Hubris: How HBOS Wrecked the Best Bank in Britain (32 page)

How much risk a bank is prepared to take is no longer a subjective process. Where once bank executives would have examined a lending proposal and rejected it on the grounds that ‘it did
not feel right’, now banks measured deals against their ‘risk appetite’. This is a complex formula, which includes among other things the probability of default and the exposure
– how much money the company is prepared to risk at any one time. It also takes in more general concerns such as earnings volatility, capital requirements, reputation, credit ratings and the
requirements of the regulatory regime under which the bank operates. The way HBOS went about calculating, allocating and reviewing risk I will examine in the next chapter, but here I want to look
at the size of its appetite for risk compared to less adventurous banks.

There is a direct relationship between risk and reward. Compared to its competitors, HBOS was hungry for growth and profit and therefore willing to take more risks. A stark illustration of that
came in 2009 when Tim Tookey, finance director of Lloyds, which by then had acquired HBOS and was belatedly going through its books in close detail, gave a presentation to a New York conference. He
examined HBOS’ lending and compared it with Lloyds’ more conservative ‘risk appetite’. Of the £255 billion lent by HBOS retail, £65 billion, or a quarter, would
not have been lent by Lloyds because it was outside their ‘risk appetite’. In corporate banking £80 billion of the £116 billion was outside Lloyds’ appetite –
more than two-thirds. In international the figures were £20 billion of the total £61 billion lent by HBOS would not have been lent by Lloyds, nearly a third. In total Lloyds would not
have lent £165 billion of the total £432 billion – 38 per cent.
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Admittedly this is comparing one of the most aggressive banks with one of the most conservative, but it does illustrate the extent to which the management culture at HBOS encouraged it to take
higher risks in order to gain larger rewards. That is not to say that Lloyds would not have done any of the deals; indeed it was the second-largest taker of secondary debt from HBOS corporate
– that is, it took a proportion of the lending which HBOS sold down to reduce its own
exposure. In these cases Lloyds was willing to accept the same probability of
default as HBOS, but not to risk the same amount of money: it made the same bets, but its stakes were smaller.

It was not only liquidity which sank HBOS. It was also bad lending. That in turn led to a third factor: lack of capital. Again, I will explore the way in which capital is calculated and the
regulatory regime operated later, but here I want to make a simple point. By the middle of 2008 mounting bad debts had consumed so much of HBOS’s capital that it was forced to go to its
shareholders for more. The failure of its 2008 rights issue showed how far investor confidence had fallen, with less than 10 per cent of its shareholders prepared to buy more shares, even at a
substantial discount to the then market price. Further revelations of bad debts through the following months effectively ended any opportunity to raise more capital from private sources, leaving
only the Government as the investor of last resort.

All three factors which contributed to the collapse of HBOS – lack of liquidity, bad lending and lack of capital – were connected. During the boom years the fact that all banks, but
especially mortgage banks like HBOS, Northern Rock, Bradford & Bingley and Abbey National, could borrow in seemingly unlimited amounts at cheap rates from the wholesale money market, enabled
them to flood the property market with cash. This was a major factor in pushing up property prices and land values, which in turn were the security used for more lending. When the money tap was
turned off banks ran out of money, falling prices eroded the collateral which underpinned their lending and the resulting bad debts destroyed their capital.

Banks had ignored another of the fundamental rules of banking: look at the borrower, not the asset.

Why didn’t they realise?

In his foreword to the 2007 annual report, HBOS chairman Lord Stevenson wrote: ‘If ever the boards of banks, regulators or rating agencies needed a reminder of the
importance of strong liquidity and strong capital, the second half of 2007 served as a wake-up call. Seemingly overnight, we moved from a scenario where the economic cycle looked set to play out in
a relatively benign way, to one where a credit crunch in the USA rapidly deteriorated into what is, as I write this, a worldwide liquidity dislocation.’ So far so good, few would dispute his
analysis. He went on: ‘In the eye of the storm, nemesis followed hubris, with traditional market solutions seemingly impossible. Banks now know, as in truth they always did, that first and
foremost, it is the duty of the board to ensure that the group has financial stability and the wherewithal to continue in business profitably. Gradually this current market liquidity dislocation
will pass.’

Few would disagree with that sentiment either. It was his conclusion which now looks extraordinary:

We now know that it was complete nonsense. HBOS did not have strong capital, and within ten months of those words being published
would have to forfeit its independence
and accept government cash to avoid bankruptcy. The self-congratulation over the liquidity management of HBOS was unjustified: the dependence of the bank on the wholesale funding market made it
acutely vulnerable. Rigour and financial conservatism were the last adjectives you would have used to describe the quest for profit that the Bank had been and was still pursuing, regardless of
risk. The HBOS board turned out to be anything but good custodians of the business.

Dennis Stevenson is not a cynic. When he wrote those words I am sure he believed them and so did all, or at least most, of his board. The fact that Stevenson, Hornby, Cummings and other
directors piled into the shares at a time when others were selling shows how much they believed in the business. They subsequently lost most of their money. Were they naïve? Were they misled?
Were they incompetent? Did they rely on checks and balances which looked sound on paper, but were so flawed as to be useless?

Two things can be said with certainty about the corporate governance of HBOS. First, it was very elaborate. The Bank took expert advice from some of the leading consultants in the field on the
design of its structure, which involved numerous committees monitoring all aspects of risk. These groups included executive and non-executive members and were supported by a large department of
risk and governance specialists, who produced huge volumes of reports. Able men and women spent substantial amounts of their time reading and discussing these thick documents. There was a clear
upward line of reporting, which ended with the bank board.

