Banking Standards

Submission from Lloyds Banking Group (S039)


The global banking industry’s role in the financial crisis and the subsequent support provided by central banks and governments, together with historic remuneration structures have contributed to the mistrust that people now have in our industry. More recent issues such as mis-selling of PPI policies, SME derivatives, the alleged manipulation of LIBOR, money-laundering accusations and "rogue state" financing have only compounded the problem. Trust has broken down, not only in banks but also in bankers.

A number of these ills were caused by an obsession with financial success and an over-riding fixation on short-term performance, driven by investors ratcheting up required returns, the "war for talent" driving up expected individual returns (i.e. pay and bonuses) and the regulators relying on the market. Customer outcomes and financial soundness arguably took second place. As a consequence, Boards and Executive Management in a significant number of banks, to a greater or lesser degree, failed.

One of our principal challenges is to restore trust - the trust of our customers, shareholders, policymakers and regulators. Trust goes to the heart of what banking is about. Customers need to be able to trust their bank to look after their savings. They need to trust their bank to manage their financial transactions smoothly; trust that their bank will be diligent and not provide levels of credit or mortgage that are more than the customer can re-pay; and trust their bank to provide products that genuinely meet the customer’s needs and which the customer can understand. In commercial banking, sound businesses need to know that their bank will be with them through difficult as well as good times and will not suddenly change terms or withdraw support. At the start of this year, Lloyds Banking Group ("Lloyds") set out a public target to make at least £12bn of gross lending available to SMEs, since increased to £13bn; in terms of net lending, Lloyds has increased lending by 4% whilst the market has reduced by the same amount.

As an industry, we need to re-earn the trust of policy-makers and regulators too. Good legislation can provide the framework for safe and stable banks. Regulation can punish wrong-doing or negligence. However, regulation should be a back-stop not a substitute for trust. In the absence of that trust, banks do not function effectively, undermining the vital role they play in the economy.

The introduction of ring-fencing has the potential, if carefully executed in the legislation, to help rebuild consumer trust in the banking sector and more clearly separate the different cultures of retail/commercial and investment banking. Investment banking has a different business model and culture as it is done deal by deal; retail and commercial banking is about the processes and procedures that see many thousands of individual transactions conducted daily to the satisfaction of the millions of customers who bank with them. The latter must be much more ordered and regimented to ensure that each of those thousands of transactions is conducted efficiently to rules and levels of risk that customers should be able to take for granted. Lloyds has focused hard on reducing customer complaints and their causes. Complaints have fallen by 42% over the last two years (excluding PP I ) .

Banks are not faceless institutions. We are collections of people who make decisions and act as the ambassadors in our daily interaction with customers and other stakeholders. The tone and example needs to come from the top - having leaders with the highest integrity and values, who think and act for the long-term and with proper incentives.

We know, having talked with our customers and other stakeholders, that it will only be through an unswerving determination to 'do the right thing' and a fundamental commitment to anchor our business in activities which support the broader economy and contribute to prosperity, that we can address and rebuild that trust.

We have to make things right, especially for legacy issues such as Payment Protection Insurance (PPI), where Lloyds was the first bank to break ranks and provide certainty for customers by offering compensation to those who were mis-sold. That was the right decision to rebuild trust, driven by a desire to embed a more customer-centric culture where we do the right things. Also part of our journey is a focus on a clearer and simpler range of products, our pledge to retain the number of branches and not to close a branch if it is the last one in a community.

We want Lloyds and its individual businesses to be a source of pride for our employees. We can only do that through having the trust of our customers and the wider public. Commitment from all colleagues to personal integrity and professionalism is a key part of making Lloyds a trusted, contributing corporate member of society, and we are taking steps to reinforce this across all of our business.

Throughout the bank, we are taking the necessary steps to ensure that colleagues are well trained, uphold the highest ethical standards in the way they behave and are appropriately incentivised.

Restoring trust to the levels we want and expect will take time and effort - but we have to undertake it. In the absence of trust, banks do not function effectively, undermining the vital role they play in the economy. This is critical as the future of the banks and the economy are inextricably linked; there are no strong economies without healthy banks and healthy banks require sound and strong economies.

Lloyds is different to other UK banks, being focused on UK retail and SME customers. Being a successful and responsible business, and the largest retail and commercial bank in the UK, means that we are able to benefit society and help Britain prosper.


1. To what extent are professional standards in UK banking absent or defective?

Standards ultimately depend on the culture and values within which individuals work. With hindsight, it is clear that the culture of banking in recent years failed to consistently reinforce the right behaviours. While long term profitability should go hand in hand with dedication to customer service, in some areas of both investment and retail banking, the culture shifted too far towards pursuing short term profit at the expense of doing the right thing for customers.

