HBOS HOTCHPOTCH

At least seven years after the event, the official report by the Financial Conduct Authority and the Prudential Regulation Authority on the failure of HBOS has now been published. It makes sorry reading, all 405 pages, a chronicle of mismanagement and poor leadership. The era of “banker-bashing” can now draw to a close – the culprits are identified and must live with their disgrace – but the overwhelmingly respectable banking profession can turn over a new page and steadily rebuild the esteem it once enjoyed.

Dennis Stevenson (chairman) James Crosby 1st CEO Andy Hornby 2nd CEO

Now that most of the facts about the two major UK banking failures, Royal Bank of Scotland (RBS) and Halifax Bank of Scotland (HBOS) have been revealed, it is possible to draw some tentative conclusions.

HBOS, unlike RBS, was not a complex bank. It was not involved in investment banking – its offerings were principally personal overdrafts and mortgages (it came to hold 20% of the UK mortgage market) together with commercial loans (principally to housebuilding and property companies). Its overseas operations were not extensive although it lent heavily in Ireland and in Australia. The company’s origins derived from the merger in 2001 of Halifax, the large, long demutualised UK building society and now a bank, and Bank of Scotland, established in 1695, a strong regional financier but quite small in UK terms. The ambition was to develop BOS into a much larger UK player and for Halifax to retain its leading rank among mortgage providers.

A drive to grow the HBOS balance sheet ensued by rapidly acquiring new customers and making larger loans. This hectic drive resulted in poor quality loans being made to second rate borrowers, imprudent credit being granted on the basis of over-optimistic property valuations and executives concentrating on their sales targets upon which their advancement and bonuses depended. The HBOS balance sheet grew in the 2002-5 period from £312bn to £540bn; in the buoyant pre-2007 financial market HBOS flourished and few questioned its business model.

Yet there were fundamental flaws. A bank cannot expand indefinitely without expansion of its funding. HBOS’ lending, often long-term, soon outpaced the growth of its deposit base. It depended too much on short-term funds, for say 1 month, from the wholesale inter-bank money market to finance the business. This mismatch of funding is a commonplace of banking and HBOS should have realised it was becoming ever more illiquid and cut back its lending. It failed to do so and was in a uniquely vulnerable position when the 2007-8 crisis struck. Wholesale lines of credit dried up and HBOS was unable to meet its liabilities; only a hasty takeover by Lloyds Bank in 2008 prevented an ignominious collapse. Lloyds itself had to be bailed out by the UK government with £20.5bn when the size of HBOS’ losses engulfed it.

Strange to relate, there was a shortage of banking experience at the highest level at HBOS. The chairman, Dennis Stevenson, was a management consultant with much knowledge of the media, but not much of banking. Unusually he participated in the sales-orientated share option plan, so he had a vested interest in rapid growth. The first CEO, James Crosby, was an actuary rather than a banker (though he was bizarrely recruited to the board of the FSA) and the second CEO Andy Hornby had worked for 3 years in the bank but his main career had been with supermarket group Asda, and was essentially a salesman. There were senior bankers at HBOS but hardly any had any outside experience: they were home-grown, loyalist and parochial. There were normally 9 non-exec directors offering their wisdom, but their eminence derived from quite different businesses. Their contribution was invisible, as they did not have the knowledge to question the dense banking information provided; only when John Mack of Bank of America joined the board in 2007 was any challenge mounted, much too late. HBOS was an accident waiting to happen.

I guess there are many lessons and I touch on a few:

(1)    The Bank of England needs to vet the suitability of the Chairmen and Chief Executives of banks with especial rigour.

(2)    The FCA (formerly the FSA), fatally complimented for its “light touch” in the early 2000’s, should have the staff resources thoroughly to analyse and insist on change in any financial institution. Place no confidence in non-execs for this purpose.

(3)    Auditors have proved useless in flagging or overseeing change in banks. They rarely stand up to assertive bankers as the banks are plum clients generating enormous fee income.

(4)    These reports, with their lengthy Maxwellisation process, take far too long to produce – in the case of HBOS their publication came after the relevant Statute of Limitations expired and no penal sanctions on those named are possible. The process leaves Fred Goodwin of RBS and Andy Hornby of HBOS untouched, inevitably to much public unease.

(5)    Whatever the City objections, ideally the separation on the Glass-Steagall model or at worst the ring-fencing of investment banking from retail banking should be enshrined in law. This would hopefully reduce the chances of another taxpayers’ bail-out – but would have made no difference to HBOS which had no investment banking activities.

A very dark era in the world of finance is ending. May the next chapter tell a happier story.

SMD

22.11.15

Text Copyright © Sidney Donald 2015