The failure of HBOS plc (HBOS) A report by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA) November 2015 1 Contents Foreword 7 Introduction 11 Part 1: Executive summary and recommendations 13 1.1 Why did HBOS fail? 14 1.2 Background 16 1.2.1 The HBOS Group 16 1.2.2 External economic environment 17 1.3 HBOS’s strategy during the Review Period 18 1.4 How HBOS failed 20 1.4.1 The final year 20 1.4.2 Asset quality 23 1.4.3 Underlying balance sheet vulnerabilities 26 1.5 Management, governance and culture 29 1.5.1 Board composition and challenge to the executive management 29 1.5.2 Formation of strategy and risk appetite 30 1.5.3 Risk management framework 30 1.5.4 Risk culture 31 1.6 FSA supervision 32 1.6.1 A deficient regulatory approach 32 1.6.2 Supervision of HBOS in the pre-crisis period 33 1.6.3 Supervisory response to the deteriorating economic environment 35 1.7 Recommendations 37 1.7.1 Changes to the regulatory framework and approach 37 1.7.2 Recommendations for firms 38 1.7.3 Recommendations for regulators 38 Part 2: How did HBOS fail? 41 2.1 Introduction 42 2.2 Overview of the external market environment 44 2.2.1 Introduction 44 2.2.2 Growing vulnerabilities 44 2.2.3 The onset of the financial crisis 48 2.2.4 Ireland and Australia 51 The failure of HBOS plc A report by the FCA and PRA 2 2.3 The HBOS Group 54 2.3.1 The merger of Halifax and Bank of Scotland to form HBOS in 2001 54 2.3.2 HBOS Group structure 55 2.3.3 HBOS’s strategy and business plans: 2004 to 2008 56 2.3.4 HBOS Group’s reported performance: 2004 to 2008 60 2.3.5 Did HBOS deliver on its strategy? 63 2.3.6 HBOS’s performance from 2008 69 2.4 Asset quality – Corporate Division 73 2.4.1 Introduction 73 2.4.2 Divisional strategy 73 2.4.3 Performance 76 2.4.4 Higher-risk speculative lending 84 2.4.5 Commercial property 86 2.4.6 Investment in capital instruments 89 2.4.7 Leveraged transactions 90 2.4.8 Stress testing/scenario analysis 92 2.4.9 Loan impairment losses in Corporate 94 2.5 Asset quality – International Division 98 2.5.1 Introduction 98 2.5.2 Divisional strategy 98 2.5.3 Performance 101 2.5.4 Losses in International 107 2.6 Asset quality – Retail Division 111 2.6.1 Introduction 111 2.6.2 Divisional strategy 111 2.6.3 Performance 113 2.6.4 Peer comparisons 117 2.6.5 Losses in Retail Division 118 2.7 Asset quality – Treasury Division 120 2.7.1 Introduction 120 2.7.2 Balance sheet assets 121 2.7.3 Performance 122 2.8 Funding and liquidity 125 2.8.1 Introduction 125 2.8.2 Funding structure: did the firm’s structural funding position make it more vulnerable to liquidity risk? 125 2.8.3 Asset-backed commercial paper (ABCP) conduits: Grampian and Landale 130 2.8.4 The liquidity portfolio: an insurance policy against times of stress? 131 2.8.5 Key events and triggers: what were the events which triggered the liquidity crisis leading to the firm’s failure? 131 The failure of HBOS plc A report by the FCA and PRA 3 2.8.6 The Basel III liquidity regime: would it have reduced the liquidity risk? 137 2.9 Capital 139 2.9.1 Introduction 139 2.9.2 The firm’s overall capital strategy and philosophy 139 2.9.3 The firm’s actual capital positions 141 2.9.4 The composition of capital resources 146 2.9.5 The determination of capital requirements 147 2.9.6 HBOS’s loss absorbing capacity 148 2.9.7 Basel III estimates 149 2.10 Shifting market perceptions of HBOS 152 2.10.1 Introduction 152 2.10.2 Market perceptions of HBOS in 2007 152 2.10.3 Market perceptions of HBOS in 2008 157 2.10.4 Market discipline 164 2.11 HBOS financial reporting 167 2.11.1 Introduction 167 2.11.2 2006 169 2.11.3 2007 170 2.11.4 2008 172 2.11.5 HBOS Treasury Division 190 Part 3: Management, governance and culture 193 3.1 Introduction 194 3.2 Design of the management and governance arrangements 195 3.2.1 Introduction 195 3.2.2 Composition and responsibilities of the Board 195 3.2.3 The risk management framework 198 3.2.4 Group Board meetings and management information 202 3.3 Management and governance failings in practice 204 3.3.1 Introduction 204 3.3.2 Key failings of the Group Board, Chairman and CEOs 204 3.3.3 Risk management 206 3.3.4 A capable Board but lacking experience and knowledge of banking 214 3.3.5 Accountability for the