Panel on HBOS

MEETING OF THE DIRECTORS

held at The Mound, Edinburgh

at 10.30 am on 27TH JANUARY 2004

3. FSA- GROUP ARROW RISK ASSESSMENT

Mike Elllis's paper reported that four letters had been received from the FSA- in relation to Retail; IID; Commercial Property lending in Corporate Banking; and the Group. The conclusions being drawn by the FSA, and the shift in the Internal Capital Ratio ("ICR"), were a significant warning shot. The individual points raised were not new, in that they had already been identified by the Group (and, in some cases, were already being addressed). But the FSA's perspective was that the Group's growth had outpaced the ability to control risks. The Group's strong growth, which was markedly different than the position of the peer · group, may have given rise to "an accident waiting to happen", in their view. Whilst the shift in ICR would not affect the bottom line directly, it would increase the challenges involved in managing the Group's overall capital position.

Returning the ICR to 9% by the end of the year was a key objective (and the FSA had confirmed this was achievable if we could satisfy them on the points they have raised).

A measured response was essential. The FSA's perceptions needed to be shifted -through the quality of the Group's delivery in relation to risk and control issues- and robustly tackling the Risk Mitigation programmes that were being agreed with the FSA. It was essential to demonstrate commitment to addressing weaknesses, and to deliver the necessary risk mitigation actions - particularly in those areas where the FSA had highlighted concerns already identified by the Group.

The Risk Assessment for IID focused on Clerical Medical. The 3 key issues raised by the FSA related to the:

• with profits fund - including the need for a clear strategy in relation to the future management of the fund;

• relationship with Equitable - which the FSA did not want to be a major distraction for HBOS management;

• management stretch, as a result of the changes planned and being implemented.

In relation to Retail, there were 3 points of concern:

• the control environment and culture. Strong sales performance, ahead of peers, had given rise to concerns - (but the Group firmly believed that controls had kept pace with this growth);

• the credit environment. Actual credit performance had been strong- but the FSA were concerned that strong growth could lead to a deterioration in credit quality;

• management stretch, where the FSA were concerned about the combined impact of challenging sales and profit targets and merger integration. (Stretch in 2004 should, in fact, be less than in 2003 and this was not believed to be an issue that warranted real concern).

The concerns raised in relation to Commercial Property were potentially the most difficult to address. Comments in relation to management information and risk grading systems were being addressed. But the FSA was also concerned about the Group's atypical, individual, approach to credit assessment and decisioning (rather than a portfolio approach based on parameters, specialists and "independent" credit sanctioning).

Prior to responding in detail to the FSA on these concerns, it was agreed that the Board should review in detail the Corporate Banking approach to credit issues, and the pro's and con's of that approach, particularly compared with the approach adopted by the peer group.

The FSA had commissioned a S.166 skilled persons report on the overall risk management framework. The conclusions of the report would be a key factor in determining whether the ICR decision would be reversed. A meeting was due to take place with the FSA on the following day, involving both the Chief Executive and the Group Finance Director, to discuss how this issue should be taken forward.

MEETING OF THE DIRECTORS

held at Old Broad Street, London

at 10.30 am on 27TH JULY 2004

5. OVERALL REVIEW OF RISK MANAGEMENT

Mike Ellis reported that the s.166 Skilled Persons Report prepared by Price Waterhouse Coopers (PWC) was now close to finalisation. One further change had been made since the version of the Report circulated to directors and would be commented on later.

Whilst the Report contained a number of recommendations about improvements that could be made to the Group's Risk Management Controls and Infrastructure, PWC were clearly satisfied that Risk Management within HBOS was effective and satisfactory. In Mike's view the FSA (and the Board) should be satisfied with the outcome of this exercise. The final version of the Report, together with a copy of Mike's covering paper, would be submitted to the FSA within the next few days. A tri-lateral meeting would take place in August.

Although this had been a costly and time consuming exercise, three years after the merger the Group had received external validation, following a very thorough review, that its Risk Management Infrastructure was sound. Implementation of the agreed recommendations would be used as an opportunity to reinforce the Operating Philosophy, and re-emphasise the importance of Risk Management throughout the Group.

