Hubris: How HBOS Wrecked the Best Bank in Britain

by Perman, Ray

  It was announced that James Crosby and Mike Ellis would have offices in The Mound and both men rented flats in Edinburgh. Ellis worked out of his office except when group business took him elsewhere and quickly won respect from the Bank of Scotland management for his professionalism, experience and the hard work he put into mastering the new business. Crosby was seen in his office much less often. He admitted to the Independent that he would only visit once a week and was immediately branded the ‘once-a-week Scot’. He would continue to live in Yorkshire, where three of his four children were at school. He was recognised as very intelligent, but not an easy man to talk to or to read. With Hornby based in Halifax, the days of the close corporate collaboration of the Bank of Scotland general managers with offices grouped together on the same floor of The Mound were gone. It was much more difficult to get an overview of the business or a sense of shared values and mission.

  Non-executive directors for the combined board were chosen by the executives – who issued invitations to five from each side. The Bank provided Deputy Governor and former Shell executive Sir Bob Reid, Sir Ron Garrick, former chief executive of the engineering group Weir, John Maclean, an accountant who had been in shipping, Brian Ivory, who had run a whisky company, and Lord Simpson of Dunkeld, whose stewardship of the electronics group Marconi, which was facing collapse, was coming under sustained attack by workers and investors alike. He lasted less than a year before resigning under shareholder pressure. Notable among those not asked to serve as an HBOS director was Lesley Knox, who had a reputation for asking pointed and difficult questions on the Bank board. She also had experience in corporate finance and asset management, working for an investment bank. In the years to come her expertise would be missed.

  There was also a lack of banking experience among the former Halifax directors. They were Charles Dunstone, the founder of Carphone Warehouse, Tony Hobson, who had been finance director of the life assurance company Legal & General, Coline McConville, who was in advertising, Louis Sherwood, whose background was television and retail, and Philip Yea from the drinks industry.

  Bank of Scotland had got by without ex-bankers among its non-executives, but the process of ‘homologation’ – the cross-examination of executives on specific initiatives, including major lending decisions – meant that they had built up a detailed picture of how the Bank ran and where the pitfalls might be hidden. Those directors who moved to HBOS found that the board was expected to operate in a very different way. ‘Stevenson didn’t see the point of close questioning the executives,’ one director recalls, ‘but there was a point. Over time you could see a growing over-confidence: we lent money and we were never wrong. The board lost the habit of challenge.’ HBOS was on a different scale to Bank of Scotland and a much more complex organisation. The formal governance demands on boards had also grown, with new regulations and new City codes. ‘Board papers were inches thick and if you asked a question at a board meeting an executive could always point to a report of 156 pages and tell you that your question was answered on page 144. You had never got to it – there just wasn’t time to read it all.’

  Another director recalls: ‘The HBOS governance structure was well thought through, they had taken external advice and on paper it looked very strong. In practice Dennis, James and Andy were a very tight team and they ran the company. We thought Peter would be part of it, but he wasn’t.’

  Yet despite the misgivings there was a feeling that the Bank had found a way out of its long-standing funding dilemma. But had it? Despite the fabled strength of its balance sheet, Halifax had not completely eliminated the reliance on wholesale funding markets. In its last year as an independent company, Bank of Scotland had lent £66 billion and been able to cover 54 per cent from customer deposits. Although HBOS could cover 66 per cent of its lending from deposits, it was still reliant on the wholesale market for a third of its advances and, worryingly, there was no significant business area where deposit growth was keeping up with the rise in lending.

  Responsibility for keeping the group funded fell to Gordon McQueen, who had merged the two treasury operations. Bank of Scotland had always been conservatively run, never venturing into proprietary trading, but seeing itself only as a service department for the Bank and its customers. Since demutualisation Halifax had started a small trading business, which, although it involved some risk, was well run and profitable, but McQueen closed it. Treasury was expected at least to cover its costs from the prices it charged corporate customers and the lending businesses within the group for the capital they needed, but McQueen wanted to go further and use higher internal pricing to force the retail, business and corporate banking operations to target deposit growth as well as lending increases. The proposal was vetoed by Crosby. To do so would hold the whole business back, he said.

  However, there was nothing to fear on the wholesale funding market. The combined group had a strong balance sheet and was viewed as low-risk by those who lent to it. The rating agencies graded 99 per cent of its investment portfolio as A or better, and 86 per cent was graded AAA – the highest level. For Bank of Scotland’s continued growth in corporate lending the outlook was good: following the merger its senior debt had been upgraded from A+ to AA by Standard & Poors, one of the leading ratings agencies.2 This was a mark of approval and meant that the Bank would be able to borrow at lower rates, making it more competitive in its drive to take business from its London rivals.

  12

  A clash of cultures

  HBOS shares made their debut on the London Stock Exchange the day before the attack on the Twin Towers in New York in September 2001. The market was already in a grim mood fearing a recession and the FTSE index suffered a major fall, but the new bank’s shares bucked the trend and rose more than three per cent on the day, a good omen. The previous few months had seen the deal approved by both sets of shareholders in ballots and at special meetings. Sir Jack Shaw and other Bank of Scotland directors who were not joining the HBOS board bowed out and more than three centuries of independence for Britain’s oldest commercial bank had come to an end.

