have just one point, because we keep mentioning the 2008 ARROW, so we better have a quick look at that-in C15. Was this a full ARROW review?

Clive Briault: Yes, it was.

Q1140 David Quest: The letter was issued in April 2008. The pages are not numbered, I am afraid, but if you turn to the fourth page, there is a heading "Credit Risk", under which it states: "We did not explicitly review credit risk management during the ARROW process (except for retail unsecured credit provisioning) but relied on our recent IRB waiver review work. Although you have not to date had any major credit losses from the recent market turbulence, in the context of the UK banking sector the Group is one of the most exposed to the risks of a UK downturn"-then it talks about the concentration in property.

Is it not a bit late to be making that point? It was obvious from the outset, was it not, that HBOS was heavily exposed to property and would no doubt suffer in a property downturn? In a sense, this is not really helping it, is it, to raise it in April 2008 when it is already too late?

David Strachan: Certainly, as I think we have said, this is not news. Supervisors were aware of the broad make-up of the group. What has changed following this assessment is two things. First, the external economic environment is completely different from what it was in 2006. By this stage, it is beginning to be clear that we were moving from a liquidity crisis into effects on the real economy, so what would have been less of an issue two years ago was now a significant-

Q1141 David Quest: Is it not now too late to do anything about it because they have already got that exposure?

David Strachan: It is too late to alter the size of the exposure. However, as we have discussed, the supervisors have been looking at the controls on this book. Through the supervisory process, they have been doing work on the Basel II waiver and, as I mentioned, when you look to the risk mitigation programme, you see that the supervisors are preparing to carry out more detailed reviews of the elements of the book.

Q1142 David Quest: We will look through the risk mitigation programme, but another point I wanted to make on this letter is that, certainly in the body of the letter, as far as I can see, there is nothing that expresses the concerns about risk controls that later appear in the FSA final notice. So even by April 2008, when you have done your full ARROW, we do not see real concern being expressed about inadequacy of controls. That is right, is it not-I am not missing anything in the letter?

David Strachan: I think you see in the risk mitigation programme evidence of concern. The ARROW discovery is a process, carried over a number of weeks, that is a series of structured interviews with a large variety of people across the organisation. That, in this case, has led to a risk mitigation programme that contains a significant amount of detailed work around credit and corporate. So they are on notice that there are issues here that need to be dealt with through more detailed work, and the letter ended with a very clear statement: "If our review work indicates inadequate credit risk management…this will substantially change our assessment and the regulatory tools employed."

Q1143 David Quest: If.

David Strachan: Yes. The types of reviews that are mentioned in the RMP are significant use of FSA resources. That makes it clear that there are some serious reviews to be done. The letter, quite properly, cannot prejudge the outcome of those reviews, but anyone reading this would be in no doubt that there were potentially serious consequences, depending on the outcome of that work.

Clive Briault: May I pick up on your previous question about whether it is too late to do anything? As is evident from a section in the FSA’s report on RBS-I think I can refer to it from that context-at much the same time, the FSA was also reviewing the capital position of the major UK banks generally, not just of HBOS. That led to a number of banks, including HBOS, raising additional capital at the beginning of 2008; in the HBOS case, there was a rights issue announced in April, and that raised the money in July 2008, if I remember correctly, but, again, I had left the FSA by then.

That was across the banks; it was, if you like, a thematic piece of work, saying, "We think that the UK banks, given the worsening economic climate and the risks, should hold capital somewhere in the region of 5% core tier 1 capital ratio." A number of banks were then encouraged to go out and raise that additional capital, and you can see, as a matter of public record, what capital raising was undertaken in the first half of 2008. That was a supervisory judgment, based on how much capital banks should raise, given the changed circumstances of the time. It was not quite too late, in that sense-

Q1144 David Quest: My problem is that it was too late to do anything about the loan book. As you say, because they had this loan book, they needed to go and get more capital.

Clive Briault: Absolutely. Loan books are very difficult to turn round. That was one of the considerations in terms of the capital. As things turned out, the nature of the shock, referred to by some people as a seismic shock, in September 2008, with the collapse of Lehmans and various other events, meant, in terms of the weaknesses in the world economy, which had not been generally predicted beforehand, that even the amount of additional capital that had been raised did not prove sufficient to protect all banks from running into problems from September 2008 onwards.

