Read Hubris: How HBOS Wrecked the Best Bank in Britain Online
Authors: Ray Perman,Alistair Darling
Achieving sell-down to the target hold position was a vital element of the corporate business model as a means of reducing its exposure to large leveraged transactions. But there were
significant problems. The division’s loans distribution capability was limited in comparison to other banks and there were issues with the effectiveness and authority of the loans
distribution unit. Deal teams resisted selling down parts of their deals because part of the fees earned had to be passed on to the buying banks and this directly affected their results and
incentives. They priced transactions primarily in order to secure the business rather than in order to facilitate sell-down. The aggressive deal structures used by HBOS also made selling down loans
harder, but deal teams continued to structure deals aggressively in order to secure the business.
In a number of large transactions, the corporate loans distribution unit expressed concerns about their ability to sell down particular transactions given the proposed pricing and/or structuring
of the transaction. Those concerns were overridden and the transactions were sanctioned. In a number of these transactions, the target level of sell-down was not achieved and HBOS remained exposed
to the whole risk.
Throughout the corporate division there was a ‘culture of optimism’ which made managers reluctant to admit how bad things really were. This meant that, even when potential or actual
default had been identified, managers were slower than they should have been in referring the transaction to the specialist High Risk team, which meant that the risk of defaults was
under-estimated. The FSA commented: ‘There was a significant risk that this would have an impact on HBOS’s capital requirements. It also meant that the full extent of stress in the
corporate portfolio was not visible to the group
executive, auditors and regulators.’ It added: ‘This optimism was unwarranted, without foundation and at the
expense of prudence.’
HBOS adopted an optimistic approach to levels of provisioning against problem loans despite repeated warnings from its auditors and the corporate division’s risk specialists. The optimism
bias was not challenged by the Group Risk department. The FSA listed the deteriorating situation as illustrated by HBOS’ repeated restatements of the level of ‘impaired assets’
within the corporate division’s portfolio and the level of provisions which had been made:
On 19 June 2008, HBOS issued a prospectus in relation to its rights issue. Corporate’s year-to-date impairment losses were not quantified or commented on in the
prospectus, but management information indicated that, as at 31 May 2008, it had year-to-date impairment losses of £369.9 million. However at the end of July, HBOS published its interim
results which stated that, as at 30 June 2008, there were year-to-date impairment losses of £469 million – a rise of £100 million in a month.
On 18 November 2008 in its prospectus for the placing of shares to the Government, HBOS said that, as at 30 September 2008, there were year-to-date impairment losses of £1.7 billion
– a rise of £1.2 billion in three months. One month later – HBOS published a trading update which stated that, as at 30 November 2008, there were year-to-date impairment
losses of £3.3 billion – a rise of over £2 billion in two months.
Throughout this period, HBOS’ auditors KPMG agreed that the overall level of the firm’s provisioning was acceptable. However, in relation to corporate, they consistently
suggested that a more prudent approach would be to increase the level of provision by a significant amount. The firm consistently chose to provision at what KPMG identified as being the
optimistic end of the acceptable range for corporate. KPMG’s view of what constituted the acceptable range was informed by management’s assessment of the degree of credit risk in
particular transactions,
the FSA said.
The corporate division’s risk department also consistently suggested that a more prudent approach would be to increase provisions significantly, but HBOS consistently rejected this advice.
‘For example, in December 2008, the Corporate Risk function identified a range of between £4.5 billion and £6.4 billion for provisioning to the
year-end.
The Corporate Risk function specifically warned against provisioning at the lower end of this £2 billion range, given the likely impact of deteriorating economic conditions on the
transactions they had assessed and the anticipated migration from the good book of other transactions, and recommended that provisions should be taken at a higher level. However the firm rejected
this recommendation and set the provision at the lowest end of this range,’ said the FSA.
The December 2008 management accounts issued by HBOS had assessed corporate’s year-to-date impairment losses as at 31 December 2008 as £4.7 billion. On 16 January 2009, Lloyds
completed its takeover of HBOS and a month later issued a trading update, which noted that impairment losses for the corporate division as at 31 December 2008 were now assessed at approximately
£7 billion. On 27 February 2009, Lloyds issued HBOS’ preliminary results for 2008. This confirmed the impairment losses in corporate as £6.7 billion including £1.6 billion
against property lending, £1.3 billion against deals done by HBOS’ Joint Ventures team and £900 million on deals done by ISAF.
These impairment amounts were approximately £2 billion higher than the equivalent amounts accounted for by HBOS. This difference was attributable to the level of corporate’s exposure
to property, where pronounced falls in property values and other investments had also resulted in substantial losses from the investment portfolio, primarily in Joint Ventures and ISAF. The shape
of the corporate book and in particular its exposure to house builders, risk capital and large single credit exposures, also exacerbated the impact of the economic downturn. Property-related
sectors accounted for around 60 per cent of the individual impairment provisions.
The FSA concluded that the corporate division’s credit risk management had been unable to react quickly enough to contain the severe economic deterioration in the second half of 2008. This
was made more difficult by the concentration in property-related sectors and had resulted in a dramatic increase in impairment losses. The substantial increase was partly the result of economic
conditions, but it also reflected the imposition of more prudent and robust risk management and impairment policies and methodology by Lloyds. Ironically, HBOS’ own corporate risk department
had recommended an increase in the level of provision of up to approximately £6.4 billion in December 2008, but had been ignored.
Why didn’t the regulators stop HBOS?