Second, it did not work.

A devastating critique of corporate governance and risk management in HBOS was published by the FSA in 2012. It showed a system undermined by a culture that put revenue before risk, management
information which failed to show the real dangers the group was running, ineffective control and monitoring and a bias towards optimism, particularly when deciding how big provisions against bad
debts should be.
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Corporate governance had developed dramatically since the 1980s; in fact, then the term would not have been used or understood. Boards, even of the largest companies, were chosen by the
chairman, who sometimes was also the chief executive. A former Governor of Bank of Scotland described the process to me: ‘When
there was a vacancy coming up, I asked
around and when I thought I had a likely candidate I might have discussed his name with the deputy Governors, but then I just called him up.’ Criteria for choosing board candidates would not
have been explicit, even to the person making the appointment, but included experience, connections and personal preference – ‘Will he fit in?’ Again, I say ‘he’
because women on boards were still very rare. The Bank board of the 1970s and 1980s would not have looked very different from any other major company board of the period: white, middle-aged,
middle-class and male.

Some high-profile financial scandals in the early 1990s, largely seen as the result of loose systems of corporate governance, which allowed crooked individuals to manipulate companies, triggered
a revolution. The Cadbury report recommended a much more systematic approach to appointing directors and to their rights and responsibilities, especially over the financial oversight of the
company. This was followed a few years later by the Greenbury report, which suggested further refinements, particularly over the way in which executive pay was determined. These two reports were
merged into a combined Code of Corporate Governance which was modified by a series of later inquiries and given semi-legislative status by being incorporated into the Stock Exchange listing rules
and policed by regulators. At the same time there was a general acceptance that boards should be more diverse, include more women, younger people, more ethnic minorities, more people with
disabilities.

The assessment and control of risk in financial companies was also undergoing a reappraisal. National and international regulation, globalisation and the fear of ‘contagion’ –
the fall of one institution bringing down others – led to a formalising of the systems for monitoring and controlling risk. New international accounting standards were introduced, which
changed the way in which assets and liabilities were to be treated and demanded more detailed reporting. ‘Gut feel’ was to be replaced by a much more systematic, formulaic and
mathematical approach. Part of the drive was intended to make companies themselves think more seriously about the risks they were running and partly it aimed at a more public process so that
shareholders, regulators and counterparties (the companies and individuals with whom banks and financial institutions do business) would be able to gauge the level of risk more accurately.

‘Gut feel’ had severe limitations, but in the best institutions it was never just an instinctive feeling. It had been shorthand for an experience-based
approach. In the Bank, lending and other major financial decisions were subjected to several levels of scrutiny: credit committees, area boards, general managers and the Chief Executive, and often
the main board of the Bank. When executives said a deal ‘did not feel right’ they were not expressing a vague dislike, but drawing on years or decades of experience. In the 1990s this
was supplemented by more sophisticated analysis, but underlying it was the fact that the ‘ownership’ of the risk was always with the manager making the loan, who was likely to be in
post for a long period. It was his or her responsibility to know the customer, assess the creditworthiness and see the loan repaid – with the implicit sanction that too many bad debts would
damage career chances.

The Bank’s area boards also brought in outsiders, businessmen with knowledge of local industries and individual companies. This was obviously fraught with potential for conflicts of
interest: how did you know whether an area board member was expressing a genuine concern over the creditworthiness of an applicant, or trying to damage a business rival? But for the Bank, it seemed
to work. The whole system was driven by an ingrained culture which valued ethics and trusteeship – the acknowledgement that the money being handled did not belong to the Bank, but to its
depositors and its shareholders, which the Bank called ‘proprietors’ – owners.

Halifax, in its years as a building society, would have had a very similar ethos, derived from its roots in the savings and self-help movements of the nineteenth century. Those arrangements were
breaking down, even before the HBOS merger, to be replaced by a much more formal and transparent system. Professionalism had to replace amateurism. Written codes had to replace unspoken culture.
Risk departments supplanted individual responsibility.

The new system also broke the direct relationship of the lending officer to the risk. At the same time the sales culture, which was reaching all parts of banks, emphasised sales performance as
the principal measure of achievement. In the old days managers who wanted to get on had to prove they could bring in the business, but also knew that too many bad debts would blight their careers.
In the new system risk could seem like someone else’s responsibility. For ambitious managers, sales were what mattered.

‘It seems some of them envisaged they could further their careers by creating the biggest possible loan portfolio and if the risk department turned some down they
would find other loans to take their place,’ comments one retired senior bank executive. ‘Lack of continuity in career structures also meant they would probably not be around when the
loan was due to be repaid. In my day the senior team also had continuing access to the composition and spread of the total portfolio of loans and how this changed over time. I considered that one
of my prime responsibilities was to understand the risks we were taking on and whether the balance was acceptable. This was my/our job – not that of a risk department inside the bank or an
external regulator.’

Business grandees, like Cadbury and Greenbury, and regulators like the FSA may have seen the new corporate governance and risk disciplines in terms of principle and ethics, but to professional
services companies they were a new business opportunity. The major accountancy firms and international consultancies set up corporate governance and risk departments, which would help companies
design their systems to be ‘compliant’ and ‘state of the art’. HBOS took expensive advice – indeed it would have been open to criticism had it not done so. Systems had
not only to be comprehensive and sophisticated, but they had to be seen to be so.