Nevertheless, that was, again, a supervisory judgment at the time, reported in the RBS report, in terms of what the FSA approach to capital should be. Clearly, part of that was to protect against the possibility of future losses.

Q1145 David Quest: I just have one final point for both of you. You were here when Mr Foot was giving evidence, and his view was that the impairments that were subsequently suffered in the loan book were such that, even leaving aside the liquidity issues, and without the injection of substantial new capital, HBOS would essentially have failed anyway, because of the quality, or lack of quality, of its loan book. Do you agree?

Clive Briault: As a matter of fact, I am not aware of how large those impairments turned out to be.

Q1146 David Quest: The figures we have been given are between £40 billion and £50 billion.

Clive Briault: If they were between £40 billion and £50 billion-if those two figures are correct-and the capital base of HBOS in terms of regulatory capital was somewhere in the region of £35 billion, that would, as a matter of mathematics, have wiped out the regulatory capital of the bank, so, in that sense, yes, I agree.

The other factor that should be borne in mind is the counterfactual question-again, this comes back to the supervisory judgment about the amount of capital that the bank should go out and raise in the first half of 2008. What, at that time, was not just the central expectation, but a reasonable downside expectation, of what might happen to the real economy over the next two or three years?

One basis for that might, for example, have been the Bank of England’s inflation report projections in February 2008. If you look at their famous fan chart, but in this case of real GDP growth, rather than inflation, over the next two years, even the bottom of the fan-I forget which confidence interval that is in terms of probability, but 95% or 99% probability will be within the fan-remained in positive real growth territory on a quarter-by-quarter basis. If the supervisors had looked at that as a reasonable view of the downside risk-not the central forecast-they might have said, "We need, at the very least, to protect against that possibility and the losses that might give rise to." That is, of course, a difficult calculation.

What actually happened after September, as we know, is that the UK economy, and indeed some other economies in the world, entered a severe recession. Presumably there is some link-I don’t know what it is because I cannot do the maths backwards-between the depth of the recession and the size of the impairment and the losses on banks’ loan books, including HBOS. I am just saying that there is a difficult supervisory judgment. It would not have been easy to predict-I don’t believe anyone knew with any degree of certainty in March 2008-just how severe the recession would prove to be after September 2008, and therefore how severe the impact would be on the losses.

In answer to your first question, absolutely, yes, the size of the losses would have, by the sound of it, wiped out HBOS’s capital, which clearly would have caused them to fail, by definition. The immediate cause of the failure was the liquidity crisis of September 2008, but clearly there was something else going on. I am not saying for a moment that no losses would have come through; I am only making the point that the degree of the losses is presumably related to the degree of the recession in the economy, which itself was difficult to predict.

Q1147 David Quest: That must be, obviously, right. However, what is striking here is that the impairments taken by HBOS were significantly greater than the impairments taken by its competitors. That presumably has to do with the formulation of its loan book, which was particularly exposed to property.

Clive Briault: Yes, that may well be the case. However, the impairments, if I understand it correctly, were taken mostly by Lloyds Banking Group on behalf of HBOS, which by then they had purchased. It was the view of Lloyds Banking Group at the end of 2008 of what the impairment should be on a loan book which they had just purchased.

Q1148 David Quest: Right, although I do not think there is any suggestion that all these loans have been repaid.

Clive Briault: No.

Q1149 Chair: To clarify one thing, we went through with Michael Foot the way the relationship with HBOS was managed. Presumably you followed the same philosophy that you would have engaged with the company at the CEO level but would not have engaged in the detailed work or with their board. That would have been one down. Mr Strachan, presumably you are the one down.

David Strachan: I am the one down.

Q1150 Chair: But some of the letters we have seen have come from two down. Is that right?

David Strachan: Yes. The structure was the managing director, myself as director, a head of department and a supervision manager.

Q1151 Chair: So you would be signing off the end of an ARROW process?

David Strachan: Yes. To be specific, I chaired the panel that signed off on the 2008 ARROW letter.

Chair: Okay. I think we have taken it as far as we can. We have learned quite a lot actually, so we are grateful to you. As I say, we now have to piece this together and put something to the Commission as a whole for them to draw on. I suspect what will happen is that, when their final report is issued, there will be a kind of case study appendix with some generalised lessons, some of which I think will be remarkably similar to the lessons that came out of the RBS case. Thank you very much.