Trust has broken down, not only in the banks but in bankers. Fixing that requires a shift in the tone from the top - a shift in values and culture. Standards of integrity cannot really be regulated; rather they are set by individuals and businesses and are more evident in action than in words.

Lloyds has recognised this and has set out to embed new values and culture throughout the organisation - we are enhancing the standards of integrity which our colleagues work to across our business. Across Lloyds, we are embedding enhanced standards of integrity, from the Board to the bank counter. These standards are built around new corporate values introduced in early 2012 (putting customers first; keeping things simple and making a difference together).

Over the last 18 months, Lloyds has developed its Codes of Conduct with support from the Institute of Business Ethics - the Code of Business Responsibility and the Code of Personal Responsibility. These Codes, based on our corporate values, underpin the way we do business as a Group, set out the behaviours that we all want to be known for and set stakeholder expectations.  The Codes are built around five pillars of responsible business and underpin our Ethics Policy:

· We put customers at the heart of our business.

· We aim to be a great company to work for.

· We work responsibly with our external stakeholders.

· We invest in communities to help them prosper and grow.

· We work to continually reduce our environmental impact.

We are also committed to high professional and accreditation standards as detailed below:

i) Professional Standards (externally codified criteria for professionals to follow during the course of doing business or providing a service, usually set by a regulator or a professional body)

Individuals as well as banks are already regulated, which reinforces individual accountability:

· The FSA’s regulation introduced an 'approved persons' regime for particular roles, notably senior management (such as CEOs, Compliance Officers, Money Laundering Reporting Officers) and certain customer-facing roles. This regime requires approved persons to adhere to Seven Statements of Principle. Approval is subject to assessment of 'fitness and propriety’ by the FSA.

· The FSA’s Principles for Businesses set overarching requirements for all financial services firms, including requirements to conduct business with integrity, due skill, care and diligence.

Since 2001, the scope of the FSA's regime and criteria for approval has been broadened, for example through the Retail Distribution Review (RDR) and the Mortgage Market Review (MMR). There is, increasingly, an ethical element incorporated in the FSA's approach, which is welcomed. 

ii) Accreditation Standards (passing examinations and technical skills training)

Lloyds has a strong take-up of accreditation standards. The Retail Community Bank has launched the FSA recognised Certificate in Retail Conduct of Business (Cert RBCB), helping colleagues to become more expert in banking and customer service. Available to bank managers from June 2012, the offering is being extended to other colleagues shortly. The Wholesale business has achieved accreditation of its credit training through the Chartered Banker Institute. Group Operations has achieved similar accreditation for training it provides to colleagues.

Depending on their specialism, employees may wish or need to affiliate with a professional body (e.g. ACCA) which has tailored standards that their members need to adhere. These often require attainment of particular level of competence, adherence to ethical probity and ongoing professional development.

There is no single accreditation standard in UK banking. This is being addressed through the Chartered Banker Professional Standards Board and the introduction of the Foundation Standard for Professional Bankers, which is being implemented in banks, such as Lloyds, that have signed its Code of Professional Conduct.

How does this compare to (a) other leading markets?

Lloyds is primarily a retail and commercial bank. We focus on (and champion) UK customers and business. However, these issues may be present in other leading markets, but we would defer to those more expert on those markets to give a view.

How does this compare to (b) other professions?

Professions apply to areas of work where there are multiple individuals who stand or fall by their own reputation - like medicine or the law; thus there are guilds or professional bodies that ensure basic standards.

B anking is a h ybrid of corporate and professionals ( including lawyers, finance, HR, auditors, accountants as well as client facing / relationship bankers), we look at standards that underpin the professions when considering the characteristics we want to underpin our activities – technical competence, continuous learning (or Continued Professional Development (CPD)), judgement, integrity and a commitment to maintain the stature and standing of the bank.

How does this compare to (c) the historic experience of the UK and its place in global markets?

The UK has enjoyed a strong reputation as a financial centre, driven by perceptions of high standards and regulation. London, for example, topped the Global Financial Centres Index in 2012.

It is clear that appropriate regulation, high professional qualifications and standards of integrity drive sustainable, long term development. Regarding regulation, the FSA has implemented detailed conduct of business requirements on all authorised firms since 2001; expanded in 2009 with rules on retail deposit taking. This replaced voluntary arrangements (the Banking Code and the Business Banking Code) established by the British Bankers Association and others. The move to statutory regulation coincided with the implementation of the EU Payment Services Directive in the UK. The changes represented a sensible evolution from the self-regulatory regime.

