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

HOUSE OF COMMONS

HOUSE OF LORDS

ORAL EVIDENCE

TAKEN BEFORE THE

PARLIAMENTARY COMMISSION ON BANKING STANDARDS

(SUB-COMMITTEE B)

PANEL ON HBOS

MONDAY 19 NOVEMBER 2012

SIR CHARLES DUNSTONE

SIR RON GARRICK

USE OF THE TRANSCRIPT

Oral Evidence

Taken before the Parliamentary Commission on Banking Standards

Sub-Committee B-Panel on HBOS

on Monday 19 November 2012

Members present:

Lord Turnbull KCB CVO (Chair)

Counsel: David Quest

Examination of Witness

Witness: Sir Charles Dunstone, Chair, Retail Risk Committee, HBOS, 2006-2008, examined.

Chair: Welcome, Sir Charles. Thank you for coming to give evidence to this Panel. Let me start with a little bit of context. The purpose of the whole Commission is to find out what went wrong in the financial crisis, how it went wrong and how it was allowed to go wrong. We are interested in what mechanisms failed, what warnings should have been given but weren’t, and what warnings were given but overridden.

Why is there a separate Panel, which I am leading, on HBOS? The first reason is that it is quite a remarkable story. It starts with a combined market capitalisation of about £30 billion in 2001-it is recorded at some £40 billion six years later-and then it vanishes, more or less to nothing. It was quite a remarkable event, but it has not been looked at in the same detail as RBS. The FSA has done a big report on that, and it has been examined by the Treasury Committee. We are looking at HBOS as a fertile source of lessons as to what might have gone wrong and why.

There is a constitutional innovation, in that, for the first time, a Parliamentary Commission is engaging counsel to assist in its work. I reassure you that we are not trying to turn this into a court or tribunal, still less a disciplinary hearing; it is simply that this guy is better at questioning than parliamentarians. It also allows the Chair to listen to an answer, rather than be thinking about the next question.

The Panel is assembling evidence, and we will put a view on that back to the full Commission, and it will be for them, not just me, to reach a judgment as to what lessons are to be learned from this whole affair.

I will turn over to David Quest, and I will come in with some questions of my own later.

Q747 David Quest: Good morning. To establish your role, you were a non-executive director, starting in 1999 and continuing until April 2008.

Sir Charles Dunstone: That is right.

Q748 David Quest: You started at the Halifax, and then you moved over into HBOS following the merger.

Sir Charles Dunstone: I did.

Q749 David Quest: One of the things you say quite frankly in your written submission is that you were clear at the time you joined that you did not have any experience of financial services, and that much of the bank’s activities would be new to you. It is right, is it not, that you were brought in as a non-executive director primarily because of your experience in retail business?

Sir Charles Dunstone: I believe so, yes.

Q750 David Quest: A number of witnesses have told us that, with the benefit of hindsight, it might have been useful if some of the non-executive directors had more of a banking background. Is that something you agree with?

Sir Charles Dunstone: It was a very large board, and there were a lot of people with banking experience. So I think you could also argue that we would not really have had a proper rounded view of what was happening if we only had people from a banking background. We ran a very large retail business. I think the view of the chairman and the chief executive is that banks were somewhat behind, in terms of their retail proposition and how they operated, so I think they felt they wanted, given that it was such a large board, a board with broad experience.

Q751 David Quest: You said in your submission that a number of the non-executives had extensive financial experience. Who did you have in mind?

Sir Charles Dunstone: Sir Bob Reid; Kate Nealon, who had been the chief counsel at Standard Chartered; and John Mack, who had been on the board of a bank in the USA, although I cannot remember which. There was plenty of experience on the board, I felt.

Q752 David Quest: Do you think that the balance of people on the board was correctly judged?

Sir Charles Dunstone: Yes, I do.

Q753 David Quest: One of the responsibilities of a non-executive director, as set out in the board manuals, was to satisfy you that financial controls and risk management systems were appropriate. Is that something that you felt qualified to do?

Sir Charles Dunstone: I felt I could take a view of what was being presented to me, within my experience of business and common sense, and try to make a judgment, alongside all the other expertise on the board, about what felt reasonable.

Q754 David Quest: But in terms of a more informed view-for example, adequacy of risk controls-that would really be something that someone else on the board would have to do?

Sir Charles Dunstone: Indeed, yes.

Q755 David Quest: Looking again at your written submission-have you got a copy in front of you?

Sir Charles Dunstone: I have not, but I can find one.

Q756 David Quest: If you have that file-it is a large file-in C1, for your reference, one of the points you make is that although you say you were generally impressed by the retail side, you were surprised by some of the revelations about other parts of the bank, particularly the corporate division. Before we come back to the corporate division, you mentioned revelations about other parts of the bank. Which parts apart from corporate did you have in mind?

Sir Charles Dunstone: This is really-reading your questions and what happened after I left the board-clearly the very significant losses in treasury and in corporate. I did not see any of those when I was on the board, so after I left, the situation deteriorated enormously. I was surprised.

Q757 David Quest: Not just in corporate and treasury. Were you aware that there had been very substantial losses in the international division?

Sir Charles Dunstone: Yes, of course.

Q758 David Quest: Something in the region of about £14 billion in write-offs over the years.

Sir Charles Dunstone: Yes, but since April, my source of information has been the newspapers and the web; obviously, I did not have any information from the bank.

Q759 David Quest: But all of that comes as a complete revelation to you?

Sir Charles Dunstone: Yes.

Q760 David Quest: The corporate and international losses were obviously not reported until after you left, but as you will appreciate, they were incurred on a loan book that would have been written over the whole life of the bank.

Sir Charles Dunstone: I agree, but while I was there, we were looking at the provisions we were making against those loans, and the numbers were not those numbers.

Q761 David Quest: Apart from the scale of the losses in corporate, what exactly was it that we have revealed to you about the corporate division that came as a surprise?

Sir Charles Dunstone: The extent of the losses, the need for a rights issue and then the need, ultimately, for the merger with Lloyds.

Q762 David Quest: You are aware, of course, that it was not just a question of the scale of the losses? There were also some serious criticisms by the FSA of how the corporate division had been managed.

Sir Charles Dunstone: I subsequently read that as well, yes.

Q763 David Quest: And did that come as a complete revelation to you as well?

Sir Charles Dunstone: Yes.

Q764 David Quest: One thing you say in your written submission is that you found the culture to be a very transparent one.

Sir Charles Dunstone: Yes.

Q765 David Quest: And you thought the quality of management information was very good.

Sir Charles Dunstone: Yes.

Q766 David Quest: Can you help us as to how one reconciles those two positions? How is it that if it seemed so transparent and the information seemed so good, the criticisms subsequently made come as such a revelation?

Sir Charles Dunstone: I think the losses must have been incurred, and the provisions made, after I left the board, because the information we were receiving and looking at, which I had every reason to believe in good faith, was that we were not incurring those sorts of provisions and losses.

Q767 David Quest: Let’s look at some of the specific problems that arose in corporate. If you turn to page 7 of your submission, you will see you set out what, with the benefit of hindsight, you think some of the problems were. Under the heading "The Divisions", you say, "With the benefit of hindsight, I think it is fair to assume that the following factors proved problematic: (a) concentration risk in corporate loans (real estate and leveraged loans)". Are you referring there to the fact that about a third of the loan portfolio was concentrated in commercial property?

Sir Charles Dunstone: In answer to your question, I have read the FSA document about-

Q768 David Quest: So these are points you have taken just from the FSA document.

Sir Charles Dunstone: Yes.

Q769 David Quest: Right. To take just the first one-concentration risk in real estate-are you saying you were not aware that the loan book was concentrated in real estate?

Sir Charles Dunstone: I was aware at the time that we were a large banker to people in the property market, but at the time we were very clear, and it was always explained to us, that this was not speculative development banking; this was about providing loans to people who were buying occupied and leased premises, so it was much less speculative than someone having bought a piece of land and hoping to build a block of flats on it.

Q770 David Quest: But you were aware that the proportion of the loan book which was exposed to commercial property was higher at HBOS than it was at your competitors.

Sir Charles Dunstone: Yes, and that, I understood, historically, had always been the case with Bank of Scotland.

Q771 David Quest: That was part of the strategy, wasn’t it-to focus on that kind of lending?

Sir Charles Dunstone: I think that the clients that the Bank of Scotland had had particularly strong expertise in commercial property.

Q772 David Quest: And not just commercial property. You said yourself that it was seen as a bank for entrepreneurs.

Sir Charles Dunstone: Yes.

Q773 David Quest: That was part of its selling proposition-to attract entrepreneurs.

Sir Charles Dunstone: Yes.

Q774 David Quest: It was heavily focused not just on property, but on property entrepreneurs.

Sir Charles Dunstone: And entrepreneurs who made money elsewhere and invested in property.

Q775 David Quest: Which, necessarily, is a rather higher-risk form of lending.

Sir Charles Dunstone: I think they were still looking at the value of the asset, not just the relationship they had with the person they were banking.

Q776 David Quest: But the fact that there was a concentration in corporate loans did not come as a revelation to you-you knew about that.

Sir Charles Dunstone: At the time when I was at the bank, I felt we had a broad range of business clients and a broad range of businesses, but I was aware that we had a specific focus on property.

Q777 David Quest: Similarly, when you looked at the scale of individual large exposures in corporate, that information was available to the board.

Sir Charles Dunstone: That was available.

Q778 David Quest: So, again, as a lending strategy, that was not something that came as a surprise.

Sir Charles Dunstone: No, and I am conscious that towards the end of my tenure, it was becoming increasingly difficult to sell down and syndicate the loans that you had taken. The bank may have taken on a loan hoping, or believing, that it would then sell part of it on to other financial institutions, which is what often happens. As the market began to tighten, it was more difficult to do that.

Q779 David Quest: Again, that was a specific strategy of the lending-to take on loans with the intention of selling them down.

Sir Charles Dunstone: To be fair, most corporate loans are done that way. You will have a lead bank, which will underwrite a large part of the debt, and then, subsequent to giving the loan, they will work with other institutions to syndicate it. To be honest, that would not be unusual just to HBOS.

Q780 David Quest: Again, that strategy was not something that came as a revelation to you when you read the FSA notice.

Sir Charles Dunstone: No.

Q781 David Quest: And (c), "the proportion of low-rated or unrated exposures"-again, presumably, management information about the rating of borrowers was made available to the board.

Sir Charles Dunstone: Sorry, can you repeat the question?

David Quest: Was management information about the rating of borrowers made available to the board?

Sir Charles Dunstone: Not on specifics, no.

David Quest: Are you saying you-

Sir Charles Dunstone: I am saying that the proportion of low or unrated exposures is really what I have learned since reading about the FSA report.

Q782 David Quest: So you didn’t know the level of exposure to low-rated borrowers.

Sir Charles Dunstone: No.

Q783 David Quest: What about the rest of the board? Do you think they were unaware of that, too?

Sir Charles Dunstone: It would be hard for me to answer for them.

Q784 David Quest: If you were unaware of it, with hindsight, it is probably something you should have been aware of, isn’t it?