Phil Rivett of PWC commented that the Report had been written following an extensive and comprehensive review of systems and people. In high level terms, PWC had concluded that:

• the overall approach to Risk Management, and Risk Management processes, were sound;

• in general, people quality was high;

• the Group's approach to Risk was well articulated and understood across the Group (and far better than the norm); "

• there was good engagement between businesses, who were responsible for Risk, and the Central Risk Functions.

The Report included a number of detailed recommendations, as to "improvements" that could be made. A number of these sought to achieve greater codification of Risk Management systems and approaches. Ideally this would be achieved through promulgation of "minimum standards", without excess prescription, so that practices could continue to evolve and progress.

Chris Taylor of PWC highlighted a number of key issues arising out of the

Report, as follows:

• levels of challenge. The FSA typically favoured a more centralised approach to Risk Management, and had queried whether there was sufficient "challenge" within the Group in relation to risk issues. PWC, however, were happy to support the current HBOS structure. There was a good degree of ownership of risk within the businesses. There was clarity about roles and responsibilities. Some additional codification would strengthen the position. But, based on their comprehensive review, PWC were satisfied that there was real and constructive challenge taking place within the Group;

• credit approvals in Corporate Banking. It was contended that the HBOS approach to credit approvals was atypical. It was clear, however, that current arrangements had been arrived at after careful thought and deliberation. Management were convinced that the current arrangements provided competitive advantage. PWC were happy to support the current arrangements. Although arguably atypical, they were effective and arose following conscious decision-making, for good business reasons;

• IID. Risk Management structures within IID were more embryonic. In part, this reflected the state of integration within IID; in part it reflected the fact that Risk Management within insurance businesses generally was not as well developed as in banking businesses. Matters were progressing, however, and PWC were satisfied that current arrangements were at least as strong as in other equivalent businesses.

PWC had originally recommended that there should be three IID RCC's (one for each Operating Division) but, following further discussions with the Chairman of the Audit Committee, PWC had been convinced of the benefits of simplicity, and the current (single RCC) structure. This change would be reflected in the final version of the paper: but the situation should be kept under review, and changed if the single liD RCC approach proved unworkable.

Phil Rivett confirmed that, in PWC's experience, HBOS was not being "singled out" by the regulator. Most, if not all, major banks had been the subject of s.166 reviews - at least one of which had focused on risk management systems and controls. James Crosby commented that, in fact, it was quite likely that the considerable efforts devoted to discussing risk management systems with the FSA at the time of merger had "deferred" the FSA's interest in this topic at HBOS. Without those efforts, the FSA could have launched an earlier s.166 review.

The Group was still discussing the details of some of the recommendations made by PWC: in general terms, however, the Group would commit to delivering the changes recommended by PWC, and delivery would be subject to internal verification and audit.

The s.166 Report contained a number of recommendations in relation to the credit authorisation process within Corporate Banking - including a proposal that non-executive directors should not be involved in making decisions in relation to individual credits (although they had a critical and continuing role in defining appetite and the general credit risk framework). It was accepted by George Mitchell that PWC's recommendations in this area were logical and sensible, although logistical difficulties would need to be overcome.

On behalf of the Board, the Chairman thanked PWC for their thorough yet balanced Report, which contained a number of valuable recommendations as to worthwhile improvements that could be made, and for the positive and refreshing way in which they had approached this task.

7. REVIEW OF SALES AND CONTROL CULTURE WITHIN RETAIL BANKING

As agreed earlier in the year, Group Regulatory Risk ("GRR") had conducted a review of the sales and control culture within Retail: in particular, to comment on whether controls had kept pace with the Division's sales culture. As Paul Moore commented, ambitious sales targets inevitably led to tensions in relation to risk management systems and controls. HBOS had the most highly developed and effective sales culture within UK financial services: it was essential, therefore, that it had an equally high quality and effective governance framework.

In summary, the GRR review confirmed that the Retail governance framework and high level systems and controls were fit for purpose; and Retail regulatory risk appetite was low; but improvements could undoubtedly be made - to meet the growing demands of the business, and emerging regulatory requirements. This was acknowledged by Retail to be the case: but it was essential to effect improvements without destroying the key strengths of the business.