We would refer the Commission to the response of TheCityUK, which is better placed to comment on these more global issues.

2. What have been the consequences of the above for (a) consumers, both retail and wholesale, and (b) the economy as a whole?


a) retail consumers?


The consequences of a perceived deterioration in professional standards and integrity have, for retail customers, led to a reduction in trust of the financial services industry generally, which could be detrimental for personal financial planning, e.g., savings, pensions and investments.

a) wholesale consumers?

Lloyds has limited investment banking, directed at serving the needs of retail and commercial customers. We distinguish between wholesale clients and commercial/retail customers. Wholesale clients generally have a deeper understanding of the role individual banks have played in the crisis and are better able to differentiate between financial institutions. Our Wholesale Division, for example, is focused on facilitating trade and commerce for UK businesses and for those non-UK businesses looking to invest in the UK. This focus is a key differentiator – we have been winners of the CBI FD’s Awards as best commercial bank for eight years in a row. Lloyds Wholesale has also seen a relative improvement in independent rankings (e.g. FD Awards, Greenwich, etc). We recognise that challenges remain and monitor progress as an industry through the Edelman Trust Barometer and direct client feedback, which is also crucial for understanding customer needs.

Many of the regulatory or business driven changes since 2008 have focused on Wholesale - e.g. balance sheet and cost of capital disciplines; ensuring that compensation and performance measures focus on long-term performance.

There is clearly a balance - regulation needs to be fit for purpose whilst not being so constraining as to choke the provision of banking services to UK companies, or those non-UK companies wishing to invest here. If the regulation is not fit for purpose, then possible results could include an increase in unregulated lending, an increase in provision by differently regulated non-UK firms (e.g. a repeat of Iceland) and non-UK banks intercepting FDI (Foreign Direct Investment) into the UK, with a critical impact on the UK economy.

b) the economy as a whole?

Banks which encountered severe difficulties or failed, shared some common characteristics from a pre-crisis era:

· A focus on growth and returns rather than risk adjusted returns.

· Limited experience of banking and credit.

· A management structure in which risk was subordinated, rather than reporting to the Board or CEO.

· A management style that encouraged complacency rather than rigorous challenge.

In the pre-crisis boom, the poor risk management practices in some UK banks led to excessive lending, drove the price of credit to uneconomic levels and encouraged bank borrowers to take on dangerously high levels of debt. To fund the rapid growth in their lending, some banks relied excessively on borrowing from wholesale markets, often with a maturity mismatch between the funding raised in those markets and the credit extended to customers. The emphasis on growth also encouraged those banks to seek extra profit from proprietary trading in financial markets.

Banks with weak risk management cultures became exposed to three types of risk; liquidity risk from the maturity mismatch between their assets and their liabilities; credit risk from the rapid growth in their lending; and market risk from the rapid growth of their proprietary trading business.

In the crisis, the collapse of such banks (as credit and market losses mounted and wholesale funding markets dried up) together with the inability of bank investors and creditors to fully distinguish good banks from bad, caused a sudden stop in the availability of bank funding and capital with severe consequences for the economy.

The main economic impact post-crisis has been more limited supply of bank capital and funding.

3. What have been the consequences of any problems identified in question 1 for public trust and in, and expectations of, the banking sector?

According to E&Y's Global Consumer Banking Survey 2012    (based on 28,560 customers, across 35 countries), 87% of global customers are either satisfied or very satisfied with their main bank. Satisfaction is particularly strong in branch and internet banking. Our own research supports these conclusions.

However, the twelve months to March 2012 shows a 65% decrease in UK customer confidence towards the UK banking industry, against a global decline of 40%. E&Y conclude that whilst mis-selling and alleged LIBOR manipulation has clearly contributed to this decline, pay is the main driver for dissatisfaction (cited by 80% of respondents). At the same time, customer expectations regarding integrity and service have rightly increased.

4. What caused any problems in banking standards identified in question 1? The Commission requests that respondents consider (a) the following general themes.

5. What can and should be done to address any weaknesses identified? To what extent are such weaknesses subject to remedial corporate, regulatory or legislative action, domestically or internationally?

For the ease of reference, the comments below address both questions 4-5 for each sub-category of question identified. The answers to question 4 are shown as bullets (where appropriate); the answers to questions 5 are shown in a box below.

i) The culture of banking, including the incentivisation of risk-taking

With regards to incentives, the following problems characterise the behaviours of the last decade across the industry:

· A culture that placed too much emphasis on short term profit at the expense of delivering value to customers.

· Incentives based on financial results with a focus on sales, without due consideration of risk, costs and important non-financial measures, notably customer satisfaction.