Sir Charles Dunstone: I believed that we had a reasonable spread of loans of different types of exposure and different types of rating, and that it was a balanced portfolio, and that was what the credit committee would have ensured was the case.

Q785 David Quest: If there was a significantly greater proportion of low-rated and unrated exposures than you or the board were aware of, that is not really compatible with management information being of very good quality, is it?

Sir Charles Dunstone: This is an enormous organisation with a variety of committees and levels of hierarchy, who at a divisional level are looking at things in enormous detail, and by the time it gets to the board, it has been synthesised into a manageable amount of information. I think the board would have assumed that the people running the division and the credit committee would have paid very special attention to that, and that they were happy and comfortable with the portfolio.

Q786 David Quest: No one is suggesting the board should be looking at every individual credit, but on the other hand it is surely right, isn’t it, that that board should understand the balance of the loan book and whether it is targeted at lower-rated or higher-rated credits? That is something the board should know.

Sir Charles Dunstone: Yes, but I was not aware-it is very hard, because I was not there at a time when I could question that, so I did not believe that we had an unbalanced portfolio. Really, this is what I have learned since the FSA report. That is what the FSA say; I have had no chance to go and ask anyone else who was on the board or in the business whether they agree with that and what the background was.

Q787 David Quest: I appreciate that you were not there when the provision started coming in, but obviously you were there up until April 2008, when the loans were being made.

Sir Charles Dunstone: Yes, but I am learning this information after leaving the board, without the ability to go and find out more about the details of what they discovered. Whether the organisation agrees with the FSA I have not been able to challenge or question at all.

Q788 David Quest: I think the FSA notice recites at the start that it has been accepted by the firm. The other point you mention is finance provided by equity participation. Again, that was a special feature of HBOS’s business, wasn’t it? It specialised in taking equity participations.

Sir Charles Dunstone: Yes.

Q789 David Quest: And again, that was something that differentiated it from its competitors.

Sir Charles Dunstone: Yes.

Q790 David Quest: You make the point in your submission that the bank was lead into areas of business in which its clients wanted to participate. Can you just expand a little bit on what you mean by that?

Sir Charles Dunstone: It really comes back to the point I made: they had very strong client relationships, particularly with people from an entrepreneurial background, so if we chose to back a particular entrepreneur and they then said, "I would like to make a bid to buy this business or invest in this category", very often the first place that they would call would be HBOS, because they were the people who had the trusted relationship with them. I think the bank saw it as a benefit, really, because we got the first chance to look at this sort of transaction before they were offered to other banks.

Q791 David Quest: Again, that is something that differentiated HBOS-presumably intentionally-from its competitors.

Sir Charles Dunstone: Yes, indeed.

Q792 David Quest: But lending of that kind, at least with the benefit of hindsight, is something that is more likely to be very badly affected by an economic downturn.

Sir Charles Dunstone: Obviously it depends on the asset that we were lending against, but clearly commercial property, yes.

Q793 David Quest: Part of your role on the board, of course, was to consider and approve strategy, including the strategy of all of the divisions, even though you were focused on retail.

Sir Charles Dunstone: Yes.

Q794 David Quest: You say in your written submission that there were regular board presentations from all of the divisions. Again, just focus for a moment on the corporate division. As you said, you are primarily from a retail background-to what extent did you feel that you were effectively able to challenge the strategy that was being proposed by corporate?

Sir Charles Dunstone: I think it would be about the speed at which the corporate division grew, the controls that they had in place that we talked about a great deal, their ability to get us into a position to be approved for Basel II ahead of other banks. Most of the other divisions of the bank were in a good place for Basel II before the corporate division were. So, on a wide range of issues.

The issue of the credit quality of the people we were lending to, we assumed was being correctly managed by the division and the credit committee.

Q795 David Quest: What about the overall strategy, for example, the strategy of taking equity participations in borrowers? That is a relatively innovative banking idea. You did not have any background in corporate banking. Realistically, were you in a position to second-guess what the corporate division was saying to you?

Sir Charles Dunstone: As someone who works in business and deals with banks I obviously have a strong experience of what it is like to be on the other side and what other banks are doing. The feeling that I had was that this was a group of people who had been doing what they did, working with the clients, for a long period of time, and had been very successful at it.

We did not have the balance sheet that the large four banks had. There was a view that there was a lot of money being lent on terms such as covenant-light loans by other banks, and that was anathema to HBOS. That felt like very risky lending, so that was something that we steered away from. We thought we would stick with the clients that we had experience with and stick with the areas that we understood.

Equity participation was a way to align ourselves with our clients but also hopefully to get a better return on the money that we were lending, because we also enjoyed some of the upside in the growth of the asset.

Q796 David Quest: The strategy that corporate was following, as you understood it, was a strategy that it had been following since before the merger.

Sir Charles Dunstone: Yes.

Q797 David Quest: So it was a strategy that had been brought to HBOS from Bank of Scotland.

Sir Charles Dunstone: Yes.

Q798 David Quest: And, as far as you understood it, it had continued more or less unchanged.

Sir Charles Dunstone: Yes.

Q799 David Quest: Except that it had obviously grown very significantly.

Sir Charles Dunstone: It had grown but we were still lending against the same sort of assets to the same sort of people.

Q800 David Quest: Is it also right that one of the advantages thought to be taken from the merger was the ability to use the larger combined balance sheet to increase corporate earning?

Sir Charles Dunstone: Indeed.

Q801 David Quest: Did you-did anyone on the board-ever suggest that that strategy ought to be changed?

Sir Charles Dunstone: People would challenge the business plan and the presentation by the corporate division, as non-execs should, but I think everyone was comfortable, year by year, with the plan that they presented.

Q802 David Quest: No one ever suggested, for example, that to have such a large concentration in entrepreneur-led commercial property might not be a good idea?

Sir Charles Dunstone: No.

Q803 David Quest: If you were to point to someone on the board who is the main challenger of the corporate division, who do you think that would be?

Sir Charles Dunstone: Probably in the first stages a gentleman by the name of Philip Yea. I think he was on the risk control committee as well for the corporate bank. There would also be perhaps more challenge and more experience from the non-execs who had joined the board from the Bank of Scotland side of the merger.

Q804 David Quest: If one focuses on the slightly later period-2005 to 2007-in terms of members of the board who had a background in corporate banking, that was really just Mr Cummings and Mr Matthew, wasn’t it?

Sir Charles Dunstone: No. You’ve got a non-exec from Standard Chartered and from-I’m embarrassed to say that I can’t remember which bank it was that John Mack had been under. Those are just two examples. There were people who had worked within large corporate banks as non-execs.

Q805 David Quest: Right. But the person you mentioned was a lawyer, essentially.

Sir Charles Dunstone: Yes, but at a very senior level within Standard Chartered, which is a very large commercial bank.

Q806 David Quest: But in terms of people who had experience of corporate lending, it was just Mr Cummings-well, first, Mr Mitchell and then Mr Cummings and Mr Matthew.

Sir Charles Dunstone: And, I think, John Mack

Q807 Chair: He joined in 2007, didn’t he? He comes pretty late to this process.

Sir Charles Dunstone: Without the benefit of the papers I cannot remember exactly when everyone joined and everyone left.

Q808 David Quest: In your submission on page 4-item 5, just above the heading "Risk Management"-you say: "the non-executive directors challenged the Executive team most often on the ability of the organisation to effectively manage the growth of transactions, particularly in the Retail division." Did you observe, while you were on the board, any difference between the way in which the challenge of retail proceeded and the way in which the challenge of corporate proceeded?

Sir Charles Dunstone: No, there were more issues in the retail bank, year by year, that we had to deal with, starting with endowment mis-selling and going onwards. The retail division was such a large business that it always felt like we had a particular issue that we were dealing with, so as a result there was always a question about what was happening in retail. Issues were not coming forward from the corporate bank in the same way that they did from the retail bank.

Q809 David Quest: What issues, if any, were coming forward from corporate?

Sir Charles Dunstone: Basel II. There were issues about control. There was obviously the ARROW report in 2004. But, as I say, our control issues and just the volume of transactions that we were doing and the scale of the integration that we had to do with IT systems and things within the retail division was of a much, much greater scale.

Q810 David Quest: Quite a lot of the people on the board had come from Halifax and therefore from retail backgrounds. Obviously you were from a retail background as well. Was there a sense that more people on the board understood in depth the retail side than understood in depth the corporate side?

Sir Charles Dunstone: No, we just had more accidents happening in retail.

Q811 David Quest: It might be said that these divisions such as corporate and international, where there was very strong growth, were most in need of challenge.

Sir Charles Dunstone: It is hard for me to answer.

Q812 David Quest: What about international? What degree of involvement did you have in considering the international strategy?

Sir Charles Dunstone: There was a lot of thought and debate about our dependence on the UK economy by comparison with our competitors. We were almost exclusively a UK-based bank, and that was seen in the end as making us more vulnerable to shocks in the UK that might not occur elsewhere. I think we also began to feel, particularly in areas such as retail, that we might reach a stage where it was hard for us to continue to grow the retail bank, given the very large share of the market that we had, and we needed to explore new markets to expand into.

Q813 David Quest: You were expanding into markets that already had established players.

Sir Charles Dunstone: Yes, but they were markets that were perceived-with my retail banking hat on, they were particularly markets that had less competitive retail markets than we were used to in the UK and we could bring the learnings that we had to those markets successfully.

Q814 David Quest: You mentioned that one of the reasons for doing it was, as it were, to hedge against the possibility of shocks in the UK and invest in places where there might not be similar downturns. The irony is that one of the places in which you lost significant amounts of money on international was Australia-Australia has not had a recession.

Sir Charles Dunstone: No; that’s correct.

Q815 David Quest: Are you able to explain how that came about?

Sir Charles Dunstone: I don’t know. Again, because these things have come to light since I left, I have no-I can read the last management report that I had when I left; I have received nothing since.

Q816 David Quest: Certainly it looks rather remarkable that HBOS managed to lose so much even in a country where there wasn’t a recession, doesn’t it?

Sir Charles Dunstone: I don’t know the details of the losses. I don’t know how the losses are made up and what sort of assets they are made up against.

Q817 David Quest: I think there were 10 board meetings a year. Is that right?

Sir Charles Dunstone: Yes.

Q818 David Quest: How long was each one?

Sir Charles Dunstone: From 10 or 10.30 till 1 or 1.30.

Q819 David Quest: So three hours, 10 times a year. You said that, particularly in retail, there were quite a lot of individual problems that needed to be discussed. Do you think, looking back on it now, there was enough time in these meetings to properly consider all the divisions?

Sir Charles Dunstone: At times, we would also go away as a board and spend a day looking at the business and talking about things in greater detail. The agendas were very full; they covered the full scope of the activities of the business. It was well choreographed and organised well in advance. The papers were strong. The chairman always worked on the basis that everyone would have read all the papers. The management team would come in and perhaps present two or three slides in a PowerPoint presentation summarising the points that they were making, and all the time was given over to debate rather than them reading the presentation to us.

Q820 David Quest: Okay. Let me go back to the corporate division for a moment and ask you about the growth of that division. You accept in your submission that the corporate division did grow strongly, and it continued to grow, I think, throughout the life of HBOS.