failings of the Board 217 3.3.6 Accountability for the failings in strategy and risk culture 218 3.4 Failings in the implementation of the risk management framework 223 3.4.1 Introduction 223 3.4.2 Three lines of defence roles and responsibilities 223 3.4.3 The second line of defence 224 3.4.4 Third line of defence 228 The failure of HBOS plc A report by the FCA and PRA 4 3.5 Practical illustrations of management, governance and cultural weakness 232 3.5.1 Balance sheet management 232 3.5.2 Management and governance failings in relation to the Corporate Division 234 3.5.3 Management and governance failings in relation to International Division 240 Part 4: FSA Supervision 247 4.1 Introduction 248 4.2 The FSA’s philosophy and approach to supervision 249 4.2.1 Introduction 249 4.2.2 Regulatory and political context 250 4.2.3 The FSA’s approach to supervision in the pre-crisis period 252 4.2.4 The roles of the FSA Board and ExCo 257 4.3 Prudential supervision of HBOS 266 4.3.1 Introduction 266 4.3.2 Timeline of HBOS ARROW assessments 267 4.3.3 Supervisory priorities for HBOS 268 4.3.4 Evolution of the FSA’s risk assessment of HBOS 271 4.3.5 Close and continuous supervision of HBOS 272 4.3.6 Supervision team resources and turnover 274 4.3.7 Involvement of FSA senior management in the supervision of HBOS in the pre-crisis period 277 4.3.8 Supervisory relationship with HBOS 278 4.4 Supervisory approach to asset quality 281 4.4.1 Introduction 281 4.4.2 Approach to the supervision of asset quality 281 4.4.3 Supervision of asset quality in Corporate 282 4.4.4 Supervision of asset quality in International 288 4.4.5 Supervision of asset quality in Retail 292 4.5 Supervisory approach to liquidity and Treasury asset quality 295 4.5.1 Introduction 295 4.5.2 The FSA’s regulatory approach to liquidity 295 4.5.3 Resource and supervisory approach to liquidity risk in HBOS 297 4.5.4 Supervision of HBOS’s liquidity and Treasury assets in the pre-crisis period 297 4.5.5 Supervision of HBOS’s liquidity and Treasury assets in the financial crisis period 300 4.6 Supervisory approach to capital and Basel II implementation 303 4.6.1 Introduction 303 4.6.2 Supervisory approach to capital 303 4.6.3 Basel II implementation 306 The failure of HBOS plc A report by the FCA and PRA 5 4.7 Supervisory approach to management, governance, culture and control functions 316 4.7.1 Introduction 316 4.7.2 The FSA’s approach to assessing the effectiveness of management, governance, culture and controls 316 4.7.3 Evolution of management, governance, culture and controls risk probability scores for HBOS 317 4.7.4 Supervision of Group oversight of controls 318 4.7.5 Assessment of the degree of reliance that could be placed on HBOS senior management 330 4.7.6 Assessment of board effectiveness 332 4.8 Contingency planning 333 4.8.1 Introduction 333 4.8.2 September 2007 – February 2008 334 4.8.3 March 2008 – August 2008 336 4.8.4 September 2008 – 1 October 2008 344 4.8.5 Was there more the FSA could have done during the contingency planning period to prevent the failure of HBOS? 346 Appendices 349 Appendix 1: Review Period, scope and processes followed 350 Appendix 2: Detailed Terms of Reference for the HBOS Review 354 Appendix 3: Chronology of key events 357 Appendix 4: Questions from the Parliamentary Commission on Banking Standards 362 Appendix 5: Comparison of HBOS with Halifax and Bank of Scotland 376 Appendix 6: Summary of HBOS directors’ roles and experience 381 Appendix 7: Timeline of membership of HBOS Board 383 Appendix 8: HBOS plc structure of Board committees 384 Appendix 9: The FSA’s management and Board during the Review Period 386 Appendix 10: Glossary of main terms, other acronyms and abbreviations 390 The failure of HBOS plc A report by the FCA and PRA 6 The failure of HBOS plc A report by the FCA and PRA 7 Foreword This Report produced by the FCA and PRA explains why HBOS failed in October 2008 and sets out conclusions and recommendations. The story of the failure of HBOS is important both to provide a record of an event which required a major contribution by the public purse, and because it is a story of the failure of a bank that did not undertake complicated activity or so-called racy investment banking.