· Individuals regarded reward outcomes as dependent on individual performance rather than the performance of the organisation as a whole.

· Pressure from shareholders to increase share price by more than competitor group, and to generate quarter-by-quarter returns, encouraged greater risk-taking.

· The so-called "war for talent" led to generous employment terms and the potential to reward failure.

· Retention fears created ratchet effect on pay and bonus levels as companies sought to protect their franchise.

· Use of buy-outs and guaranteed bonuses encouraged movement between companies, exacerbating the above.

Wide-ranging changes were implemented within the third Capital Requirements Directive (CRD III) and the FSA’s Remuneration Code. CRD III has been implemented since the beginning of 2011 (although the UK introduced the provisions early). There is also EBA Guidance on remuneration disclosure practices.

The provisions of CRD III follow the FSB Principles for Sound Compensation Practice and apply to employees whose activities have a material impact on their employers’ risk profile, including senior management, risk takers, employees in control functions and employees in the same remuneration bracket as senior management and risk takers.

CRD III requires banks to establish remuneration policies that are aligned with effective risk management and ensure that incentives promote the long-term interests of the institution to avoid the pursuit of short-term gain at the expense of long-term results. The rules discourage up-front cash bonuses based on expected performance and to strengthen the linkage between performance and payment through deferrals and potential claw back. Additional changes are being discussed as part of CRD IV due to be implemented shortly.

ii) The impact of globalisation on standards and culture

Globalisation appears to have had an impact on the incentive structures of international and investment banks.

iii) Global regulatory arbitrage

With regards to regulatory arbitrage, the following problems have been observed:

· The scale of regulations (proposed and existing) facing banks is immense. While principles may be agreed at G20 level, implementation approaches can vary substantially across different jurisdictions, (UK, EU, US, etc).

· Firms may seek opportunities for arbitrage, e.g., for capital, between the banking and trading books and/or between the credit risk and securitisation frameworks.

The Basel Committee has updated the rules to minimise / eliminate such opportunities. On an ongoing basis, the FSA and EBA (amongst others) identify these arbitrage opportunities and address them through approvals, peer group reviews, etc. Variations in country approaches in Europe are also addressed by the EBA and their binding technical standards; the EU Banking Union is likely to drive formal convergence across the Eurozone states.

iv) The impact of financial innovation on standards and culture

Financial innovation is critical for retail customers. The introduction of ATMs, internet banking, mobile payments, telephony, free-if-in-credit accounts, loyalty credits, contactless payments, savers prize draw and mobile apps are some of the best examples of where innovation enables greater choice and competition across financial services.

Some financial innovation has been less helpful. Some Collateralised Debt Obligations (CDOs) mis-priced risk ultimately to the detriment of all - customers, shareholders and the wider economy.

v) The impact of technological developments on standards and culture

The interaction between banking standards and technology are most acute when things go wrong, as identified in the recent (and well publicised) UK bank system error and problems with Anti-Money Laundering (AML) payments. When it works well, we see technology, standards and culture working ‘hand in hand’ to achieve the right environment for customers, banks and UK plc:

· Telephone and Internet banking have made the provision of Banking Services a 24/7 activity.

· Significant growth in e-retailing in the UK underlines the acceptability of the internet within the UK to drive commerce. The industry, particularly in the Cards arena, has worked hard to support that growth through the development of capability and fraud management solutions to protect consumers and businesses.

· The proliferation of mobile/smart phones and tablet devices has a real impact on the ways our customers access products, services and advice. In the near future, more customers will access their accounts using mobile devices rather than desk top technology.

· Such technology gives customers immediate and direct control of their products and accounts.

· Social media plays an ever increasing role. Customers choose to communicate with us in different (and often) public ways. The communications between firms and customers will, as a result, continue to evolve.

· Technology also facilitates new market entrants from non-banks.

We support the development of global standards for payments - without them we would not have the security, functionality and inter-operability that we see today between banks. For example, we protect our customers by ensuring payments are made in a standardised way so that our filtering technology can undertake sanction and AML checks.

The EU's Single European Payments Area (for which the Payment Services Directive provided the legislative framework) is a key development in establishing cross-EU standards. We have also developed the Faster Payments system using state of the art technology along with existing standards that enables the speedier delivery of customer payments.

Lloyds is currently enhancing existing systems or developing new technology that benefits both customers and the UK as a whole. This includes functionality to allow customers to switch accounts more easily, make mobile payments more simply and improve the interaction between consumers and e-retailers.