Banking regulation is a fearfully complicated subject and I am not an expert, so what follows is subjective and simplified. Compared to the cut and thrust of banking, it can
also be boring and you could argue that the role of a successful regulator is to make banking, if not boring, then certainly less exciting. The last 30 years have seen successive governments
wrestle with the problem of the extent to which banks should be confined and restricted. The instincts of the right have been towards less regulation and allowing enterprise and competition to
guide the market and protect consumers. The left distrusts the motives of bankers and believes they must be controlled. You cannot easily allocate these opposing views to the Conservative and
Labour parties. In government at some point each has swung from one side to the other.
Where to start? In the context of Bank of Scotland and HBOS the changes made by the Conservative government of Margaret Thatcher are certainly relevant. The removal of exchange controls, while
they had no immediate effect, opened the way for Britain to join the globalisation of banking. The exposure of HBOS to overseas markets, particularly the US, was limited in comparison with the
investment banks and its rival the Royal Bank of Scotland, but had exchange controls still been in place it would not have been able to hold as high a proportion of its assets in US mortgage
securities as it did. I am not arguing for exchange controls – their abolition undoubtedly enabled a big expansion in trade – but it was a factor.
So too was the removal of restrictions on building societies. It is possible to argue that this too led to substantial social and economic benefits, such as enabling a big expansion of home
ownership. But it is worth remarking that none of the building societies which took advantage of the freedom to demutualise and turn themselves into banks now survive as independent companies.
Some, like the Woolwich
and Cheltenham & Gloucester, were taken over while they were viable. Others like Northern Rock, Halifax (HBOS), Bradford & Bingley and Abbey
had to be rescued. There was a precedent for this in the deregulation in the 1980s of the Savings & Loans, or ‘Thrifts’, the US equivalent of building societies. Freed of
restrictions, nearly a quarter of the 3,200 institutions went bust.
In 1986 the Thatcher Government also ushered in ‘Big Bang’, an ending of restrictive practices in the London Stock Exchange, which was also the signal for the start of an era of
massive expansion in financial services, with little regulatory constraint. ‘Self-regulation’ was the fashion. For the first time banks were allowed to buy stockbroking firms, market
makers, insurance companies and investment managers. The lines between banking and other services blurred and business models were developed which depended not on service to customers, but on
cross-selling ‘products’.
American banks piled into London. They were prevented at home from entering the securities industry by the Glass-Steagall Act, the banking reform brought in after the Wall Street Crash, which
was not repealed until 1999.
Up until 1997, the banking regulator in Britain was the Bank of England which operated through a series of rules, some written, some not, to police the banking system. It was not perfect and
under its supervision periodic banking crises occurred, such as the near bankruptcy of NatWest in the secondary banking collapse, of Lloyds in the Latin American debt crisis and the failure of
Barings Bank in the Nick Leeson scandal. The Bank also had economic duties and powers, particularly over monetary policy and in 1997, as one of its first acts, the Labour Government with Gordon
Brown as Chancellor, took banking supervision away from the Bank of England and gave it to a new ‘super-regulator’ the Financial Services Authority (FSA), which also had responsibility
for overseeing the rest of the financial services industry.
FSA policy towards the banks was partly shaped by domestic considerations and partly by international regulation. Since the early 1970s international banking standards have been determined by a
committee of regulators from the major economic nations meeting in Basel, home of the Bank for International Settlements. The first Basel rules were introduced in response to the failure of a
German and an American bank, events that seem trivial compared to the spectacular
crashes of the credit crunch, but were enough to alert governments to the fact that banking
crises could spread across borders and needed co-ordinated action. At the beginning of the 1990s the Basel committee introduced a system of international regulation (now known as Basel I) which
sought to standardise the amount of capital banks should be required to keep.
I touched on the need for banks to keep capital in chapter 5 and on the Basel accords in chapter 17. To recap briefly, banks are required to keep capital (their shareholders’ equity, plus
any profits retained in the business and some specified other securities which could be easily sold for cash in an emergency) to protect their depositors. Any losses from defaulting loans should be
met from the capital, not deposits. Basel I set a minimum capital – 8 per cent of risk-weighted assets (loans). Risk weighting was supposed to compensate for the fact that some borrowers were
more unreliable than others. Lending to Western governments was assumed to have no risk, and therefore carried a risk weighting of zero, meaning that you could do as much of it as you liked and it
would not affect your capital requirement. (This was long before Greece’s default.) On the other hand, lending to large businesses carried a risk weight of 100 per cent, meaning that for
every loan you made, a sum equal to 8 per cent of it had to be maintained in capital.
Banks try to minimise their capital requirement because it is very nearly dead money – investing in risk-free assets earns very little return. The problem with Basel I was that it left too
many loopholes. The risk weights specified were fairly arbitrary: lending to a blue-chip FTSE 100 company carried the same risk weight as lending the same amount in unsecured personal loans. For
the same total of lending both needed the same amount of capital to be set aside, but you could charge the personal customers a lot higher interest and make more profit from them. The consequence
was that within the same band of risk, banks moved their lending towards the more profitable categories. They also found other ways around the rules. Securitisation was one, parcelling up bundles
of loans and moving them off the balance sheet. This enabled banks to grow without increasing their capital, indeed between 2004 and 2008 HBOS expanded its balance sheet very rapidly through
securitisation among other means, but at the same time reduced its capital by buying back £2.5 billion of shares.
Basel II, which was introduced after five years of consultation, was intended to be a much more comprehensive attempt at regulation and more sophisticated in its
approach. It refined the risk weights and allowed banks to calculate their own weights if they could persuade their own national regulator that they had the ability to do it properly. In addition
it laid down guidelines for individual country regulators and forced the banks to disclose more information about how they calculated risk and the amount of capital they set aside against it. HBOS
adopted the Basel II approach at the beginning of 2008 and was given permission by the FSA to calculate its own risk weights under the ‘Advanced IRB’ system.