Sir Charles Dunstone: Yes.

Q821 David Quest: It grew very quickly at the beginning, but its average rate of growth across the seven years was, I think, in excess of 10%, which is by any standards a fairly rapid rate of growth. Do you agree?

Sir Charles Dunstone: Yes.

Q822 David Quest: Did anyone at board level question whether that was too much growth too quickly?

Sir Charles Dunstone: No, because-I think you will have seen in the papers that are in here that the business looked at what areas it could grow in most profitably and could afford to fund and which areas were going to give the greatest return to shareholders. The decision on which divisions to allocate funds to for growth was taken by the group exec and group finance department and then presented to the board as part of the annual business plan.

Q823 David Quest: So, if I have understood that correctly, the focus was on where you could make the profit.

Sir Charles Dunstone: Yes.

Q824 David Quest: But from a risk perspective, was anyone saying, "We can make profit here, but perhaps in order to achieve those aims, we’re growing too quickly and taking on too much risk"?

Sir Charles Dunstone: No. You have to look at the fact that the UK corporate market is enormous, and although we were growing at, as you say, 10% per year, we still had a very small market share of the corporate loan market of the UK. So there can be no doubt that there was space to grow into and that there were good assets to lend against. It may subsequently have proved that the assets lent against were not of sufficient quality and that mistakes were made in the assets that were chosen, but it is not to say that we had an enormous market share and we could only grow by taking on poor-quality assets. We were a small player in an enormous market.

Q825 David Quest: But you ended up taking on a fairly large share of the overall corporate market as a result of your rapid growth, did you not?

Sir Charles Dunstone: But versus the other big four, we would still be small.

Q826 David Quest: You ended up with a larger share than Barclays.

Sir Charles Dunstone: In particular asset categories, but not in corporate lending.

Q827 David Quest: I am told that you ended up with a larger share than Barclays of the corporate lending market.

Sir Charles Dunstone: I have not seen the figure but I cannot begin to believe that.

Q828 David Quest: If you are growing your business successfully, is it not right that you should always be asking yourself whether you are doing that because you really are more competitive than everyone else, or whether it is because you are taking more risky propositions? Was anyone asking that question?

Sir Charles Dunstone: As I say, the plans were challenged. The belief of the board was that we were lending against good assets, that the credit committee was functioning, and that we were happy. Generally, the credit committee was happy with the quality of the assets that we were lending against.

Q829 David Quest: The growth that we have been discussing continued throughout 2006 and 2007. If you have the file in front of you, I want to show you something in the FSA final notice, which you will find at tab E13. Figure 4.56 states that the business plan for 2006/2010 set out targets for 2006 of profit growth of 9% and lending growth of 6.4%. Subsequently, in figure 4.65 on the next page, you will see that the 2007 targets were even more aggressive in corporate-profit growth of 22% and lending growth of 9%-so even as late as 2006 and 2007, you were still planning for fairly aggressive growth in corporate.

Sir Charles Dunstone: My understanding at the time-this is an important distinction to make-was that from then onwards, there was quite a focus in the corporate division to sell down the equity stakes that they had built up in assets, so the growth in profitability was driven by the sales of equity stakes rather than our ability to make larger margins. It looks kind of magical, does it not, to imagine that you can grow your profit by 22% by lending 9% more? I do not think the margins were there to do that. The growth in profit was driven by us selling down equity stakes that we had in assets, and that was a deliberate policy to raise funds for the bank and to cash in on high asset prices.

Q830 David Quest: You are selling down, but you have still got a pipeline of new propositions. That is driving your lending growth, isn’t it?

Sir Charles Dunstone: Indeed it is, but at a lower rate than we had previously been growing lending rates.

Q831 David Quest: I am not sure that that is right, because you can see that the forecast lending growth between 2006 and 2007 increases.

Sir Charles Dunstone: Yes, sorry, but from memory if you go back to pre-2006 years, the lending growth was higher than 6% or 9%.

Q832 Chair: I think the evidence we had from George Mitchell was that lending growth started at 20%-plus and came down year by year until 2006, when it was about 6%. He expressed surprise that at a time when the economy had been growing for quite a long time, there was then a return to faster rates of growth. In a way, my interpretation of the final notice is that it is this re-acceleration that the FSA are particularly critical of.

Sir Charles Dunstone: I understand. It is hard for me to remember the exact discussion about that at the time.

Q833 Chair: On the characterisation of corporate, you say in your submission "there was not obviously an ‘aggressive’ growth strategy within the Corporate division", but the first board meeting, in September 2001, dealt with business banking synergies related to projected aggressive growth. Even the people there, in corporate-

Sir Charles Dunstone: Is that corporate or business banking?

Chair: That is-you are right.

Sir Charles Dunstone: Business banking. We had been very unsuccessful, particularly in Halifax, at having business accounts for small businesses and medium-sized companies. We worked very hard to try to grow our business banking marketplace because that was a very good source of deposits.

Q834 Chair: Right, and later on business banking and corporate banking got merged. Initially they were two separate divisions.

Sir Charles Dunstone: No; business banking, almost until the end, was always separate, and it was always more of a branch-based operation than through the corporate lending.

Q835 Chair: I understand that. Can I come back to this question of the board composition? The questioning from us is not saying that you and others were not qualified people; it is more that when you add them all together, certain aspects of the skill set were not strongly enough represented. So you have a chairman who is not, by career, a banker, still less a corporate banker. You have two CEOs, one of whom starts as an actuary and comes out of the Halifax. Andy Hornby is a retailer and Mike Ellis, again, comes out of the Halifax side.

I get the impression-I wonder whether you can confirm this-that the BOS people in the new merged entity take the lead on corporate lending and the Halifax people take the lead on retail lending, and the degree to which one can challenge another is quite weak. You get to a board where the two people who knew most about corporate lending were Mitchell/Cummings and Colin Matthew, but they marked each other’s homework, so to speak, and the challenge that came from outside those two was relatively weak. Is that a fair characterisation?

Sir Charles Dunstone: I have to say I think all divisions of the bank were challenged by the non-execs, and there was a wide breadth of experience on the board. Could there have been more? There could always be more. It did not feel as though the corporate division were working offside, in the dark, without an awareness of what they were doing from the rest of the business or an understanding of how their business worked.

Q836 Chair: But you told us that if you add up the number of hours that the board met, retail took up quite a large proportion.

Sir Charles Dunstone: No, I did not say that. The most challenges that came were towards the retail business.

Q837 Chair: You said the most difficult issues were tending to come from retail.

Sir Charles Dunstone: Yes.

Q838Chair: The impression I get looking at these papers is that international in particular was not the subject of a lot of broad discussion, and yet the impairments that came out of that were about a third of the total.

Sir Charles Dunstone: I accept that not nearly as much time was spent discussing international as was spent discussing corporate or retail. I think that that is fair.

Q839Chair: Another feature that appears is that in all the discussions that have taken place and in all of the public statements, there is, in a sense, the "innocent victim" defence. This was a bank that was doing well; the share price and the profits were going up. Then it was engulfed by something that it could not have predicted. What we are questioning is whether that is an adequate explanation. The impairments-first, in corporate, secondly in international and thirdly, in treasury and retail-were such that in the end, the bank was going to be in serious trouble anyway.

Sir Charles Dunstone: My recollection of what was happening during 2007, despite the focus that you have on the corporate division, is that the bank was finding it increasingly difficult to fund itself because of our exposure to the retail market. As the sub-prime problems grew in the USA with people wilfully mis-selling sub-prime mortgages and packaging them up in these synthesised CDO products, the wholesale markets stopped really trusting any business with a large retail mortgage book. You can see the dominoes that start falling with Northern Rock and Bradford and Bingley. HBOS was the obvious next organisation to look at. No one knew whether we would be writing lots of sub-prime business, but we were a big mortgage provider and that really scared wholesale funders.

Q840 Chair: The Halifax had been around for decades. Therefore, it was so big that its ability to expand and gain market share was limited. There was then a conscious decision to go into what was euphemistically called specialist mortgages-buy to let, self-certification and so on. Those tended to be looked after by separate entities.

Sir Charles Dunstone: Separate brands.

Q841 Chair: Did those separate brands, Birmingham Midshires and the mortgage, whatever the B stands for, get the attention that they should have done from the board or from you with your particular responsibility for retail credit?

Sir Charles Dunstone: I think they did. We did a lot of work stress-testing those books and trying to look at the quality of what we were underwriting. The difficulty was that the traditional mortgage market had become so unprofitable due to people remortgaging so quickly, which was driven by mortgage brokers. By the time I left, the average mortgage that we signed lasted 36 months. You would take a mortgage, get an incentive, have it for three years and then go straight on to the next deal. It was becoming increasingly difficult to write traditional mortgage business. We had an enormous amount of experience in the housing stock: quality of assets, surveying, collections. We proceeded cautiously at first, but then we became increasingly confident about buy to let and self-certified marketplace. I don’t know what provisions were finally put against those divisions, but it was a team I had a great deal of confidence in, that they knew what they were doing. I still look at repossessions, defaults and the fall in house prices in the UK, and what has happened is not nearly as bad as we imagined in our stress-testing, despite the economic market.

Q842 Chair: What I make it is something like £2 billion; when compared with what was going in corporate, this is quite small.

Sir Charles Dunstone: Given the scale of the mortgage business, that is quite small.

Chair: Is there anything else you need to do in establishing the narrative or shall I carry on for a bit?

David Quest: Carry on.

Q843 Chair: One of the claims of HBOS is that it had a consumer or customer focus. On the other hand, you then get to the whole PPI affair, and I think you say somewhere in your evidence that you’d looked at this product and thought that it was a fair product to be selling. Yet as a rough guess, if Lloyd’s is providing about £5 billion for this, I guess half of that was inherited from HBOS. A very large amount of mis-selling has been going on.

Sir Charles Dunstone: Yes.

Q844 Chair: What steps were taken? Why did you conclude that this was a reasonable and fair product to sell to your customers?

Sir Charles Dunstone: The first thing I would say, with my experience within the bank and what I saw, is that I cannot reconcile the fact that the quantity of policies that people are claiming were mis-sold, were mis-sold. The numbers that have been given in compensation seem to be completely mad to me. We have spawned an industry now of people who are incentivising you to claim. I don’t think that the policies were mis-sold in the way that the FSA believe that they were, as a first point.

We would look very closely at the terms of the policies, then, in particular, at the retail risk control committee, we would look at the number of policies that were cancelled within 30 or 90 days. My experience is that, if someone has been mis-sold something and they didn’t realise they were buying it, you will get a high level of cancellations when people get their first statement and say, "What on earth is that? I had no idea that I was going to be paying another £90 a month"-or whatever it is-"for this policy."

I joined in 2000 and took over the committee in 2001, and I was alarmed that the number was too high. We had 14 % or 15% of people cancelling the policy within the first 90 days. Through work that we did in the branches, making the wording and the policy clearer, and making it a part of people’s bonuses, we drove that to between 6% and 9%. I felt with that level that there was probably some buyer’s remorse in there-having agreed to buy it in the first place, they then decided that they actually didn’t want to have it-and that the incidences of mis-selling were well under control.