Security is the main concern with mobile banking: 78% of young people responding to the E&Y Global Customer Banking Survey said they would make greater use of mobile banking if they had greater confidence in security. Cross-industry agreement on and compliance with standards, whether statutory or otherwise, is critical to meeting those customer and security expectations. Given this, we welcome the Government's consultation on the future of regulation for UK payments.

vi) Corporate structure, including the relationship between retail and investment banking

· IMF research shows that during the recent crisis, commercial banks were much less likely to get into trouble than investment banks or universal banks (which combine investment and commercial banking). This supports the UK proceeding with the recommendations of the ICB to insulate commercial from investment banking.

· The investment banking divisions of universal banks have effectively been cross-subsidised by the commercial banking divisions of the same banks, both in terms of their cost of funding and the likelihood of state support.

Ring-fencing, as proposed in the Banking Reform White Paper (ICB), should help, if legislated correctly. It is important that the ring-fence allows firms to continue to provide those essential risk management products that are required by its customers, to ensure that those key contributors to the real economy are able to manage risk associated with currency, interest rates, etc.

Ring-fencing is the best way to separate universal banks as it allows investors to consider if there are sufficient synergies remaining to keep both sides in the same Group or to take the decision to spin off the investment bank. The introduction of ring-fencing has the potential, if carefully executed in the legislation, to help rebuild consumer trust in the banking sector and more clearly separate the different cultures of retail/commercial and investment banking. Investment banking, moving forward, needs to focus on activities which genuinely support the customer.

vii ) The level and effectiveness of competition in both retail and wholesale markets, domestically and internationally, and its effects

· The level and effectiveness of competition in retail and wholesale banking markets (domestically and internationally) is not a cause of any alleged problems for professional standards in UK banking. On the contrary, the "virtuous circle" (by which consumers can access and assess products and services and then act by switching supplier if they are dissatisfied or a better offer is available) drives competition and helps maintain professional standards. 

· The ICB broadly concluded that competition is effective in the mortgage, deposit, and credit card markets. Competition in the Personal Current Account (PCA ) sector will be boosted by the Lloyds Verde divestment, by the new s witching  s ervice and improvements in transparency for customers. We agree with this assessment; competing vigorously but fairly is a key component of our vision to be the best bank for customers.

The banking sector is subject to extensive ongoing regulatory scrutiny (such as the OFT's review of PCAs and proposed reviews of SME banking and payment systems, the European Commission's reviews of bank accounts / payment systems and the Scottish Government’s development of a new banking strategy for Scotland). The FCA’s new competition remit will contribute further to this environment.

Transparency requirements (currently being considered as part of the OFT's PCA review and to be further developed by the FCA in the spring of 2013) will bolster the ability of the consumer to assess the performance of suppliers and to compare rival offerings.

The new industry-wide, world-leading switching s ervice, due for implementation in 2013, will significantly enhance a consumer’s ability to change supplier. Suppliers will recognise that they must behave according to the professional standards which consumers expect, or be punished by customers switching to rival suppliers.

Promoting the virtuous circle of competition thus encourages banks to abide by high professional and ethical standards.

viii) Taxation, including the differences in treatment of debt and equity

The following perceptions exist around banking standards and tax:

· Under-taxation: the perception of under-taxation is often repeated, based on the fact that financial services are VAT exempt. However, there is evidence that this exemption results in a higher cost for the sector (as Banks are able to reclaim only a small proportion of their VAT). In general, the exemption is beneficial to retail consumers (lower pricing), but not for suppliers.

· Debt bias: deductibility is an established feature of the UK tax system. Recently, commentators have raised the concern that tax deductibility was a factor in some excessive debt levels in the run up to the crisis. The anecdotal evidence is that the overarching funding decisions of a bank are not driven by the tax treatment.

· Structured finance: prior to 2008, the UK banking sector operated a large and sophisticated ‘structured finance’ market, which generated transactions for banks and their customers that were ‘tax efficient’ (at a very generalised level, 'tax avoidance' transactions which generated tax benefits which did not reflect the underlying economics of the transaction but were, nonetheless, completely legal under the letter of the law). The scale of this activity and its impact on tax revenues was significant.

In response to the perception of under-taxation, the UK government introduced the bank levy at £2.5bn per annum to ensure that we pay a ‘fair share’ and contribute to the cost of the crisis and to disincentivise short-term wholesale funding in favour of equity and deposit funding.

With regards to Structured Finance, HMRC has been taking action for a number of years, primarily through the Tax Avoidance Disclosure rules and the Banking Code of Practice, (BCOP). BCOP requires a bank to take into account Parliament’s intentions rather than simply the strict words of the law itself and to engage with the tax authorities in an open and transparent way to discuss transactions prior to entering into them. The BCOP is not a substitute for good law but acting in accordance with it is important for Banks to demonstrate their commitment to acceptable behaviour with respect to tax. The need for banks to consider their wider group of stakeholders in their tax positions is reinforced by increasing reputational downside of any perceived tax abusive transaction and intense media coverage.