  The vote of Bank shareholders had produced a final example of the personal attention to detail for which chief executives of the Bank had been known. A small shareholder, Dr George Fieldman, complained that because of an administrative error he and others like him who held their shares in a tax-free savings plan had been denied a vote. After complaining, getting no satisfaction and threatening to take it further, he was surprised to receive a telephone call from Peter Burt.

  ‘He seemed a very polite and thoughtful individual and said he had heard that there was a problem. I explained how I and many other customers holding BoS shares in a BoS Personal Equity Plan had been disenfranchised and that the Bank had actually profited by failing to meet its obligations. I outlined how they must have saved money by not having to pay for the necessary paper, printing, postage and processing for the vote which failed to take place. Mr Burt said: “All true but what can we do about it?” I suggested he should add up the total amount that the Bank had saved by dint of its mistake and give the equivalent sum to charity. He asked, “Which charity?” I said, “You choose.” He suggested “Save the Children”, and I agreed. Shortly afterwards I received a letter, dated 3 September 2001, from Peter Burt informing me that he had sent a cheque for £4,000 to the Save the Children Fund, and so a degree of satisfaction was obtained.’1

  A few weeks later Bank of Scotland reported half-year results – its last as a separate company. Profits rose by 7 per cent on lending, up by nearly a quarter, but HBOS shares fell on the revelation that bad debt provisions had risen by 27 per cent – a portent of the harsher economic times which were coming.

  HBOS’s first annual report laid heavy stress on partnership. The cover, with the caption ‘The New Force’, showed two shirt-sleeved arms with hands clasped in friendship. One set of cufflinks bore the cross of St George, the other the saltire of St Andrew. In his chairman’s introduction Lord Stevenson promi
sed ‘shared values, shared vision and an ambition to seek out new opportunities’. The speed at which the merger had been agreed and concluded was testimony to the closeness of view of the two sides. ‘This was a merger of equals where relative size was always secondary to the shareholder value that teams with a shared vision can create.’

  The overview of the group’s activities highlighted its strength in various areas through a very selective use of the numbers. Retail banking was number one in mortgages and savings, the report trumpeted. There was no claim for market position for insurance, merely that it had £1.1 billion of life, pension and investment premium income. Similarly the document reported £19 billion of business lending (a figure which would have put it fairly low down the list of lenders to small and medium firms) but claimed HBOS was market leader in the UK in management buyouts, bank finance for social housing and public-to-private financing. To round it off it was also a ‘major sterling money market presence’.

  In his narrative, James Crosby emphasised the bank’s solidity and its intention to be a consumer champion. For personal customers he promised realistic pricing and transparent charging coupled with ‘pro-consumer PR work’. For corporate banking he described the ‘old world’ character of the lending book – and indeed the Bank of Scotland portfolio was old world. It had avoided the excesses of the new economy’s ‘dot.com’ boom and bust and preferred to lend to traditional industries like engineering, manufacturing, construction and property and have its loans backed by real-world assets like land, bricks and mortar. In an echo of the traditional Bank philosophy of ‘staying at the table’, he promised, ‘We also pride ourselves on having the flexibility, whenever realistic, to see customers through the bad times as well as the good. After all a bank that pulls back at the first whiff of trouble does not deserve the partnership we seek with each of our corporate customers.’

  You had to look deeper into the accounts to spot some of the less satisfactory aspects of the group’s performance. In retail, the area run by Andy Hornby which made up half the total group business, profits had declined despite increased lending. Costs and provisions against bad debts were up and interest margins were lower. It was insurance, which was benefiting from the acquisition of the Equitable Life salesforce a year earlier, and corporate banking, which saw lending increase by a third and profits by even more, that provided the group’s growth.

  Deep inside the report, it was revealed that the merger had been the occasion for substantial increases in salaries for the top management. James Crosby saw his total remuneration (salary plus bonus) leap from £690,000 to over £1 million, a rise of 56 per cent and a sum which made him better paid than the chief executive of LloydsTSB. Peter Burt was not far behind, seeing a rise from £682,000 to £994,000. Mike Ellis received 55 per cent more, Andy Hornby 64 per cent more and the three former Bank executives, Gordon McQueen, Colin Matthew and George Mitchell more than doubled their total takings. Even the part-time chairman, Lord Stevenson, saw his remuneration jump from £265,000 to £363,000.

  The extra pay would not stop with the end of employment. Since bank employees enjoyed pensions based on their final salary at age 60 – typically at two-thirds – the HBOS executives could look forward to retirements considerably more comfortable than they had been expecting before the merger.