A detailed action plan had been agreed between GRR and Retail, and was supported by Andy Hornby. The action plan included developments in relation to:

• the balance between sales and controls. A "customer champion" approach demanded that this balance was maintained, and customer interests were recognised and protected. Retail fully accepted that their Plans needed to reflect the tension between sales targets and systems controls;

• addressing current and potential regulatory requirements -where the regulator's wider agenda, and the likely course of future regulatory demands, needed to be appreciated;

• communications with customers - which needed to be appropriately balanced;

• the sales process - which would be reviewed for all products and services, to ensure that a consistent and fair approach was being adopted. Ultimately, there would be a limit to the volumes of sales that could be delivered through the available capacity without resulting in unacceptable risk for customers;

• risk management systems, and training - which would be improved and monitored by the Retail Risk Control Committee. The key was to apply disciplines required in relation to regulated sales and unregulated sales, in a proportionate way.

Considerable efforts had been devoted to refining incentive structures, to ensure that there was an appropriate emphasis on risk management, but more could probably be done. Behaviours that were subject to measurement would be delivered - which underscored the importance of simplicity, and measuring the right issues.

EXECUTIVE COMMITTEE AWAY DAYS

Monday 5th and Tuesday 6th June 2006

Gleneagles Hotel, Auchterarder

1. INTRODUCTION

Andy Hornby introduced the Sessions planned for the Away Days by confirming that Day One of the Away Days would focus on the organic plans and issues for each Division - with exploration of inorganic possibilities taking place on Day Two. Project Holly and Capital Management would also be considered on Day Two, and the debate would focus, in particular, on the Group's positioning around Holly in the context of the Interim Results, and the market's general view of the Group's growth ambitions and prospects.

Overall, the Group had outperformed its peers over the past four years, driven in particular by strong performance in Retail and Corporate. Current Plans would reverse this profile, however - with the strongest planned growth being in I&I and International. This approach begged the issue of whether sufficient emphasis was being given to growth ambitions in Retail and Corporate. This, in turn, led to a key question for consideration at these Away Days, namely:

"what is the right level of growth that HBOS should target in the core UK businesses?"

The Group continued to have a range of competitive strengths:

• the safest balance sheet in the sector;

• multi-brand distribution capabilities;

• strength in bancassurance;

• the Integrated Finance proposition;

• low cost:income ratios;

• strong capital ratios; and

• a strong top team.

It was right to question, however, whether these advantages were being sufficiently leveraged.

Conversely, the Group had a range of strategic weaknesses:

• unsatisfactory customer service levels;

• lack of sufficient credit risk capabilities;

• over-reliance on wholesale funding;

• lack of England and Wales SME share, notwithstanding the ambitions set out at the time of merger;

• an unclear strategy in the Intermediary investment market;

• lack of International diversification;

• potential inorganic opportunities that looked very hard to deliver, in the current climate; and

• lack of "strength in depth" in the senior talent pool.

The Business Plan 2007-2011 needed to address these shortcomings. Challenge sessions prior to finalisation of the Business Plan would consider the extent to which individual Plans, and the cumulative Business Plan, gave appropriate priority to this objective.

2. CURRENT POSITION

Phil Hodkinson's presentation considered:

• the Group's current absolute performance position;

• HBOS relative performance compared to peers; and

• the market's views and expectations.

The high-level financial analysis of the current position reflected both Holly and Chip, and assumed continuation of the buyback programme throughout the period of the current Plan (even though there was no commitment to do so). Numerous other potential impacts - including Drive, Regulatory Tide, branch expansion and other issues - were not yet reflected in the numbers, however.

Not surprisingly, 2006 and 2007 financials were the best developed:

later years were higher level estimates. The current (2006-2010) Plan showed:

• a likely strong outturn in 2006 - but insufficient growth and performance in 2007;

• relatively modest RWA growth in Retail and Corporate, in particular. There was no suggestion in this Plan of an early return to significantly more aggressive rates of UK growth;

• returns on Equity that continued to drift upwards during the Plan period, suggesting that the Group had the choice of pursuing additional opportunities for growth, rather than simply pursuing returns;

• the cost:income ratio falling below 40%. Achieving this in 2007 would be the internal (albeit not necessarily the external) commitment. Keeping costs growth below 6%, to produce strong positive JAWS, was important. Savings should, in part at least, be used to help fund and fuel further or future growth;