A general anti-abuse rule is due to come into force from 2013. This will further reduce the effectiveness of more aggressive tax avoidance.

Other themes not included above


and (b) weaknesses in the following somewhat more specific areas:

ix) The role of shareholders, and particularly institutional shareholders

Shareholder behaviour "pre-crunch" focused on a drive for growth with emphasis placed on delivering potentially unsustainable returns, without recognition of the downside risks. This was a factor in creating a culture that arguably led to failure in the sector.

In 2010, the UK Financial Reporting Council issued the UK Stewardship Code aimed at institutional investors holding voting rights in UK companies. Its principal aim is to make institutional shareholders actively engage in corporate governance. The Code is on a statutory comply or explain basis under the Financial Services and Markets Act and the UK Listing Rules.

The Kay Review of Equities Markets (June 2012) proposed the development of an investors' forum to facilitate collective engagement and consultation with major long-term investors on board appointments. The EU is also looking at shareholder rights, and how shareholders are impacted (in extremis) under the EU crisis management framework.

Lloyds has a close relationship with its main shareholders, including UKFI, which manages the Government’s 39% stake. There is a close dialogue on key issues, including remuneration and bonus policy. More broadly, Lloyds has the largest private shareholder base in the UK.

x) Creditor discipline and incentives

There were a number of key lessons learnt across the financial services industry, many of which arise from poor quality lending:

· Culture: strong Executive appetite for asset growth, over reliance on borrowers’ historic performance/track record and perceived robustness of certain sectors. Inappropriate methods of incentivisation of colleagues (credit and front line).  Lack of independent control and authority in the decision making.  Poor monitoring and control, and early warning signs missed or ignored.  Credit Policy and Appetite seen as optional rather than rules.  No additional control of out of policy decisions.

· Business Assessment: insufficient understanding of underlying key business or sector drivers, with either a lack of supporting due diligence or inappropriate diligence undertaken, to verify key information or fill knowledge gaps.  Inappropriate, or inadequate, sensitivity analysis.  Too much lending against hope value or for speculative purposes, especially in Corporate Real Estate.  No aggregation of connected counterparties leading to material single name/group concentrations.

· Management Assessment: too often an overly positive view of management teams held, with a lack of suitable assessment tools available to determine whether such individuals or teams had the suitable skills sets, experience (especially change management, acquisition, integration or downturn/upturn), financial discipline or team cohesion.  Particularly true of family businesses or where autocratic/entrepreneur style of leadership were evident.  Lack of effective use of professional due diligence or internal, independent resources.

· Facility Structuring: heavily influenced by strong credit appetite at times, resulting in over leveraged/highly geared structures, with a greater reliance placed upon increases in underlying asset values (especially in Real Estate lending) as opposed to stress testing of viability.  Some structuring controls (e.g. financial covenants, review periods / tenor lengths) either inappropriate for business/sector or too generous headroom provided, resulting in ineffective early warnings.

· Security: lack of appreciation of values of secured assets in stressed scenarios, with over-reliance placed on perceived realisable values; inappropriate security being looked to e.g. unsupported personal guarantees; some imperfections in the control of security processes; and a lack of consistency in documentation controls.

Lloyds today has adopted a rigorous approach to risk management. Strengthened over the last two years, we manage these risks through a combination of the following (some of which apply more to wholesale rather than retail lending):

- A Three Lines of Defence Model where the frontline customer facing business areas are the First Line of Defence and have responsibility for customer acquisition, developing lending propositions and monitoring of customer lending exposures.  The Second Line of Defence, the Risk Division, is independent of the frontline and provides rigorous challenge and oversight.  Additionally, Group Audit provides a Third Line of Defence to provide assurance on the implementation of Credit Policies and oversight by the second line.

- A prudent approach to Credit Risk appetite agreed by the Board and cascaded down through Risk to the frontline customer facing Business Units.

- A focus on cash flow. We do not lend against hope value nor do we lend for speculative purposes.  We lend on the basis of supporting our chosen clients through the cycle and we look to at least two clear and ideally independent sources of repayment.

- Holding senior debt on the balance sheet; we avoid subordinated debt and equity with only very limited and controlled exceptions permitted.

- Requiring financial covenants for any business lending in excess of one year in tenure and all lending to corporate and commercial customers is reviewed and re-authorised at least annually.

- Applying industry sector risk appetites with tightly defined policies for high risk sectors.