Q845 Chair: But people could have given up for two reasons. One is that they decided, in effect, to self-insure; or else they could have seen the small print and said, "Well, given who I am, because I am self-employed"-or something like that-"I am not going to be able to make a claim." It is the experience of people trying to make claims and then being repudiated that has really created the anger, isn’t it?

Sir Charles Dunstone: I think one of the things that we tried to do within the business is to be less dependent on intermediaries and to sell more products through the branches, which is why we worked so hard to drive the branches to become more like banking retail outlets than traditional banking branches. We felt that if our own employees were selling the products, we had much greater control over what they were doing than if we were relying on third parties who were just sending us in signed documents, and where we had not seen the sales process.

Q846 Chair: Last month, the FSA-the Wheatley side of the organisation-produced a report on selling incentives. I do not know who they had in mind, but there were examples where per thousand of business that people transacted, they got remunerated six times more if they added various features or sold additional features. In retail risk, did you look at the risk that the remuneration structure that you were running-having brought it back in-house-was still incentivising people to mis-sell?

Sir Charles Dunstone: I do not believe that we were. Enormous amounts of efforts were put into the quality of sales and measuring quality of sales. It mattered enormously to the bonuses for the branch how we perceived the quality of what they were doing, in a whole wide range of things-completing the paperwork correctly, keeping the paperwork correctly, how they were sold and how they did in mystery shopping-and lots of activities, with an enormous focus on the quality of what we were doing. Of course, from time to time, we would find examples of where it was not working, but I felt much more comfortable that we were doing it in our own branches with our own oversight, rather than its being done by complete third parties, about whom we had no idea.

Q847 Chair: A difference between you and a big retailer-although you had this strong retail culture-is that if I buy tomatoes from Tesco, I know immediately whether I have bought good tomatoes or bad tomatoes, and next week, if I am dissatisfied, I will go somewhere else. In financial services, there is a huge asymmetry of information. You can go on selling a product, which turns out not to have been good value for your customer, for a great deal of time. Indeed, people deliberately exploit that inertia.

Sir Charles Dunstone: The approach of HBOS and particularly of the Halifax brand was to try to reverse that, and to make banking as clear and as transparent as we could, and to sell more through our own branches, where we could measure and monitor the sales process. Our advertising was very clear and very approachable. We tried to make our products as clear and as straightforward as possible. That was absolutely the strategy of the organisation.

Q848 Chair: But you still ended up with one of the largest mis-selling bills of anyone.

Sir Charles Dunstone: All I can say is that I just cannot reconcile what I saw-what I saw in the stores, and the people, the processes and the figures-with what I now read in the paper, as to the manner in which people are able to get these claims upheld. It feels to me that perhaps the banks have just surrendered and have decided that they are so unpopular, they should just pay the money.

Q849 Chair: One of the major debates going on in the Commission as a whole is around culture, and whether something-a cross-contamination-from investment banking culture has somehow got into retail banking culture, and that therefore the only way to prevent and control this is to separate it off. Basically, the Glass-Steagallists or the Volckerists, so to speak, believe that the only way of preventing this cross-contamination is a greater degree of separation than is provided for in the ICB’s ring-fence proposals. Does that have any resonance in an HBOS context?

Sir Charles Dunstone: HBOS, in a way, was the ultimate ring-fenced bank because it did not have any investment banking; it was just a simple traditional bank.

Q850 Chair: So you come back to this: why did it all go so wrong?

Sir Charles Dunstone: As I was saying earlier, I think something quite extraordinary happened in America, where people were wilfully mis-selling sub-prime mortgages and selling them on to other people. Neither we, nor the FSA nor the Bank of England ever conceived-I don’t think anyone ever did-that it was possible that an entire industry in a nation as big as the USA could go completely insane in the way that it provided credit to people. The contagion that ran from that was that, if you were in the business of banking, particularly the business of banking mortgages, you became toxic. Everyone was terrified; no one knew who had loads of sub-prime and who had loads of CDOs. If you look at the subsequent impairments, it always felt to me that HBOS’s funding problems were created because it had such a large share of the retail marketplace, when in fact the problems lay within the corporate division, but it was not the corporate division that was actually scaring people off from lending money to the bank.

Q851 Chair: So the Achilles heel of the organisation, which was identified literally from day one in the first discussion, was the heavy dependence on wholesale funding? Although bringing the two organisations together produced more capital for BOS to operate with, it was actually a merger of two organisations that both had quite large wholesale funding requirements. There is a history of identifying that as a problem, but the organisation never quite got on top of it. You then get to ’07-’08, and you still had £100 billion-plus of short-term funding and perhaps more than £100 billion or £200 billion of wholesale funding in total. I do not quite understand why that problem, having been identified right at the start in the first corporate plan ever produced, did not get addressed more aggressively.

Sir Charles Dunstone: Going back to the point that I have just made, the organisation made strenuous efforts to increase how long-dated wholesale funding was. We did equity raisings and we securitised the mortgage book. We actually made good progress in improving our funding position. We simply did not foresee-I do not think anyone foresaw-that the cliff would occur where the market just absolutely stopped. We did stress-testing and all sorts of analysis of different scenarios for the effect of different economic situations. We did not imagine a situation where every bank stopped trusting every other bank in the way that they did.

Q852 Chair: But what you had in effect was a bank that pictured itself as a new force in banking and wanted to become one of the top four. The bank wanted to grow very fast, so it took more risk in virtually every division-you can identify where they added a level of risk-and combined that with a high-risk funding strategy.

Sir Charles Dunstone: I do not think we took more risks than other people within the retail division. By the time I left, we still had the best loan-to-value ratio of any mortgage provider in the UK. The book was very strong, and I think its subsequent performance has demonstrated that. There was a clear understanding that as we got better and wanted to challenge the other big four, we had to improve our wholesale funding position and get longer dated funding, and we worked very hard to achieve that. As I say, hindsight is a wonderful thing, but really nobody foresaw the cliff that we all fell over.

Q853 Chair: A question we will need to look at is whether your loan-to-value ratios were as sound as you claim. I was under the impression you had some rather high loan-to-value ratios.

Sir Charles Dunstone: From memory, across the retail book, it was around 50%.

Q854 Chair: By the end of 2008, the proportion of book with an LTV over 70% was over 60%.

Sir Charles Dunstone: The last figures I saw were around 50%.

Q855 David Quest: Can I just follow up on a couple of those points? The explanation that you gave as to why, in the end, it all went wrong, you said was based on what was happening in the United States-and that created a catastrophe which no one could have foreseen. But the fact remains that, in relation to HBOS specifically, HBOS suffered losses of tens of billions of pounds on impairments on loans in its corporate and international books, and those losses were suffered in the end because poor lending decisions were made. That has got nothing to do with decisions taken in the United States. That is to do with decisions taken at HBOS to structure its loan book in that way.

Sir Charles Dunstone: But all you might be able to argue is that if the bank had been able to fund itself, would it have been able to work through those loans, as many other banks are doing with their clients, without, if you like, marking to market and fixing at the absolute low water mark those provisions?

Q856 David Quest: These losses are not about marking to market. These are impairment provisions because the borrowers could not repay the money.

Sir Charles Dunstone: No, I do not think that is strictly true, because, for instance a property loan-of a commercial property loan-will have a loan-to-value ratio on it: one of the covenants. If you breach that covenant the loan is non-performing any more. It does not actually mean that the rental income that your client is receiving is still not covering the interest costs. So the loan is still performing; whereas on a residential mortgage you could be in negative equity: that does not breach the covenant of a residential loan.

Q857 Chair: Is not this simply a liquidity issue? The taxpayer who put in a large amount of money could have got his money back. He would have had to lend a lot of money temporarily, stabilise it-and then, also, the bigger bank lawyers would have helped it; but there does not seem to be any prospect in this case of getting the money back. The real losses, on a very large scale, have been made.

Sir Charles Dunstone: I agree. Anything I am saying about that is speculation, because I had left and I was not there.

Q858 David Quest: If these figures that we have seen are right, and they are taken from Lloyds’s own annual report, so there is no reason to doubt them, the levels of impairments taken on the corporate and international loan book would have the effect of making HBOS insolvent, were it not for the further capital injection that was put in by the taxpayer. The level of impairments are simply such that HBOS could not have sustained them.

Sir Charles Dunstone: As I say, I have never seen the figures beyond what I have read in the FSA report and what I have read in the newspapers.

Q859 David Quest: If that is right, then it cannot all just be blamed on a global liquidity crisis.

Sir Charles Dunstone: I think I am straying into speculating again but the global liquidity crisis itself dramatically reduced the price of commercial property because there was no funding around to go and buy the assets, so the price of the assets fell; and, as you say, we were very exposed to commercial property. It is a double whammy: you cannot fund the business, and no one can afford to buy commercial property, so the price of commercial property falls, and your loans become non-performing. One does lead to the other.

Q860 David Quest: The consequence of that kind of argument seems to be that when times are good and the loan book is profitable, the bank congratulates itself on having managed things effectively, but when times are bad and loans are loss making, it says, "It’s a consequence that no one could have foreseen. It’s not our fault." You seem to be having the best of both worlds.

Sir Charles Dunstone: I do not think that anyone who was running the bank was running it on the basis of, "Oh well, we’ll just write all this business, and if it all goes wrong, the Government will be there." People were making what they thought were good commercial judgments; they were working very hard to run the business, to get a good return for their shareholders and to do a good job for their customers.

Chair: We have probably taken that far enough. Thank you for your evidence. It is a question of filling in all the pieces of the jigsaw so that we get a complete picture. You have been very helpful to us. We are very grateful to you. Thank you very much.

Examination of Witness

Witness: Sir Ron Garrick, Deputy Chairman, Senior Independent Director and Chair, Corporate Risk Committee, HBOS, 2006-2008, examined.

Chair: I think you were here more or less from the start.

Sir Ron Garrick: I missed the start of the last session, but I did listen to the start of another session on the television.

Chair: So you understand the context. I think we will go straight in. The session will run pretty much along the same lines as with Sir Charles: we will try to establish the narrative and then some implications from it.

Q861 David Quest: Just to put your role in context, you originally joined Bank of Scotland as a non-executive director, and then you moved, following the merger, to HBOS. You remained non-executive director at HBOS until the acquisition by Lloyds.

Sir Ron Garrick: Yes.

Q862 David Quest: You had a number of other roles. You were, at various times, deputy chairman and senior independent director. You were chair of the corporate risk control committee, and you were a member of the international risk control committee.

Sir Ron Garrick: Correct.

Q863 David Quest: And you were a non-executive director of the Bank of Ireland.

Sir Ron Garrick: Yes.

Q864 David Quest: So as well as your role on the board, you were specifically involved in two divisions-namely, corporate and international-which we know, in the end, performed fairly catastrophically. Your background is in engineering, is that right?

Sir Ron Garrick: Yes. I am a qualified engineer.

Q865 David Quest: You did not have any banking experience before you joined?

