by Perman, Ray
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.
23
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.
The new accord was thought by the banks to be more advantageous to them than the old one (HBOS expected to be able to make a higher return on equity), but this did not stop them lobbying for even more relaxation. The submission by Bob Brooks, the HBOS head of balance sheet risk, to the Basel committee arguing against further regulation on grounds of cost and complexity, looks ironic given the date on which it was sent, 3 October 2008, by which time HBOS was hurtling towards bankruptcy. ‘The events of the last 12 months have demonstrated that the level of VaR [Value at Risk] based capital has proved inadequate to withstand the impact of unprecedented market stress and, with hindsight, should have been somewhat higher particularly for credit instruments,’ he concedes. ‘However, going forward, there would seem to be equal systemic dangers associated now with erring too much in the other direction and constructing a regime that is overly calibrated to abnormal conditions.’
The Basel accords clearly failed to prevent banks getting into trouble and may have exacerbated things by giving a spurious sense of comfort in apparently being able to calculate risk and set aside adequate capital to absorb expected defaults. The level of capital required had been set against historical norms in an environment where bank managements and governments were in league in lobbying against too stringent regulation. No one had realised that globalisation and the prolonged economic boom ushered in by an era of cheap money had changed the game. Banks were taking much bigger risks and the longer they got away with them, the more they felt justified in taking on more risk.
HBOS does not appear to have been any more guilty of using the system to its own advantage than many other banks. To a certain extent banks were aided and abetted by their own governments in trying to make the rules as least burdensome as possible. ‘Light touch regulation’ was a bi-partisan policy in the UK, the US and much of Europe for the first decade of the twenty-first century. Governments had a vested interest in seeing their financial institutions make as much profit as possible, because profit meant wealth creation and tax revenue. On becoming Chancellor, Alistair Darling was surprised to find how dependent the UK was on receipts from the financial sector, which made up 25 per cent of corporate taxes.
The FSA when it was set up in 1997 had a gigantic task. Not only was it responsible for supervising the banking system, which was itself growing and becoming more international by the day, but also the rest of the financial services sector – investment, insurance and everything else. At one end of the scale it was meant to be controlling the risk in complex international derivative trading, at the other seeing that consumers were not misled in buying basic financial products. Nevertheless it monitored HBOS closely and investigated a number of concerns.
The first full risk assessment of HBOS (known as an Arrow assessment) came in late 2002 soon after the formation of the group. This was the standard regulatory examination of a bank’s risk and control systems and usually results in dozens of small points, which require attention and changes. However, the FSA found a larger systemic issue which it felt needed further work and commissioned a ‘Section 166’ report from the accountancy firm PwC, which recommended management changes. Divisions within the group had different methods of assessing and managing risk and there was no consistency. It was also concerned that departments dealing with credit risk, operational risk and regulatory risk all reported to the group head of risk, who then reported to the finance director. There was clearly a concern that the head of risk did not have the authority to challenge the dominant sales culture in the group and the FSA recommended that risk should have a higher profile.
In December 2004, after a further full assessment, the FSA concluded that the risk profile of the group had improved and that it had made good progress in addressing the risks highlighted in the earlier investigation, but that the group risk functions still did not carry enough weight. This was seen as a key weakness. HBOS’ response was to appoint Jo Dawson to the board as Group Risk Director. This surprised some of the non-executives on the HBOS board, who questioned her lack of previous experience in risk management, but her appointment was confirmed. This provoked a complaint to the FSA by Paul Moore, who had been sacked as head of regulatory risk. ‘In his view,’ said the FSA, ‘the new group risk director was not ‘‘fit and proper’’ to be approved by the FSA to hold that post, by reason of lack of integrity, lack of experience in risk management, and of general attitude and approach; he also made other allegations about HBOS’ overall risk framework.’
To answer these criticisms, with the approval of the FSA, HBOS commissioned an external review from its auditors KPMG. The accountants spent 80 hours in interviews and meetings with 28 individuals including the chief executive, finance director and then head of retail, as well as with Paul Moore. KPMG’s report said it ‘did not believe that the evidence reviewed suggested that the candidate was not fit and proper’ and added ‘the process for the identification and assessment of candidates for the group risk director position appeared appropriate’ and ‘the structure and reporting lines of Group Regulatory Risk are appropriate’.
As a sanction the FSA had required HBOS at the beginning of 2004 to increase the level of capital it held by half a percentage point. This would have impacted on its profitability and acted as a spur to management to put things right. By the end of the same year the FSA was satisfied and reduced the capital requirement again.
However, the regulator was still concerned about the risk management framework in HBOS and in 2006 made another Arrow risk assessment. It found that whilst the group had made progress, there were still control issues. In particular the growth strategy ‘posed risks to the whole group and . . . these risks must be managed and mitigated’.1 The FSA told the group it would closely track progress in putting these deficiencies right.
The Arrow process was meant to be comprehensive and covered an examination of the group’s strategy and business, principal activities, capital and liquidity positions and the nature of its funding. Clearly the FSA had concerns because it did not allow HBOS the ‘regulatory dividend’ it granted to firms it considered were ‘doing the right thing’ – extending the period between regulatory assessments from the normal 24 months to 36 months. Ironically, it granted this concession to Northern Rock, a company which shared with HBOS many
of the risk factors later identified – high revenue and profit growth targets (15–20 per cent), low interest margin, low cost/income ratio and relatively high reliance on wholesale funding and securitisation.2
With the benefit of hindsight we can see that the assessment of HBOS in 2006 was completely inadequate. The very thorough investigation six years later by the FSA’s enforcement division of the failings of HBOS corporate banking found numerous flaws in risk monitoring, management and reporting and followed them right up to group level. These went back at least to the beginning of 2006, the year in which the Arrow assessment had been carried out. At the very least this suggests that the Arrow assessment was no better than superficial.
The FSA was abolished in Spring 2013 without producing a comprehensive report on the collapse of HBOS, but in its reports on the Royal Bank of Scotland and Northern Rock it admitted to failings both in the international system of regulation and of its own supervision. Lord Turner, chairman of the FSA, admitted that the regulator was too focused on conduct regulation at the time (that RBS got into difficulties) and its prudential supervision of major banks was inadequate. ‘The FSA operated a flawed supervisory approach which failed adequately to challenge the judgement and risk assessments of the management of RBS. This approach reflected widely held, but mistaken assumptions about the stability of financial systems and existed against a backdrop of political pressures for a ‘‘light touch’’ regulatory regime.’3
