Hubris: How HBOS Wrecked the Best Bank in Britain

by Perman, Ray

  Hornby and Stevenson also argued that the ‘closure’ of the wholesale markets was an unforeseen and, in fact, an unforeseeable event. Apart from the short period of dislocation after the Twin Towers attacks in 2001, markets had not suffered a general seize-up since the Wall Street crash. This was also true, but the market did not cease to operate altogether, although it treated different banks in different ways. Lloyds and HSBC, for example, both much more conservatively run institutions than HBOS and each with much less reliance on the inter-bank market, found it more difficult to raise money in the autumn of 2008 than they had six months earlier, but were able to fund themselves nonetheless. It was possible even for HBOS to borrow, although the terms of its borrowings had shrunk to a day at a time and the price had risen to levels at which it could not operate profitably.

  HBOS bore the mark of Cain on its forehead. This had happened to a single bank before, although in a less public way. In 1974 NatWest had got into such trouble by over-extending itself in the property market that other banks were reluctant to lend to it and it faced a liquidity crisis. But the world was different then and the Bank of England could create time to resolve the crisis by keeping the whole issue private. The Bank and NatWest itself told the public a deliberate lie – that NatWest was not in trouble – in order not to shake confidence in the whole banking system. The market was also smaller. Behind closed doors the Bank of England lent heavily on other banks to support NatWest and itself pumped in money to keep it going.

  By 2008 regulatory disclosure and a much more active press meant that it was impossible to keep the predicament of HBOS a secret. It was also impossible for the central bank to influence the behaviour of the inter-bank market, which had become global. This time it was the Treasury rather than the Bank of England that took the lead and Lloyds was a willing rather than a reluctant participant in the rescue. But in 1974 NatWest could survive its crisis. This time it was different: HBOS’s losses were so heavy and its management had lost so much credibility that it could not continue as an independent bank.

  How had it got itself into this position?

  To answer that question we need to go back to its beginning. The justification given for the merger in 2001 was to marry Halifax’s large, low-risk, but slow growing balance sheet with Bank of Scotland’s fast-growing lending book. Analysts were sceptical about the ability of Halifax to expand when it had few skills or experience outside personal financial services. Its dominant market share in its core business, mortgages, would be hard to defend against aggressive competition. Bank of Scotland, on the other hand, had been dogged by concerns over its increasing reliance on wholesale funding, which threatened to curtail its growth. The merger appeared to answer both concerns. By being able to tap into Halifax’s market-leading share of retail deposit accounts, the Bank would be able to continue to fund its expansion and the combined group would be able to increase its profitability safely.

  That may have been the common perception of how the newly created group would progress, but it was not one held by the management of Halifax. From the beginning James Crosby set startlingly demanding targets – to achieve a 15–20 per cent share of each of the markets in which it operated. That was a huge stretch for corporate and business banking, where the initial market share was in low single figures. In retail banking it meant an aggressive drive to attract new mortgages which inevitably diluted Halifax’s safe and solid traditional mortgage book. With a share of existing mortgages of 20 per cent, in some years HBOS also took more than 30 per cent of new mortgages.

  How did it do this? The first annual report of HBOS made lofty claims about being on the side of the consumer, but in view of the fines imposed subsequently by the FSA for various lapses in customer service, we can dismiss this as cynical marketing. In common with many other banks, HBOS’ most profitable product was payment protection insurance (PPI), one of the most blatant examples of mis-selling by financial services companies. In 2011 Lloyds Banking Group had to set aside £3.2 billion to compensate customers who had been mis-sold PPI, including many from Halifax and Bank of Scotland. The competitive advantage of HBOS was not service or concern for its customers, it was price. It sold products at margins so thin as to be unsustainable; some even though they made a loss. This was market share at any price.

  Along with low prices went a willingness to take more risks than its competitors. This led to a rapid increase in unsecured personal loans, credit card lending and ‘specialist’ mortgages – a euphemism for self-certified, buy-to-let and mortgages with very high loan-to-value ratios, including the notorious 125 per cent loans. Competition in retail financial services was intense and HBOS staff were under constant pressure to keep up with their rivals. Supersalesman Andy Hornby always ended his monthly newsletter to staff with the injunction ‘Keep smiling, keep selling’ and staff who did sell well were rewarded with cash and other incentives. According to one nonexecutive director: ‘The impression was, ‘‘Never mind the quality, feel the bonus’’.’ As Chapter 22 will show, this pattern was repeated in corporate banking.