  The late 1990s and early years of the new millennium saw a rapid explosion in top corporate remuneration, serviced by a new specialism – corporate pay consultants. These experts could produce tables of comparative salaries paid by other companies in the same sector showing why boards had to agree to match remuneration for fear that they would lose top talent to competitors, although actual instances of the highest level executives moving from one bank to another were comparatively rare. Rates also had to keep up with those paid in other countries, especially the United States, although movement between countries was even rarer. In 2001 the only recent immigrant to the highest echelon of British banking had been the Canadian Matt Barrett, hired by Barclays as chief executive. Barrett brought with him an expectation of higher pay and immediately set a benchmark for other bank chiefs. Boards were bamboozled by the calculations produced by the top pay experts and cowed into accepting their arguments. ‘We didn’t like it but we found it impossible to resist the consultants and go against the tide,’ commented one director.

  Consultancies also devised complex bonus structures including short-term incentives, long-term incentives, cash payments and the award of shares or options to acquire shares at a later date at a fixed price. These awards were granted on an assessment of performance against a cocktail of measures including earnings per share (EPS), return on equity (RoE) and profit performance. To make the whole process ‘transparent’, to use the jargon of the time, extensive notes to the accounts purported to explain each scheme. Ten pages were devoted to the report of the remuneration committee of the board in the 2001 HBOS accounts. Even for a professional shareholder, working through that volume of words and figures to determine whether the exalted salaries and bonuses were being earned or not was a daunting business.

  A simpler and cruder calculation illustrates how the pay of top executives had changed. In 1990 Bruce Pattullo, as the highest-paid director in Bank of Scotland, earned £176,000, 16 times the average salary of all staff in the Bank. There was no bonus, although these began to be introduced a few years later. By 2000 Peter Burt’s salary as chief executive and highest-paid director had risen to £426,000, some 18 times the average. One year later James Crosby’s basic pay was 25 times the average. If you add in his bonus – which nearly doubled his total remuneration – he was paid more than 43 times the average HBOS employee.

  These increases did not go totally unremarked, particularly among small shareholders who expressed their disquiet at the group’s first annual meeting, with one questioner calling them ‘obscene’. A long-term bonus scheme which could have seen Crosby and Burt earn up to £7 million more over the following three years came in for special condemnation, with even some institutional shareholders voicing concern. But small shareholders discovered the limit to their power when the chairman revealed that he already had votes in favour from institutional investors representing three-quarters of the total shareholding. The meeting also illustrated a sharp difference in style between the old days of the Bank and the new HBOS. Stevenson’s easy, casual approach contrasted sharply with the formal manner of Sir Jack Shaw and his predecessors as Bank Governors and upset at least one small shareholder who demanded an end to the ‘Andys, Bobs and Georges’ and a return to formal titles.

  Inside the Bank Stevenson’s familiar style and eclectic mind divided opinion. Some saw him as a breath of fresh air, to others ‘He was a right plonker’.

  The job of integrating the two organisations had now begun in earnest and was felt in some areas much more than in others. In corporate banking it was almost business as usual. Most of the staff and management had come from Bank of Scotland and they were still trading under the same name, with the only difference being that they had more firepower at their disposal, but in branch banking the difference was felt acutely.

  Bank of Scotland staff had been through a half-revolution of their own. With Gavin Masterton as Treasurer and Chief General Manager there had been much more emphasis on sales, with counter staff being expected to ask customers what more the Bank could do for them, rather than waiting for the customer to volunteer the information as in the old days. But the transformation had only been partially completed. ‘We were trying to downsize the branch network because of the costs and the old idea of customer service had to change. We had to move to relationship banking. But people were used to having the same manager for three or four years – when they found they had three different managers in 12 months, they got pissed off,’ recalls one executive.

  The upheaval not only discomfited customers, there was also resistance from staff. ‘Everyone realised that things had to change, that our network was old-fashioned, but a lot of people were
steeped in their ways and didn’t like change with the result that the transformation was not done as well as it should have been. There were teething problems – we would have got them fixed, but before we knew it we were into the merger.’

  Bank of Scotland employees had not been prepared for the sales-driven culture which Andy Hornby, using the retail experience and skills he had learned at Asda, had introduced into Halifax. Staff were expected to sell products rather than provide a service and were given targets to reach, and training in how to achieve them. Branch premises were also undergoing a makeover, doing away with mahogany counters and bandit screens and making them into bright, modern retail outlets. If they weren’t in the right locations they were closed and new premises opened in shopping malls and other high-footfall areas.

  Older, more traditional bank customers were unsettled and to make matters worse, the switchover of computer systems did not go smoothly. Personal customers had their accounts moved from the Bank system to the Halifax network, being given a ‘roll number’, a traditional building society identifier, in the process. Business customers stayed with the Bank system. This was a physical severing of the old Bank principle of seeing the business relationship as an extension of the personal relationship and created problems where customers had personal and business accounts with HBOS. I was one of many customers to experience difficulties when I unwittingly paid cash into my personal account in a branch which was connected to the business banking computer network. The money disappeared without trace, my account went into unauthorised overdraft and the bank started refusing to pay my standing orders and direct debits. It took me ten days to sort out the mess, with bank staff apparently powerless to help me. The threatening letters from the gas, electricity and telephone companies went on for much longer. I ended my 20-year relationship with the Bank. A personal apology from Hornby was sent to all Scottish account holders and staff, but by that time it was too late. Many loyal customers had left.