Sir Ron Garrick: Only in terms of companies borrowing and arranging overdraft facilities.

Q866 David Quest: You have an interesting experience in the sense that you moved from Bank of Scotland to HBOS. Can you tell us, in general, what cultural differences and what business differences do you observe between BOS and HBOS?

Sir Ron Garrick: There was a lot of similarity between the two companies. Both companies were conservative in much of what they did. They were cautious-that would be the way I would put it. There was a lot of intellect in both sets of management teams. They both ran pretty transparent companies. I would qualify that by saying I was only on the Bank of Scotland board for about nine months before the merger took place, so my experience and depth in Bank of Scotland was not huge.

Q867 David Quest: Can I ask you specifically about the corporate division? Were there any differences in the strategy of the corporate division before and after the merger, or did the division more or less get carried through the merger? Did anything change?

Sir Ron Garrick: I put in my statement the fact that Bank of Scotland did attempt to buy NatWest at one time. That failed, and Royal Bank of Scotland won that takeover. The reason for the bid for NatWest was simply that Bank of Scotland were constrained in what they could do because they were very strong in Scotland, but had no branch network in England and Wales. It did not have a big enough balance sheet to get into the syndication deals that other people were doing. It only took the big four. So they were looking for strategic solutions for that. That was the reason for the bid for NatWest.

In the first nine months I was in Bank of Scotland, there were a number of possible strategic moves that could be taken to improve their position in the marketplace and help to grow shareholder value. When Halifax came into the equation-someone brought the two groups together-it was clear that there were a lot of similarities between the two companies, and that together they could be much stronger than the sum of their parts. Bank of Scotland’s corporate was seen to be the logical place under which the corporate division would operate. It was their culture, it was their knowledge and capability that would lead that division. Of course, the opposite side to that was that retail was quite clearly a Halifax strength, and therefore they took over the branches and the mortgage business and all that. So they got the corporate culture from Bank of Scotland going into HBOS.

Q868 David Quest: One thing that was not similar between them was that there was not a corporate focus on the Halifax side.

Sir Ron Garrick: It was quite interesting, because an early comment on the corporate division-I think it came from the chief executive-was that Halifax had been trying to get into corporate business. He said that when he saw what the corporate division did, and how they did it, there was no chance, and they knew it, that Halifax would be successful in that marketplace. They were just so far in front of us in terms of all sorts of things. For a non-executive director on the board, that was some comfort. The corporate knew what it was about, and knew the strengths, and recognised that Halifax corporate was not very big; it was quite small.

Q869 David Quest: In terms of the strategy that was being followed by corporate, did it change as a result? It must have got larger, but leaving aside the question of scale, was the general strategy more or less the same before and after the merger?

Sir Ron Garrick: I believe so. When markets change outside, the business must change, so if there is a particularly good opportunity over here which you did not do before, you would try to take advantage of that opportunity. I am not saying it was absolutely the same, but I think the culture was pretty much the same, and that culture was cautious lending: we will not get into situations that are not attractive from a margin point of view and security point of view for the loans that we are making, and we will continue with that strategy. I believe that continued throughout the life of HBOS.

Q870 David Quest: But we know that, none the less, beginning in 2008 and in subsequent years, very large impairments were booked by the corporate division.

Sir Ron Garrick: Very large what were booked?

David Quest: Impairments against the loan book.

Sir Ron Garrick: Yes. I would quite like to go into the timing of that, because it is important. The only reason I am saying this is that I was listening to the previous session, and I think there are some discrepancies in what you are thinking. Let me do that now. I was on the risk and control committee of corporate, and that committee was there to support the audit committee. It was not there to take risk decisions. It is a little confusing, but the divisional risk committee was the first line of defence in the division. It was there to make sure the division works in accordance with the limits that have been set. The third line of defence was the audit committee, and in support of the audit committee, you had a risk and control committee. You had them in all divisions. I chaired the corporate one, and I sat on the international division risk and control committee.

Those committees were there to monitor. When credits have been established and given, one of the main roles of the committee-they cover lots of different things-was that, on credit, it had the opportunity to look in some detail at the loans and advances that had been made to customers that had gone wrong and were stressed. At every meeting, we would hear about risk from the credit manager, who would give us a list of all the stressed assets, probability of default, likely impairment, impairments to date, and so on. That was really an ability to look at what had gone before. My view as chairman of that risk and control committee was that I wanted to hear the bad news. I did not want it to be heard because we were going to discipline people and throw them out of their job. We wanted that information so that we could do things better in future and so that there was feedback within the corporate division as to what things had gone wrong and why.

One thing that impressed me about corporate was that they stuck with people. They went through the cycle with people. They went a long way to try to find work-outs for difficult situations. They did not simply say, "That is an impairment, write it off and we’ll move on to the next one," and they had a great deal of success in that. There were a number of situations where companies that had got into some serious trouble-through a process of finding suitable partners and different things-and had their loans impaired came back and were put back into the profit and loss account because it turned out that they could find the solution. That was the tradition of the Bank of Scotland’s corporate division.

This all started with the impairment situation, which you talked about. I went to the fourth meeting of the risk and control committee in 2008, and as I was walking into the meeting, the auditor approached me and said, "We need to make provisions on some of the loans out there." At the time of that meeting, the deal had already been done and it had been agreed that that Lloyds TSB would take over the company. That was the first time that we had seen what you might call serious impairments. I think the figure that was subsequently quoted for the end of the third quarter of 2008 was £1.7 billion or thereabouts.

The last HBOS board meeting that took place, in the middle of December 2008, was held at the same time as the EGM which approved the sale of HBOS to Lloyds TSB. At that stage, that board meeting was told that the provisions were no longer £1.7 billion but about twice that-£3.3 billion or £3.4 billion.

The special notice report on HBOS, which was put together by the FSA, indicated that Lloyds-at the year end, when they closed the accounts for HBOS-provisions were about £6.6 billion. I don’t remember the exact figure-

David Quest: I think it is £6.7 billion.

Sir Ron Garrick: £6.7 billion. So the first knowledge that I had of impairments in corporate division was in the third quarter of 2008, when the deal to move together with Lloyds had been taken. I think that it is important that we are aware of that timing.

Q871 David Quest: Is that because, as you understand it, the level of impairments that were going to need to be made was not known, or appreciated, within the corporate division, or had they not passed it on, up the chain?

Sir Ron Garrick: About one third of those impairments were fair-value adjustments. It was quite a shock to everyone involved that those impairments were necessary, but we were going through a really severe crisis, as everyone knows, and things were deteriorating quite rapidly. But I think the fact that those provisions were necessary came as a surprise.

From memory, I think that about a third of them were impairments. We had a number of joint ventures and we had a number of assets within the corporate division-it might have been equity stakes, and joint ventures were certainly included in that-and around the third quarter of the year, every year, a value would be put on those things. The value put on them at the end of September 2008 was substantially down because of everything that was going on around and about, so a third were fair value, and the joint ventures which had been mainly affected by that were house building. When you do a fair value adjustment, it is because of outside factors, and the outside factors were that stock markets were crashing, so on and so forth.

Those investments, if you go back to 2006 when that exercise was done at the year end, the auditors told us we were being conservative in our accounting because we were sitting on something like £200 million or £300 million-worth of profit-when those joint ventures were valued in 2006. By the time we came to the third quarter of 2008, the values had plummeted. They were still the same joint ventures, the same companies involved, doing the same thing, but the value had changed dramatically, perhaps because the businesses were not doing all that well-again, perhaps, because house prices had fallen, and house builders had built lots of apartments or estates with new homes that were not selling.

Q872 David Quest: What explanation were you given when you were told about these figures; why they were so much worse than anticipated?

Sir Ron Garrick: Because of the situation we were in with the valuations in the stock market. I think the FTSE went to 4,000. There is a formula used to value these things-it is used by venture capital-type businesses, but it is a well recognised formula. When you applied that formula to the situation we were in, fair value adjustments accounted I think for at least a third of the losses.

Q873 David Quest: What about the other £4 billion?

Sir Ron Garrick: The other two thirds were down to the fact that there was a tremendous number of casualties in the period, in 2008 itself. If you go through the list: there were huge losses being announced by banks; there was the AIG discrepancies found by its auditors, the big insurance company in the States; there were monoline insurers which people were thinking of, "They will not be able to face up to the insurances on some of the investments of HBOS"; there were companies seriously affected by the lack of funds from banks; and there was a housing market in freefall in the States and in absolute freefall in Ireland. The situation was that all of these things were impacting on business, so we were seeing a higher impairment than had ever been seen in the eight years of HBOS’s life.

Q874 David Quest: It seems from what you are saying that all of this came upon you in the last few months.

Sir Ron Garrick: That is the point that I am trying to make to you. I think you should understand that that is a very important part of the whole HBOS story. The reason why we joined up with Lloyds was to get some stability and confidence back. It was a business that we had looked at. For the parallel strategy for our wholesale funding requirements, we had looked at different possible strategic solutions throughout our life in HBOS that might have eased that need for the wholesale funding to be so high. One of the things we looked at was Lloyds TSB and a possible merger, and that was very attractive, but we did not go ahead with it-I put this into my statement-because it would have taken a year and a half to get through the Competition Commission. When the Government came along and said, "We are going to support UK banks through this liquidity problem. We will support you in that, but we want capital ratios to be strengthened, and the condition of support is that we will take capital in the bank." That was done on the basis that competition concerns were waived. Unfortunately for Lloyds TSB, or for the Lloyds Banking Group, Europe did not let them get away with it. One of the big pluses that the HBOS board saw in merging or being bought by the Lloyds Banking Group was that there were a lot of synergies to be made from that putting together-there were a lot of common parts to the business, Lloyds Banking Group had quite substantial deposits from customers and the two together looked quite attractive-but the putting together was predicated on the value that we would get from the synergies. Much of that must have been lost due to Europe.

Q875 David Quest: Can we stay for a moment on the question of the corporate loan book and how that must have affected Lloyds? We talked about the impairments in 2008, which I think were £6.7 billion.

Sir Ron Garrick: Yes. The third quarter of 2008.

Q876 David Quest: It was £6.7 billion in annual impairments.

Sir Ron Garrick: That was Lloyds’ figure, not ours.

Q877 David Quest: Yes, but there is no reason to think that it was not correct.

Sir Ron Garrick: There is no reason to think it was not pessimistic.

Q878 David Quest: But that was not the end of it, was it? In 2009 and 2010, there will have been substantial further impairments.

Sir Ron Garrick: I heard earlier this morning, listening to what you were saying to Charles Dunstone, that there were some substantial losses. In my statement, I made the point that there could have been a need for greater provisions in the £6.7 billion, but that, in my view, was because immediately after the credit crunch and after the Government came in to support, there was a deep recession, there were no gains from Europe and the recession was long. I think it is still going on, to an extent. There is not the same opportunity that there was during the first seven years. From 2002 to 2007, the opportunities were excellent.

Q879 David Quest: Leaving aside for the moment the question of the timing of provisions, let us look at the outcome of the loan book. We know that £6.7 billion was taken against it in 2008. We know that in 2009 and 2010, there were further, larger significant impairments. Similarly, there were very large impairments in 2008, 2009 and 2010 in the international book. The point I am making is that the outcome of the corporate and international loan books was that losses in the tens of billions were suffered. Do you accept that?