- Lending to key participants in chosen industry sectors. We avoid single name concentration and excessive exposure to any one borrowing customer.  This is supported by tight rules for aggregation of limits within connected customer groups.

- Applying the same criteria to the provision of underwriting services as those that apply to lending on conventional terms.

- We identify, through early reviews and monitoring, those customers that might be experiencing difficulty so we can take early action to support those customers and, wherever possible, support their return to viability.

- Risk is independent; the Chief Risk Officer reports both to the Group Chief Executive and the Board Risk Committee.  Risk plays a key part in overseeing the performance assessment of businesses within the Group and performance of key senior individuals to ensure that adherence to risk appetite and risk policies are a key determinant of their overall performance assessment and reward.

Across the industry, staff that undertake Significant Influence Function (SIF) roles are regulated by the FSA, thereby reinforcing individual accountability.

xi) Corporate governance, including the role of non-executive directors

Sound governance arrangements have a role to play in restoring trust and confidence. The focus on governance has brought about positive changes but it is difficult to say whether this is due to the codes themselves or down to Directors learning the lessons for themselves. Bank Boards need to provide the leadership and, critically, ensure that they have overriding responsibility for financial soundness, customer treatments and standards/ethics. In this regard, it is important that the Board provides appropriate oversight of the "tone from the top".

Significant progress has been made in enhancing and refining corporate governance practices in recent years. These should now have time to become established. If there is an appetite for further change, we would highlight:

- There is an opportunity to reduce the current proliferation of codes and standards by consolidating the various initiatives and removing duplication/overlapping requirements.

- A greater emphasis on the collective responsibility of the Board, consistent with legal principles.

- Greater clarity on the precise accountabilities of the Non-Executive and Executive Directors.

xii) The Compliance Function

· Compliance plays a critical role in driving standards across the Group and acts, effectively, as the first line of defence for the regulatory authorities.

· The Compliance teams need to be sufficiently resourced and managed to deliver against an ever increasing range of regulatory requirements and expectations, and needs senior visibility within a firm.

· Compliance policies, first line reviews and escalation of issues through the risk committee to the Board are key aspects that drive control.

xiii) Internal audit and controls

There are increased expectations around Group Audit’s role, both internally (various stakeholders and the Board) and externally (from regulators, shareholders and other third parties).

Seniority and direct engagement in the key strategic and operational developments across the firm is vital. The Group Audit Director attends the Group Executive Committee, providing Audit with the opportunity to challenge and influence the Lloyds’s response to the key risks faced by it, for example the PPI remediation process. The Director has a direct line into the NED Chair of the Board’s Audit Committee.

Group Audit fully complies with the Institute of Audit’s professional standards.

xiv) Remuneration incentives at all levels; recruitment and retention

We believe that reward and incentives drive behaviour and influence an organisation’s culture. They are a vital influence on how people behave, whether they are front-line staff or senior management.

In the recent past the structure of variable compensation packages across the retail banking industry has been characterised by an excessive emphasis on sales targets. This may, in some cases, have had a detrimental impact on behaviour which may, in part, have contributed to the problems the industry has experienced with mis-selling.

Pay, as identified from the E&Y survey, is a key driver of customer dissatisfaction. Change has occurred or is underway. At the top, variable pay is increasingly linked to the long-term performance of the bank; it needs to be awarded in shares rather than in cash, to align the long-term interests of top management and the bank; it must be transparently linked with success and be capable of being clawed back where decisions taken by top management subsequently turn out to have damaged the bank’s performance or adversely affected its customers.

Reward needs to be linked much more explicitly to customer-focused service, placing far greater emphasis on customer retention and long-term relationships with our customers, effective controls on risk and removal of the emphasis on sales targets.

Underlying all of this, there needs to be a complementary set of values and a culture that permeate throughout the organisation, reinforcing the right behavioural standards.

xv) Arrangements for Whistleblowing

The vast majority of our staff operate to exceptionally high standards of responsibility and probity. As with any business with 100,000 people, some colleagues may not at times meet those standards; we have a low tolerance for behaviours that do not conform to them.

Lloyds operates a Whistleblowing line – this is an important business tool for highlighting inappropriate (or illegal) behaviour. All Whistleblowing notifications are treated seriously and investigated fully, with disciplinary action and/or engagement with law enforcement taken forward where appropriate. The Board receives regular reviews of the various cases and emerging themes. We have a relationship with Public Concern at Work (PCAW) - an independent UK charity - which undertakes an independent annual review, the results of which are used to confirm/improve current arrangements (e.g. as a result of their most recent review, steps are being taken to improve communication, awareness and out of hours access).

The Commission should review the practices with regard to "Whistleblowing" in other jurisdictions to see whether additional safeguards are appropriate for the UK.