• funding that was not yet a constraint, but which could become a constraint by the end of the Plan period - as much of the Group's funding capacity was utilised simply to renew and replace existing levels of funding. The sources of funding needed to continue to expand. Expansion into non-Sterling sources of funds would increase the need to manage FX risks, of course;

• a continuing strong Capital position. The Group's current external positioning was to have a level of gearing of about 25%, plus or minus 2%. This was primarily a matter of internal discipline, rather than a source of concern for the market. This level of gearing left the Group with a relatively high level of leverage capacity. The gearing level could be allowed to rise significantly (on an interim basis) in the context of a major acquisition. Current levels of gearing would support an acquisition of up to c. £4 billion, without the need for further equity, taking gearing towards 35% on a temporary basis, without undue strain. This compared well with other UK banks but was weaker than many European and US banks;

• assets and ROE growing broadly in line with UK competitors, with Nil growth ahead of the peer group, due to the relative immaturity of the Group's businesses.

The cost:income ratio and dividend cover were strong. Concerns for investors in relation to UK banks in general, and HBOS in particular, included:

§ the sustainability of returns;

§ growth prospects; and the timing of any move to a more aggressive rate of growth;

§ managing the funding gap;

§ international ambitions, based on internationalising UK strengths -which meant low risk - but probably only slow growth;

§ acquisition risk; and

§ the new management team at HBOS, (which was associated with acquisition risk, in particular).

The correct management approach was to "ignore" the market - and to do "the right thing" in management's view - albeit informed by the market's expectations.

Buybacks were no longer "flavour of the month". Once established and "institutionalised", they tended to suggest to the market a lack of growth prospects. On balance, the market would prefer growth, albeit at lower returns, rather than higher returns at the expense of growth. The Group had the ability to grow more quickly in targeted areas, due to its capital strength, strong ROE's and low cost:income ratio, should it choose to do so. Stronger growth - even if overall Group returns were slightly diluted as a result- could be strategically compelling.

In 2007, in particular, there needed to be greater emphasis on income generation. Current cost plans in total were probably about right, although costs were not necessarily being incurred in precisely the right places.

HBOS and RBS had the strongest capacity to self-finance growth- with

LTSB the weakest. In a European context, HBOS was the 10th largest by market capitalisation: European banks had far lower ROEs; were growing at about 10% p.a. in terms of RWA's; and were making lower payouts to shareholders. The UK market remained less consolidated than in most other European countries. UK PE ratios - HBOS was at 8.7%, alongside RBS - a UK average of 10 - compared with an average of c. 12 across European banks.

The overall aims of the Planning process should be to achieve:

· double-digit upbt growth in all years. In 2007, in particular, there needed to be more income (particularly as impairment charges were a continuing threat to profit) although ROE's were currently planned to increase in 2007 in a way which suggested that greater- albeit perhaps slightly less profitable - growth was possible;

• continuing costs discipline. Current outliers in terms of costs growth were International, Treasury, and Asset Management. Investment would be targeted primarily at areas of revenue production. Although it also needed to be recognised that not all cost growth could be directly linked to revenue generation -given increasing regulatory costs, in particular;

• planned initiatives being SVA enhancing (over a reasonable timescale);

• maintaining dividend cover around 2.5 times.

The preliminary conclusion was thus that growth should be increased in targeted areas, and that some consequent dilution in overall returns could be acceptable. This preliminary conclusion would be explored further during the Away Days.

EXECUTIVE COMMITTEE

Tuesday 22nd April 2008 at 8.00am

33 Old Broad Street, London

5. COMPARATIVE TREASURY POSITIONS

Colin Matthew’s paper compared the four main UK clearing banks from the view point of the impact of recent market conditions, with particular reference to their respective:

· funding profiles, and external funding requirements;

· composition of debt securities profiles;

· write-downs and impairments.

HBOS had the largest mismatch in respect of loans to deposits. In absolute terms the external funding requirement of HBOS was less than both RBS and Barclays. External audiences were concerned about the high loan to deposit ratio and the funding of the conduit – although their liquidity facilities provided were less onerous than Barclays or Lloyds.

In terms of debt securities, HBOS had disclosed more detail relating to its asset portfolio than other banks. The RBS asset backed holdings were substantially larger than those of HBOS – and probably of inferior quality. Other banks probably had larger potential exposures to monocline insurers.

Relative position would continue to be monitored closely as further disclosures become available.