Sir Ron Garrick: I cannot accept that, because it is the first I have heard of it. I accept that you are telling me facts, but I do not know the rest of what was going on in that period, or whether it would have happened if the company had remained independent.

Q880 David Quest: Given that the impairments were taken at the end of 2008, and given the financial situation, it cannot come as a surprise to you that in subsequent years there were further impairments.

Sir Ron Garrick: It does not come as a surprise that there were further impairments. I think the economy was not in good shape.

Q881 David Quest: Clearly. If these figures are right-if it is right, as reported, that tens of billions of pounds of losses were suffered on this book going forward-those were losses at a level that HBOS could not have sustained without very significant further capital injections.

Sir Ron Garrick: I have to say that HBOS was part of Lloyds Banking Group by that time.

Q882 David Quest: And it was only because it was part of Lloyds Banking Group, and had the benefit of capital injections from Lloyds and the taxpayers, that it did not become insolvent.

Sir Ron Garrick: I cannot go as far as that, because I do not know the full extent of the issues you are putting in front of me. I am not surprised that there was a need for further impairments, but that was because the economic conditions from 2009 onwards were not easy-they were very difficult. But do not forget, also, that Lloyds bought that book at a huge discount.

Q883 David Quest: The point that we are trying to explore, and have been trying to explore with a number of witnesses, is that although a lot of people have talked about the funding crisis that befell HBOS, if these kinds of figure that one sees as losses in the corporate and international books are right-I understand your point that they are figures that you were not aware of until right at the end-HBOS had a solvency crisis, irrespective of questions of funding.

Sir Ron Garrick: I think it is a pretty big problem, but I do not know what Lloyds’ approach to that was. Was it the same approach that HBOS might have taken? I am not sure what the culture of Lloyds was. Did they write off loans as soon as there was a sign that there was something wrong-"Get rid of it, and let’s move on"? Did they write them off on the basis that they did not have the same culture as HBOS in trying to work through some of those problems? The number of them might have overwhelmed the resources that HBOS had, but I do not know how Lloyds approached the situation and how that would have compared with what HBOS might have done. But it is a serious problem, there is no question of that. By the sounds of things, the numbers you are talking about today are really small. The first time I heard those numbers, they were pretty shocking.

Q884 Chair: I want to come back to the point when, in 2008, you were told that impairments were necessary, and you were surprised. The question then is whether you should have been as surprised as you were. You also described the culture of BOS as conservative and cautious.

Sir Ron Garrick: It was what they kept telling us.

Q885 Chair: But listed in the final notice, there are a number of characteristics of this lending on the corporate side. One is that it was expanding very fast-although George Mitchell pointed out to us that it slowed in 2006, but then began to spin up again. Secondly, it became more reliant on corporate and commercial property. Thirdly, the lot size-the backing you were prepared to give to individual entrepreneurs-grew. There was a big increase in the number of people to whom you lent half a billion or more. It had a number of innovative but riskier features-equity shares and so on-and the credit rating of the people who were being lent to was weaker than in other banks. In other words, if you looked at this book, I cannot see how you could describe it as cautious.

Sir Ron Garrick: The final notice that was issued made it quite clear that the board was being told by corporate that it was continuing to take a cautious view of life and that it had always done so. It was not making lending decisions that were any riskier than before.

In my submission, I told you about the first five years of HBOS. There were benign economic conditions-no question-but the results were quite excellent. They put the two companies together and, after year 5, had doubled the profitability and increased the size of the loan book. But that was why the merger happened in the first place. That opportunity was available to us, because we were starting from quite a small base compared with the big four banks.

Q886 Chair: But you could always expand by taking on more risk. Someone who ends the year with a surplus but has not paid the insurance premium looks good, but when the following year comes, he rather regrets that he has not paid the insurance premium, which could take one of two forms: strengthening capital or strengthening liquidity. The good results of ’05-’06 were quite consistent with a number of warning signals coming out, which would be the increasingly risky nature. Within total corporate lending, commercial property was a growing proportion. We see statements in various papers and minutes of other banks beginning to withdraw from this, and the corporate side of HBOS pressed on.

Sir Ron Garrick: In a similar fashion to what it had done very successfully before, corporate and commercial property, in the Bank of Scotland, was a big number in the book. I think the FSA, in its first review of HBOS, took exception to the corporate and commercial property percentage as a total of the book; I think it was 32% or 33%. Taking the example of what you were talking about, corporate responded quite vigorously to that challenge and explained in some detail the conditions for going into commercial property. They were not into speculative office buildings in the centre of London, Manchester or wherever. They tended to support developments when there were a lot of pre-lets such as shopping centres for the big retailers.

Q887 Chair: There was also a lot of backing of entrepreneurs, which you took pride in.

Sir Ron Garrick: They had had great success with that strategy in the past. I said in my statement that, in my early days with HBOS, I made the point to George Mitchell that some huge numbers were being lent to individuals and what was that all about. He arranged for me to meet the managers who had been responsible for putting these loans in place. I found after two hours with these people, who were at the sharp end of doing the business, that the case looked extremely good. Maybe I picked the wrong two, but the two in question had a multiple number of businesses. The entrepreneur owned the corporate and the businesses were of a disparate nature. They covered all sorts of sectors. The covenants on the loans in terms of assets of those businesses all stacked up. You could not criticise those two that I looked at as being all that risky. In fact, they were much more secure than I thought they might be.

It is the same with commercial property. They argued strongly that they had chosen the property very carefully. They had only done deals that had a good chance-pre-lets-where you were going to get a rental stream and so on. If you go through these, there were unquestionably a lot of transactions going on where there were buy-outs of businesses: the KKRs, the Blackstones; they were buying businesses and putting in a management team, with a small amount of equity and a big amount of debt. HBOS supported some of these people. Some of these equities were part of an equity taken by some of these big funds that were having major successes in making industry more competitive and making business better, and really they got some superb returns.

Q888 Chair: But all this success depended on the extrapolation of the growth in the value of commercial property.

Sir Ron Garrick: It was always the biggest single item in the HBOS fund.

Q889 Chair: If you were looking at previous histories, you would know that the over-extension of commercial property has been at the heart of virtually every banking crisis we have had.

Sir Ron Garrick: I think there was a commercial property crisis in the early ’90s. Bank of Scotland did not suffer very much in that crisis. The claim they made was that that was because they chose the right ones. In fact, there were some discussions about Basel II and qualifying your business so that it complied with Basel II and so on. One of the problems we had in writing the models for corporate was that there was not a huge history of impairment losses. If you don’t have a huge history of impairment losses, it is difficult to write the model for the next crisis. That is the sort of banker we are talking about.

Q890 Chair: What you are saying is that you did not have a previous history. By the time you get to the 2000s, BOS is not operating exclusively in Scotland. It is operating on a much larger scale and a much wider geography, and then its sister company-International-goes into Ireland and ends up losing £14 billion.

Sir Ron Garrick: We could get into the Irish story if you want to. It was an absolute disaster. Remember the Celtic Tiger. All the Irishmen over the world were going back to work in Ireland, and suddenly they get a liquidity crisis and it killed it. The lending in Ireland was huge.

Q891 Chair: I do not think it was a liquidity crisis in Ireland. It was a solvency crisis. It was a classic property boom, and BOS found itself right at the centre of it. It was one of the largest lenders into this crisis.

Sir Ron Garrick: I cannot comment on that. The Irish advances, I think, were about £22 billion or £23 billion. I do not know what the rest of Ireland was doing.

Q892 Chair: Can we come to an impression? When the two companies were brought together, the BOS people largely carried on doing what they were doing, and the Halifax people largely did what they were doing. You then end up with a very federal, decentralised structure. These divisions were very powerful relative to the centre. The amount of scrutiny that the BOS side of the business applied to retail and the retail business applied to BOS was actually quite limited. Would that be fair?

Sir Ron Garrick: I do not think I get that impression. I think the chief executives of the business and the finance director-strong intellects and very capable people-were, I believe, treating each division as a business in its own right, yes, but giving the same amount of attention and challenge to each division.

Q893 Chair: Of those three-the two CEOs and the finance director-none of them had a corporate banking, commercial property background.

Sir Ron Garrick: No, I think James Crosby had quite an exposure to financial service companies. He had been an investment manager. He had looked at dozens of companies’ strategies over the years and then moved into Halifax some time in the 1990s, where he built up a most successful bank assurance business, as I understand it. I always considered him to be very capable on all financial sector issues, with very good judgment, and he would not have been afraid to challenge corporate because he was coming more from a retail background. He had a very strong intellect.

Q894 Chair: He was relying on undoubted intellect rather than hands-on experience of corporate banking.

Sir Ron Garrick: Indeed, yes, but having been with Halifax and Bank of Scotland for maybe 10 years in his career, that is quite a big chunk of experience.

Q895 Chair: Before I hand back to David Quest, can I come back to the question of the FSA? They approached you pretty aggressively in December 2003 and you responded vigorously. You were in some sense pushing back at them saying, "You are treating this as unfair." There is then a section 166 special persons investigation, but by the time of summer 2004 your positions seem to have been reconciled. They leave you with a work programme, as they always do-a risk-management plan-but they are not continuing to press you.

Then there is a very interesting piece in your evidence where you say you were surprised at the hostile nature-the critical nature-of the comments they made in the final notice. You were saying that had you been aware at the time of how poorly they thought of your risk-management procedures, the board would have responded. Where do you think the state of your relationship with the FSA had got to by, say, 2006? You had this first spat with them and there was an exchange of quite aggressive correspondence on both sides, and then you appeared to sort it out. By 2006, which is the start of what is described as the "relevant period" for the final notice, the FSA is coming back with some pretty fierce criticisms. What was going on?

Sir Ron Garrick: I always thought that the relationship that HBOS had with the FSA was quite a constructive relationship. It was a good working relationship. There were strong opinions on both sides, but at the end of those visits by the FSA there would be a report that would say, "Yes, it’s agreed, the actions that are required are as follows and they’ll be completed by this date", and the FSA said, "Yes, and we’ll be following up to make sure you do."

The school report from the FSA was always, "Could do better"; there was always something in there that could have been better. But the way in which it was approached was two senior people-up to quite senior level in both companies-sitting down and saying, "Yep, okay, we’ll accept that, we’ll accept that", or "We’ll do this by a certain time." It gave a non-executive director in HBOS a lot of comfort that here was the regulator, who is not there to run our business in terms of risk but who is there to say, "That’s not very good, that could be better", because they are looking at other banks presumably and they are seeing all the things that they can see.

I put this piece into my statement about the 2012 report a bit more in sorrow than in anger, because I’ve got no way in which I can challenge the FSA report in terms of the amount of digging that they must have done to produce the report. But what I can challenge is that what they were telling me about in that 2012 report was not the company that I was working with. That was not what I understood to be going on in that company. So I started to look for, "How could this be? What could the solution to that be?" And I have put a scenario in here that I think might explain part of it.