We are keen to explore greater punitive action against individuals who knowingly break rules and greater encouragement for Whistleblowing to increase the likelihood of more people identifying any future wrongdoing.

xvi) External audit and accounting standards

· The accounting standards are wide ranging and certain elements of them are perverse in terms of their implications and/or not aligned to regulatory approaches (e.g. the treatment of impairment on lending). As a consequence, the management reporting of many financial services companies, which supports key decision making, is different from statutory accounting.

· Internal and external audit together with the relevant Board committees ensure appropriate standards and judgements are consistent with risk appetite and that these reinforce the culture of the organisation.

· External audit must have high calibre personnel with breadth of experience. 

Accounting standards are complex - judgement is needed when implementing them. Existing development of standards (particularly in relation to financial instruments) is appropriate though accounting setters need to draw their deliberations to a conclusion to enable implementation. It is essential that changes enhance financial reporting and that their impact on regulatory capital is understood.

The extent of financial disclosure has significantly expanded in recent years and needs to be considered to ensure it remains fit for the audience.  Regulators should ensure that new requirements are value enhancing and not merely additive.

Three way meetings between auditors, Audit Committee Chairman and regulator are especially useful - and have recently been established by the FSA.

The proposal by the EU Commission to enforce rotation of auditors is undesirable; it is largely impractical due to the limit in the number of experienced auditors, the time taken to understand a bank/insurer in detail and the need to keep other firms free from all other engagements to ensure independence. Similar reasons argue against shared assignments. If further oversight or independence is required, this could be addressed by the Financial Reporting Council.

xvii) The regulatory and supervisory approach, culture and accountability

· Some characterise the FSA's prior regulatory approach as being light touch, where regulatory standards were based on principles that presumed an intelligent response on behalf of both firms and customers, and a risk-based approach to supervision which meant supervision was directed at the perceived areas of greatest risk.

· It was possible, therefore, to miss emerging issues e.g., the over-reliance on wholesale markets for funding and the consequential systemic risk.

The new system being implemented in January 2013 splits the FSA into the macro-prudential focus of the FPC; the prudential focus of the PRA; and the conduct and markets focus of the FCA. We support the Government’s changes; after all, it is the banks that are ultimately liable through the Financial Services Compensation Scheme (FSCS) for bank failures (e.g. Bradford and Bingley, Dunfermline).

xviii) The corporate legal framework and general criminal law

The corporate legal framework applicable to UK listed financial institutions (a combination of the Companies Act 2006, the Listing Rules, the Financial Services and Markets Act 2000 and the FSA handbook) is sufficiently robust to govern the behaviour of such financial institutions from a company law perspective.

The changes implemented by the Companies Act 2006, in particular in relation to the codification of Directors duties, have been helpful. It is timely for the Commission to review the current powers available to regulators to punish wilful misbehaviour or recklessness.

We note that the SFO has confirmed that existing legislation will suffice to bring criminal actions against banks and individuals in relation to alleged LIBOR manipulation.

xix) Other areas not included above

There has recently been debate regarding the 'free if in credit' banking model. Concerns have been raised that the model may create incentives for banks to mis-sell other products, because they are unable to recover the cost of providing current accounts when the product is free. This analysis ignores the various revenue streams available to suppliers of current accounts, such as interest earned on balances in the account, overdraft fee income and interchange fees on debit cards. We do not believe this drives mis-selling of other products to current account customers. The current arrangements are preferred by many of our PCA customers.

6. Are the changes already proposed by (a) the Government, (b) regulators and (c) the industry sufficient? Respondents may wish to refer to the Financial Services Bill and the Government's proposals for the Banking Reform Bill.  They may also wish to refer to proposals by the Bank of England and the Financial Services Authority on how the Financial Policy Committee, Prudential Regulation Authority and Financial Conduct Authority will operate in practice.

Ultimately, re-establishing trust is about leadership (and individual leaders) setting culture rather than encouraging further regulatory change. A substantial amount of the required re-engineering has already been achieved (ICB, changes in UK regulatory capability and framework, Basel 3 etc, etc). The focus should be on implementing quickly and securely the programme that is already underway (we are currently progressing over 80 separate initiatives across Lloyds emanating from the EU, UK, US and elsewhere).

We would welcome an enhanced role for the UK’s independent Regulatory Policy Committee in overseeing all new regulation proposed by the Prudential Regulatory Authority and Financial Conduct Authority. The Financial Services Bill provides an appropriate legislative vehicle to implement this.

It would be helpful if the Commission examined the existing approach to professional standards.

7. What other matters should the Commission take into account?


6 September 2012

Prepared 22nd September 2012