  While the market was booming the policy paid off for everyone. HBOS directors saw the benefits in their salaries and bonuses. Direct comparisons are complicated by changes of role, but in 2001 James Crosby as chief executive received a total of £1,073,000, whereas in 2007 Andy Hornby in the same job received £1,926,000 – an increase of 80 per cent.5

  In 2001 George Mitchell as head of corporate banking, received £678,000, but in 2007 Peter Cummings received £2,606,000 – an increase of 284 per cent. Lower down the pecking order rewards were not quite so spectacular, but bank staff did well with average staff salaries growing by 40 per cent over the same time period.

  The high-pressure sales culture was not unique to HBOS, but it was not shared by all banks. Among the top five big banks in the UK, HBOS, The Royal Bank of Scotland and Barclays followed aggressive expansion policies, while Lloyds and HSBC were known for being more conservatively run. This can be seen in their results. Between 2001 and 2007 HBOS grew its total lending by nearly 120 per cent, while the increase in Lloyds during the same period was less than 70 per cent. HBOS’ profits increased by 90 per cent, whereas Lloyds’ rose by only 13 per cent.

  It was not only the management which saw big rewards. HBOS investors saw the benefits of the rapid expansion in the share price, which outperformed the FT banking index for most of the period, whereas Lloyds consistently under-performed.

  When the market turned, the risks in the policy should have begun to show, yet the pressure on staff to sell continued even after the financial crisis began: ‘Despite the recession caused by this financial crisis, the company [did] not reduce staff targets significantly in any area. In some cases the targets [were] increased for retail staff. So if you’re in a little branch of HBOS in Auchtermuchty . . . and you were meant to sell five mortgages a week, or three personal loans a day, you’re still meant to be doing that even though potentially five per cent of your customers are now unemployed or they’re probably on salary freezes, you’re still meant to be doing that.’2

  By then, however, the momentum was hard to arrest. ‘The whole mood at the top was that everything had been going so well that anything was possible and nothing could go wrong,’ remembers a former director of the bank.

  Paul Moore, dismissed as HBOS head of regulatory risk by Crosby in 2005, told the Commons Treasury Committee:

  Even non-bankers with no credit risk management expertise, if asked (and I have asked a few myself), would have known that there must have been a very high risk if you lend money to people who have no jobs, no provable income and no assets. If you lend that money to buy an asset which is worth the same or even less than the amount of the loan and secure that loan on the value of that asset purchased and, then, assume that asset will always rise in value, you must be pretty much close to delusional. You simply don’t need to be an economic rocket scientist or mathematical financial risk management specialist to know this. You just need com
mon sense. So why didn’t the experts know? Or did they but they carried on anyway because they were paid to do so or too frightened to speak up?3

  Ordinary staff in the Bank were not rocket scientists, but they had doubts about the sales policy being followed:

  Although when the Northern Rock crisis broke in 2008 people saw it as not connected to them, they were stunned by it because they thought ‘How could this happen?’ They didn’t quite see the connection between what a building society in the north of England really had to do with the Bank of Scotland or HBOS. Not that long afterwards there was an end to the property boom and that had a massive impact on HBOS because it meant they didn’t have enough money. HBOS had the highest percentage of mortgages on its books in Britain, and lending practices had potentially not been as resilient as they could have been, with people lent much larger amounts than they previously would have been under a more conservative traditional banking model.

  Staff were doing what they were told and were following the rules given to them under the risk strategy that applied. But that exposed the company to quite a lot of potentially bad lending in housing, and that was a bit of an open secret.4

  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.5

  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.

  21

  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:

  For 2008 we will continue to pay careful attention to the importance of both strong capital and strong liquidity and to size our balance sheet to the certainty of both. We are, I believe, rightly proud as a board that we have been altering the risk profile of our liquidity requirements over the last four years, long before the current so-called liquidity crunch and without any external pressures from regulators or other shareholders but purely as part of being good custodians of your business. You may be quite sure that we will continue to bring to bear the same standards of rigour and financial conservatism as the business moves forward.

  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.1

  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.