Your question was about the relationship with the FSA. I thought it was a good working relationship. I think it was not in any way a fall-out all the time. There was consensus on what needed to be done and there was always something that needed to be done. It was a good relationship.

Q896 Chair: You say, "I have given much consideration to how the conflicting statements of the company could be reconciled." Just go over again how you think you can explain this discrepancy in a good working relationship with them, accepting that they left you things that you need to do and improve, but you are not in "special measures", so to speak-that is how I would explain it.

Sir Ron Garrick: Absolutely right. I am taking comfort from what happened in the past with the s166 report. An outside firm of chartered accountants came in, looked at our systems and said they were fit for purpose. That, to me, was again giving comfort to non-execs on the HBOS board.

I think what I am saying in this statement is, first of all, the FSA in their reports state quite clearly that what corporate were doing was not what they were telling the board they were doing. I am then faced with a situation where I say to myself, "Well, was there someone not being exactly truthful with the board, or was there someone keeping information back from the board?" And I don’t think that was the culture in HBOS. I think it was a transparent business. People were encouraged to tell it as it was and they did, I think. That is the conflict-on the one hand, what we were being told, and what the FSA tell me in 2012 are totally opposed to each other.

I spent quite a lot of time on the annual report and accounts, and I looked at the growth in the corporate loan book from 2006 to 2008. Some significant events took place in that period. The first thing that happened was that in August 2007-the FSA report also tells us this-the syndication market closed. That was the market where banks, with each other, split a loan up. If we gave a £100 million advance to someone, we might go with one other bank or two other banks and split the loan in two or in three. That market closed. Let me just carry on with that. The other thing you should understand about the corporate book was that there was a huge amount of churn in that book. About 30% of the book every year moved out of the book. That was partly due to the fact that we were selling investments, but it was also partly due to the fact that people redeemed their loans or they did not need them any more or whatever, but 30% moved out of the book. To keep the book standing still, you had to have acquired a lot of origination of loans. Corporate were well used to having a team that were out for business and bringing in a lot of business every year, because they were replacing 30% churn.

Come the second half of 2007, after the sub-prime thing hit the wholesale funding market, and a number of other factors started to make the economic situation more difficult, there was a lack of buyers for the investments. People started to say, "I don’t know if I want to do that just now, because I can’t get funding" or whatever, so you have a double whammy on your loan book. You cannot sell it down with the business you take, and you cannot sell the 30% churn. The only conclusion you come to is that if both of these events occur at the same time, the loan book must be growing.

Q897 Chair: So the gross lending may not be increasing very fast, but net lending-not by design, but by accident-ends up with the size of the loan book increasing, and of course you cannot sell it down, not because you have lent more money to customers-

Sir Ron Garrick: The other thing you have done in previous years is that if people wanted £200 million for a project of some kind, you granted them that facility. They do not pull it all down on the first day of the facility. If they come back to us in the third quarter of 2007 and say, "I want to take £50 million more of that loan", you cannot say no.

Q898 Chair: You made what was quite a serious charge, which was that corporate were not telling the board.

Sir Ron Garrick: I don’t believe that to be the case, if what was being said in the FSA final notice is correct.

Q899 Chair: There is a difference between saying, "In our plan we are going to lend 9%", and then coming back and saying, "Because we weren’t able to sell down, it’s turned out at 22%". Which is it? They are giving you the right information, but they are just telling you the bad news, so to speak, or they had a plan to lend 9%, but actually, without telling the board, went out and lent more.

Sir Ron Garrick: No, the board saw every month the amount that was in the loan book. They would see from the statistics, which were given to the board, what the loan book at corporate was. That information has to come out. What puzzled me with the FSA final notice was that they were saying this was just reckless lending and that no one was dishonest and lacked integrity. They said that.

Q900 Chair: This was because they could not sell down. The only way it could be reckless is if, in a different sense, they were over-reliant or over-optimistic about their ability to sell down.

Sir Ron Garrick: Or it stopped. The FSA tells you that in the report. It stopped. The date was something like August 2007. The syndication stopped.

Q901 Chair: But BOS in the end accepted the final notice.

Sir Ron Garrick: I cannot challenge that, because I do not have the information about what the FSA did. I do not know who they spoke to. I do not know whether they interviewed any of the HBOS directors at the time. They must have had a huge amount of discussion and debate with Peter Cummings himself.

Q902 Chair: It looks to me as though the real charge is not that lending accelerated, because that was an unplanned acceleration. It comes back to all these special features about the nature of corporate’s lending and its growing, rather than declining, reliance on corporate property, the backing of entrepreneurs-many of them in Ireland-

Sir Ron Garrick: Corporate had nothing to do with Ireland. That was Bank of Scotland (Ireland). On the other things, you are absolutely right.

Q903 David Quest: Reading the FSA notice, it seems to me that the main thing they are saying is that given the positioning of the corporate loan book, the planned rates of growth in 2006 and 2007 were excessive. Indeed, we had some evidence from George Mitchell the other day, and he also said that in his view the rates of growth in those years were greater than he would have expected. Do you accept that criticism? Did you know that that was the rate at which the book was increasing?

Sir Ron Garrick: From my examination of the annual report and accounts, the corporate loan book was kind of flat in the first half of 2007. It did not move much at all. In the second half of that year, it went up by something like £13.5 billion. That is what I have been saying to you. That is when the syndication stopped and it became impossible-the churn stopped in the loan book as well.

Q904 David Quest: There is a bit more to it than that. If you look at the final notice-tab E13 in the big file-planned lending growth was 6.4% for 2006 and 9% for 2007. In fact, what was achieved in 2007 was much greater, at 22%. That increase on the 9% may well be down to difficulties with syndication, but the point that the FSA makes is that even to plan growth of 9% in 2007 was excessive.

Sir Ron Garrick: You have not said to me, "What did HBOS do wrong?" I have been singing the praises about how good they were in the first five years and saying how it was a wonderful board to sit on and that I enjoyed the people, the intellect and everything. It was the best board that I had ever been on, so what went wrong? We did not call the crisis. The first indication we had was in 2006 or 2007 when there was some impairment. The first indication of some issues was the fair value adjustments in treasury’s book in one of those years-I think it was 2007. I keep asking myself what we might have done differently given the circumstances, and taking the benefit of hindsight. There is an argument that says that, as a board, we should probably have taken a much more cautious approach at the first sign of the situation getting a bit tighter in the wholesale market. The freezing of the markets took place in 2007, but I think the sub-prime mortgages, which caused most of this, were a bit earlier than that, so there were issues in the wholesale market at that time. The view that was taken for quite a bit of time was that this must sort itself out; that this cannot get into a situation where it is a crisis that is going to bring down the whole global banking system-it will be sorted out. We were thinking that it was not looking great, but it would not be as bad as it became. In that respect, the board misjudged the depth of the crisis that was coming. In mitigation, we would say that we were not alone in that; there were many-

Q905 Chair: But where you were distinctive right from day one-you probably heard this in the earlier session-was that the reliance on wholesale funding was indentified as a problem.

Sir Ron Garrick: Yes. It was given a huge amount of attention from the first business plan.

Q906 Chair: But as various witnesses have said, yes, there was a huge amount of attention, in particular by extending the maturity of this wholesale funding, but the wholesale funding gap was going up so fast that you were in effect running to stand still. You got some more longer term wholesale funding, but were still very heavily dependent. In effect, you used the benefit of that extra wholesale funding to carry on with this higher rate of lending. There does not seem to be much of a feedback loop from treasury saying, "I told you in 2001 or 2002 that we had this problem, and we’ve still got it here in 2003." It goes on. This whole problem of the wholesale funding gap is that people got these warnings, but did not really act on them vigorously enough. In the end, it proved to be exactly as people expressed at the time- that this was going to be the key vulnerability, and indeed it was.

Sir Ron Garrick: I would like to correct you on something you said. In the first five year plan we looked at, one of the biggest risks to the plan was wholesale funding. As a result of that being recognised as one of the risks-that is why I am saying that as well as growing the book, we were thinking of what the risks were too-treasury was a regular attendee at HBOS board meetings, particularly at the budget time, and rather than treasury saying to us, "This is a problem", treasury, for the first seven years of HBOS, were saying, "We can cope with this. The market is good for securitisations." They came up with some new products called "covered bonds", which were also a source of finance. At each budget meeting, treasury said, "Yes, the market for securitisation is still good. The market for covered bonds is improving", and so on and so forth, "and we can fund this plan." If treasury had ever come along and said, "We can’t fund the plan," we would have had to stop what we were doing immediately.

There was a lot of attention given to wholesale funding. When I look back on the situation, if we had taken a decision in early 2006 to reduce the wholesale funding, we would have had to take steps to reduce-the biggest user of funding was the retail division, which was twice the size of corporate. The easiest way, without spooking the market, to reduce that book would have been to reduce the mortgage book. I was of the view that an average mortgage was four years-I think Charles Dunstone this morning told you it was three years by the time he left, and he will be more up to date because he was more involved with retail than me. A lot of the mortgages came through intermediaries, and it would not have appeared to the marketplace as if we were saying, "We’re out of mortgages." That would have spooked the market I am sure. No one talked about doing it, but the fact was that would have been the easiest way.

Q907 Chair: You are talking about 2006, are you?

Sir Ron Garrick: I am talking really into 2007. The point I was making about 2006 was that if we had waited until the middle of 2007 to try to accomplish that strategy, we would not have been able to do it. The die was cast. We could not sell investments, our treasury funds became illiquid and we were not getting syndication.

Q908 Chair: That is all the more reason never to have got into that position.

Sir Ron Garrick: That is what I was trying to say to you. If we had taken a decision in 2006 there was a chance that we might have avoided some of the problems we had.

Q909 Chair: What I am saying is that warning signals were indeed there. The business plan for 2006 to 2010, "Targeted Growth", E12, stated on page 28: "We are not entirely comfortable, at this point in the cycle, that asset growth is significantly faster than deposit growth". It is an example of the warnings that came year by year from the Treasury side, and no one really responded with urgency to it. Indeed, it turned out to be the crucial element. By this stage, elsewhere in the papers-I am not sure where-it is quite clear that HBOS’s dependence on this market was bigger than that of all the other banks put together. That should have been quite a warning sign that you were adopting a model that had a risk element in it. As you illustrated for us earlier, once that went wrong, it triggered a whole series of other things and you found yourself in a downward spiral.

Sir Ron Garrick: Let me try to respond to the points you have made. The comment on page 28, reading it for the first time-well, I obviously read it in 2006, but reading it again-does that not demonstrate to you that we were looking at the risks?

Q910 Chair: Looking at the risks, but not responding adequately to them.

Sir Ron Garrick: Well, it then goes on to say: "A key challenge in 2006 is thus to reverse this trend". I am pretty certain that if I go through this plan and take it page by page, I will find emanating from it a list of actions that are required, which would presumably focus in on what we saw as a considerable risk.

