Hubris: How HBOS Wrecked the Best Bank in Britain (36 page)

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

It was not only politicians who were trying to rein in the regulator, there were also frequent complaints from banks and other financial firms about the level of the contributions they made to
the FSA’s funding though levies. Under pressure to cut costs, the regulator actually reduced its staff in its Major Retail Groups Division by 20 people between 2004–8 at a time when it
was taking new responsibilities such as supervision of the introduction of Basel II. In its report on lessons to be learned from the Northern Rock collapse, the FSA also found that where its staff
had doubts about the management of banks they were not always raised with senior management at the regulator or with the bank itself.
⁴

The FSA admitted many of its failings and was abolished and
replaced with a new regulator and a new supervisory system. In the report on the Royal Bank of Scotland,
Turner describes

For ‘RBS’ in the previous paragraphs we could reasonably substitute ‘HBOS’.

In his evidence to the Treasury select committee Lord Turner also drew attention to the failures of both the Basel I and Basel II international regulatory regimes. ‘The global capital
standards applied before the crisis were severely deficient and liquidity regulation was totally inadequate. Banks across the world were operating on levels of capital and liquidity that were far
too low. These prudential regulations have been changed radically since the crisis, with the internationally agreed Basel III standards.’ His conclusion on the Royal Bank was: ‘Had
Basel III been in place at the time, not only would RBS have been unable to launch the bid for ABN AMRO, but it would have been prevented from paying dividends at any time during the Review Period,
i.e. from at least 2005 onwards.’ In the case of HBOS we could surmise that its pace of growth would have severely slowed had it been required to retain more capital.

It could be argued that every society gets the regulators it deserves. The last decade was a period when we were all not only permitting bank executives and boards to pursue reckless growth
policies, but
encouraging them to do so by favouring the shares of fast-growing companies over the more cautious ones and enjoying high dividends, high interest on current
accounts and easy low-cost mortgages. Successive governments, encouraged by the banks themselves, urged ‘light touch’ regulation and turned a blind eye to excessive executive salaries
and bonuses. The reward was high tax revenue which paid for high public spending. The press was mostly uncritical, fawning over ‘successful’ chief executives. At the height of the boom,
very few journalists were calling for tougher regulation and the cost in time and money of supervision was seen as unnecessary and expensive ‘red tape’.

In an environment like that we can no more expect a financial regulator to stop all bank collapses than we can expect the police to stop all crime. If we want things to change, the remedy is in
our own hands.

The end of history

In the summer of 1981 during a period of austerity imposed by Mrs Thatcher’s government, English cities erupted in sustained and violent rioting. Afterwards Environment
Secretary Michael Heseltine led a party of business leaders to look at the devastation in Liverpool, a city which had been deprived of investment. ‘Where are the financial services
companies,’ he demanded? Bruce Pattullo, then Treasurer of Bank of Scotland, replied that once every English region – including the North-west – had had its own local banks,
responding to local needs and supporting local industry and jobs. The Bank of Liverpool, founded in 1831, took over Martins Bank and grew to 700 branches before being absorbed by Barclays in 1969.
By the 1980s only Scotland and Yorkshire still had financial institutions with any autonomy. Now those too have succumbed to consolidation.

This is not just a regional loss, it is part of the cause of the national disaster of the banking crash of 2008. A banking system loses its resilience if it is reduced to a handful of national
institutions which are too big to fail. A sustainable ecosystem has big and small, specialist and generalist, regional and national. Local banks used to attract managers who were able and talented,
but knew the limits of their ambition. I remember in the early 1980s attending the annual results press conference of Yorkshire Bank in Leeds. The chief executive wilfully misheard a question on
the bank’s exposure to sovereign debt in Mexico and started talking about what it was doing in Mexborough, a town in the south of the county. His intention was to show that the bank did not
take big risks by investing outside its area of competence, but it did know and care about what was happening in its own locality. Mexborough was not without its problems, but it did not have the
potential to bring down major financial institutions, which is what nearly happened to much bigger banks that bet too heavily on Mexico.