As part of the transparency I was talking about, this was the sort of information that the board got. The board said, "What are we doing about it?" and the management team said, "We are doing this, this, this and this." Okay, I can guess that answer would have been, "We are growing deposits," which the business plan mentions here: "More deposit growth in our International businesses." The management team might have said, "We are going to grow deposits and we are going to stop buying back shares," or something like that. Buying back shares, as we were because we had the capital adequacy to do that, was another fault we should never have got into. We should never have been buying back shares at any period, given the situation; I will hold my hand up and say that we should not have been doing that.

But that, to me, is constructively looking at the risk situation we have in this plan. If you look at that plan, it was targeted growth. In the outlook for that year, a cautious stance was taken on-the way it was worded in the outlook statement was that we thought that certain parts of corporate could not go on growing at the rate they were growing at. That was because they had taken a dislike to some of the business that was out there. On the front page of the plan, the title for the year was "Targeted Growth", because we were actually changing the emphasis to areas that we thought were more likely to produce good returns and not give us problems. In doing that, we came up with a situation in which they identified this wholesale funding. It came up every year, and the actions we were taking to try to improve it included actions by the management.

Q911 Chair: I think we started this part of the conversation because you yourself were beginning to identify where you had missed a turning in the road. I thought I was trying to illustrate the point for you, but now, because I have put it to you, you are contesting it.

Sir Ron Garrick: Well, I didn’t realise that. If you were trying to do that to support my stance earlier, I think I agreed with that. To call that in 2006 was extremely difficult. Even the FSA have admitted that it was not reasonably foreseen-

Q912 Chair: Do you happen to recall whether there was a second ARROW review in 2006?

Sir Ron Garrick: I mention in my statement that I think there was an ARROW review in 2007 and 2008. I do not have any information that tells me what that ARROW review said. The point I was making, though, was that the report that we get in 2012 is just horrible reading for anyone who was involved in HBOS. They couldn’t have been saying those things to us in 2007 and 2008, because if they had we would have been taking action.

Q913 Chair: This is a crucial point in the story, which we will need to dig into further. Another example of warning signs is at tab E2, in section 12. It is the minutes to an executive committee away day-presumably they held that meeting before you had the whole board away day. You need to find the section entitled "Funding", which is section 12. This is late 2006, and there is this phrase at the bottom: "HBOS had the highest wholesale funding need of any of the UK banks (and was close to the other Big Four banks combined)." That is quite a strong warning. It may be that, by the time it gets to the board, it isn’t portrayed with quite that urgency, but this was surely a warning sign-

Sir Ron Garrick: Can I just have a chance to read this?

Chair: Yes. If you go over the page to the paragraph marked "Timing"-

Sir Ron Garrick: Well, the paragraph does go over the page, and I am just wondering what it goes on to say.

Q914 Chair: Look towards the second half of the paragraph beginning with "Timing" in bold, where it says: "In the longer term, the position was untenable and unsustainable". The executive group at least was receiving warnings that Lindsay Mackay was getting worried about this. But you don’t remember the board ever-

Sir Ron Garrick: Let me just read it. The last sentence says that "the Group had benefited in this respect in recent years by decisions made (for other reasons) to reduce the rate of asset growth." The language over the page is quite strong, I have to admit, and I would not be sure whether it went to the board. I am not trying to dodge the question, but I just do not know. There would be a funding section in the plan that went to the board, and whether or not this was part of the same wording, I think the board would have said, "Well, what do we do about it?" Presumably it was not left in a position whereby in 2009 we knew that we were going to have difficulties funding the plan. I think that would not have been acceptable.

Is this the same targeted-growth plan that we were looking at earlier?

David Quest: The plan we were looking at earlier was the 2006-2010 plan.

Sir Ron Garrick: We were looking earlier at 2006. Was it E-something?

David Quest: It was E12.

Sir Ron Garrick: Let’s just have a look at what it says about funding in there. Is this the same year?

Q915 David Quest: Well, the 2006-2010 plan would have been prepared at the end of 2005, and the document we are looking at is at the end of 2006. So the document we are looking at is a year after the preparation of that plan.

Sir Ron Garrick: This was not the plan itself; this was the away day when the executives were looking at the issues so they could build how to handle them into the plan.

Q916 Chair: So what you are saying is that we should look at the 2007-2011 plan to see whether Lindsay Mackay’s greater urgency of language has got into it?

Sir Ron Garrick: Yes, I am sure Lindsay Mackay did not write that. The minute taker wrote that, but I am sure Lindsay Mackay said it if the minute taker had it down. I think it would be necessary to look at that plan to see what the outcome was.

Q917 David Quest: I want to pick up on one point from your statement, going back to the question of how one can reconcile the FSA notice with what you say was your understanding of the position. If you look at page 7 of your submission, you say in the third paragraph: "With the benefit of hindsight, Corporate was probably running the business in a similar manner to that which had been successful since the formation of HBOS. Strong loan origination was a feature of that model". Why do you say that is with the benefit of hindsight? As I understand it, it was understood by everyone-indeed, it was part of the plan-that corporate would continue to follow the strategy that had been successful in previous years.

Sir Ron Garrick: I am not sure I understand the question.

Q918 David Quest: When you say "Corporate was probably running the business in a similar manner to that which had been successful since the formation of HBOS," you say that that is with the benefit of hindsight. But, presumably, the board was aware at the time of what strategy was being followed by corporate. That is not a question of hindsight, is it?

Sir Ron Garrick: I think the point I was trying to convey was that, to account for the difference in opinion between the FSA and what I thought the company was doing and what the board thought the company was doing, the only conclusion I could come to that made any sense was what I put here. I am just wondering why I put in "with the benefit of hindsight."

Q919 Chair: It is not for me to tell you what you wrote, but "with the benefit of hindsight" covers the whole paragraph, and really the hindsight comes right at the end. That is how I read it, any way.

Sir Ron Garrick: Thank you for that, Chair.

Q920 David Quest: The point I am trying to clarify is whether, as I think you have already said, the way corporate was approaching lending and the strategy it adopted was transparent to the board.

Sir Ron Garrick: I believe that to be the case, yes.

Q921 David Quest: And the growth rates, or at least the planned growth rates, that we saw in the FSA notice were, again, growth rates that no one challenged. People were happy with those growth rates.

Sir Ron Garrick: Risks were identified, so there were challenges on the risks as to what we were doing. I do not think we were saying-or that no one ever said-stop the growth.

Q922 David Quest: There was no serious pressure to reduce it.

Sir Ron Garrick: No, because in the first five years of HBOS it had been necessary. We set out to be customer champions, and that meant that we introduced a lot of competition-more so in retail than in corporate. In corporate, we set out to work with individuals, and work with the entrepreneurs you talked about, to do things better than we had done them before, but it was a similar path to the one we had been on.

The fact that we grew the business so well we were pleased with, because that was really the basis on which the merger was put together-that we could grow this business. We were starting from quite a low base, because corporate was strong in Scotland, but it was not really strong across the UK and was at nothing, really, internationally.

We were proud of the achievements we made in the first five years. Perhaps, these achievements got us used to the fact that we could grow this business because we were competitive. We were taking market share from others, and we were doing that because we were offering the customer a better proposition, and we made banking much more competitive as a result. We were the first people to offer interest on current accounts. There were all sorts of other areas in which we were offering better products, and we did that because we felt that the time had gone when people were going to have one bank for life, or to have one insurance broker or one insurance company for life.

It was a time of change, and it was a time of opportunity. We saw us taking that opportunity, and we were getting the rewards for taking that opportunity in the growth that we were seeing for the business.

Q923 David Quest: Looking back on it, and looking back certainly at what happened to corporate, do you think that the fact that corporate happened to do very well from the previous recession bred a sense of what proved to be the unjustified optimism that they had some special skill?

Sir Ron Garrick: I think we were probably optimistic rather than pessimistic, but even the pessimists never forecasted the extent to which the liquidity crisis would strike and the impact it would have. The collapse of Lehman-the biggest bankruptcy ever-in September 2008 really was disastrous for a whole stack of things and a whole stack of people. We were one of them. We were on the beach when the tsunami came in; we were not on high ground.

Q924 Chair: I want your view on a question I put to Sir Charles on the culture. Was investment banking a part of this or was it something different? The FSA refers to a culture of optimism. Is that valid, do you think?

Sir Ron Garrick: I think we tended to be optimistic when we should have been a bit more pessimistic, yes. Does that answer your question?

Q925 Chair: Do you think that that new force in banking could have become a bit "new kid on the block" almost-that you were a bit over-confident?

Sir Ron Garrick: Yes. I think some of the advertisements we ran in Ireland and in Australia, where we considered that the market was ready for the same sort of approach that we had adopted in the UK in those particular markets, were "new kid on the block" and about the bankers having been ripping you off for years. I would say that was a bit aggressive.

I would admit to aggression on that, but we were offering products which were tailor-made for customers. We spent a lot of time on what was called the customer contract. We wanted to be the bank that gave the customer a clear, easily understood contract with us. That was a major project that was running from about 2003 to 2005. We were not doing too well because it tied in with treating customers fairly, which was a project run by the FSA to improve transparency between bank and customers. We were falling a bit short in some of the requirements of TCF, as the FSA calls it, but we were attempting, during the early part of the life of HBOS, to get a customer contract in place that would take away all the uncertainty of the mis-selling. We recognised that people were not going to have the same banker or insurance broker for life. They were demanding better value and more transparency and we were trying to provide it.

Q926 Chair: The final question is about shareholders. I am struck by the fact that in 2003 you had a rights issue, which shareholders grumbled about.

Sir Ron Garrick: We often got complaints that our capital ratios were fine. We did not need more capital. That was the attitude of the shareholder. As you well know, you have a rights issue-

Q927 Chair: But history tells you that you were absolutely right to seek more capital.

Sir Ron Garrick: Thank you very much, yes. It was part of the exercise. We did it, but it was not popular.

Q928 Chair: There are other reports. The Kay report talked about investors. That is an example of where they wanted the growth but were not prepared to put up the capital to support it.

Sir Ron Garrick: You mentioned-this is nothing to do with HBOS-the separation in your ongoing Committee. When I got involved in this, I started looking at the TV to see what you were doing and what it was all about. I saw the interview between Mr Haldane and the full Committee, and I thought what a wonderful non-exec he would have made at HBOS-presumably there would have been conflicts of interest. The thought struck me that separating the functions within a bank would be very difficult, but if you had six Mr Haldanes sitting on the main banks of the UK as a Government-appointed figure, although perhaps not as a director-

Q929 Chair: This is not strictly about HBOS, but the plan that the Government are proceeding with is a ring-fencing plan. It is not a Volcker separation plan. How far would you take this? Are there any activities in the HBOS group that you feel should not belong in the HBOS group, even in the non-ring-fenced subsidiary?

Sir Ron Garrick: I think it is quite difficult to control a corporate division, or a retail division, because they will go where they see opportunity. You could find that some of the things that corporate started to do are more like investment banking. How do you stop that? I do not think that you can if it is ring-fenced.

Q930 Chair: One of the things is that you apply a greater risk weighting, so that kind of activity looks less profitable.

Sir Ron Garrick: Anyway I am verging in to territory that has nothing to do with me.

Chair: You are. Thank you for your evidence. We are piecing together the bits of the story, and you have been very helpful to us, so thank you.